News Column

USA SYNTHETIC FUEL CORP - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

August 19, 2014

The following information should be read in conjunction with the financial statements and notes appearing elsewhere in this Quarterly Report on Form 10-Q and in our Annual Report on Form 10-K dated December 31, 2013. We are a development stage company and have had no revenues for the quarter ended June 30, 2014 and had no revenues for the quarter ended June 30, 2013. We do not expect to receive any significant revenues from operations until we begin to receive some revenues from operations at our Lima Energy Project, which we estimate will be at a minimum approximately twenty-four to thirty months after we obtain funding for the first phase of the project.

Certain information included in this report contains, and other reports or materials filed or to be filed by the Company with the Securities and Exchange Commission ("SEC") (as well as information included in oral statements or other written statements made or to be made by the Company or its management) contain or will contain, "forward-looking statements" within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, Section 27A of the Securities Act of 1933, as amended, and pursuant to the Private Securities Litigation Reform Act of 1995. The forward-looking statements may relate to financial results and plans for future business activities, and are thus prospective. The forward-looking statements are subject to risks, uncertainties and other factors that could cause actual results to differ materially from future results expressed or implied by the forward-looking statements. They can be identified by the use of terminology such as "may," "will," "expect," "believe," "intend," "plan," "estimate," "anticipate," "should" and other comparable terms or the negative of them. You are cautioned that, while forward-looking statements reflect management's good faith belief and best judgment based upon current information, they are not guarantees of future performance and are subject to known and unknown risks and uncertainties.

Any forward-looking statements are made pursuant to the Private Securities Litigation Reform Act of 1995, and are current only as of the date made.

As used in this Quarterly Report on Form 10-Q, the terms "we," "our," "us," "the Company" and "USASF" mean USA Synthetic Fuel Corporation, a Delaware corporation and its consolidated subsidiaries, unless the context indicates otherwise.

Overview

We are a development stage environmental energy company focused on the development of low-cost clean energy solutions from the deployment and operation of commercial Ultra Clean Btu Converter facilities which we define as facilities utilizing a series of commercially proven and available processes to cost-effectively convert lower value solid hydrocarbons such as coal, renewables or petroleum coke ("petcoke") into higher value, ultra clean energy products. Our Ultra Clean Btu Converter technology we plan to use will consist of commercially proven and technologically established gasification processes, gas purification processes and catalytic manufacturing processes to convert these solid hydrocarbon feed sources into higher value, environmentally cleaner Ultra Clean Synthetic Crude ("UCSC") for sale in transportation fuel markets.

We believe that efficient and economical conversion of solid hydrocarbons using our Ultra Clean Btu Converter process can produce low cost, clean energy products at a lower cost than traditional methods. As of June 30, 2014, the spot price of a barrel of West Texas Intermediate crude was $106.07, and the spot price of a barrel of oil equivalent, or BOE, of natural gas was $25.46. We believe we can manufacture UCSC at a lower cost than traditional fuel products, and this cost advantage does not depend on government subsidies or tariffs.

The major activities in the second quarter of 2014 focused on arranging the necessary financing to complete the construction of, and put into commercial operation, our Ultra Clean Btu Converter facility in Lima, Ohio. In 2013, Lima Energy Company signed a 10-year agreement with Husky Marketing and Supply Company, a subsidiary of Husky Energy, Inc. (collectively, "Husky") pursuant to which Husky has agreed to purchase all the expected output from the Lima Energy Gas 1 facility, to a maximum amount of 8,500 barrels per day. Husky also has the option to purchase additional output from the Gas 1 facility and all output from the Lima Energy Gas 2 facility. The current focus for Lima Energy Company has been site development work. The Company has structured a bond transaction with a leading investment bank, which we anticipate will be completed in 2014. Proceeds from the financing will be used for the construction of Gas 1, repayment of debt, and working capital purposes. There can be no assurance that this financing will be completed successfully, which could impact our ability to complete the construction of, and put into commercial operations, our Ultra Clean Btu Converter Facility in Lima, Ohio.

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Manufacturing Plan

In order to introduce our high value, low cost UCSC product to market and support our business strategy, we plan to acquire or construct commercial-scale Ultra Clean Btu Converter facilities. We plan to fund our business strategy with proceeds from equity, debt, bonds, and internal cash flows. We intend to outsource the engineering, procurement, and construction ("EPC") and operations and maintenance ("O&M") of all of our Ultra Clean Btu Converter facilities to a third party, most likely Gasification Engineering Corporation ("GEC") in all production locations. GEC is a related party to the Company because our Chairman, Harry H. Graves, is Chairman and sole shareholder of GEC.

Lima Facility

We are actively working towards the financing and development of the first phase of the Lima Energy Ultra Clean Btu Converter Facility, ("Lima Facility"), Gas 1. We currently expect to complete this financing in 2014. However, there can be no assurance that the financing will be completed in the targeted time frame or at all. Once the financing is complete, we will continue the construction of Gas 1, which is anticipated to take 24 months to 30 months to complete and cost approximately $521 million. Note that project costs include capital, engineering, procurement and construction and other owner costs incurred up to commencement of operations (such as interest during construction and development fees), but do not include annual fixed or variable facility operations and maintenance costs, including the cost of purchasing solid hydrocarbon feedstock which itself reflects the cost of extraction and delivery of the solid hydrocarbons. Once commercial operations begin, Gas 1 is expected to produce approximately 2.8 million barrels per year of UCSC.

The second phase of the Lima Facility, Gas 2, will be located at the same site as Gas 1 and will cost an estimated $1.2 billion to construct. We plan to use Ohio Air Quality Development Authority bonds to finance this phase. We estimate the construction period for Gas 2 to be approximately 30 months. Once commercial operations begin, Gas 2 is expected produce an average of over 15,000 barrels per day, or 5.5 million barrels annually, of UCSC, bringing our total expected production at the Lima Facility to over 22,000 barrels per day, or 8.3 million barrels annually and our total expected production capacity to over 10 million barrels per year. Husky has an option to purchase a portion or all of the volume of the UCSC produced by Gas 2.

Cleantech Energy Facility

The third project that we have identified is a synthetic fuel production facility in Johnson County, Wyoming using our Ultra Clean Btu Converter technology that we plan to build, own and operate. It is anticipated that the Cleantech Energy Facility will be designed to produce approximately 78,000 barrels per day, or 30.6 million barrels annually, of synthetic fuel products, initially concentrating on UCSC. We plan to enter into an agreement for the sale of our UCSC product with a refinery, containing terms and conditions similar to the Lima Energy agreement with Husky. Financing for the Cleantech Energy Facility has not yet been secured and there can be no assurance that we will be able to secure financing at all. We plan to build the Cleantech Energy Facility adjacent to the Wyoming BOE Energy Asset, contingent upon our ability to secure the rights of the Wyoming BOE Energy Asset with the $70 million activation payment.

Performance Drivers

We expect the fundamental drivers of our financial results going forward will include the following:

Commercialization of our UCSC product. We expect to commence recognizing revenues for UCSC sales when we complete construction of Lima Energy Gas 1 and it begins commercial operations. We expect to grow our revenue base through the construction and commercial operation of Lima Energy Gas 2 to manufacture our UCSC. Our revenues for future periods will be impacted by our ability to construct and bring to commercial operations the Lima Facility phases in the timeframe we have planned. Our results will be impacted by the speed with which we execute our strategy and the capital cost and operating expenses of each of these facilities.

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Feedstock and other manufacturing input prices. We plan to use solid hydrocarbons, such as coal, renewables and petcoke, as our feedstock for producing our UCSC product. We intend to locate our facilities near readily available sources in order to ensure reliable supply of cost-competitive feedstock. We currently intend to use petcoke as the initial feedstock for Gas 1 and Gas 2, and we believe we will be able to obtain a sufficient supply of petcoke for these facilities on acceptable terms. In addition, we own an estimated 200 million BOE of coal in Vigo County, Indiana, which we call our Indiana BOE Energy Asset. Although we do not currently intend to use the Indiana BOE Energy Asset to provide feedstock for Gas 1 and Gas 2, we believe we would be able to use it for this purpose if petcoke or other feedstocks are not available to us at acceptable prices. Contingent upon payment of a $70 million activation payment and certain other milestones, we will have an additional 1.02 billion BOE of coal available to us in our Wyoming BOE Energy Asset, which we currently intend to use to provide feedstock for our planned Cleantech Energy Facility, planned to be located adjacent to this BOE Energy Asset.

Petroleum prices. We expect sales of our UCSC product to be impacted by the price of petroleum. In the event the petroleum prices increase, we may see increased demand for our product as refineries seek lower-cost alternatives to petroleum. Conversely, a long-term reduction in petroleum prices may result in our product being less competitive with other petroleum-derived alternatives. In addition, oil prices may also impact the cost of certain feedstocks we use in our process, such as petcoke, which may affect our margins.

Future Capital Requirements

The initial phase of our production strategy is the construction and operation of our Ultra Clean Btu Converter Facility in Lima, Ohio, which we expect to finance using the proceeds from our potential financing, described in detail below. We intend to produce UCSC at the planned Lima Energy Gas 1 and sell it to the adjacent refinery owned by Husky, as described above.

Our cash requirements depend on many factors, including the pace of our project development activities and the employee team build-up to drive our future growth. Over the next four years, we expect to make significant expenditures to expand our projects currently under development and construction to bring them into commercial operation. We estimate that total project costs to bring each project into commercial operation will be approximately $521 million to complete the construction of Lima Energy Gas 1, approximately $1.2 billion for full construction of Gas 2, and approximately $4.1 billion for full construction of the Cleantech Energy Facility. Project costs include capital expenditures, EPC and other owner costs incurred up to commencement of operations (such as interest during construction and development fees), but do not include annual fixed or variable facility operations and maintenance costs, including the cost of purchasing solid hydrocarbon feedstock which itself reflects the cost of extraction and delivery of the solid hydrocarbons.

Future Capital Sources

We have focused our efforts to date on obtaining large amounts of capital to fund our planned project development activity.

We have structured, and are currently working to complete, a private placement of secured limited recourse bonds in 2014, the proceeds of which we would use primarily to fund construction of Lima Energy Gas 1. However, there can be no assurance that this potential financing will be completed in the targeted time frame or at all. We expect that the proceeds of this financing will be held by a trustee, who will manage the drawdown schedule. Following completion of this transaction, we anticipate commercial operations at the Lima Facility to commence in approximately twenty-four to thirty months.

On February 25, 2014, we filed a shelf registration statement on Form S-3 for up to $150 million of our common stock (the "Form S-3") and filed an amendment on May 9, 2014.. On July 15, 2014, we received a formal notice of default from Third Eye in conjunction with the Note Purchase Agreement which is discussed in Note 8 - Subsequent Events section of this Quarterly Report on Form 10-Q. Our failure to make the required July and August interest payments under the Note Purchase Agreement and the Unit Purchase Agreement has made us ineligible to use Form S-3, and we will remain ineligible to use it until, at least, we file our next Form 10-K. Accordingly, if we seek to make a registered offering of our securities, we will be required to use Form S-1 to register the securities, which we expect will be materially more expensive and time-consuming than using Form S-3 would have been.

In addition, we have a major energy asset that may be utilized to increase liquidity. Due to the uncertainties inherent in the methodologies used to determine a fuel asset valuation, we cannot offer any assurances as to the value that could be ultimately realized.

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Recent Financing Transactions

Promissory Note to Related Party

On May 29, 2014, we issued a 10% convertible promissory note to Bridgewater Capital Corporation, a related party, in the amount of $1,000,000. The note accrues interest at the rate of 10% per annum beginning on the day the funds are received but including the date the payment is made to BCC. BCC is a related party to the Company because a member of our board of directors, James R. Treptow, is Chief Executive Offer and President and sole shareholder of BCC. The principal amount and any unpaid interest are due on October 30, 2014. The principal amount and any unpaid accrued interest can be repaid by the issuer in cash, in full or in part, at any time prior to the maturity date. Bridgewater Capital Corporation can also convert the outstanding principal and unpaid interest to common shares of our stock at any time at a price of $10 per share. As part of the note, we issued a warrant to purchase up to 2,000,000 shares of common stock for $20.00 per share until January 7, 2016. As of the date of this filing, we have received $499,651 in proceeds from this note. We received $100,000 on March 27, 2014 as and advance from a related party associated with Bridgewater Capital Corporation that was later included in the short term promissory note. The remaining proceeds will be funded with the commencement of our bond issue marketing.

Note Purchase Agreement and Unit Purchase Agreement Amendments

On May 2, 2014, certain provisions of the Note Purchase Agreement and Unit Purchase Agreement between Lima Energy Company, the Company, the noteholders and the unit holders, and Third Eye, as administrative agent, were amended effective March 31, 2014 as previously discussed in this Quarterly Report on Form 10-QThe amendments included a reduction to the minimum balance required to be maintained in the Minimum Cash Blocked Account to $900,000, establishing payment options for interest due and payable on May 1, 2014 and June 1, 2014 interest payment dates for the Note Purchase Agreement and deferral of interest due and payable on the May 1, 2014 and June 1, 2014 interest payment dates until redemption or conversion of the note under the Unit Purchase Agreement. There were amendment fees totaling $800,000 that are payable to the administrative agent on or before June 1, 2014 by either issuing 800,000 shares of common stock of the Company (or penny warrants to purchase equivalent shares) or paying $800,000 in cash. On June 1, 2014 we issued 800,000 shares of common stock, valued at $648,000, in lieu of cash for payment of these amendment fees.

During this quarter, Lima Energy Company issued two promissory notes, in lieu of cash, in the amount of $271,233 and $337,850, representing payment of the interest due for the month of April 2014 and May 2014, respectively, under the terms and provisions of the Note Purchase Agreement, pursuant to the May 2, 2014, amendments. For the quarter ended June 30, 2014, we recognized $7,310 in interest expense on these notes.

Third Eye Investment

On November 18, 2013, we issued a 4% secured convertible note in the amount of $1,200,000 to Third Eye Capital Corporation of Toronto, Canada, or Third Eye, as administrative agent for the holders. This note was issued under the provisions of the Note Purchase Agreement discussed above. The principal amount and accrued interest are due November 18, 2014. We can repay the principal amount and accrued interest on the note in cash or common stock without penalty any time prior to the maturity date. The note bears interest at the rate of 4% per annum, and commences accruing on February 1, 2014. Interest will be payable in arrears, on the earlier of the stated maturity date, an equity raise in an aggregate sum of not less than $20 million or change of control. This note covers the fee to obtain a $60 million standby letter of commitment from Third Eye for future acquisitions.

Fundamentals of our Business

The Ultra Clean Btu Converter technology that we plan to utilize will consist of commercially proven and technologically established gasification processes, gas purification processes and catalytic manufacturing processes to convert the solid hydrocarbon feed sources such as coal, renewables or petcoke, into higher value, environmentally cleaner UCSC for transportation fuel markets.

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Although we have not generated any revenue to date, we expect to generate revenue from the sales of our UCSC product from our planned Btu Converter facilities. We may also generate revenues from the sale of electric power, carbon dioxide and sulfur, all of which are produced during the gas-to-liquids Btu Converter process.

We expect our cost of goods sold will consist of facility-related fixed costs, feedstock and other variable costs.

Facility-related fixed costs. As an industrial process, our facilities will require a baseline level of staffing consisting of process engineering, monitoring staff, testing personnel, health safety and environmental personnel and maintenance personnel. Other fixed costs include maintenance materials and casualty and liability insurance, as well as property taxes. We plan to outsource the operations and maintenance functions to GEC, a related party. GEC is a related party to the Company because our Chairman, Harry H. Graves, is Chairman and sole shareholder of GEC. Feedstock. Our Ultra Clean Btu Converter facilities are being designed to convert a variety of solid hydrocarbons, such coal, renewables or petcoke, into UCSC. The cost of procuring and preparing the feedstock to be used in our Ultra Clean Btu Converter process will be a major component of cost of goods sold. Our actual feedstock costs may be higher or lower, depending on then-prevailing market conditions. Our flexible feedstock strategy will allow us to reduce our feedstock cost by taking advantage of current feedstock market conditions. Other variable costs. We expect to use water, natural gas and other variable cost items associated with our catalysts in our Ultra Clean Btu Converter process.



Our largest expenditures are the capital costs associated with the construction of our commercial-scale Ultra Clean Btu Converter facilities. These costs are comprised of land acquisition, site preparation, utilities, permitting, facility construction, start-up and contingency costs and related financing costs. We expect that the depreciation of these facilities costs will be included in cost of goods sold.

Our operating expenses currently consist primarily of general and administrative expenses.

Financial Operations Overview

Revenue and Cost of Goods Sold

To date, we have not generated any revenue or incurred any cost of goods sold, and we do not expect to do so until at least twenty-four to thirty months from securing financing for the Lima Gas 1 project.

Operating Expenses

Operating expenses consist of general and administrative expenses. General and administrative expenses consist primarily of personnel-related expenses related to salaries and benefits, professional services, liability insurance and cost of compliance with securities, corporate governance and other regulations. Professional services consist principally of external legal, accounting, tax, audit and other consulting services. We expect to incur additional costs as we hire personnel and enhance our infrastructure to support the anticipated growth of our business.

Interest Income

Interest income consists primarily of interest income earned on our restricted cash balance. The restricted cash balance is required under the Third Eye Note Purchase Agreement. Release of restricted cash is at the sole discretion of Third Eye.

Derivative Gains and Losses

Our outstanding warrant to purchase 10,312,500 shares of our common stock is required to be classified as a liability and to be adjusted to its fair value at the end of each reporting period. Any changes in fair value of this warrant liability are required to be recorded as a gain or a loss, as applicable, in the period that the change in value occurs.

Interest Expense

We incur interest expense in connection with our outstanding business loans. Interest expense is reflected as net interest expense, which also includes amounts related to amortization of debt discounts, amortization of debt related fees and accrued debt redemption costs. In the event the costs of our commercial facilities are funded with debt, we will capitalize interest related to the construction of those commercial facilities.

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Income Taxes

We use the liability method in accounting for income taxes. Deferred income tax assets and liabilities are determined based upon differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse.

The potential benefit of net operating loss carry forwards has not been recognized in the accompanying financial statements since we cannot be assured that it is more likely than not that such benefit will be utilized in future years.

The net operating loss carryforwards for income tax purposes are approximately $19,354,000 and will begin to expire in 2029. However, pursuant to Section 382 of the Internal Revenue Code, use of our net operating loss carryforwards may be limited if we experience a cumulative change in ownership of greater than 50% in a moving three year period. Ownership changes could impact our ability to utilize net operating losses and credit carryforwards remaining at the ownership change date. The limitation will be determined by the fair market value of common stock outstanding prior to the ownership change, multiplied by the applicable federal rate.

Basic and Diluted Net Income and Net Loss per Share

Basic earnings per share is computed by dividing net income (loss) available to common stockholders (numerator) by the weighted average number of shares outstanding (denominator) during the period. Diluted earnings per share gives effect to all potentially dilutive common shares outstanding during the period. Diluted earnings per share excludes all potentially dilutive shares if their effect is anti-dilutive.

Results of Operations

For the Quarters Ended June 30, 2014 and June 30, 2013

Operating Expenses

Our operating expenses increased $357,483 to $1,314,991 for the quarter ended June 30, 2014 compared to $957,508 for the quarter ended June 30, 2013. The increase is primarily attributable to higher general and administrative expenses related to stock-based compensation to certain executives and directors, increased professional services, and independent director fees.

Other Income

Other income, which includes interest income, decreased $1,122 to $0 for the quarter ended June 30, 2014. The decrease in interest income is related to the quarter over quarter total interest income earned on the restricted cash balance which decreased by $2,100,000 to $900,000 early in this quarter. This restricted cash account is required under the Note Purchase Agreement with Third Eye. Any release from the restricted cash account is at the sole discretion of Third Eye.

Interest Expense

Interest expense increased $279,087 to $1,550,962 for the quarter ended June 30, 2014 compared to $1,271,875 for the quarter ended June 30, 2013. The increase in interest expense is primarily attributable to a $74,700 in interest expense related to the summary judgment previously discussed in this filing, $72,517 in interest expense in debt discount amortization of the $648,000 in amendment fees related to the May 2, 2014 amendments to the Note Purchase Agreement and the Unit Purchase Agreement, $61,161 in interest expense in debt discount amortization of the beneficial conversion feature related to the Third Eye transaction, $57,447 in interest expense related to the paid-in-kind ("PIK") notes issued under the May 2, 2014 amendments previously mentioned and $15,758 in interest expense related to the short term notes payable.

Derivative Gain (Loss)

We recognized $5,526,000 in derivative gains for the quarter ended June 30, 2014 compared to $7,027,000 in derivative losses for the quarter ended June 30, 2013. The derivative gains and losses recognized during the quarters ended June 30, 2014 and June 30, 2013 related to recording the fair value of the stock warrant associated with the 4% subordinated secured convertible debt, discussed in previous filings, for the reporting periods under the mark to market approach.

Income Taxes

For the quarters ended June 30, 2014 and 2013, there were no provisions for income taxes recorded.

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Net Income and Net Loss

We recognized net income of $2,660,047 or $0.03 per basic share and a net loss of $.04 per diluted share, for the quarter ended June 30, 2014 compared to a net loss of $9,255,261, or $0.11 per basic and diluted share, for the quarter ended June 30, 2013, an improvement of $11,915,308. The improvement in net earnings is primarily attributable to $5,526,000 in derivative gains for the quarter ended June 30, 2014 as compared to $7,027,000 in derivative losses for the same period in 2013 as discussed previously in this filing. The derivative gains were offset in part by higher professional fees, debt related costs associated with the financing from Third Eye, stock compensation expense for certain key executives and board members and interest expense associated with the Dorsey complaint against us and GEI.

Basic and Diluted Net Income and Net Loss per Share

Our net income for the quarter ended June 30, 2014 was $0.03 per basic share and a net loss of $.04 per diluted share, compared to a net loss of $0.11 per basic and diluted share for the quarter ended June 30, 2013. The decrease in net loss per basic share was driven primarily by derivative gains related to recording the fair value of the stock warrants associated with the 4% subordinated secured convertible debt.

For the Six Months Ended June 30, 2014 and June 30, 2013

Operating Expenses

Our operating expenses increased $1,122,835 to $2,946,443 for the six months ended June 30, 2014 compared to $1,823,608 for the six months ended June 30, 2013. The increase is primarily attributable to higher general and administrative expenses related to stock-based compensation to certain executives and directors, increased professional services and independent director fees, totaling $1,094,788.

Other Income

Other income, which includes interest income, decreased $2,375 to $99 for the six months ended June 30, 2014. The decrease in interest income is related to the period over period total interest income earned on the restricted cash balance which decreased due to a lower average restricted cash balance. This restricted cash account is required under the Note Purchase Agreement with Third Eye. Any release from the restricted cash account is at the sole discretion of Third Eye.

Interest Expense

Interest expense increased $768,646 to $3,303,626 for the six months ended June 30, 2014 compared to $2,534,980 for the six months ended June 30, 2013. The increase in interest expense is primarily attributable to a $387,875 change in estimate and interest expense related to the summary judgment previously discussed in this filing, the recognition of $172,517 in fees and amortization of debt discount related to the amendments made to the Note Purchase Agreement and Unit Purchase Agreement since December 31, 2013, $122,322 in debt discount amortization of the beneficial conversion feature related to the Third Eye transaction, and $57,447 in interest expense related to the PIK notes issued under the May 2, 2014 amendments previously mentioned.

Derivative Gain (Loss)

We recognized $10,368,000 in derivative gains for the six months ended June 30, 2014 compared to $8,265,000 in derivative losses for the six months ended June 30, 2013. The derivative gains and losses recognized during the six months ended June 30, 2014 and June 30, 2013 related to recording the fair value of the stock warrant associated with the 4% subordinated secured convertible debt, discussed in previous filings, for the reporting periods under the mark to market approach.

Income Taxes

For the six months June 30, 2014 and 2013, there were no provisions for income taxes recorded.

Net Income and Net Loss

We recognized net income of $4,118,030 or $0.05 per basic share and a net loss of $.08 per diluted share, for the six months ended June 30, 2014 compared to a net loss of $12,621,114, or $0.16 per basic and diluted share, for the six months ended June 30, 2013, an improvement of $16,739,144. The improvement in net earnings is primarily attributable to $10,368,000 in derivative gains for the six months ended June 30, 2014 as compared to $8,265,000 in derivative losses for the same period in 2013 as discussed previously in this filing. The derivative gains were offset in part by higher debt related costs associated with the financing from Third Eye, stock compensation expense for certain key executives and board members and interest expense associated with the Dorsey complaint against us and GEI.

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Basic and Diluted Net Income and Net Loss per Share

Our net income for the six months ended June 30, 2014 was $0.05 per basic share and a net loss of $.08 per diluted share, compared to a net loss of $0.16 per basic and diluted share for the six months ended June 30, 2013. The decrease in net loss per basic share was driven primarily by derivative gains related to recording the fair value of the stock warrants associated with the 4% subordinated secured convertible debt.

Liquidity and Capital Resources

As of June 30, 2014, we had $28,267 of operating cash and $900,000 in restricted cash on our balance sheet. This restricted cash account is required under the Note Purchase Agreement with Third Eye. Any release from the restricted cash account is at the sole discretion of Third Eye. On March 31, 2014, in conjunction with Third Eye, the administrative agent for the note holders and unit holders, we amended the Note Purchase Agreement and Unit Purchase Agreement to allow us to utilize $1,100,000 in funds from the Minimum Cash Blocked Account. All fees and interest due and payable through April 1, 2014 in conjunction with these agreements were paid from these funds. As of the date of this report, $900,000 remains in the Minimum Cash Blocked Account.

In the six months ended June 30, 2014, we received $123,934 in advances from related parties to use for working capital purposes. On May 29, 2014, we issued a 10% convertible promissory note to Bridgewater Capital Corporation, a related party, in the amount of $1,000,000. As of the date of this filing, we have received $499,651 in proceeds from this note. We received $100,000 on March 27, 2014 as an advance from a related party associated with BCC that was later included in the short-term promissory note. BCC is a related party to the Company because a member of our board of directors, James R. Treptow, is Chief Executive Offer and President and sole shareholder of BCC. The remaining proceeds will be funded with the commencement of our bond issue marketing.

We anticipate further losses during the development stage and it is reasonably possible that we will not be able to fund our operations or comply with certain financial covenants over the next 12 months without taking certain actions. Such actions include, but are not limited to modifying current debt agreements, entering into new debt agreements, issuing capital stock, reducing operating expenses and liquidating assets.

We expect construction of Lima Energy Gas 1 will require approximately $521 million to complete. We have structured, and are currently working to complete, a private placement of secured limited recourse bonds that we believe will provide sufficient proceeds for construction of Gas 1, repayment of our Third Eye Notes and for working capital purposes. There can be no assurance that this financing will be completed successfully, which could impact our ability to complete the construction of, and put into commercial operations, Gas 1.

On July 15, 2014, we received a formal notice of default from Third Eye in conjunction with the Note Purchase Agreement. The notice of default specifies that the Company (i) failed to pay interest for June 2014 which was due and payable on July 1, 2014, (ii) the Company failed to comply with required liquidity ratios for May 2014 and June 2014 and (iii) the Company's receipt of a notice and subpoena of a formal confidential and non-public investigation by the Securities and Exchange Commission. We are currently in discussions with Third Eye to establish means to cure the default. There can be no assurance that we will be able to cure the default, raising doubt as the Company's ability to continue as a going concern.

We have been working to complete major capital transactions that were targeted to be complete in the near future. We had been focusing our efforts to date on obtaining large amounts of capital to fund our planned project development activity. We had structured, and we were working to complete, a private placement of secured limited recourse bonds in 2014, the proceeds of which we would use primarily to fund construction of our initial project, Lima Energy Gas 1. Three subsequent events, each as described more fully in "Item 8 - Subsequent Events," have occurred which, individually or collectively, may restrict our ability to complete any major capital transaction in the near future. First, on July 2, 2014, the Company received a subpoena from the SEC Division of Enforcement seeking certain documents and information about the Company's accounting practices and internal controls. Second, on July 15, 2014, the Company received a formal notice of default from Third Eye under the Note Purchase Agreement, identifying a July 1, 2014 interest payment default and asserting that the Company also failed to comply with certain financial covenants during May and June 2014. Third, we have been informed by Third Eye that an independent engineer's preliminary appraisal, which we have not seen, indicates that the estimated fair market value of our Indiana BOE Energy Asset and the valuation of our Wyoming BOE Energy Asset could be less than we have previously believed Management has performed an internal valuation of the Indiana BOE Asset and has determined that an impairment to current carrying value is not required at this time. Management will continue to monitor and re-evaluate the Indiana BOE Asset's value and as additional information becomes available, we will make adjustments to the carrying value if needed. Given these three subsequent events, there can be no assurance that any potential financing will be completed in the targeted time frame or at all, unless or until the three issues raised can be addressed fully.

Cash Flows

Six Months Ended June 30, 2014 2013



Cash used in operating activities $ (2,160,525 )$ (1,615,788 ) Cash used in investing activities

(625 ) (1,657,265 )



Cash provided by financing activities 1,624,826 955,158 (Decrease) in cash

$ (536,324 )$ (2,317,895 )



Net Cash Used In Operating Activities

For the six months ended June 30, 2014, cash used in operating activities increased to $2,160,525 compared to $1,615,788 for six months ended June 30, 2013. Major items affecting operating cash included $16,739,144 improvement in net earnings, which included an decrease of $17,139,993 in non-cash expenses related primarily to recording the fair value of the stock warrants associated with the 4% subordinated secured convertible debt for this reporting period under the mark to market approach, other debt related amortization costs, paid-in-kind interest and stock-based compensation. Our cash expenses increased $1,657,932. The increase in cash expense was more than offset by the net affect of an increase in our current liabilities of $1,269,100 and a decrease of $1,487,672 in the interest prepaid to Third Eye. For the six months ended June 30, 2014, our primary uses of funds were related to interest payments, professional fees related to the financing of our Lima Energy Project and SEC reporting and compliance costs for the current fiscal year. For the six months ended June 30, 2013, our primary uses of funds were related to salary and associated costs, professional fees related to the financing of our Lima Energy project and SEC reporting and compliance costs for the last fiscal year.

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Net Cash Used in Investing Activities

For the six months ended June 30, 2014, cash used in investing activities decreased by $1,656,640 to $625 compared to $1,657,265 for the six months June 30, 2013. The decrease is primarily attributable to us fulfilling our initial committed spend requirement for site work at the Lima Facility location and deferring continued construction activities of our Technology Innovation Center. During the six months ended June 30, 2013, we invested $1,123,818 and $514,114, respectively, in site work for the Lima Facility and further construction activities of our Technology Innovation Center.

Net Cash Provided by Financing Activities

For the six months ended June 30, 2014, we generated $1,624,829 in cash from financing activities as compared to generating $955,158 in cash from financing activities for the six months ended June 30, 2013. During the six months ended June 30, 2014, we received $1,101,241 in funds related the May 2, 2014 amendment of the Note Purchase Agreement and Unit Purchase Agreement which allowed for the reduction of the Minimum Restricted Cash Account to be reduced from $2,000,000 to $900,000. We received $123,934 in advances from related parties of which $100,000 was subsequently included in the $499,651 of proceeds received from the issuance of a promissory note to a related party, BCC. BCC is a related party to the Company because a member of our board of directors, James R. Treptow, is Chief Executive Offer and President and sole shareholder of BCC. All of the funds received during the six-month period ending June 30, 2014 have been used for working capital purposes or to pay for interest and fees that were due and payable to Third Eye. In the six months ended June 30, 2013, we received $1,093,425 of proceeds from the 4% subordinated secured convertible note which was offset in part by us using $139,507 in cash to fund an escrow account for future construction activities of our Technology Innovation Center.

Cash Position and Outstanding Indebtedness

Our total indebtedness at June 30, 2014 increased by $3,062,273 to $46,014,932 from $42,952,659 as of December 31, 2013. Our indebtedness is comprised of debt from financing transactions with Third Eye, as well as accounts payable, accrued liabilities, promissory note issued to a related party and advances from related parties. This increase was primarily attributable to an increase in current liabilities. The amount reflected in Long Term Liabilities in our Consolidated Balance Sheets is net of $4,623,999 and $4,868,769 in debt discounts and unamortized fees expense at June 30, 2014 and December 31, 2013, respectively.

At June 30, 2014, we had current assets of $81,771 compared to current assets of $584,558 at December 31, 2013. We had long-term assets of $31,161,883 at June 30, 2014 and long-term assets of $32,264,935 at December 31, 2013.

Off-Balance Sheet Arrangements

During the periods presented, we did not have, and we do not currently have any off-balance sheet arrangements.

Inflation

Due to our limited operating history with respect to the production of energy and energy producing fuels, our production offerings and supplies have not been subject to significant price fluctuations as a result of inflationary or other market conditions; however, certain of our product offerings and supplies may be subject to future price fluctuations due to inflationary and other market conditions. We believe that we will largely be able to pass such increased costs on to our customers through price increases, although we may not be able to adjust our prices immediately due to fixed price contracts for specific terms. In general, we do not believe that inflation has had a material effect on our results of operations in recent years. The effect of technological advances on costs has not been determined, and in some cases has not caused prices on certain products to decrease, which could have a negative impact on margins.

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Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, expenses and related disclosures. We base our estimates and assumptions on historical experience and on various other factors that we believe to be reasonable under the circumstances. We evaluate our estimates and assumptions on an ongoing basis. The results of our analysis form the basis for making assumptions about values of assets and liabilities that are not readily apparent from other sources. Our actual results may differ from these estimates under different assumptions and conditions.

While we have provided a detailed review of our significant accounting policies in Note 2 in our Annual Report on Form 10-K dated for year ended December 31, 2013, we believe the following critical accounting policies involve significant areas of management's judgments and estimates in the preparation of our consolidated financial statements.

Impairment of Long-Lived Assets

We assess impairment of long-lived assets and test long-lived assets for recoverability when events or changes in circumstances indicate that their carrying amount may not be recoverable. Examples of such events or changes in circumstances that could trigger a review include, but not limited to, a decrease in market price of the assets, adverse change in business climate, legal or regulatory factors, obsolescence or significant damage to the assets. In such cases we determine the fair value based upon forecasted, undiscounted cash flows which the assets are expected to generate and the net proceeds expected from their expected sale. If the carrying amount exceeds the fair value of the asset, it is decreased by the difference between the two being the amount of the impairment. As of June 30, 2014 and December 31, 2013, we have not identified evidence of the impairment of our long-lived assets.

Accounting for Derivative Instruments

In connection with the Unit Purchase Agreement, as discussed in previous filings, we issued a warrant to the unit purchasers granting the right to purchase an aggregate of 10,312,500 shares of our common stock. The warrant included certain anti-dilution protection that requires the fair value of the warrant to be recorded as a liability. As a liability, we are required to record the fair value of the stock warrant liability each reporting period. We recognized a derivative gain of $10,368,000 and a derivative loss of $8,265,000 for the six months ended June 30, 2014 and 2013, respectively.

Going Concern Assumption

We are a development stage environmental energy company focused on low cost clean energy solutions from the deployment of proven Ultra Clean Btu Converter technology. The accompanying consolidated financial statements have been prepared on a going concern basis of accounting, which contemplates that the Company will continue in operation for the foreseeable future and will be able to realize its assets and discharge its liabilities and commitments in the normal course of business.

As of June 30, 2014, we had $28,267 of cash on hand and an additional $900,000 in restricted funds. On May 29, 2014, we issued a $1,000,000 convertible promissory note to BCC, a related party. BCC is a related party to the Company because a member of our board of directors, James R. Treptow, is Chief Executive Offer and President and sole shareholder of BCC. As of the date of this filing, we have received $499,651 in proceeds from the promissory note and will receive the remaining proceeds upon commencement of bond issue marketing. On May 2, 2014, certain revisions were made to the Note Purchase Agreement and the Unit Purchase Agreement, effective March 31, 2014, that reduced the restricted fund requirement to $900,000, allowing for $1,100,000 in funds to be used to pay interest due and payable and other fees owed to the lender. As of the date of this report, $1,100,000 has been used to pay such interest and other fees. The promissory note issuance and the revisions to the Note Purchase Agreement and Unit purchase Agreement are discussed in more detail in "NOTE 6 - Borrowing" section of this Quarterly Report on Form 10-Q. We anticipate further losses during the development stage and it is reasonably possible that we will not be able to fund our operations or comply with certain financial covenants over the next 12 months without taking certain actions. Such actions include, but are not limited to, modifying current debt agreements, entering into new debt agreements, issuing capital stock, reducing operating expenses and liquidating assets.

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We currently are working to complete major capital transactions that are targeted to be completed in the near future. These transactions are discussed in more detail in the "Future Capital Requirements" section of this Quarterly Report on Form 10-Q. In addition, we have a major energy asset to $75 million that may be utilized to increase liquidity. In addition, we have a major energy asset that may be utilized to increase liquidity. Due to the uncertainties inherent in the methodologies used to determine a fuel asset valuation, we cannot offer any assurances as to the value that could be ultimately realized.

We have been working to complete major capital transactions that were targeted to be complete in the near future. We had been focusing our efforts to date on obtaining large amounts of capital to fund our planned project development activity. We had structured, and we were working to complete, a private placement of secured limited recourse bonds in 2014, the proceeds of which we would use primarily to fund construction of our initial project, Lima Energy Gas 1. Three subsequent events, each as described more fully in "Item 8 - Subsequent Events," have occurred which, individually or collectively, may restrict our ability to complete any major capital transaction in the near future. First, on July 2, 2014, the Company received a subpoena from the SEC Division of Enforcement seeking certain documents and information about the Company's accounting practices and internal controls. Second, on July 15, 2014, the Company received a formal notice of default from Third Eye under the Note Purchase Agreement, identifying a July 1, 2014 interest payment default and asserting that the Company also failed to comply with certain financial covenants during May and June 2014. Third, we have been informed by Third Eye that an independent engineer's preliminary appraisal, which we have not seen, indicates that the estimated fair market value of our Indiana BOE Energy Asset and the valuation of our Wyoming BOE Energy Asset could be less than we have previously believed Management has performed an internal valuation of the Indiana BOE Asset and has determined that an impairment to current carrying value is not required at this time. Management will continue to monitor and re-evaluate the Indiana BOE Asset's value and as additional information becomes available, we will make adjustments to the carrying value if needed. Given these three subsequent events, there can be no assurance that any potential financing will be completed in the targeted time frame or at all, unless or until the three issues raised can be addressed fully.

Stock-Based Compensation

We account for employee stock-based compensation in accordance with Financial Account Standards Board, or FASB, Accounting Standards Codification, ASC, 718, Compensation - Stock Compensation. Under the fair value recognition provisions of this statement, share-based compensation is measured at grant date based on the fair value of the award and is recognized as an expense over the applicable vesting period of the stock award (generally two years) using the straight line method. During the six months ended June 30, 2014, the Company issued stock awards of 830,000 shares to certain key executives and board members, of which 190,000 vested immediately, and no stock options or warrants. The stock awards in the quarter ended June 30, 2014 had a fair value of $1,409,000. We record expense on a straight-line basis for awards with installment vesting. If the required performance measure is determined to be probable by management, the fair value of the performance stock awards at the grant date is amortized on a straight-line basis over the vesting period and recorded as an expense. Management will reassess the probability of achieving the required performance metric periodically. If management determines that the required performance metric is not achievable, the expenses recognized to date for such awards will be reversed. For awards that are granted with immediate vesting, we record expense in the month of which awards are granted. For the quarter and six month ended June 30, 2014, we recognized equity compensation expense of $146,694 and 597,388, respectively, and have unrecognized costs related to unvested shares totaling $805,381. During the quarter and six months ended June 30, 2013, the Company issued no stock awards and issued no stock options or warrants in connection with employee compensation.

Recent Accounting Pronouncements from Financial Statement Disclosures

There are no recent accounting pronouncements that have an effect on our financial statement disclosures.


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