Item 1. Business
Overview
We are a leading developer and licensor of a proprietary process for converting natural gas to synthetic liquid hydrocarbons, a process generally known as gas-to-liquids, or GTL, technology. We sell licenses to use our GTL technology, the Syntroleum Process, for the production of fuels, and we plan to develop and own GTL plants based on the Syntroleum Process that produce fuels and refined specialty products. We anticipate that the Syntroleum Process will be an attractive solution in many cases for companies with natural gas reserves that are not economic to produce using traditional technology.
The Syntroleum Process produces synthetic liquid hydrocarbons, also known as synthetic crude oil, that are substantially free of contaminants normally found in conventional products made from crude oil. These synthetic liquid hydrocarbons can be further processed into higher margin products through conventional refining processes. These products include:
. Premium, ultra-clean liquid fuels, such as synthetic diesel, kerosene, gasoline, naphtha, and fuel for fuel cells, and
. Specialty products, such as synthetic lubricants, process oils, high melting point waxes, liquid normal paraffins, drilling fluids, and chemical feedstocks.
We believe that the costs to produce ultra-clean fuels and specialty products from natural gas using the Syntroleum Process can be competitive with the costs to produce comparable quality products from conventional processes. We also believe that these ultra-clean fuels meet or exceed new and proposed environmental requirements.
Key advantages of our technology over traditional GTL technologies are the use of air in the conversion process (in contrast to the requirement for pure oxygen in other technologies) and the use of our proprietary catalysts, which enhance the conversion efficiency of the catalytic reaction. We believe these advantages will reduce capital and operating costs of GTL plants based on the Syntroleum Process, while also permitting smaller unit sizes, including mobile plants that could be placed on skids, barges and ocean-going vessels. Based on our demonstrated research, we believe that the Syntroleum Process can be economically applied in GTL plants with throughput levels from less than 10,000 to over 100,000 barrels per day. The advantages of our technology, combined with the large worldwide resource base of stranded natural gas, provide what we believe is a significant market opportunity for the use of the Syntroleum Process by our company and our licensees to develop cost-effective GTL plants.
We have successfully demonstrated many elements and variations of the Syntroleum Process in pilot plant operations and laboratory tests, including our joint participation in a 70 barrel per day GTL demonstration plant with one of our licensees, ARCO, a subsidiary of BP. While we have not yet built a commercial-scale GTL plant based on the Syntroleum Process, we are currently developing a nominal 11,500 barrel per day specialty product GTL plant based on the Syntroleum Process known as the Sweetwater plant to be constructed in Western Australia. We are also evaluating the potential development of additional GTL plants with our licensees and others, including facilities that will produce synthetic fuels.
To date, we have entered into license agreements with the following entities or their affiliates:
ARCO (a subsidiary of BP) Kerr-McGee Corporation
Commonwealth of Australia Marathon Oil Company
Enron Corp. Repsol-YPF, S.A.
Ivanhoe Energy Inc. Texaco Inc. (a subsidiary of Chevron/Texaco)
In addition, we have from time to time participated in joint development, testing, marketing or strategic relationships with various companies, including:
AMEC Process and Energy Ltd. Ivanhoe Energy Inc.
Criterion Catalyst Company L.P. The Lubrizol Corporation
DaimlerChrysler AG Lyondell Petrochemical Company
FuelCell Energy Marathon Oil Company
GE Power Systems Nuevera (formerly Epyx Corporation)
General Motors Corporation Tessag Industrie-Anlagen GmbH
IdaTech (formerly Northwest Power Systems) Volkswagen of America
Business Strategy
Our objectives are to rapidly establish the Syntroleum Process as an industry standard and maximize our market share relative to alternative GTL technologies. Our business strategy to achieve these objectives involves the following key elements:
Broadly License the Syntroleum Process. We intend to work with our existing licensees to develop new GTL plants and to continue selling licenses to use the Syntroleum Process. We estimate that there are over 200 oil and gas companies with natural gas reserves located outside the United States. We believe that many of these companies are potential licensees. We believe that widespread licensing, combined with research and development activities to further improve the Syntroleum Process, provide advantages over competing technologies, strengthens our relationships with our existing licensees and attracts new licensees.
Develop and Own GTL Plants. We intend to own significant equity interests in joint ventures with our licensees and other energy industry and financial partners that will develop and own GTL plants for the production of specialty products and fuels. For example, we are currently developing a nominal 11,500 barrel per day Sweetwater plant to be constructed in Western Australia, in which we will own a significant equity interest. In addition, we are actively pursuing development of other GTL plants in various locations in which we expect to own significant equity interest, including our combined NGL/GTL project under development in the Talara region of Peru. We have also signed a nonbinding letter of intent with Petroleum Geo-Services ASA to form a joint venture to develop, market and operate mobile marine production facilities based on the Syntroleum Process.
We generally retain the exclusive right to manufacture specialty products under our license agreements. We believe that our proprietary reactor designs and catalysts, combined with our improvements to existing refining methods, will enable us to produce relatively high margin, high quality specialty products more economically than conventional techniques.
Further Expand and Develop Product Markets. We intend to continue to develop new markets for Syntroleum synthetic fuels and specialty products in order to promote the construction of GTL plants by our licensees and to establish markets for the products of GTL plants developed and owned by us. We believe that our technology can cost-effectively provide environmentally superior ultra-clean fuels for use in diesel, gasoline and jet engines. When made from domestic natural gas, Syntroleum diesel fuels qualify as alternative fuels under the Energy Policy Act. In addition, we have applied for certification that Syntroleum diesel fuels made from foreign natural gas qualify as alternative fuels under the Energy Policy Act. We also believe that the availability of our fuels will foster the successful development and economic application of fuel cells and other clean combustion technologies.
Further Reduce Costs through Networked Research and Development Activities. We intend to continue research and development activities with a focus on improving the efficiency of the Syntroleum Process, further reducing capital and operating costs of GTL plants based on the Syntroleum Process, and better understanding the unique qualities of, and markets for, the synthetic products produced by the Syntroleum Process. We conduct research and development activities using our own resources and through our network of joint development arrangements with licensees and other industry partners. We believe that this network will provide us and our
licensees with important competitive advantages and enhance our ability to attract additional licensees and joint development partners. We generally obtain title or exclusive rights to inventions or improvements that result from our joint development activities with others. We regularly review technological advances of others in related fields and actively seek to acquire rights to technologies that may enhance the Syntroleum Process.
The Syntroleum Advantage
We expect that products of the Syntroleum Process will become a competitive source of supply for the anticipated demand for ultra-clean synthetic transportation fuels and the existing market for fuels and specialty products, based on our belief that these products can be:
. produced at costs competitive with costs to produce many comparable products that are currently produced using conventional processes, including diesel fuel, gasoline and lubricants, assuming crude oil prices of at least $15.00 per barrel and natural gas prices lower than $1.00 per thousand cubic feet (levels at which stranded natural gas may be purchased in many parts of the world),
. produced substantially free of contaminants normally found in fuels and specialty products made from crude oil,
. used as blending stock to upgrade conventional fuels and specialty products made from crude oil,
. used unblended in traditional combustion engines to significantly reduce emissions,
. used in advanced combustion and fuel-cell engines that require sulfur and aromatic-free fuels, and
. transported using the existing infrastructure for crude oil and refined products.
The cost to produce a barrel of fuel includes the amortized plant or refinery capital costs, the operating costs and the feedstock costs (cost of natural gas in the case of the Syntroleum Process and cost of crude oil in the case of conventional refineries). Based on our current technology, we expect the combined capital and operating costs per installed barrel of capacity to be higher for a GTL plant based on the Syntroleum Process than for a conventional refinery. However, we believe lower prices for natural gas relative to crude oil can result in a total cost per equivalent barrel of product from a GTL plant based on the Syntroleum Process that is substantially less than the equivalent total per barrel cost for conventional refineries. Specifically, we believe the price of stranded natural gas used as a feedstock for the production of synthetic crude oil compares favorably with the price of crude oil in many markets. In addition, we believe conventional refineries will face additional capital and operating costs to meet the recently adopted EPA requirement to reduce the sulfur content level of diesel fuel to 15 parts per million by 2006. The American Petroleum Institute estimates that a requirement to reduce this sulfur content to 15 parts per million would add approximately $4.20 per barrel of additional costs for conventional refining. In contrast, the Syntroleum Process produces diesel fuel that already meets the new low sulfur requirement, providing an incremental relative cost advantage compared to conventional refineries.
We anticipate that the Syntroleum Process will be an attractive solution in many cases for companies with natural gas reserves that are not economic to produce using traditional methods. This is based on our belief that the Syntroleum Process can be low cost, used in large or small formats, adaptable and portable.
Market Potential
We believe that significant market potential exists for the Syntroleum Process and its products due to the existing and growing demand for refined fuels, the anticipated demand for ultra-clean fuels for both internal combustion engines and fuel cells, the existing demand for high-quality specialty products, and the large existing supply of stranded natural gas worldwide.
We expect demand for products created through the Syntroleum Process to result from the following.
Large Market for Transportation Fuels. The existing market for transportation fuels is large, comprising 66% of the approximately 67 million barrels per day of refined petroleum products produced worldwide in 2000, as derived from information in the BP Statistical Review of World Energy, 2001. Moreover, according to the Energy
Information Administration, estimates show that diesel fuel demand is growing at a faster rate than the total demand for refined products due to the superior fuel efficiency of the diesel engine. We believe that a significant portion of the growing demand for transportation fuels can be satisfied through the conversion of natural gas into ultra-clean Syntroleum fuels. We also believe that even if substantial volumes of Syntroleum fuels were to flow into these markets, these additional volumes would not cause a significant price degradation based on the large size of the market. We estimate worldwide consumption of refined petroleum products as follows:
Worldwide Consumption of Refined Petroleum Products
- -------------------------- (1) Consists of aviation and motor gasoline and light distillate feedstock. (2) Consists of jet and heating kerosenes, gas oils and diesel oils. (3) Consists of fuel oil, refinery gas, propane, solvents, petroleum coke, lubricants, bitumen, wax and refinery fuel and loss. Source: Derived from information in the BP Statistical Review of World Energy, 2001.
Increasing Demand for Ultra-Clean Fuels. The market demand for ultra-clean fuels in particular is increasing due to more stringent environmental standards in most of the world's industrialized countries and the need for vehicle manufacturers to respond to the challenge of producing fuel-efficient engines that meet these standards. The burden of producing cleaner fuels from conventional crude oil is expected to substantially increase refining costs. We believe that these factors will promote the creation of markets for premium ultra-clean fuels produced by the Syntroleum Process. In addition, we believe that Syntroleum fuels, either alone or blended with conventional fuels, can be used in existing and new generation diesel engines on a cost-effective basis to meet or exceed current and scheduled fuel specifications and emissions standards.
Increasingly Restrictive Environmental Legislation. Key domestic and international environmental regulations and initiatives that affect the demand for ultra-clean fuels include the Clean Air Act of 1970, which establishes specific responsibilities for government and private industry to reduce emissions from vehicles, factories and other pollution sources. In December 1999, the EPA issued rules mandating that sulfur levels in highway diesel fuel be lowered from the current level of 500 parts per million to 15 parts per million beginning in 2006. The burden placed on the petroleum refining and automobile industries to meet these new gasoline and diesel sulfur levels is significant. In the last eight years, the sulfur content of crude oil refined in the U.S. has increased by 20 percent as a result of shifts in the production mix of the world's crude oil.
The Energy Policy Act mandates that, by the year 2001, 75% of all affected federal and state government vehicle purchases, and 90% of all affected vehicle purchases by private alternative fuel suppliers, must be alternative fuel vehicles. In addition, the Act provides the Department of Energy with a goal of displacing 30% of transportation fuel with non-petroleum replacement fuels, including alternative fuels, by the year 2010. For the goals set forth by the Energy Policy Act to be successful, we believe an alternative fuel must be found that offers consumers the convenience of using existing fuel distribution systems, while at the same time meeting their expectations for vehicle power and range performance.
Under the Corporate Average Fuel Economy standards established under the 1975 Energy Policy and Conservation Act, mandatory fleet fuel economy standards were imposed on all manufactures of passenger cars and light trucks sold in the U.S. Automakers are turning to the use of diesel engines in their attempts to supply the demand for these vehicles without violating these Federal fuel-efficiency standards. While they do offer better fuel economy, traditional diesel engines, when fueled by conventional diesel fuels, produce higher emission levels of nitrous oxide and particulate matter. To comply with more stringent environmental standards, automakers have been partnering with oil companies to develop ultra-clean fuels for conventional diesel engines.
States are also looking for emission reductions. For example, the California Air Resources Board has announced plans to implement stringent new regulation on transit bus emissions. Under the new regulation, agencies electing to continue using older diesel buses will be required to implement new emission controls to reduce exhaust emission and to use low-sulfur fuels (containing a maximum of 15 parts per million) or to shift to alternative fuels. The regulation also requires reduced exhaust particulate matter and nitrogen oxides from new diesel engines. These reductions are expected to be achieved only through the use of ultra-clean fuels.
Finally, the European Union is also seeking sharp reductions in engine emissions. Sulfur content from the current level of 350 parts per million to below 50 parts per million is currently mandated for diesel fuel by 2005. In addition, the Commission of the European Communities has issued a proposal which, if adopted, would require diesel fuel with a maximum sulfur content of 10 parts per million to be made available on a broad geographic basis within each member state of the European Union by January 1, 2005. The proposal would also require all diesel fuel to have a maximum sulfur content of 10 parts per million by 2011.
We believe that Syntroleum fuels are positioned to take advantage of the demand for ultra-clean fuels that we expect will develop as a result of these environmental and emission standards. Syntroleum fuels are substantially free of contaminants, including sulfur, aromatics and heavy metals, and demonstrate high operating efficiency. As a result, we believe that Syntroleum fuels, either alone or blended with conventional fuels, can be used in existing and new generation diesel engines on a cost-effective basis to meet or exceed current and scheduled fuel specifications and emissions standards. When made from domestic natural gas, Syntroleum diesel fuels qualify as alternative fuels under the Energy Policy Act. In addition, we have applied for certification that Syntroleum diesel fuels made from foreign natural gas qualify as alternative fuels under the Energy Policy Act. By eliminating the need for specially equipped vehicles or refueling stations, Syntroleum ultra-clean fuels can avoid the infrastructure problems that have challenged the widespread use of other alternative fuels to date.
Existing Market for High-Quality Specialty Products. Synthetic crude oil produced by the Syntroleum Process can be further refined into specialty products using conventional refining processes that can be simplified to take advantage of the ultra-clean nature of the synthetic feedstock. We retain the exclusive right to manufacture these products using the Syntroleum Process under our license agreements and intend to develop and own significant equity interests in GTL plants designed to produce these specialty products. We believe that Syntroleum specialty products have environmental and performance characteristics that are superior to comparable conventional crude oil products. For example, we expect our synthetic lube-base oil will meet or exceed new high performance and emissions standards established by the United States federal government and the automobile industry for lubricants in new vehicles beginning in 2003. Our targeted specialty product markets include the following:
. Lube-Base Oils. Lube-base oils have a variety of industrial applications, including use as transformer oil, passenger car motor oil, heavy-duty lubricants and synthetic basestock. Worldwide demand for all lubricants is approximately 800,000 barrels per day. Historically, lube oil prices have varied from approximately $40 per barrel for the lowest quality grades to over $200 per barrel for the highest quality synthetic grades.
Beginning in 2003, lubricants initially supplied with new vehicles in the United States will be required to possess very high performance and emissions characteristics, such as those produced by the Syntroleum Process. The National Petroleum Refining Association has estimated that 60% of the current volume of lubricants produced will not meet these specifications. We believe that this requirement will cause a substantial increase in demand for high quality lubricants. We have developed with others a proprietary process and catalyst system for use in the production of high quality synthetic lube oils.
. Process Oils. Process oils are used in a number of industries involved in the production of chemicals, textiles, rubber and plastics. These products have a wide variety of applications, from mold release agents to ingredients in personal care products. Process oils can also be used in electrical transformers as a cooling and insulation agent. Historically, prices for these products have ranged from $35 per barrel to over $200 per barrel.
. Waxes. Waxes are longer linear chain hydrocarbon molecules that are solid at room temperature and have a variety of applications, including adhesives, coatings and other products. These markets have primarily been supplied with petroleum-derived waxes. Historically, prices have varied
between $30 per barrel for the lowest quality wax to over $150 per barrel for high melting point synthetic wax.
. Normal Paraffins. Normal paraffins are saturated linear hydrocarbons with molecular ranges between ten and 15 carbon atoms. These products must be 98% pure, have low odor levels and be of water clear quality. They are primarily used in the production of laundry detergent, cosmetics, pharmaceuticals, paints, stains, aluminum rolling oils and other products. Prices for normal paraffins historically have averaged between $60 and $85 per barrel.
. Drilling Fluids. Drilling fluids are used in the drilling of oil and gas wells as a coolant and lubricant for the drill bit and to remove cuttings from the well bore as well as to enhance safety during drilling operations by maintaining well pressure. Drilling fluids mixed with well cuttings can accumulate under offshore platforms. Crude oil-based fluids, which have been used historically, degrade slowly and can suffocate aquatic plant and animal life. In response to increased environmental pressures, synthetic drilling fluids have been developed and used in the Gulf of Mexico and other offshore locations, where prices have generally ranged between $250 and $300 per barrel. We have developed a synthetic drilling fluid product that we expect will meet or exceed all current applicable environmental requirements for use in the drilling of oil and gas wells.
Increasing Demand for Fuel Cells. We believe that Syntroleum fuels have the potential to become ideal fuels for fuel cells and to significantly enhance commercial opportunities for many fuel-cell applications. The absence of sulfur, aromatics and heavy metals from Syntroleum fuels allows for simplified fuel cell processor design, construction and operation. As the storage and processing of the fuel for a fuel cell are simplified, the physical size of fuel-cell components can be reduced. Because Syntroleum fuels have almost twice the hydrogen content of other liquid fuels, including methanol, Syntroleum fuels enable greater utility and wider application of fuel-cell power for vehicles. We believe that Syntroleum fuels can be distributed using the existing conventional fuel distribution infrastructure and have lower toxicity and similar solubility compared to conventional fuels. A fuel cell is a device that combines hydrogen, which can be derived from a fuel like natural gas, propane, methanol, gasoline or diesel, with oxygen from the air to produce electric power without combustion. Fuel-cell systems have advantages over conventional power generation systems including low or no pollution, higher fuel efficiency, greater flexibility in installation and operation, quiet operation, low vibration and potentially lower maintenance and capital costs. Fuel cells are being developed to support a variety of markets, including transportation and continuous stationary (residential and commercial power).
Supply of Natural Gas
Natural Gas Resource Base. Set forth below and elsewhere in this Annual Report on Form 10-K are estimates of identified reserves of oil and natural gas. These estimates do not constitute proved reserves in accordance with the regulations of the Securities and Exchange Commission. Under Securities and Exchange Commission regulations, proved oil and gas reserves are the estimated quantities of crude oil, natural gas and natural gas liquids, which geological and engineering data demonstrate with reasonable certainty to be recoverable in future years from known reservoirs under existing economic and operating conditions (i.e., prices and costs as of the date the estimate is made). We compiled these estimates of identified reserves from the referenced industry publications and other publicly available reports to identify the magnitude of the gas resource base. We have not independently verified this information. Accordingly, we cannot assure you as to the existence or recoverability of the estimates of identified reserves of oil and natural gas set forth in this Annual Report on Form 10-K. References below and elsewhere in this Annual Report on Form 10-K to the conversion of identified amounts of natural gas into amounts of synthetic crude oil assume that all of the referenced natural gas could be converted at anticipated conversion rates. Actual amounts of synthetic crude oil produced will vary based on the ability of the producer to extract the natural gas, the composition of the natural gas and process conditions selected for the plant, and this variance may be material.
World natural gas reserves provide an extensive resource base from which Syntroleum fuels and specialty products can be produced. According to information derived from the BP Statistical Review of World Energy, 2001, and the Department of Energy, worldwide identified natural gas reserves are estimated to be approximately 5,304 trillion cubic feet.
The following table presents the 2000 worldwide identified natural gas reserves, consumption and ratio of reserves to consumption (i.e., reserve life) by region.
Identified 2000 Worldwide Natural Gas Reserves, Consumption and Reserve Life
- --------------------------- Source: Information derived from BP Statistical Review of World Energy, 2000, and the Department of Energy.
Identified natural gas reserves have grown at a rapid rate. Identified natural gas reserves in 1990 were estimated to be approximately 4,207 trillion cubic feet, according to the BP statistical Review of World Energy 2001. However, in 2000, these reserves were estimated to be approximately 5,304 trillion cubic feet. This increase occurred despite the fact that, over the same time frame, demand for natural gas increased 22%.
Natural Gas Field Size Distribution. The table below lists an estimate of the distribution, by field size, of the world's natural gas fields. Only 179 of these fields are larger than five trillion cubic feet, which is generally considered to be the minimum size necessary to support the development of a full-scale liquefied natural gas (LNG) plant based on a typical 20-year plant life.
The World's Natural Gas Fields
Number of Reserves Fields - -------- ------ (trillion cubic feet)
Between 50 and 500........................ 16 Between 5 and 50.......................... 163 Between 1 and 5........................... 641 Between .5 and 1.......................... 668 Between .25 and .5........................ 940 Between .1 and .25........................ 1,620 Between .01 and .1........................ 5,085 Less than .01............................. 6,243 ----- Total................................. 15,376 ======
- --------------------------- Source: IHS Energy Group, 1998.
Based on field size and portability, we believe GTL plants based on the Syntroleum Process can potentially access over 9,133 of the world's natural gas fields, representing approximately 95% of the total reserves held in these fields. Assuming a typical 30-year plant life, of the 15,376 natural gas fields shown above approximately:
. 16 contain sufficient reserves to support ten or more 50,000 barrels per day plants,
. an additional 163 contain sufficient reserves to support one or more 50,000 barrels per day plants,
. an additional 641 contain sufficient reserves to support one or more 10,000 to 50,000 barrels per day plants,
. an additional 668 contain sufficient reserves to support one or more 5,000 to 10,000 barrels per day plants, and
. an additional 940 contain sufficient reserves to support one or more 2,500 to 5,000 barrels per day plants.
An additional 6,705 of these 15,376 fields contain sufficient reserves to support a portable 2,000 barrels per day plant for a shorter plant life.
Stranded Natural Gas Reserves. The Oil and Gas Journal has estimated that of the world's identified natural gas reserves, approximately 60%, or 3,182 trillion cubic feet, currently have no economic market (equivalent to approximately 310 billion barrels of synthetic crude oil).
The term "stranded gas" generally refers to gas which exists in reservoirs that have been discovered, but no economic market can be found for the production, or production would be too prolific for the limited markets available. Typically, this low value gas is managed by either not producing, or "shutting in," the gas, flaring or venting the gas, or reinjecting the gas into the geologic formation from which it is produced.
The large amount of stranded natural gas throughout the world is caused by a combination of four primary factors. First, much of the world's stranded natural gas is located in fields of less than five trillion cubic feet, which is generally considered the minimum size necessary to support the development of a full-scale LNG plant for a typical 20-year plant life. The small size of many of these fields makes the production of natural gas from the fields uneconomical. Second, much of the world's stranded natural gas is located in areas where there is no local market and the distance to large natural gas consuming areas is great. This makes transportation costs high and often renders development projects uneconomic. Third, even in circumstances where a transportation system is available for natural gas, the cost of transporting natural gas in a gaseous state is generally substantially higher, on an energy equivalent basis, than that of oil. Finally, we estimate that the worldwide LNG market is approximately 2.4 million oil-equivalent barrels per day, which is relatively small compared to the approximately 44 million barrels per day transportation fuels markets. Natural gas can also be converted to ammonia and methanol. Based on industry publications, we currently estimate that the market for ammonia on a barrel of oil equivalent basis is approximately 1.5 million barrels per day and the market for methanol on a barrel of oil equivalent basis is approximately 443,439 barrels per day. These markets are small relative to the size of the worldwide natural gas resource base and relative to the approximately 67 million barrels per day market for crude oil and related products.
We believe that energy companies with stranded natural gas reserves will be able to cost-effectively use our GTL technology to produce Syntroleum fuels and products that can be sold in well-developed global markets. As a result, we believe these companies would be able to generate a return on the exploration and development expenditures associated with their stranded natural gas reserves.
Licensing Arrangements
We currently market four types of license agreements. Our master license agreement generally grants to the licensee the non-exclusive right to enter into an unlimited number of site license agreements to construct GTL plants based on the Syntroleum Process to produce fuels worldwide. Our volume license agreement generally grants to the licensee the non-exclusive right to enter into an unlimited number of site license agreements to construct GTL plants based on the Syntroleum Process, subject to specified aggregate production capacity limits. Our regional license agreement generally grants to the licensee the non-exclusive right to enter into an unlimited number of site license agreements to construct GTL plants based on the Syntroleum Process within a designated region. Finally, our site license agreement generally grants to the licensee the non-exclusive right to use the Syntroleum Process in a GTL plant at a single, specified location for the life of the plant. This type of license may be granted under our master, regional or volume license agreements or may be granted to licensees for a specific site who have not otherwise entered into a master, regional or volume license agreement. The licenses generally exclude the right to use the Syntroleum Process in North America as well as in China and India due to intellectual property protection concerns.
By entering into a master, volume or regional license agreement, a licensee secures pricing terms for site licenses and obtains the right to use the Syntroleum Process, the right to acquire catalysts from us for which we charge a fixed mark-up over our cost and the right to future improvements in our GTL technology. To date, we have entered into master license agreements with ARCO (a subsidiary of BP), Ivanhoe Energy, Marathon and Texaco (a subsidiary of Chevron Texaco), and we have entered into volume license agreements with the Commonwealth of Australia, Enron, Kerr-McGee and Repsol-YPF. We intend to continue to market the Syntroleum Process for license primarily to companies with significant stranded natural gas reserves.
At the inception of a master, volume or regional license agreement, the licensee generally makes an initial deposit to us, which is credited against future site-specific license fees. The amount of the initial deposit depends on market conditions and, in the case of volume and regional license agreements, the volume limitation and the size and
location of the region covered. We have received an aggregate of $38 million in cash as initial deposits and option fees under our existing license agreements. In some cases, we have acquired technologies or commitments to provide funding for future development activities in lieu of initial cash deposits. For a discussion of license fees, see "Management's Discussion and Analysis of Financial Condition and Results of Operations--Operating Revenues--License Revenues."
As part of our network model for improving our GTL technology, we generally acquire a royalty-free, non-exclusive license to any invention or improvement to the Syntroleum Process that is developed by the licensee, together with the right to grant corresponding sublicenses to our other licensees who have granted us similar rights. Licensees also generally acquire the right to use subsequent inventions or improvements to the Syntroleum Process that we acquire from other licensees. Our license agreements may be terminated by the licensee, with or without cause, upon 90 days' notice to us.
Key Testing and Commercial Projects
The following sets forth our progress to date in implementing our business strategy. Although we have made significant progress towards commercializing the Syntroleum Process, we cannot assure you that licensees will construct any plants under their license agreements, that we will be able to obtain financing for specialty product or fuels gas-to-liquids plants, that design and construction of any of these plants will be successfully completed, that any of these plants will be commercially successful or that these plants will be constructed or utilized on a cost-effective basis. See "Risk Factors."
In addition to our nominal two barrel per day pilot plant and laboratory facilities located in Tulsa, Oklahoma, which are the primary sites for our research and development activities, we have been or are currently involved in several projects and initiatives, including the following.
Cherry Point Project. We were a joint participant with ARCO in a 70 barrel per day GTL demonstration plant located at ARCO's Cherry Point refinery in the State of Washington. The plant began operating in July 1999 and operated successfully until it was shut down at the completion of testing shortly after June 30, 2000. ARCO funded the construction and operation of this plant under our joint development agreement. Plant operations exceeded our expectations and successfully demonstrated a number of key aspects of our proprietary autothermal reformer and moving bed reactor designs and related catalyst performance. This plant has been recently disassembled and moved to Tulsa, Oklahoma where we expect to reassemble the plant as part of our expected fuels project with the DOE discussed below. The data and experience generated from our participation in plant operations will be useful in our efforts to apply these reactor designs on a commercial basis both for fuels and specialty product plants. We are currently conducting engineering studies with others for commercial-scale plants using these reactor designs.
Sweetwater Project. We are developing a nominal 11,500 barrel per day specialty product plant in Australia that we call the Sweetwater plant. We currently anticipate that this plant will produce synthetic lube oil, normal paraffins, process oils and light paraffins. The plant will use a fixed tube reactor design which produces a high yield of the desired products with high wax content and has lower scale-up risks than other reactor designs and will include additional refining equipment necessary to produce the targeted specialty products. We plan to construct this plant through a joint venture with other parties who we expect will furnish a significant portion of the needed equity financing . In February 2000, we selected a site for the plant about four kilometers from the North West Shelf liquid natural gas facility on the Burrup Peninsula of Western Australia. We have entered into a firm, lump-sum engineering, procurement and construction contract, an operation and maintenance contract, a natural gas supply contract and other contracts for this plant. We currently expect the capital costs of the Sweetwater plant to be funded primarily by senior and subordinated debt at the project level, as well as equity financing from third parties, together with our own equity contribution. We are currently in discussions with several parties regarding equity financing for the Sweetwater project. However, we cannot assure you that we will be successful in obtaining either the debt or equity financing for this project.
Joint Venture to Provide Contract GTL Services. We have entered into a nonbinding letter of intent with Petroleum Geo-Services ASA to form a joint venture to develop, market and operate mobile, marine-based production facilities that use the Syntroleum Process. If the transaction is completed, the joint venture will be a separate operating company offering contract GTL services to gas producers to convert natural gas from offshore fields into synthetic hydrocarbon products. Use of these services could enable monetization of gas that is normally flared or otherwise wasted. Under the letter of intent, the planned joint venture will have its initial operations in
Aberdeen, Scotland and will be the exclusive means by which we and PGS offer mobile, marine-based contract GTL services to third parties. Formation of the joint venture is subject to negotiation and execution of definitive agreements by the parties. We cannot assure you that the joint venture will be formed or commence actual business operations.
DOE Project. During the third quarter of 2001, the U.S. Department of Energy (DOE) concluded an agreement with Integrated Concepts & Research Corporation (ICRC) to provide funding to a team of companies for the GTL Ultra-Clean Fuels Production and Demonstration Project for which preliminary approval was announced by us in October 2000. We are the prime subcontractor for this project under an agreement with ICRC. Under the terms of the agreement, the DOE will fund $16 million of the $36 million project, and the other project participants will provide the remaining $20 million. We are currently in discussions with Marathon Oil Company and others regarding their participation in this project. Under the program, Syntroleum's Cherry Point GTL facility, which has been disassembled and relocated from ARCO's Cherry Point Refinery in Washington State to a site near Tulsa, Oklahoma, is expected to become the basis for construction of a new GTL facility expected to produce up to approximately 70 barrels per day of Syntroleum ultra-clean diesel fuel and synthetic naphtha. The relocation of the Cherry Point GTL facility to Tulsa, Oklahoma was completed in 2001. Construction of the new facility in Tulsa is currently expected to begin in 2002, with fuel production expected to commence in 2003. The fuels from this facility are expected to be tested by other project participants in advanced power train and emission control technologies and are also expected to be tested in bus fleets by the Washington Metropolitan Area Transit Authority and the U.S. National Park Service at Denali National Park in Alaska. Completion of the project is subject to continued congressional appropriation of project funds. In addition, construction of this project will be subject to the risks of delay inherent in any large construction project.
Talara Project. During the fourth quarter of 2001 we announced plans to develop an integrated NGL/GTL (natural gas liquids/gas-to-liquids) project in the Talara Basin of Northwest Peru. We expect to develop this project in three phases. Phase I is expected to consist of construction of a nominal 2,000 barrel per day NGL plant to upgrade and replace an existing plant. Phase II is expected to involve the expansion of the NGL plant and the construction of a 5,000 barrel per day GTL plant. Phase III is expected to involve expansion of the GTL facility if additional natural gas reserves and production in the area are developed. In connection with this proposed project, we signed a license contract with the government of Peru under which we have acquired exploration and production rights to the offshore Peruvian oil and gas block designated as Z-1. Previous exploration activity in the area has identified possible gas and condensate prospects, which we believe have remained undeveloped up to now due to lack of an adequate market for the gas. We anticipate that development of these prospects would facilitate the third phase of the Talara project. Completion of this project is subject to satisfaction of several conditions including negotiation and execution of definitive gas purchase agreements, engineering, procurement and construction agreements and other agreements, site acquisition and financing. We cannot assure you that this project will commence actual operations. In addition, this project will be subject to the risks of delay inherent in any large construction project.
DOD Project. During the first quarter of 2002, we announced that Congress had appropriated $3.5 million for a proposed Flexible JP-8 (single battlefield fuel) program under the Department of Defense Appropriation Bill, 2002. We expect to negotiate a contract with the DOD to participate in the program, which will provide for the design of a marine-based fuel-production plant, as well as testing of synthetically-made JP-8 fuel in military diesel and turbine engine applications. We cannot assure you that we will be successful in concluding a contract with DOD to participate in this program.
Research and Development
One of our key strategies is to continue to lower the capital and operating cost of our GTL technology through research and development. We have spent approximately $8.3 million in 1999, $12.6 million in 2000 and $16.2 million in 2001 on pilot plant and research and development facilities and activities. Our continued research and development efforts will take place in four primary areas: process design, catalyst development, reactor design and heat integration/power recovery. For a discussion of our efforts in these areas, see "--The Syntroleum Process."
We lease a 4,500 square foot laboratory and own a 16,500 square foot laboratory facility located on approximately 95 acres of land where we are engaged in extensive development and testing of Syntroleum products. These facilities also house our product refining research and development activities, including hydrogen saturation, hydroisomerization, hydrocracking and distillation capabilities, as well as a fully automated dual train bench scale hydroprocessing unit. We have recently completed construction of a large scale hydroprocessing pilot unit that is
currently operational. Our laboratories currently have 24 fixed tube reactors, two fluidized bed reactors, and seven continuous stirred tank reactors in which automated tests are run and catalyst systems are evaluated and developed. We also have arrangements with a number of universities and companies for a full range of state-of-the-art catalyst evaluation.
As of March 1, 2002, we had 81 employees in our laboratory, pilot plant and engineering departments, 53 of whom are chemists, engineers or other degreed professionals (21 with masters or Ph.D. degrees) devoted to research and development activities. A number of other chemists, engineers and professionals that are employed by our licensees and joint development partners also contribute to the further development and commercialization of the Syntroleum Process.
Sales and Marketing
We intend to maintain an active marketing and sales effort to promote the Syntroleum Process through several channels. We have been and will continue to be an active participant at industry conferences relating to GTL processes. We also intend to continue to write and publish papers on topics regarding the implications of GTL technology to the energy and transportation industries. Additionally, we will continue to educate and inform our customers through the use of multi-media and print presentations. We also intend to continue our efforts to establish brand recognition for specialty products to be produced by our specialty plants. "Syntroleum" is a registered trademark and service mark in the United States, and applications are pending to register the trademark in various foreign countries.
In addition, RWE (formerly Tessag), AMEC and other engineering companies are familiar with our GTL technology and have assisted us in marketing the Syntroleum Process. Our agreements with engineering firms sometimes provide these firms with the right to market the Syntroleum Process. We believe that these relationships will expand our marketing effort in a cost-effective manner. As of March 31, 2002, we had 14 employees in our business development and marketing departments, seven of whom hold advanced degrees, and we also retain a full-time sales representative in London, England. We also have representation relationships with several other organizations and individuals covering Europe, portions of Africa and Russia.
The Syntroleum Process
The Syntroleum Process involves two catalytic reactions. The first reaction converts natural gas into synthesis gas through our proprietary autothermal reformer reactor, and the second reaction converts the synthesis gas into hydrocarbons through the Fischer-Tropsch reaction over a proprietary catalyst. The following diagrams illustrate the elements involved in these reactions, but are not in exact proportions.
Step 1 Conversion of Natural Gas to Synthesis Gas
Step 2 Fischer - Tropsch Synthesis
Our goal in developing this process has been to substantially reduce both the capital and operating costs and the minimum economic size of a GTL plant. We have developed and continue to develop variations of our basic process design in an effort to further lower costs and increase the adaptability of the Syntroleum Process to a wide variety of potential applications.
Although we believe that the Syntroleum Process can be utilized in commercial-scale GTL plants, we cannot assure you that commercial-scale GTL plants based on the Syntroleum Process will be successfully constructed and operated or that these plants will yield the same economics and results as those demonstrated on a pilot plant basis. In addition, improvements to the Syntroleum Process currently under development may not prove to be commercially applicable. See "Risk Factors--Risks Relating to our Technology."
Fischer-Tropsch Catalyst Systems
We have developed several different proprietary catalysts systems for use in the Fischer-Tropsch reaction in order to allow for matching a catalyst system to a particular reactor design and provide more flexibility in matching the Syntroleum Process to the desired application.
Based upon pilot tests of catalysts that we have manufactured, we believe that a number of proprietary catalyst systems meet or exceed the activity and selectivity targets necessary for commercial application in some current Syntroleum Process designs, including the catalysts associated with the moving bed reactor recently operated at the pilot plant jointly developed with ARCO at ARCO's Cherry Point refinery.
Most Fischer-Tropsch catalysts produce a very waxy synthetic crude oil. Typically, more than 50% of a barrel of synthetic crude oil is solid at room temperature due to the high wax content. These waxy hydrocarbons are typically processed through a hydrocracker to convert them into liquid hydrocarbons at room temperature that can be further processed into transportation fuels. Our proprietary "high alpha" catalyst produces a very waxy synthetic crude oil which can be further processed through hydrocracking to make liquid synthetic fuels, or, with other refining processes, the waxy portion can be converted into higher value specialty products such as synthetic lubricants.
Under our arrangements with various catalyst manufacturers, the manufacturers have manufactured, in their respective commercial facilities, batches of our catalysts in quantities sufficient to confirm that the performance of these catalysts is comparable to the same catalyst produced by us and that these catalysts can be produced in commercial quantities at targeted cost levels. We estimate that the useful life of our Fischer-Tropsch catalysts will be three to five years under normal operating conditions.
We plan to improve existing catalysts and continue to develop additional catalyst formulations for use in the Syntroleum Process. Catalyst development is a complex process requiring significant scientific skill and resources. We have in the past and intend to continue to devote substantial resources to research and development activities to produce Fischer-Tropsch catalysts with improved activity rates, selectivity and active life, all at reasonable manufacturing cost. In addition, we intend to enhance our catalyst development activities through catalyst joint development programs with our joint development partners and catalysis experts retained on a consulting basis.
Fischer-Tropsch Reactor Designs
We have tested at our pilot plant several different proprietary Fischer-Tropsch reactor designs and associated catalysts for use in the Syntroleum Process. These include multiple fixed bed and moving bed reactors. In addition, under its agreement with Syntroleum, ARCO constructed and operated a 70 barrel per day GTL pilot plant that tested the moving bed reactor on a larger scale. As discussed elsewhere, we have recently moved this plant to Tulsa, Oklahoma where we expect to reconstruct it for additional operation. We have several pending United States and foreign patent applications related to our Fischer-Tropsch reactors.
Heat Integration and Power Recovery
Compression is the primary energy consumer in the Syntroleum Process. Engineering studies conducted by various engineering companies have demonstrated that the heat generated by the two catalytic reactions in the Syntroleum Process can be captured in the form of mechanical and electrical energy sufficient to supply all of a GTL plant's needs plus a surplus for other uses, if desired. We have developed several heat integration and power recovery schemes with partners such as GE Power Systems to broaden the flexibility of the Syntroleum Process and, in some cases, lower the capital cost as well as the number of pieces of major equipment necessary for operation of a GTL plant.
Different configurations of GTL plants based on the Syntroleum Process can also change the energy sources within the plant and the excess energy produced. For example, a steam turbine can be incorporated into the process and utilize the steam produced by the auto-thermal reformer and Fischer-Tropsch reactions to produce energy for
compression, and electrical power for commercial sale. In addition, we have developed a configuration that utilizes the low-heating-value residue stream from the process as feedstock for a specially designed gas turbine that can utilize very low-heating-value gas. Several of these heat integration and power recovery schemes are the subject of United States patents and patent applications and foreign patent applications and are a part of our joint development efforts with others.
Product Upgrading
Synthetic liquid hydrocarbons made from the Syntroleum Process can be refined into fuels using conventional refining processes such as hydrocracking. However, we believe that because of the purity and uniform nature of the synthetic hydrocarbon molecules, conventional process configurations and conditions may not be optimum. We have developed new processes to further refine synthetic liquid hydrocarbons made from the Syntroleum Process in a manner that maximizes the value of the refined product streams, while minimizing the processing cost. In August 2000, we began offering our licensees access to proprietary hydrocracking technology optimized for converting synthetic crude oil into ultra-clean, sulfur-free synthetic transportation fuels, primarily diesel and jet fuels.
Advantages Over Competing Processes
We believe that the method by which our process uses air directly from the atmosphere is a unique characteristic and a primary competitive advantage of the Syntroleum Process. Competitive processes for the conversion of natural gas into synthetic hydrocarbons generally utilize either steam reforming or a combination of steam reforming and partial oxidation with pure oxygen in the conversion of natural gas to synthesis gas. Steam reformers react steam with natural gas to produce synthesis gas. A conventional steam reformer is a relatively complex unit that consists of a large fired heater with catalyst-filled tubes. Because the reaction operates at high temperature and pressure, the tubes are made of exotic alloys and are expensive. Operating costs are increased due to the endothermic nature of the process, which requires a continuous input of heat. Processes that utilize a combination of steam reforming and partial oxidation with pure oxygen also require an air separation plant to produce pure oxygen. The air separation plant must be constructed with expensive metals and materials, because its operation involves very low temperatures and requires significant energy input, as well as operating risks inherent in handling pure oxygen. Moreover, the use of pure oxygen generates synthesis gas that is free of nitrogen. While the Fischer-Tropsch reaction in competitive processes is designed to occur without the presence of nitrogen, the Syntroleum Process is designed to utilize the nitrogen in the Fischer-Tropsch process to remove a portion of the heat generated by the process. Use of the auto thermal reformer reactor in the Syntroleum Process also provides advantages over competitive processes because of its relatively low capital and operating costs. In addition to lowering the capital cost, the elimination of an air separation plant and steam reformer has the additional advantage of reducing the size and complexity and lowering the energy requirements of GTL plants based on the Syntroleum Process.
We believe that another advantage of the Syntroleum Process is the absence in several design configurations of recycle loops necessary in some competitive processes, which also tends to lower capital costs. In the Fischer-Tropsch stage of some competitive processes, a recycle loop is utilized in order to maximize the output of hydrocarbons and help control the heat generated by the reaction. As a result, these processes are designed to avoid the introduction of inert gases (including nitrogen) into the process, which would otherwise build up in the system and hinder the reaction.
Feedstocks
The Syntroleum Process is designed to produce approximately 6 million British thermal units of liquid hydrocarbons from between 9.5 and 13 million British thermal units of natural gas feedstock. Conversion efficiency varies depending on gas composition and process conditions selected for each plant. One of the benefits of the Syntroleum Process is its ability to utilize natural gas containing nitrogen and carbon dioxide, up to specified levels, without removing these impurities prior to consumption by the plant. However, natural gas that contains sulfur, metals and other materials that poison catalysts must be processed in order to remove these contaminants prior to the use of the natural gas in the first catalytic reaction.
Byproducts and Emissions
A byproduct of the Syntroleum Process is synthesized water that, with treatment to remove organic materials, could be sold commercially as industrial or irrigation water in areas where sufficient demand exists. Based
on pilot plant tests, we believe that slightly more than one barrel of synthesized water can be produced for each barrel of synthetic crude oil produced.
Depending on the process configuration, emissions from the Syntroleum Process are expected to include nitrous oxide, carbon monoxide, carbon dioxide and light hydrocarbons, which we believe will generally be within applicable emissions standards. Spent catalysts are expected to be processed by a catalyst reclaimer, which will recover useful metals and be responsible for disposal of the nonreclaimed portion of the catalyst.
Intellectual Property
Our success depends on our ability to obtain, protect, and enforce our intellectual property rights, to successfully avoid infringing the valid and enforceable intellectual property rights of others and, if necessary, to defend against any alleged infringements. We regard the protection of our proprietary technologies as critical to our future success and we rely on a combination of patent, copyright, trademark and trade secret law and contractual restrictions to protect our proprietary rights. We pursue protection of the Syntroleum Process primarily through patents and trade secrets. It is our policy to seek, when appropriate, protection for our proprietary products and processes by filing patent applications in the United States and selected foreign countries and to encourage or further the efforts of others who have licensed technology to us to file patent applications. Our ability to protect and enforce these rights involves complex legal, scientific and factual questions and uncertainties.
We currently own, or have licensed rights to more than 120 patents or patent applications pending in the United States and various foreign countries that relate in general to one or more embodiments of the Syntroleum Process.
We cannot assure you that additional patents will be granted with respect to any patent applications filed by us or our licensors. Any patents issued or licensed to us might not provide us with commercial benefit or might be infringed, invalidated or circumvented by others. The approval or rejection of our patent applications by the U.S. Patent Office may take several years.
The availability of patents in foreign markets, and the nature of any protection against competition that may be afforded by such patents, is often difficult to predict and varies significantly from country to country. Moreover, we or our licensors may choose not to seek, or may, for a variety of reasons, be unable to obtain, patent protection in a country that might become an important market for our GTL technology.
In addition to patent protection, we also rely significantly on trade secrets, know-how and technological advances, which we seek to protect, in part, through confidentiality agreements with our collaborators, licensees, employees and consultants. If these agreements are breached, we might not have adequate remedies for the breach. In addition, our trade secrets and proprietary know-how might otherwise become known or be independently discovered by others.
It is our policy to honor the valid, enforceable intellectual property rights of others. Our success depends on our ability to avoid infringing these rights and, if need be, defending ourselves against any claims of infringement. While we have made efforts to avoid any such infringement, commercialization of our GTL technologies may give rise to claims that the technologies infringe upon the patents or other proprietary rights of others.
Although it is our policy to regularly review patents that may have applicability in the GTL industry, we may not become aware of these patents or rights until after we have made a substantial investment in the development and commercialization of those technologies. Legal actions could be brought against us, our partners or our licensees claiming damages and seeking an injunction that would prevent us, our partners or our licensees from testing, marketing or commercializing the affected technologies. Major energy companies seeking to gain a competitive advantage may have an interest in bringing one of these actions. If such an action was successful, in addition to potential liability for damages, we, our partners or our licensees could be required to obtain a license in order to continue to test, market or commercialize the affected technologies. Any required license might not be made available or, if available, might not be available on acceptable terms, and we could be prevented entirely from testing, marketing or commercializing the affected technology. We may have to expend substantial resources in litigation, either in enforcing our patents, defending against the infringement claims of others, or both. Many possible claimants, like the major energy companies that have or may be developing proprietary GTL technologies competitive with the Syntroleum Process, have significantly more resources to spend on litigation. We have conducted a review of several hundred existing patents applicable to the GTL field and believe that we are not
infringing on the valid, enforceable patents of others. We have not been notified of any claim that our GTL technology infringes the proprietary rights of any third party. However, we cannot assure you that third parties will not claim infringement by us with respect to past, present or future GTL technologies.
In any potential intellectual property dispute involving us, our licensees could also become the target of litigation. Our license agreements require us to indemnify the licensees against specified losses, including the losses resulting from patent and trade secret infringement claims, subject to a cap of 50% of the license fees received. Our indemnification and support obligations could result in substantial expenses and liabilities to us. These expenses or liabilities could have a material adverse effect on our business, operating results and financial condition. See "Risk Factors--Risks Relating to our Technology."
Employees
We had 125 employees at March 1, 2002, including 60 employees involved in research and development and pilot plant operations, 14 employees in business development and marketing, 21 employees in engineering, and 30 employees in finance, legal, information technology and administration. None of our employees are represented by a labor union. We have experienced no work stoppages and believe that our relations with our employees are excellent.
Government Regulation
We will be subject to extensive federal, state and local laws and regulations relating to the protection of the environment, including laws and regulations relating to the release, emission, use, storage, handling, cleanup, transportation and disposal of hazardous materials and employee health and safety. In addition, our GTL plants will be subject to the environmental and health and safety laws and regulations of any foreign countries in which these plants are to be located. For example, our Sweetwater project will require us to comply with extensive Australian environmental, health and safety laws. Violators of these laws and regulations may be subject to substantial fines, criminal sanctions or third party lawsuits. We may be required to install costly pollution control equipment or, in some extreme cases, curtail operations to comply with these laws. These laws and regulations may also limit or prohibit activities on lands lying within wilderness areas, wetlands or other protected areas. Our operations in the United States are also subject to the federal "Superfund" law, and similar state laws, which can impose joint and several liability for site cleanup, regardless of fault, upon statutory categories of parties, including our company, that sent wastes offsite for disposal and current owners and operators of property. Environmental laws and regulations often require the acquisition of a permit or other authorization before activities may be conducted and compliance with laws and regulations, and any requisite permits, can increase the costs of designing, installing and operating our GTL plants. For example, we are required to obtain numerous Australian environmental, health and safety permits in connection with our Sweetwater project.
GTL plants will generally be required to obtain permits under applicable state and federal clean air and water laws and various permits for industrial siting and construction. Emissions from a GTL plant, primarily from the gas turbine, will contain nitrous oxides and may require abatement equipment to be installed in order to meet state and federal permit requirements. Additionally, GTL plants will be required to adhere to state and federal laws applicable to the disposal of byproducts produced, including waste water and spent catalyst.
Although we do not believe that compliance with environmental and health and safety laws in connection with our current operations will have a material adverse effect on us, we cannot predict with certainty the future costs of complying with environmental laws and regulations and containing or remediating contamination. In the future, we could incur material liabilities or costs related to environmental matters, and these environmental liabilities or costs (including fines or other sanctions) could have a material adverse effect on our business, operating results and financial condition. We do not currently carry environmental impairment liability insurance to protect us against these contingencies but may, in the future, seek to obtain insurance in connection with our participation in the construction and operation of GTL plants if coverage is available at reasonable cost and without unreasonably broad exclusions.
Operating Hazards
Operations at our GTL plants will involve a risk of incidents involving personal injury and property damage due to the operation of machinery in close proximity to individuals and the highly flammable nature of natural gas and the materials produced at these plants. The frequency and severity of personal injury and property damage
incidents will affect our operating costs, insurability and relationships with customers, employees and regulators. Any significant frequency or severity of these incidents, or the general level of compensation awards, could affect our ability to obtain insurance and could have a material adverse effect on our business, operating results and financial condition.
MANAGEMENT AND DISPOSITION OF REAL ESTATE AND MISCELLANEOUS ASSETS
Our predecessor, SLH Corporation, owned real estate assets which we are currently liquidating. These assets reflect the remaining assets of a real estate development business that was conducted by Lab Holdings in association with a previously owned life insurance company that was sold in 1990. Real estate assets, as of December 31, 2001, consisted of land in Houston, Texas comprised of 255 acres of undeveloped land and 69 residential lots available for sale known as the "Houston Project." The total real estate inventory had an aggregate carrying value at December 31, 2001 of approximately $3.0 million.
Our real estate assets are owned by our subsidiary, Scout Development Corporation. The Houston Project is owned by 529 Partners, Ltd., a Texas limited partnership in which Scout holds a 75% interest. 529 Partners is developing the property for residential and light commercial purposes. During 2001, 529 Partners sold 125 lots of the Houston Project for residential use for approximately $2.6 million. We expect that the balance of the tract will be developed by 529 Partners for residential use and ultimate sale.
Our other assets at December 31, 2001 included (1) $46,532,000 of cash, government securities and current receivables, (2) an investment in a privately owned developer of proprietary bone substitute technology, which had a carrying value of approximately $506,000, (3) an investment in a privately held venture capital limited partnership, which had a carrying value of $476,000, (4) and an equity investment in a recently renovated hotel in Tulsa, Oklahoma. During 2001 we sold our 49.9% partnership interest in a retail shopping center in Gillette, Wyoming for a gain of $1.9 million. We plan to liquidate these remaining investments, other than the cash, government securities and current receivables, in an orderly manner to maximize their value to stockholders.
We believe that the real estate properties are adequately covered by insurance with coverages for real and personal property, commercial general liability, commercial crime, garage keepers legal liability, earthquake, flood, windstorm and hail.
Our subsidiary, Scout, is subject to contingent obligations under leases and other instruments incurred in connection with real estate activities and other operations. We believe that adequate accruals have been made for the contingent liabilities on our financial statements and that none of these are deemed to be material, individually or in the aggregate.
Scout is subject to several United States environmental laws, including: the Clean Air Act, the Comprehensive Environmental Response, Compensation, and Liability Act, the Emergency Planning and Community Right-to-Know Act, the Federal Water Pollution Control Act, the Oil Pollution Act of 1990, the Resource Conservation and Recovery Act, the Safe Drinking Water Act and the Toxic Substances Control Act. Scout is also subject to the United States environmental regulations promulgated under these acts, as well as state and local environmental regulations that have their foundation in the foregoing United States environmental laws. As is the case with many companies, Scout may face exposure to actual or potential claims and lawsuits involving environmental matters with respect to its current inventory of real estate as well as previously owned real estate. However, no such claims are presently pending and Scout has not suffered, and does not anticipate that it will suffer, a material adverse effect as a result of any past action by any governmental agency or other party, or as a result of noncompliance with such environmental laws and regulations.
RISK FACTORS
You should carefully consider the risks described below. The risks and uncertainties described below are not the only ones facing our company. If any of the following risks actually occur, our business, financial condition or results of operations could be materially adversely affected. In that case, the trading price of our common stock could decline, and you may lose all or part of your investment in our common stock.
RISKS RELATING TO OUR TECHNOLOGY
We might not successfully commercialize our technology, and commercial-scale GTL plants based on the Syntroleum Process may never be successfully constructed or operated.
To date, no commercial-scale GTL plant based on the Syntroleum Process has been constructed. A commercial-scale GTL plant based on the Syntroleum Process might never be successfully built either by us or by any of our licensees. Our success depends on our ability, and the ability of our licensees, to economically design, construct and operate GTL plants based on the Syntroleum Process on a commercial scale. The successful commercial construction and operation of a GTL plant based on the Syntroleum Process depends on a variety of factors, many of which are outside our control. Although we are currently developing the Sweetwater plant, our first commercial-scale GTL plant, we do not know if we will be successful in obtaining the necessary debt and equity financing for this plant. We do not know when construction of this plant will begin or when it will become operational. We do not have significant experience managing the financing, design, construction or operation of commercial-scale GTL plants, and we may not be successful in doing so.
Commercial-scale GTL plants based on the Syntroleum Process might not produce results necessary for success, including results demonstrated on a laboratory and pilot plant basis.
. A variety of results necessary for successful operation of the Syntroleum Process could fail to occur at a commercial plant, including reactions successfully tested on a laboratory and pilot plant basis. Results that could cause commercial-scale GTL plants to be unsuccessful include:
. lower reaction activity than that demonstrated in laboratory and pilot plant operations, which would increase the amount of catalyst or number of reactors required to convert synthesis gas into liquid hydrocarbons and increase capital and operating costs,
. shorter than anticipated catalyst life, which would require more frequent catalyst regeneration, catalyst purchases, or both, and increase operating costs,
. excessive production of gaseous light hydrocarbons from the Fisher-Tropsch reaction compared to design conditions, which would lower the anticipated amount of liquid hydrocarbons produced and would lower revenues and margins from plant operations,
. inability of the gas turbines or heaters integrated into the Syntroleum Process to burn the low-heating-value tail gas produced by the process, which would result in the need to incorporate other methods to generate horsepower for the compression process that may increase capital and operating costs, and
. higher than anticipated capital and operating costs to design, construct and operate a GTL plant.
In addition, these plants could experience mechanical difficulties, either related or unrelated to elements of the Syntroleum Process.
Many of our competitors have significantly more financial and other resources than our company, and GTL technologies developed by our competitors could become more commercially successful than our technology or render our technology obsolete.
The development of GTL technology is highly competitive, and other GTL technologies could become more commercially successful than our technology. The Syntroleum Process is based on chemistry that has been used by several companies in synthetic fuel projects over the past 60 years. Our competitors include major integrated oil companies that have developed or are developing competing GTL technologies, including BP, Conoco, Exxon, Sasol (including through its participation in a joint venture with Chevron) and Shell. Each of these companies has significantly more financial and other resources than us to spend for research and development of their technologies and for funding construction and operation of commercial-scale GTL plants. In addition to using their own GTL technologies in competition with us, these competitors could also offer to license their technology to others. In addition, several small companies have developed, and are continuing to develop, competing GTL technologies. The Department of Energy has also sponsored a number of research programs relating to GTL technology that, in many cases, could potentially lower the cost of competitive processes.
As GTL technologies continue to be developed by our competitors, one or more of our current technologies may become obsolete. Our ability to create and maintain technological advantages is critical to our future success. As new technologies develop, we may be placed at a competitive disadvantage, and competitive pressures may force us to implement new technologies at a substantial cost. We may not be able to successfully develop or expend the financial resources necessary to acquire new technology.
Our ability to protect our intellectual property rights involves many complexities and uncertainties, and commercialization of the Syntroleum Process could give rise to claims that our technology infringes upon the rights of others.
Our success depends on our ability to protect our intellectual property rights, which involves complex legal, scientific and factual questions and uncertainties. We rely on a combination of patents, copyrights, trademarks, trade secrets and contractual restrictions to protect our proprietary rights. We cannot assure you that additional patents will be granted, and our existing patents might not provide us with commercial benefit or might be infringed upon, invalidated or circumvented by others. In addition, the availability of patents in foreign markets, and the nature of any protection against competition that may be afforded by those patents, are often difficult to predict and vary significantly from country to country. We or our licensors may choose not to seek, or may be unable to obtain, patent protection in a country that could potentially be an important market for our GTL technology. The confidentiality agreements that are designed to protect our trade secrets could be breached, and we might not have adequate remedies for the breach. In addition, our trade secrets and proprietary know-how might otherwise become known or be independently discovered by others.
Commercialization of the Syntroleum Process may give rise to claims that our technologies infringe upon the patents or other proprietary rights of others. Although it is our policy to regularly review patents that may have applicability in the GTL industry, we may not become aware of these patents or rights until after we have made a substantial investment in the development and commercialization of those technologies. We cannot assure you that third parties will not claim infringement by us with respect to past, present or future GTL technologies. Legal actions could be brought against us, our partners or our licensees claiming damages and seeking an injunction that would prevent us, our partners or our licensees from testing, marketing or commercializing the affected technologies. If an infringement action were successful, in addition to potential liability for damages, our partners, our licensees or we could be required to obtain a license in order to continue to test, market or commercialize the affected technologies. Any required license might not be made available or, if available, might not be available on acceptable terms, and we could be prevented entirely from testing, marketing or commercializing the affected technology. We may have to expend substantial resources in litigation, either in enforcing our patents, defending against the infringement claims of others, or both. Many possible claimants, like the major energy companies that have or may be developing proprietary GTL technologies competitive with the Syntroleum Process, have significantly more resources to spend on litigation.
We could have potential indemnification liabilities to licensees relating to the operation of GTL plants based on the Syntroleum Process or intellectual property disputes.
Our license agreements require us to indemnify the licensee, subject to a cap of 50% of the license fees we receive, against specified losses relating to, among other things:
. the use of patent rights and technical information relating to the Syntroleum Process,
. acts or omissions by us in connection with our preparation of process design packages for plants, and
. performance guarantees that may be provided by us.
Our indemnification obligations could result in substantial expenses and liabilities to us in the event that intellectual property rights claims are made against us or our licensees, or GTL plants based on the Syntroleum Process fail to operate as designed.
If improvements to the Syntroleum Process are not commercially viable, the design and construction of lower-cost GTL plants based on the Syntroleum Process could be delayed or prevented.
A number of improvements to the Syntroleum Process are in various early stages of development. These improvements will require substantial additional investment, development and testing prior to their commercialization. We might not be successful in developing these improvements and, if developed, they may not be capable of being utilized on a commercial basis. If improvements to the Syntroleum Process currently under development do not become commercially viable on a timely basis, the total potential market for GTL plants that could be built by us and our partners and by our licensees could be significantly limited.
For example, we are seeking to develop improvements to the heat integration of the Syntroleum Process designed to lower capital and operating costs. These improvements may not occur because further integration of the gas turbine into the process might not be technically feasible due to the operating tolerances of the materials in the gas turbine.
Industry rejection of our technology would make the construction of GTL plants based on the Syntroleum Process more difficult or impossible and adversely affect our ability to receive future license fees.
As is typical in the case of any evolving technology, demand and industry acceptance for our GTL technology is subject to a high level of uncertainty. Failure by the industry to accept our technology would make our construction of GTL plants more difficult or impossible and adversely affect our ability to receive future license fees and to generate other revenue. Should a high profile industry participant adopt the Syntroleum Process and fail to achieve success or should any commercial GTL plant based on the Syntroleum Process fail to achieve success, other industry participants' perception of the Syntroleum Process could be adversely affected. In addition, some oil companies may be motivated to seek to prevent industry acceptance of GTL technology based on their belief that widespread adoption of GTL technology might negatively impact their competitive position.
RISKS RELATING TO OUR BUSINESS
We will need to obtain funds from additional financings or other sources for the Sweetwater project and our other business activities. If we do not receive these funds, we would need to reduce, delay or eliminate some of our expenditures, including those for the Sweetwater project.
We have expended and will continue to expend a substantial amount of funds to continue the research and development of our technologies, to market the Syntroleum Process and to design and construct GTL plants. We intend to finance the Sweetwater plant primarily through non-recourse debt financing at the project level, as well as equity financing, and plan to obtain additional funds for our GTL plant projects primarily through a combination of equity and debt project financing. We also intend to obtain additional funds through collaborative or other arrangements with strategic partners and others and debt and equity financing in the capital markets. Financing may not be available when needed or on terms acceptable or favorable to us. In addition, we expect that definitive agreements with equity and debt participants in the Sweetwater project and our other capital projects will include conditions to funding, many of which could be outside of our control. If adequate funds are not available, we would be required to delay or to eliminate expenditures for the Sweetwater project and may be required to reduce, delay or eliminate expenditures for our other capital projects, research and development, and other activities. We could also be forced to license to third parties the rights to commercialize additional products or technologies that we would otherwise seek to develop ourselves. If we obtain additional funds by issuing equity securities, dilution to stockholders may occur. In addition, preferred stock could be issued in the future without stockholder approval and the terms of our preferred stock could include dividend, liquidation, conversion, voting and other rights that are more favorable than the rights of the holders of our common stock.
Assuming the commercial success of the plants based on the Syntroleum Process, we expect that license fees, catalyst sales and sales of specialty products from GTL plants in which we own an interest will be a source of funds for operations. However, we may not receive any of these revenues, and these revenues may not be sufficient for capital expenditures or operations and may not be received within expected time frames. If we are unable to generate funds from operations, our need to obtain funds through financing activities will be increased.
The construction of the Sweetwater plant and other GTL plants based on the Syntroleum Process will be subject to the risks of delay and cost overruns inherent in any large construction project.
The construction of GTL plants based on the Syntroleum Process, including the Sweetwater plant currently under development in Western Australia, will be subject to the risks of delay or cost overruns inherent in any large construction project resulting from numerous factors, including the following:
. shortages of equipment, materials or skilled labor,
. unscheduled delays in the delivery of ordered materials and equipment,
. engineering problems, including those relating to the commissioning of newly designed equipment,
. work stoppages,
. weather interference,
. unanticipated cost increases, and
. difficulty in obtaining necessary permits or approvals.
We have incurred losses and anticipate continued losses.
As of December 31, 2001, we had an accumulated deficit of $99 million. We have not yet achieved profitability and expect to continue to incur net losses until we recognize sufficient revenues from licensing activities, GTL plants or other sources. Because we do not have an operating history upon which an evaluation of our prospects can be based, our prospects must be considered in light of the risks, expenses and difficulties frequently encountered by small companies seeking to develop new and rapidly evolving technologies. To address these risks, we must, among other things, continue to attract investment capital, respond to competitive factors, continue to attract, retain and motivate qualified personnel and commercialize and continue to upgrade our GTL technologies. We may not be successful in addressing these risks. We cannot assure you that we will achieve or sustain profitability.
Our anticipated expense levels are based in part on our expectations as to future operating activities and not on historical financial data. We plan to continue to fund research and development and project development activities. Capital expenditures will depend on the progress we make in developing various GTL projects on which we are currently working. Increased revenues or cash flows may not result from these expenses.
The economic application of GTL plants based on the Syntroleum Process depends on favorable crude oil prices and other commodity prices.
Our belief that the Syntroleum Process can be cost effective at GTL plants with throughput levels under 10,000 to over 100,000 barrels per day is based on our assumption that oil prices in the range of at least $15 to $20 per barrel will prevail. However, the markets for oil and natural gas have historically been very volatile and are likely to continue to be very volatile in the future. Although world crude oil prices were approximately $18 per barrel in December 2001, during 1998 crude oil prices fell to historically low levels of below $10 per barrel for a period of time and could return to low levels in the future.
Because the synthetic crude oil, liquid fuels and specialty products that GTL plants based on the Syntroleum Process are expected to produce will compete in markets with oil and refined petroleum products, and because natural gas will be used as the feedstock at these GTL plants, an increase in natural gas prices relative to prices for oil and refined products, or a decrease in prices for oil and refined products, could adversely affect the operating results of these plants. Higher than anticipated costs for the catalysts and other materials used in these plants could also adversely affect operating results. Factors that could cause changes in the prices and availability of oil, natural gas and refined products include:
. the level of consumer product demand,
. weather conditions,
. domestic and foreign government regulation,
. the actions of the Organization of Petroleum Exporting Countries,
. political conditions in oil and natural gas producing countries,
. the supply of foreign crude oil and natural gas,
. the location of GTL plants relative to natural gas reserves and pipelines,
. the capacities of pipelines,
. fluctuations in seasonal demand, and
. the price and availability of alternative fuels and overall economic conditions.
We cannot predict the future markets and prices for oil, natural gas, or other materials used in the Syntroleum Process or refined products.
The economic application of GTL plants based on the Syntroleum Process depends on favorable plant operating conditions.
The economic application of GTL technology depends on favorable plant operating conditions. Among the operating conditions that impact plant economics are the site location, infrastructure, weather conditions, the size of the equipment, the quality of the natural gas feedstock, the type of plant products and whether the natural gas converted by the plant is associated with oil reserves. For example, if a plant were located in an area that requires the construction of substantial infrastructure, plant economics would be adversely affected. In addition, plants that are not designed to produce specialty products or other high margin products and plants that are not used to convert natural gas that is associated with oil reserves will be more dependent on favorable natural gas and oil prices than plants designed for those uses. We do not expect these plants to be cost-effective at price levels below the range of at least $15 to $20 per barrel for oil.
GTL plants will depend on the availability of natural gas at economic prices, and alternative uses of natural gas could be preferred in many circumstances.
The construction and operation of GTL plants will depend on the availability of natural gas at economic prices. The market for natural gas is highly competitive in many areas of the world, and in many circumstances, the sale of natural gas for use as a feedstock in a GTL plant will not be the highest value market for the owner of the natural gas. The cryogenic conversion of natural gas to liquefied natural gas may compete with our GTL plants for use of natural gas as feedstocks in many locations. Local commercial, residential and industrial consumer markets, power generation, ammonia, methanol and petrochemicals are also alternative markets for natural gas. Unlike us, many of our competitors also produce or have access to large volumes of natural gas, which may be used in connection with their GTL operations. The availability of natural gas at economic prices for use as a feedstock for GTL plants may also depend on the production costs for the gas and whether natural gas pipelines are located in the areas where these plants are located. New pipelines may be built in, or existing pipelines may be expanded into, areas where GTL plants are built, and this may affect the operating margins of these plants as other markets compete for the available natural gas. The United States and Western Europe have well-developed natural gas markets. In these markets, the relationship between natural gas prices and liquid hydrocarbon prices would likely make investments in GTL plants that produce fuels uneconomic based upon current natural gas and refined product prices, as well as other market, environmental and regulatory conditions. Other areas around the world that have developed local markets for natural gas may also have higher valued uses for natural gas than as feedstocks for GTL plants. In addition, the commercialization of GTL technologies may have an adverse effect on the availability of natural gas at economic prices.
Our receipt of license fees depends on substantial efforts by our licensees, and our licensees could choose not to construct a GTL plant based on the Syntroleum Process or to pursue alternative GTL technologies.
Our licensees will control whether we issue any plant site licenses and, as a result, whether we receive any additional license fees under our license agreements. To date, no licensee of the Syntroleum Process has exercised its right to obtain a site license. Under most circumstances, a licensee will need to undertake substantial activities and investments before we issue any plant site licenses and receive license fees. These activities may include performing feasibility studies, obtaining regulatory approvals and permits, obtaining preliminary cost estimates and final design and engineering for the plant, obtaining a sufficient dedicated supply of natural gas, obtaining adequate commitments for the purchase of the plant's products and obtaining financing for construction of the plant. A licensee will control the amount and timing of resources devoted to these activities. Whether licensees are willing to expend the resources
necessary to construct GTL plants will depend on a variety of factors outside our control, including the prevailing view of prices for crude oil, natural gas and refined products. In addition, our license agreements may be terminated by the licensee, with or without cause, upon 90 days' notice to us. If we do not receive payments under our license agreements, we may not have sufficient resources to implement our business strategy. Our licensees are not restricted from pursuing alternative GTL technologies on their own or in collaboration with others, including our competitors.
Our success depends on the performance of our executive officers, the loss of whom would disrupt our business operations.
We depend to a large extent on the performance of our executive officers, including Kenneth L. Agee, our founder, Chief Executive Officer and Chairman of the Board and inventor with respect to many of our patents and patent applications, and Mark A. Agee, our President and Chief Operating Officer. Given the technological nature of our business, we also depend on our scientific and technical personnel. Our efforts to develop and commercialize our technology have placed a significant strain on our scientific and technical personnel, as well as our operational and administrative resources. Our ability to implement our business strategy may be constrained, and the timing of implementation may be impacted, if we are unable to attract and retain sufficient personnel. At March 1, 2002, we had 125 full-time employees. Except for a $500,000 life insurance policy held by us on the life of Kenneth L. Agee, we do not maintain "key person" life insurance policies on any of our employees.
We depend on strategic relationships with manufacturing and engineering companies. If these companies fail to provide necessary components or services, this could negatively impact our business.
We intend to, and believe our licensees will, utilize third party component manufacturers in the design and construction of GTL plants based on the Syntroleum Process. If any third party manufacturer is unable to acquire raw materials or to provide components of GTL plants based on the Syntroleum Process in commercial quantities in a timely manner and within specifications, we or our licensees could experience material delays, or construction plans could be canceled, while alternative suppliers or manufacturers are identified and prepare for production. We have no experience in manufacturing and do not have any manufacturing facilities. Consequently, we will depend on third parties to manufacture components of GTL plants based on the Syntroleum Process. We have conducted development activities with third parties relating to our proprietary catalysts and turbines that may be used in the Syntroleum Process, and other manufacturing companies may not have the same expertise as these companies.
We also intend to utilize third parties to provide engineering services in connection with our efforts to commercialize the Syntroleum Process. If these engineering firms are unable to provide requisite services or performance guarantees, we or our licensees could experience material delays, or construction plans could be canceled, while alternative engineering firms are identified and become familiar with the Syntroleum Process. We have limited experience in providing engineering services and have a limited engineering staff. Consequently, we will depend on third parties to provide necessary engineering services, and these firms may be asked by licensees or financial participants in plants to provide performance guarantees in connection with the design and construction of GTL plants based on the Syntroleum Process.
Our operating results may be volatile due to a variety of factors and are not a meaningful indicator of future performance.
We expect to experience significant fluctuations in future annual and quarterly operating results because of the unpredictability of many factors that impact our business. These factors include:
. timing of any construction by us or our licensees of GTL plants,
. demand for licenses of the Syntroleum Process and receipt and revenue recognition of license fees,
. oil and gas prices,
. timing and amount of research and development expenditures,
. demand for synthetic fuels and specialty products,
. introduction or enhancement of GTL technologies by us and our competitors,
. market acceptance of new technologies, and
. general economic conditions.
As a result, we believe that period-to-period comparisons of our results of operations are not meaningful and should not be relied upon as any indication of future performance. Due to all of the foregoing factors, it may be that in some future year or quarter our operating results will be below the expectations of public market analysts and investors. In that event, the price of our common stock would likely be materially adversely affected.
We are subject to extensive laws relating to the protection of the environment, and these laws may increase the cost of designing, constructing and operating our GTL plants.
If we violate any of the laws and regulations relating to the protection of the environment, we may be subject to substantial fines, criminal sanctions or third party lawsuits and may be required to install costly pollution control equipment or, in some extreme cases, curtail operations. Our GTL plants will generally be required to obtain permits under applicable environmental laws and various permits for industrial siting and construction. Compliance with environmental laws and regulations, and any requisite environmental or construction permits, may increase the costs of designing, constructing and operating our GTL plants. We may also face exposure to actual or potential claims and lawsuits involving environmental matters with respect to our current real estate inventory as well as previously owned real estate.
We plan to construct GTL plants in foreign countries, where we would be subject to risks of a political nature and other risks inherent in foreign operations.
We plan to construct GTL plants in foreign countries, where we would be subject to risks of a political nature and other risks inherent in foreign operations. These risks include changes in domestic and foreign taxation, currency exchange risks, labor disputes and uncertain political and economic environments as well as risk of war, terrorism, civil disturbances or other events that could limit or disrupt production and markets or result in the deprivation of contract rights or the taking of property by nationalization or appropriation without fair compensation. International operations and investments may also be adversely affected by laws and policies of the United States affecting foreign trade, investment and taxation, which could affect the conduct or profitability of these operations.
Recent terrorist attacks and United States military action could result in a material adverse effect on our business.
On September 11, 2001, the United States was the target of terrorist attacks of unprecedented scope. In October 2001, the United States commenced military action in Afghanistan in response to these attacks. Military action by the United States may continue indefinitely and may escalate and armed hostilities may begin or escalate in other countries. Further acts of terrorism in the United States or elsewhere may occur. These developments have caused instability in the world's financial and insurance markets and will likely significantly increase political and economic instability in the geographic areas in which we may wish to operate. In addition, these developments could lead to increased volatility in prices for crude oil and natural gas.
Following the terrorist attacks on September 11, 2001, insurance underwriters increased insurance premiums charged for many coverages and issued general notices of cancellations to their customers for war risk, terrorism and political risk insurance in respect of a wide variety of insurance coverages. Insurance premiums could be increased further or coverages may be unavailable in the future.
United States government regulations effectively preclude us from actively engaging in business activities in certain countries. These regulations could be amended to cover countries where we may wish to operate in the future. These developments could subject the operations of our company to increased risks and, depending on their magnitude, could have a material adverse effect on our business.
Sufficient markets for the synthetic products of the Syntroleum Process or products that utilize these synthetic products, including fuel cells, may never develop or may take longer to develop than we anticipate.
Sufficient markets may never develop for the synthetic products of the Syntroleum Process, or may develop more slowly than we anticipate. The development of sufficient markets for the synthetic products of the Syntroleum Process may be affected by many factors, some of which are out of our control, including:
. the cost competitiveness of the synthetic products of the Syntroleum Process,
. consumer reluctance to try a new product,
. environmental, safety and regulatory requirements, and
. the emergence of more competitive products.
In addition, a new market may fail to develop for products that utilize our synthetic products. For example, the establishment of a market for the use of these products as fuel for fuel cells is uncertain, in part because fuel cells represent an emerging market, and we do not know whether distributors will want to sell them or if end-users will want to use them.
If sufficient markets fail to develop or develop more slowly than we anticipate, we may be unable to recover the losses we will have incurred in the development of our technology and may never achieve profitability.
ITEM 2.
ITEM 2. PROPERTIES
We own and operate a nominal two barrel-per-day pilot plant located on two acres leased in Tulsa, Oklahoma. We also lease 4,500 square feet of laboratory and office space and approximately 37,000 square feet of executive office space in Tulsa, Oklahoma. In addition, we own a 16,500 square foot laboratory facility located on approximately 100 acres of property in Tulsa, Oklahoma.
We lease approximately 10 acres of land at the Port of Catoosa near Tulsa, Oklahoma on which we intend to construct a 70 barrel per day GTL demonstration plant as part of our clean fuels project with the DOE. The primary term of the lease is ten years and the rent is $3,250 per month.
Our real estate assets are described under "Item 1. Business-Management and Disposition of Real Estate and Miscellaneous Assets."
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
We are not a party to, nor are any of our properties the subject of, any pending legal proceedings that, in the opinion of management, are expected to have a material adverse effect on our consolidated results of operations or financial position.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
EXECUTIVE OFFICERS OF THE REGISTRANT
The following table sets forth certain information concerning our executive officers as of May 1, 2002. Unless otherwise indicated, each of our executive officers has served in the indicated positions since the closing of the merger of Syntroleum Corporation and SLH Corporation on August 7, 1998 and served in the same position with Syntroleum Corporation before the merger. References to positions held with our company before the date of the merger refer to positions held with our predecessor company, Syntroleum Corporation, an Oklahoma corporation.
Kenneth L. Agee is our Chief Executive Officer and Chairman of the Board. Mr. Kenneth L. Agee founded our company in 1984 and initially served as President and a director. He became Chief Executive Officer in February 1996 and Chairman of the Board in November 1995. He is a graduate of Oklahoma State University with a degree in Chemical Engineering and is a licensed Professional Engineer in the State of Oklahoma. In addition, he has over 15 years of experience in the energy industry and is listed as Inventor on several United States and foreign patents and several pending patent applications, all of which have been assigned to us by Mr. Agee.
Mark A. Agee is our President, Chief Operating Officer and a director. Mr. Mark A. Agee joined our company in 1994 as Vice President of Finance and became President and Chief Operating Officer in February 1996. He has served as a director since March 1985. From 1989 to May 1993, he served as President, Chief Executive Officer and Director of Convergent Communications, a company which he founded in 1989 and sold in 1993. From 1981 to 1989, he served as President, Chief Executive Officer and a Director of XETA Corp., a computer company which he founded in 1981 and which became public in 1987. He holds a Bachelor's degree in Chemical Engineering from the University of Tulsa and is a licensed Professional Engineer in the State of Oklahoma.
Charles A. Bayens is our Vice President of Engineering. Mr. Bayens joined our company in July 1997 as Business Development Manager and became Vice President of Engineering in December 1997. Prior to joining our company, Mr. Bayens was with Shell Oil Company from 1967 to 1997 in various technical and business assignments. From 1991 to 1997, he was President of Shell Synthetic Fuels, Inc., where he managed the commercialization of Shell's suite of synfuels technologies. Concurrently, from 1991 to 1994, he was also Manager, Technology Licensing for Shell. Mr. Bayens holds a Ph.D. in Chemical Engineering from Johns Hopkins University.
Carla S. Covey is our Controller. Ms. Covey became our Director of Accounting in June 1997. Prior to joining our company, Ms. Covey served as Accounting Manager/Human Resource Manager and Manager, Facility Operations for AGC Manufacturing Services, Inc., in Tulsa, Oklahoma from 1995 to 1997. Ms. Covey also served as Assistant Director of Human Resources for the Adam's Mark Hotel in Tulsa, Oklahoma from 1994 to 1995. Ms. Covey received her B.A. degree in Business Administration from Drury University and her M.S. degree in Management from Southern Nazarene University. Ms. Covey has also completed the Harvard Business School's Executive Management Program in Financial Engineering. Ms. Covey is a certified public accountant.
Eric Grimshaw is our Vice President, General Counsel and Secretary. Prior to joining our company in June 1997, Mr. Grimshaw was a partner with the law firm of Pray, Walker, Jackman, Williamson & Marlar. Mr. Grimshaw received a B.A. degree from the University of Colorado and received his law degree from the University of Tulsa.
Paul F. Schubert is our Vice President of Research and Development. Dr. Schubert joined us as Research Project Manager in May 1998. From 1996 to 1998, Dr. Schubert was Vice President of Monitor Labs, Denver, Colorado, where he was responsible for the research, development and marketing of catalytic and laser-based air emissions monitoring devices. From 1990 until 1996, Dr. Schubert served in a variety of roles with Catalytica, Inc. (Mountain View, California), a company engaged in research and development of catalytic processes. In his last few years at Catalytica, he served as Vice President of their Advanced Sensor Devices Division, which was sold to Monitor Labs in 1996. Prior to joining Catalytica, Dr. Schubert worked with Phillips Petroleum and Englehard Corporation in research, development and manufacturing of catalysts for the petrochemical industry. Dr. Schubert received a B.S. with High Honors from the University of Arkansas and a Ph.D. in Inorganic Chemistry from the University of Illinois at Urbana-Champaign. He is an inventor or co-inventor of 13 U.S. patents, and has authored over two dozen technical publications.
Michael L. Stewart is our Vice President of Information Systems and has served in that position since November 1998. Mr. Stewart joined our company in May 1997 as information technology manager, bringing over 23 years of computer and information systems related experience. From 1993 until joining us, he was a management consultant involved in data processing, systems operation, planning and organization. Earlier, he held the positions of Vice President--Management Information Services for Convergent Communications, Inc., and database design specialist for Continental Savings and Loan.
Randall M. Thompson is our Vice President and Chief Financial Officer. Mr. Thompson joined our company in January 1997. From January 1994 through December 1996, he held various financial and marketing positions with Tenneco Energy Corporation, as Vice President of Strategic Planning, Vice President of Marketing and Vice President of Business Development. From 1983 through 1994, Mr. Thompson was employed by Atlantic
Richfield Company and held financial management positions. Mr. Thompson holds a B.A. in Economics from the University of Colorado and an M.B.A. from The Wharton School at the University of Pennsylvania.
Larry J. Weick is our Vice President of Licensing and Business Development. Mr. Weick joined our company in 1996. From 1971 to 1982, he held positions in engineering, planning and project development in the natural gas and electric utility industry. From 1982 to 1994, he held several finance, planning and business development positions with Atlantic Richfield Company. From 1994 to 1996, Mr. Weick served as a consultant to us. He holds a B.S. in Electrical Engineering from the University of Nebraska at Lincoln and an M.S. in Engineering-Economics from Stanford University. Mr. Weick is also a Licensed Professional Engineer in both Nebraska and Texas.
There are no family relations, of first cousin or closer, among our executive officers, by blood, marriage or adoption, except that Mr. Kenneth L. Agee and Mr. Mark A. Agee are brothers.
Part II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Stock Prices. Our common stock is traded on the National Market System of the Nasdaq Stock Market under the symbol "SYNM." The table below reflects the high and low sales prices for the common stock for each quarter during 2000 and 2001.
Sales Price ----------- ------- ------- High Low ------- ------- Year Ended December 31, 2000: First Quarter 26.38 7.13 Second Quarter 26.50 16.38 Third Quarter 20.81 12.88 Fourth Quarter 20.81 11.81
High Low ------- ------- Year Ended December 31, 2001: First Quarter 16.75 11.13 Second Quarter 14.74 7.00 Third Quarter 8.75 3.62 Fourth Quarter 7.25 4.10
Record Holders. As of March 1, 2002, we had approximately 1,390 record holders of our common stock (including brokerage firms and other nominees).
Dividends. Cash dividends have not been paid since inception. We currently intend to retain any earnings for the future operation and development of our business and do not currently anticipate paying any dividends in the foreseeable future. Any future determination as to dividend policy will be made, subject to Delaware law, in the discretion of our board of directors and will depend on a number of factors, including our future earnings, capital requirements, financial condition and business prospects and other factors that our board of directors may deem relevant. Although we are not currently a party to any agreement that restricts dividend payments, future dividends may be restricted by our then-existing financing arrangements. See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations-Liquidity and Capital Resources."
Our stock price may continue to be volatile and could decline in the future. Historically, the market price of our common stock has been very volatile. The trading price of our common stock is expected to continue to be subject to substantial volatility in response to numerous factors, including publicity regarding actual or potential results with respect to development of the Syntroleum Process and design, construction and commercial operation of plants using our process, announcements of technological innovations by others with competing GTL processes, developments concerning intellectual property rights, including claims of infringement, annual and quarterly variances in operating results, changes in energy prices, competition, changes in financial estimates by securities analysts, any differences in actual results and results expected by investors and analysts, investor perception of our favorable or unfavorable prospects and other events or factors. In addition, the stock market has experienced and
continues to experience significant price and volume volatility that has affected the market price of equity securities of many companies. This volatility has often been unrelated to the operating performance of those companies. These broad market fluctuations may adversely affect the market price of our common stock. There is no guarantee that an active public market for our common stock will be sustained.
Future sales of our common stock could adversely affect our stock price. Substantial sales of our common stock in the public market, or the perception by the market that those sales could occur, could lower our stock price or make it difficult for us to raise additional equity capital in the future. These sales could include sales of shares of our common stock by our directors and officers, who beneficially owned approximately 41.1% of the outstanding shares of our common stock as of March 1, 2002. We cannot predict if future sales of our common stock, or the availability of our common stock for sale, will harm the market price for our common stock or our ability to raise capital by offering equity securities.
REGISTRATION STATEMENT
In early 2000 we filed a Registration Statement on Form S-3 (Registration No. 333-32968), as amended (the "Registration Statement"), in connection with the registration of shares of our common stock with an aggregate offering price of up to $120,000,000. The Securities and Exchange Commission declared the Registration Statement effective on April 25, 2000. As described in a prospectus supplement dated June 29, 2000, an offering commended on June 29, 2000 pursuant to the Registration Statement, and resulted in (i) the sale by us of 5,250,000 shares of common stock on July 6, 2000 and (ii) the sale by us of 400,000 shares of common stock on July 19, 2000 pursuant to the exercise of the underwriters' over-allotment option.
The net proceeds to us from the offering were approximately $92 million. To date, we have used approximately $48 million in such net proceeds for the development of our Sweetwater project. The remaining net proceeds from the offering are currently invested in short-term cash and cash equivalents. None of such payments were direct or indirect payments to our directors or officers or their associates, to persons owning ten percent or more of any class of our equity securities or to our affiliates.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following selected financial information should be read in conjunction with "Item 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
OVERVIEW
We are incurring costs with respect to developing and commercializing the Syntroleum Process and do not anticipate recognizing any significant revenues from licensing our technology or from production from either a fuel or specialty plant in the near future. As a result, we expect to continue to operate at a loss unless and until sufficient revenues are recognized from licensing activities, gas-to-liquids plants or real estate sales.
OPERATING REVENUES
During the periods discussed below, our revenues were primarily generated from the following:
. sales of real estate holdings owned by SLH Corporation prior to the merger of Syntroleum Corporation and SLH Corporation,
. reimbursement for research and development activities associated with the Syntroleum Process, and
. other sources, including rent generated by real estate holdings owned by SLH prior to the merger.
. Because substantially all of our real estate portfolio has been sold, we expect to receive lower levels of revenues from these sources in future periods.
. In the future, we expect to receive revenue relating to the Syntroleum Process from four principal sources:
. licensing,
. catalyst sales,
. sales of products from or fees for the use of GTL plants in which we own an equity interest, and
. revenues from research and development activities carried out with industry partners.
Until the commencement of commercial operation of GTL plants in which we own an interest, we expect that cash flow relating to the Syntroleum Process will consist primarily of license fee deposits, site license fees and revenues associated with joint development activities. We will not receive any cash flow from GTL plants in which we own an equity interest until the first of these plants is constructed. Our future operating revenues will depend on the successful commercial construction and operation of GTL plants based on the Syntroleum Process, the success of competing GTL technologies and other competing uses for natural gas. We expect our results of operations and cash
flows to be affected by changing crude oil, fuel and specialty product prices. If the price of these products increases (decreases), there could be a corresponding increase (decrease) in operating revenues.
License Revenues. The revenue earned from licensing the Syntroleum Process is expected to be generated through four types of contracts: master license agreements, volume license agreements, regional license agreements and site license agreements. Master, volume and regional license agreements provide the licensee with the right to enter into site license agreements for individual GTL plants. A master license agreement grants broad geographic and volume rights, while volume license agreements limit the total production capacity of all GTL plants constructed under the agreement to specified amounts, and regional license agreements limit the geographical rights of the licensee. Master, volume and regional license agreements require an up-front cash deposit that may offset or partially offset license fees for future plants payable under site licenses. In the past, we have acquired technologies or commitments of funds for joint development activities, services or other consideration in lieu of the initial cash deposit in cases where we believed the technologies or commitments had a greater value.
Our site license agreements currently require fees to be paid in increments when milestones during the plant design and construction process are achieved. The amount of the license fee under our existing master and volume license agreements is currently determined pursuant to a formula based on the present value of the product of: (1) the yearly maximum design capacity of the plant, (2) an assumed life of the plant and (3) our per barrel rate, which currently is approximately $.50 per barrel of daily capacity, regardless of plant capacity. Our licensee fees may change from time to time based on the size of the plant, improvements that reduce plant capital cost and competitive market conditions. Our existing master and volume license agreements allow for the adjustment of fees for new site licenses under certain circumstances. Our accounting policy is to defer all up-front deposits under master, volume and regional license agreements and license fees under site license agreements and recognize 50% of the deposits and fees as revenue in the period in which the engineering process design package for a plant licensed under the agreement is delivered and recognize the other 50% of the deposits and fees when the plant has passed applicable performance tests. The amount of license revenue we earn will be dependent on the construction of plants by licensees, as well as the number of licenses we sell in the future.
Catalyst Revenues. We expect to earn revenue from the sale of our proprietary catalysts to our licensees. Our license agreements currently require our catalyst to be used in the initial fill for the licensee to receive a process guarantee. After the initial fill, the licensee may use other catalyst vendors if appropriate catalysts are available. The price for catalysts purchased from us pursuant to license agreements is equal to our cost plus a specified margin. We will receive revenue from catalyst sales if and when our licensees purchase catalysts. We expect that catalysts will need to be replaced every three to five years.
GTL Plant Revenues. We intend to develop GTL plants and to retain significant equity interests in these plants. These plants will enable us to gain experience with the commercial operation of the Syntroleum Process and, if successful, are expected to provide ongoing revenues. The anticipated products of these plants (i.e., synthetic fuels, lube base oils, process oils, waxes, drilling fluid and liquid normal paraffins) have historically been sold at premium prices and are expected to result in relatively high sales margins. We anticipate forming joint ventures with energy industry and financial partners in order to finance and operate these plants. We anticipate that our GTL plants will include partners who have low-cost gas reserves in strategic locations and/or have distribution networks in place for the synthetic products to be made in each plant.
Joint Development Revenues. We continually conduct research and development activities in order to reduce the capital and operating costs of GTL plants based on the Syntroleum Process. We conduct our research and development activities primarily through two initiatives: (1) independent development utilizing our own resources and (2) formal joint development arrangements with our licensees and others. Through these joint development agreements, we may receive revenue as reimbursement for specified portions of our research and development or engineering expenses. Under some of these agreements, the joint development partner may receive credits against future license fees for monies expended on joint research and development.
Real Estate Sales Revenues. As of December 31, 2001, our real estate inventory consisted of land in Houston, Texas comprised of 255 acres of undeveloped land and 69 lots known as the "Houston Project." This real estate inventory was owned by SLH Corporation prior to the merger of Syntroleum Corporation and SLH Corporation and reflects the remaining assets of a real estate development business that was conducted by SLH's former parent corporation. Our total real estate inventory had an aggregate carrying value at December 31, 2001 of approximately $3.0 million. The Houston Project is being developed for commercial and residential use and ultimate sale. The timing of real estate sales will create variances in period-to-period earnings recognition. We do not intend to acquire additional real estate holdings for development and/or sale outside our core business interests, and real
estate sales revenues should decrease as the current real estate inventory is liquidated.
In February 2000, the Company sold its parking garage in Reno, Nevada to Fitzgeralds Reno, Inc. The sale price of $3 million was paid by $750,000 in cash and the balance in the form of a promissory note in the principal amount of $2,250,000 together with the assumption of the lease payments due under the ground lease. The note bears interest at the rate of 10% per annum and is payable in monthly installments of principal and interest based on a 20 year amortization, with the entire unpaid balance due in 10 years. The note is secured by a deed of trust covering the leasehold estate created by the ground lease on which the garage is located, as well as the parking garage and an assignment of leases. In December 2000, Fitzgeralds Reno, Inc., a Nevada corporation ("FRI") doing business as Fitzgeralds Hotel & Casino Reno, along with several affiliates, filed voluntary petitions for reorganization under Chapter 11 of the United States Bankruptcy Code in the United States Bankruptcy Court, District of Nevada. Fitzgeralds continues to make the monthly payments due on the note and the ground lease and has informed the Company that it intends to continue making these payments until Fitzgeralds is able to sell the parking garage. The Company's deed of trust contains a "due on sale" provision until the note is paid. After the note is paid, the Company's deed of trust remains in effect to secure Fitzgeralds' performance of its obligations under the ground lease and provides that any assignee of Fitzgeralds in the event of the sale of the parking garage must meet certain net worth requirements in order for Fitzgeralds to assign the ground lease.
OPERATING EXPENSES
Our operating expenses historically have consisted primarily of pilot plant, engineering, including third party engineering, and research and development expenses and general and administrative expenses, which include costs associated with general corporate overhead, compensation expense, legal and accounting expense and expenses associated with other related administrative functions.
Our policy is to expense pilot plant, engineering and research and development costs as incurred. All of these research and development expenses are associated with our development of the Syntroleum Process. Research and development expenses include costs to operate both our laboratory and technology center, salaries and wages associated with these operations, research and development services performed by universities, consultants and third parties and additional supplies and equipment needs for these facilities.
We have also recognized depreciation and amortization expense primarily related to office and computer equipment and patents. Our operating expenses have also included costs of real estate sold and real estate operating expense. Our general and administrative expenses have increased substantially as we have expanded our research and development, engineering and commercial activities, including staffing levels. We also expect to continue to incur pilot plant, engineering and research and development expenses as we continue to develop, improve and commercialize our GTL technology.
As a result of the completion of a substantial portion of the engineering and process/product testing associated with our Sweetwater project and in an effort to conserve working capital, we plan to decrease our operating expenses compared to prior years while continuing to fund our most critical research and development and project development activities.
If we are successful in developing a GTL plant in which we own an interest, we expect to incur significant expenses in connection with the start-up of the plant. For example, we expect that our expenses will increase at the time of commencement of construction of the Sweetwater plant. Upon the commencement of commercial operation of the Sweetwater plant, we will incur cost of sales expenses relating primarily to the cost of natural gas feedstocks for this plant and operating expenses relating to this plant, including labor, supplies and maintenance. Due to the substantial capital expenditures associated with the construction of GTL plants, we expect to incur significant depreciation and amortization expense in the future. Our policy is to expense costs associated with the development of GTL plants until financial close unless they have future economic value for future projects. Engineering costs are capitalized once an engineering contract leading to a firm lump sum price has been signed.
RESULTS OF OPERATIONS
Overview
Our primary research and development projects during 2001 related to the GTL technology we plan to use in the Sweetwater plant, including confirmation of catalyst performance and reactor designs. Of the $22 million
expenses for pilot plant, engineering and research and development during 2001, approximately $3.9 million directly related to the Sweetwater plant and $1.5 million related to our new pilot scale refining unit at our Technology Center in Tulsa, Oklahoma. Operation of this unit allowed us to complete a battery of confirmation tests and detailed engineering of our proposed Sweetwater plant relating to product properties and yields. In addition, an aggregate of $11.8 million of expenses incurred during 2001 related to salaries and wages, outside contract services, lab equipment and improvements and pilot plant and laboratory operating expenses, which primarily supported work on technology we plan to use in the Sweetwater plant. Another significant research and development project during 2001 related to technology associated with our moving bed reactor design, for which we incurred $2.6 million of directly related expense during 2001. We also incurred $2.1 million in relocation and preliminary engineering costs relating to our DOE clean fuels project.
During 2001, we entered into a letter of intent with Petroleum Geo-Services ASA (PGS) to form a joint venture to develop, market and operate mobile, marine-based production facilities that use the Syntroleum Process. If the transaction is completed, the joint venture is expected to be a separate operating company offering contract GTL services to gas producers to convert natural gas from offshore fields into synthetic hydrocarbon products. Under the letter of intent, the planned joint venture will have its initial operations in Aberdeen, Scotland and will be the exclusive means by which we and PGS offer mobile, marine-based contract GTL services to third parties. Formation of the joint venture is subject to negotiation and execution of definitive agreements by the parties. We cannot assure you that the joint venture will be formed or commence actual business operations.
During the third quarter of 2001, the U.S. Department of Energy (DOE) concluded an agreement with Integrated Concepts & Research Corporation (ICRC) to provide funding to a team of companies for the GTL Ultra-Clean Fuels Production and Demonstration Project for which preliminary approval was announced by us in October 2000. We are the prime subcontractor for this project. Under the terms of the agreement, the DOE will fund $16 million of the $36 million project, and the other project participants will provide the remaining $20 million. We are currently in discussions with Marathon Oil Company regarding its participation in this project. Under the program, Syntroleum's Cherry Point GTL facility which has been disassembled and will be relocated from ARCO's Cherry Point Refinery in Washington State to a site near Tulsa, Oklahoma, is expected to become the basis for construction of a new GTL facility expected to produce up to approximately 70 barrels per day of Syntroleum ultra-clean diesel fuel and synthetic naphtha. Construction for the project is currently expected to begin in 2002, with fuel production expected to commence in early 2003. The fuels from this facility are expected to be tested by other project participants in advanced power train and emission control technologies and are also expected to be tested in bus fleets by the Washington Metropolitan Area Transit Authority and the U.S. National Park Service at Denali National Park in Alaska. Completion of the project is subject to continued congressional appropriation of project funds as well as our ability to attract the remaining necessary funds not otherwise provided by the DOE. In addition, construction of this project will be subject to the risks of delay inherent in any large construction project.
During the fourth quarter of 2001 we announced plans to develop an integrated NGL/GTL (natural gas liquids/gas-to-liquids) project in the Talara Basin of Northwest Peru. We expect to develop this project in three phases. Phase I is expected to consist of construction of a nominal 2,000 barrel per day NGL plant to upgrade and replace an existing plant. Phase II is expected to involve the expansion of the NGL plant and the construction of a 5,000 barrel per day GTL plant. Phase III is expected to involve expansion of the GTL facility as additional natural gas reserves and production in the area are developed. In connection with this proposed project, we signed a license contract with the government of Peru under which we have acquired exploration and production rights to the offshore Peruvian oil and gas block designated as Z-1. Previous exploration activity in the area has identified possible gas and condensate reserves, which, up to now, have remained undeveloped due to lack of an adequate market for the gas. It is anticipated that development of these reserves would facilitate the third phase of the Talara project. We expect to partner with an experienced oil and gas exploration and production company with respect to any exploration activity we may engage in on the Z-1 block. Under the terms of the Z-1 block license contract we have provided a letter of credit in the amount of $300,000 to secure a performance bond issued to secure our work program obligations during the first two years of the license contract. The amount of the performance bond will increase in subsequent periods of the work program. During 2002, we expect to spend approximately $1,000,000 in our efforts to develop the Talara project. Completion of the Talara project is subject to satisfaction of several conditions including negotiation and execution of definitive gas purchase agreements and engineering, procurement and construction agreements and other agreements, site acquisition and financing. We cannot assure you that this project will commence actual operations. In addition, this project will be subject to the risks of delay inherent in any large construction project.
During the first quarter of 2002, we announced that Congress had appropriated $3.5 million for a proposed Flexible JP-8 (single battlefield fuel) Pilot Plant program under the Department of Defense Appropriation Bill, 2002.
We expect to negotiate a contract with the DOD to participate in the program, which will provide for the design of a marine-based fuel-production plant, as well as testing of synthetically-made (gas-to-liquids) JP-8 fuel in military diesel and turbine engine applications. We cannot assure you that we will be successful in concluding a contract with DOD to participate in this program.
2001 Compared to 2000
Joint Development Revenue. Revenues from our joint research and development and pilot plant operations were $2,239,000 in 2001, up $1,073,000 from 2000 when they were $1,166,000. The increase was primarily due to joint development efforts related to our DOE project and feasibility studies for our licensees and prospective licensees.
Real Estate Sales Revenue. Revenues from the sale of real estate were $4,484,000 in 2001, down $274,000 from $4,758,000 in 2000. The decrease was due to the sale of our Powder Basin Partnership and the sale of 125 lots from our Houston project in 2001, compared to the sale of our Reno parking garage and the sale of 82 lots from our Houston Project during 2000. Real estate sales revenues should continue to decrease as the remaining real estate inventory is sold.
Licensing Revenue. Revenues from license activities were zero in 2001 compared to $2,000,000 in 2000. This decrease was a result of our recognition of $2 million in previously deferred license revenue as a result of the expiration of an option held by a licensee to expand the licensee's licensed territory during 2000.
Other Revenue. Other revenues were $2,000 in 2001, down $82,000 from 2000 when they were $84,000. The decrease resulted primarily from the lower parking and retail rentals from our parking garage in Reno, Nevada, which we sold in February 2000.
Cost of Real Estate Sold and Real Estate Operating Expense. The cost of real estate sold was $1,447,000 in 2001, down $2,199,000 from $3,646,000 in 2000. The decrease resulted from the sale of our Powder Basin Partnership and the sale of 125 lots from our Houston project during 2001, compared to the sale of our Reno parking garage and the sale of 82 lots from our Houston Project during 2000. Real estate operating expense was $116,000 during 2001, down $134,000 from $250,000 in 2000. This decrease was the result of decreased costs associated with the parking and retail operation of the Reno garage.
Pilot Plant, Engineering and R&D. Expenses from pilot plant, engineering and research and development activities were $21,908,000 in 2001, up $3,388,000 from 2000 when these expenses were $18,520,000. The increase was primarily the result of the continued expansion of our Tulsa, Oklahoma pilot plant facility, the construction of a product upgrading pilot plant at our technology center, higher research and development spending and higher consulting expense associated with the design and engineering of the Sweetwater plant.
General and Administrative Expense. General and administrative expenses were $17,301,000 in 2001, up $4,183,000 from 2000 when these expenses were $13,118,000. The increase is attributable primarily to higher wages and salaries resulting from our higher staffing levels, higher rent expense and higher expense for outside consultants and advisors.
Investment, Interest and Other Income. Investment, interest and other income decreased to $4,219,000 in 2001, down $625,000 from 2000 when this income was $4,844,000. The decrease was primarily attributable to lower cash balances and lower interest rates and foreign currency exchange gains.
Provision for Income Taxes. Income tax expense was $472,000 in 2001 down from $2,486,000 in 2000. This tax expense is an Australian withholding tax on payments made to the Company by the Commonwealth of Australia under our license and loan agreements with the Commonwealth. We expect to incur similar withholding tax expense with respect to any future payments to the Company by the Commonwealth under either of these agreements. We incurred a loss in both 2001 and 2000 and did not recognize an income tax benefit for such loss.
Net Income (Loss). In 2001, we experienced a loss of $30,300,000. The loss was $5,132,000 higher than 2000 when we experienced a loss of $25,168,000. The increase in the loss is a result of the factors described above.
2000 Compared to 1999
Joint Development Revenue. Revenues from our joint research and development and pilot plant operations
were $1,166,000 in 2000, down $820,000 from 1999 when they were $1,986,000. The decrease was primarily due to reduced funding received under our joint development agreement with ARCO relating to the construction of the pilot plant at ARCO's Cherry Point refinery in Washington. Construction of this pilot plant was completed in 1999 and we continued to receive funding for the operation of this pilot plant through June 2000. Testing was completed and the plant was shut down in early July 2000.
Real Estate Sales Revenue. Revenues from the sale of real estate were $4,758,000 in 2000, up $3,539,000 from $1,219,000 in 1999. The increase was due to the sale of our Reno parking garage and the sale of 82 lots from our Houston Project during 2000, compared to our sale of the Santa Rosa land in Kansas City and the sale of 38 lots from our Houston project during 1999. Real estate sales revenues should continue to decrease as the remaining real estate inventory is sold.
Licensing Revenue. Revenues from license activities were $2,000,000 in 2000 compared to zero in 1999. This increase was a result of our recognition of $2 million in previously deferred license revenue as a result of the expiration of an option held by a licensee to expand the licensee's licensed territory.
Other Revenue. Other revenues were $84,000 in 2000, down $566,000 from 1999 when they were $650,000. The decrease resulted primarily from the lower parking and retail rentals from our parking garage in Reno, Nevada, which we sold in February 2000.
Cost of Real Estate Sold and Real Estate Operating Expense. The cost of real estate sold was $3,646,000 in 2000, up $2,822,000 from $824,000 in 1999. The increase resulted from the sale of our Reno parking garage and the sale of 82 lots from our Houston Project during 2000 compared to our sale of the Santa Rosa land in Kansas City and the sale of 38 lots from our Houston project during 1999. Real estate operating expense was $250,000 during 2000, down $531,000 from $781,000 in 1999. This decrease was the result of decreased costs associated with the parking and retail operation of the Reno garage.
Pilot Plant, Engineering and R&D. Expenses from pilot plant, engineering and research and development activities were $18,520,000 in 2000, up $7,657,000 from 1999 when these expenses were $10,863,000. The increase was primarily the result of the continued expansion of our Tulsa, Oklahoma pilot plant facility, the construction of a product upgrading pilot plant at our technology center, higher research and development spending and higher consulting expense associated with the design and engineering of the Sweetwater plant.
General and Administrative Expense. General and administrative expenses were $13,118,000 in 2000, up $2,709,000 from 1999 when these expenses were $10,409,000. The increase is attributable primarily to higher wages and salaries resulting from our higher staffing levels, higher rent expense and higher expense for outside consultants and advisors.
Investment, Interest and Other Income. Investment, interest and other income increased to $4,844,000 in 2000, up $2,980,000 from 1999 when this income was $1,864,000. The increase was primarily attributable to higher interest income from increased cash balances and foreign currency exchange gains during 2000 compared to 1999.
Provision for Income Taxes. Income tax expense was $2,486,000 in 2000 up from zero in 1999. This tax expense is an Australian withholding tax on payments made to the Company by the Commonwealth of Australia under our license and loan agreements with the Commonwealth. We expect to incur similar withholding tax expense with respect to any future payments to the Company by the Commonwealth under either of these agreements. We incurred a loss in both 2000 and 1999 and did not recognize an income tax benefit for such loss.
Net Income (Loss). In 2000, we experienced a loss of $25,168,000. The loss was $8,010,000 higher than 1999 when we experienced a loss of $17,158,000. The increase in the loss is a result of the factors described above.
LIQUIDITY AND CAPITAL RESOURCES
General
As of December 31, 2001, we had $44,737,000 in cash and short-term investments and $4,428,000 in current liabilities. Our long-term debt as of December 31, 2001 was $1,190,000, and this debt matures in 2025. The long-term debt amount reflects cash loan proceeds received in under our loan agreement with the Commonwealth of Australia which are held in escrow (AUD $18 million which is approximately U.S. $9 million) and which are discounted over the remaining term of the loan using an imputed interest rate of nine percent. The difference
between the cash received and the discounted long-term debt amount of $1,190,000 has been recorded as a reduction in the costs of the related Sweetwater project. The long term debt amount reflected for these proceeds will, excluding the effect of currency exchange rate fluctuations, increase over time as the remaining term of the loan declines. Pending satisfaction of conditions relating to the financing, construction and completion of the Sweetwater plant, loan proceeds will be held in escrow. Should the conditions not be fully satisfied by August 2004, any loan proceeds remaining in escrow may be returned to the Commonwealth.
At December 31, 2001, we had $1,795,000 in accounts and notes receivable outstanding. During the third quarter of 2001, we sold our interest in the Powder Basin Partnership which owns a shopping center in Gillette, Wyoming, and we were released from our guaranty of partnership debt. The related security for our guaranty was likewise released. We also had $16,506,000 in restricted investments as of December 31, 2001 of which $16,206,000 are held in escrow representing funds received from the Commonwealth of Australia under our loan and license agreements with the Commonwealth and $300,000 is pledged as security for a $300,000 letter of credit issued in connection with the guaranteed work program under our license contract for the Z-1 block in Peru.
Cash flows provided by (used in) operations were ($34,184,000) in 2001 compared to $5,316,000 in 2000 and ($16,599,000) in 1999. This increase in cash flows used in operations was primarily the result of the receipt in 2000 of $27,520,000 in deferred revenue offset by the recognition in 2000 of $2,000,000 of previously deferred revenue. Cash flows used in operations also increased because of the sale of the Reno garage during 2000 offset by the sale of the Powder Basin Partnership during 2001. Cash flows used in investment activities were $4,275,000 in 2001 compared to $39,656,000 in 2000 and $4,094,000 in 1999. The decrease in 2001 resulted primarily from the decreased capitalized costs for our Sweetwater project and the decrease in restricted funds associated with the Commonwealth of Australia license and loan agreements.
Cash flows provided by (used in) financing activities were ($1,059,000) in 2001 compared to $97,539,000 in 2000 and $6,028,000 in 1999. The decrease in 2001 was primarily due to the completion of the sale of 5,650,000 shares of common stock pursuant to a public offering in which we received net proceeds of approximately $92,242,000 after the underwriting discount and offering expenses and the receipt of $757,000 in long-term debt under the Commonwealth of Australia loan agreement during 2000.
We have expended and will continue to expend a substantial amount of funds to continue the research and development of our GTL technologies, to market the Syntroleum Process and to design and construct GTL plants. We intend to finance the Sweetwater plant primarily through non-recourse debt financing at the project level, as well as equity financing, and plan to obtain additional funds for our other GTL plant projects primarily through a combination of equity and debt project financing. We also intend to obtain additional funds through collaborative or other arrangements with strategic partners and others and debt (including debt which is convertible into our common or preferred stock) and equity financing. We have an effective registration statement for the proposed offering from time to time of shares of our common stock, preferred stock, debt securities, depositary shares or warrants for an aggregate initial offering price of $250,000,000. We also intend to obtain additional funding through joint ventures, partnerships, license agreements and other strategic alliances, as well as various other financing arrangements. Definitive agreements with equity and debt participants in the Sweetwater project and our other capital projects are expected to include conditions to funding, many of which could be outside of our control. If adequate funds are not available, we may be required to delay or to eliminate expenditures for the Sweetwater project and our other capital projects, as well as our research and development and other activities or seek to enter into a business combination transaction with another company. We could also be forced to license to third parties the rights to commercialize additional products or technologies that we would otherwise seek to develop ourselves. If we obtain additional funds by issuing equity securities, dilution to stockholders may occur. In addition, preferred stock could be issued in the future without stockholder approval and the terms of our preferred stock could include dividend, liquidation, conversion, voting and other rights that are more favorable than the rights of the holders of our common stock. We can give no assurance that any of the transactions outlined above will be available to us when needed or on terms acceptable or favorable to us.
Assuming the commercial success of the plants based on the Syntroleum Process, we expect that license fees, catalyst sales and sales of specialty products from GTL plants in which we own an interest will be a source of funds for operations. However, we may not receive any of these revenues, and these revenues may not be sufficient for capital expenditures or operations and may not be received within the expected time frame. If we are unable to generate funds from operations, our need to obtain funds through financing activities will be increased.
We have sought and intend to continue to temporarily invest our assets, pending their use, so as to avoid becoming subject to the registration requirements of the Investment Company Act of 1940. These investments are
likely to result in lower yields on the funds invested than might be available in the securities market generally. If we were required to register as an investment company under the Investment Company Act, we would become subject to substantial regulation that would materially adversely affect us.
Initial Specialty Product GTL Plant
We are developing a nominal 11,500 barrel per day specialty product GTL plant in Australia that we call the Sweetwater plant. We currently anticipate that this plant will produce synthetic lube oil, normal paraffins, process oils and light paraffins. The plant will use a fixed tube reactor design which produces a high yield of the desired products with high wax content. The plant design has lower scale-up risks than other reactor designs and will include additional refining equipment necessary to produce the targeted specialty products. We plan to construct this plant through a joint venture with other parties who we expect will furnish a portion of the needed equity financing. After receiving a financial commitment from the Commonwealth of Australia, we selected a site for the plant about four kilometers from the North West Shelf liquid natural gas facility on the Burrup Peninsula of Western Australia. We have applied for and received most of the necessary permits for the plant.
We currently expect the capital costs of the Sweetwater plant to be funded primarily by non-recourse senior and subordinated debt at the project level, as well as equity financing from third parties, together with our own equity contribution. We are seeking third party equity participation in the project and to obtain debt financing to fund final design, construction, and start-up of the plant. However, we cannot assure you that we will obtain the necessary financing for this project.
The State of Western Australia has announced its intention to assist the Sweetwater project with an AUD $30 million (approximately U.S. $15 million) common use infrastructure package, including construction of a desalination plant to which the Sweetwater plant will supply steam and from which the plant will receive cooling water. In addition, we have entered into a gas purchase agreement with the North West Shelf Gas Partners, whose members include affiliates of BHP Petroleum, BP, Chevron, Mitsui, Mitsubishi, Royal Dutch Shell and Woodside Energy Ltd. Subject to certain conditions, North West Shelf Gas Partners have agreed to supply the Sweetwater plant with the natural gas required to operate the plant at full capacity for 20 years. The agreement provides fixed purchase prices for the gas, subject to fixed periodic escalation provisions.
In August 2000, we entered into a license agreement with the Commonwealth of Australia to license the Syntroleum Process as part of a program designed to unlock the value of Australia's energy reserves and improve the quality of the environment. Under the license agreement, the Commonwealth made an AUD $30 million (approximately U.S. $15 million) deposit, of which AUD $15 million (approximately U.S. $7 million) is currently held in escrow pending satisfaction of conditions relating to the construction of the Sweetwater plant. AUD $20 million (approximately U.S. $10 million) of the license fee may be credited against future site license fees otherwise payable under the Commonwealth license. At the same time, we entered into a loan agreement with the Commonwealth under which the Commonwealth will make a non-amortizing, interest-free loan to us in the amount of AUD $40 million (approximately U.S. $22 million) with a 25-year maturity to support the further development and commercialization of GTL technologies in Australia and under which we have agreed to conduct a feasibility study on constructing a large-scale GTL fuels plant in Australia. Loan proceeds are to be made available to us in three successive advances. Pending satisfaction of conditions relating to the financing, construction and completion of the Sweetwater plant, loan proceeds will be held in escrow. Should the conditions not be fully satisfied by August 2004, any license and loan proceeds remaining in escrow may be returned to the Commonwealth. To date, we have received three advances of loan proceeds under our loan with the Commonwealth, which are currently being held in escrow.
In April 2001, we entered into an agreement with Clough-PGS Joint Venture to provide operating and maintenance services for the Sweetwater plant during the construction and provisional acceptance phases and for the following 10 operating years. Clough-PGS is a joint venture between Clough Engineering Ltd., an Australian company that is part of Clough Ltd., and PGS Production Pty. Ltd., an Australian subsidiary of Petroleum Geo-Services ASA. The agreement provides for total payments to Clough-PGS of approximately AUD$350 million (approximately U.S. $173 million) over the ten year operations phase of the agreement. In addition, we will pay Clough-PGS on a monthly basis for services provided to us during the construction and provisional acceptance phases of the Sweetwater plant, as well as reimburse Clough-PGS for additional services not otherwise within the scope of the contracted services. The agreement also provides additional financial incentives for Clough-PGS to maximize plant revenues and financial penalties for plant underperformance.
We have also entered into multiple agreements with the Dampier Port Authority in April 2001. These 30-year agreements provide us with access to the Dampier port facilities and services for shipping products produced at the Sweetwater plant. The port facilities agreement provides us with priority loading of vessels carrying products from the plant. Under that agreement, the port will construct additional facilities that will enable accommodation of increased traffic at the port. The related lease agreement provides us with a small parcel of land adjacent to the wharf that will be used for loading equipment, pumps and storage tanks. The related easement agreement provides us with right of way access on Dampier Port Authority land for laying and operating product pipelines from the plant to the wharf.
In August of 2001, we entered into an engineering , procurement and construction (EPC) contract with Tessag Industrie Anlagen GmbH (as a result of a recent name change, now known as RWE Industrie-Losugen GmbH), a subsidiary of RWE AG. The EPC contract covers engineering, procurement, construction, pre-commissioning, commissioning and testing of the Sweetwater plant, plus personnel training for a lump sum price of $599.5 million. The plant's operating capacity has increased from the original 10,000 to 11,500 nominal barrels-per-day as a result of pilot plant tests demonstrating higher conversion rates than those included in the original design as well as standard engineering design margins which had not been considered previously. The price is an increase from Tessag's February 2001 quote of $506 million, primarily as a result of an increase of $35 million for Tessag's contingency and margin, which now totals more than $100 million, higher costs associated with additional product upgrading facilities, expanded operating parameters for the autothermal reformers (ATRs) and Fischer-Tropsch (F-T) reactors, higher labor costs due to wage-rate inflation in the Western Australia region and changes in foreign currency exchange rates. The final price may also vary up or down with exchange rates until financial close on the project, when the price will be fixed in U.S. dollars. Tessag's final price does not include interest during construction and other owner's costs, which include proprietary catalysts to be supplied by Syntroleum. Our current estimate of these costs, excluding interest during construction, is approximately $90 million. Financing for and construction of the plant will be subject to the risks inherent in any large construction project.
In addition to the EPC contract, during 2001 we completed several other agreements important to the Sweetwater plant.
. In September 2001, we signed an option with the State of Western Australia, which grants us the irrevocable right to lease the approximately 160 acre site for the Sweetwater plant. The lease option is for a term of two years and execution of the final lease agreement is subject to completion of project financing and notice to Tessag to proceed with construction of the plant under the engineering, procurement and construction contract discussed above.
. In October 2001, we signed a 20 year agreement with the Water Corporation of Western Australia for the supply of water to the Sweetwater plant. Under the terms of the agreement, Water Corporation will, subject to construction of a new water desalination plant and satisfaction of various other conditions, supply over 1.4 million gallons of water per day for use in process cooling. In return, we will provide Water Corporation steam and electricity produced by the plant, along with a modest operating fee.
. In October 2001, we concluded a contract with a major Australian natural gas pipeline company for transportation of natural gas from the Northwest Shelf LNG facility to the Sweetwater plant site and transportation of products produced at the plant site to the Dampier public wharf, where they will be loaded to tankers. This agreement is for a term of 20 years at a fixed price, with extension options. Under the terms of the agreement, a natural gas pipeline to the plant site will be constructed and approximately six product pipelines will be constructed from the plant site to the wharf.
REAL ESTATE AND OTHER ASSET SALES
As of December 31, 2001, our real estate inventory consisted of land in Houston, Texas comprised of 255 acres of undeveloped land and 69 lots known as the "Houston Project." This real estate inventory was owned by SLH Corporation prior to the merger of Syntroleum Corporation and SLH Corporation and reflects the remaining assets of a real estate development business that was conducted by SLH's former parent corporation. Our total real estate inventory had an aggregate carrying value at December 31, 2001 of approximately $3.0 million. The Houston Project is being developed for commercial and residential use and ultimate sale. The timing of real estate sales will create variances in period-to-period earnings recognition. We do not intend to acquire additional real estate holdings for development and/or sale outside our core business interests, and real estate sales revenues should decrease as the
current real estate inventory is liquidated.
During 2001, we sold 125 lots from the Houston Project for $2.6 million. Also during the third quarter of 2001, we sold our partnership interest in the Powder Basin Partnership which owns a shopping center in Gillette, Wyoming for a gain of approximately $1.9 million dollars. The investment had a negative carrying value of $104,000. This sale also released approximately $3.2 million in short-term investments which secured 49.9% of a letter of credit issued to secure obligations of the partnership.
In February 2000, the Company sold its parking garage in Reno, Nevada to Fitzgeralds Reno, Inc. The sale price of $3 million was paid by $750,000 in cash and the balance in the form of a promissory note in the principal amount of $2,250,000 together with the assumption of the lease payments due under the ground lease. The note bears interest at the rate of 10% per annum and is payable in monthly installments of principal and interest based on a 20 year amortization, with the entire unpaid balance due in 10 years. The note is secured by a deed of trust covering the leasehold estate created by the ground lease on which the garage is located, as well as the parking garage and an assignment of leases. In December 2000, Fitzgeralds Reno, Inc., a Nevada corporation doing business as Fitzgeralds Hotel & Casino Reno, along with several affiliates, filed voluntary petitions for reorganization under Chapter 11 of the United States Bankruptcy Code in the United States Bankruptcy Court, District of Nevada. Fitzgeralds continues to make the monthly payments due on the note and the ground lease and has informed the Company that it intends to continue making these payments until Fitzgeralds is able to sell the casino and parking garage. The Company's deed of trust contains a "due on sale" provision until the note is paid. After the note is paid, the Company's deed of trust remains in effect to secure Fitzgeralds' performance of its obligations under the ground lease and provides that any assignee of Fitzgeralds in the event of the sale of the parking garage must meet certain net worth requirements in order for Fitzgeralds to assign the ground lease.
We plan to liquidate our real estate assets and other investments in an orderly manner to maximize their value. The timing of these sales will create variances in period-to-period earnings recognition. We do not intend to acquire additional real estate holdings for development or sale outside our core business interests, and revenue from real estate sales should decrease as the current real estate inventory is liquidated. We estimate that construction and disposal costs relating to our Houston real estate project for the current year will be approximately $2 million, although the actual amount could be materially different than this estimated amount. We expect these costs will be offset by lot sales in 2002 and 2003
Our other assets at December 31, 2001 included an investment in a privately owned developer of proprietary bone substitute technology, which had a carrying value of approximately $506,000; an investment in a privately held venture capital limited partnership, which had a carrying value of $476,000; and an equity investment in a recently renovated hotel in Tulsa, Oklahoma.
CURRENCY RISK
We expect to conduct a portion of our business in currencies other than the United States dollar. We may attempt to minimize our currency exchange risk by seeking international contracts payable in local currency or we may choose to convert our currency position into United States dollars. Our engineering, procurement and construction contract for the Sweetwater plant is denominated primarily in Australian dollars and Euros but, upon the closing of the debt and equity financing for the plant, the contract will be converted to and denominated in United States dollars at then prevailing exchange rates. Until then, we expect the contract to subject us to risks associated with exchange rate fluctuations. In addition, we expect to seek contractual purchase price adjustments based on an exchange rate formula related to United States dollars. In the future, we may also have significant investments in countries other than the United States. The functional currency of these foreign operations may be the local currency, and accordingly, financial statement assets and liabilities may be translated at prevailing exchange rates and may result in gains or losses in current income. Currently, all of the Company's subsidiaries use the U.S. dollar for their functional currency. Monetary assets and liabilities are translated into United States dollars at the rate of exchange in effect at the balance sheet date. Transaction gains and losses that arise from exchange rate fluctuations applicable to transactions denominated in a currency other than the U.S. dollar are included in the results of operations as incurred.
NEW ACCOUNTING PRONOUNCEMENTS
In June 1998, the Financial Accounting Standards Board issued Statement No. 133, "Accounting for Derivative Instruments and Hedging Activities." Statement No. 133 establishes accounting and reporting standards requiring that every derivative instrument (including certain derivative instruments embedded in other contracts) be
recorded in the balance sheet as either an asset or liability measured at its fair value. Statement No. 133 requires that changes in the derivative's fair value be recognized currently in earnings unless specific hedge accounting criteria are met. Special accounting for qualifying hedges allows a derivative's gains and losses to offset related results on the hedged item in the income statement. Companies must formally document, designate and assess the effectiveness of transactions that receive hedge accounting. We do not currently purchase futures contracts nor do we hold derivative investments. We adopted Statement No. 133 beginning January 1, 2001. Adoption of Statement No.133 did not have a material effect on our financial statements.
In July, 2001, the FASB issued Statement No. 141, Business Combinations, Statement No. 142, Goodwill and Other Intangible Assets, and Statement No. 143, Accounting for Asset Retirement Obligations. Statement No. 141 requires all business combinations initiated after June 30, 2001, to be accounted for using the purchase method of accounting. Under Statement No. 142, goodwill is no longer subject to amortization over its estimated useful life. Rather, goodwill will be subject to at least an annual assessment for impairment by applying a fair-value-based test. Additionally, an acquired intangible asset should be separately recognized if the benefit of the intangible asset is obtained through contractual or other legal rights, or if the intangible asset can be sold, transferred, licensed, rented, or exchanged, regardless of the acquirer's intent to do so. Under these statements there will be more recognized intangible assets, such as unpatented technology and database content, being separated from goodwill. Those assets will be amortized over their useful lives, other than assets that have an indefinite life. Statement No. 142 is required to be applied starting with fiscal years beginning after December 15, 2001. The Company does not believe the adoption of Statement No. 142 will have a material impact on the financial conditions and results of operations.
Statement No. 143 requires entities to record the fair value of a liability for an asset retirement obligation in the period in which it is incurred and a corresponding increase in the carrying amount of the related long-lived asset. Statement No. 143 is effective for fiscal years beginning after June 15, 2002. The Company is currently assessing the impact of Statement No. 143 on its financial condition and results of operations.
In August, 2001, the FASB issued Statement No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. Statement No. 144 supercedes the previously issued Statement No. 121, Accounting for the Impairment of Long-Lived Assets and Long-Lived Assets to be Disposed Of and addresses financial accounting and reporting for the impairment or disposal of long-lived assets. Statement No. 144 is effective for fiscal years beginning after December 15, 2001. The Company is currently assessing the impact of Statement No. 144 on its financial condition and results of operations.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We had $45 million in cash equivalents in the form of money market instruments as of December 31, 2001. We also hold restricted funds in the form of Australian escrow accounts. These funds earn interest at approximately 3.5% and are marked to market at the end of each reporting period. These accounts can have fluctuating balances relating to foreign currency exchange between the U.S. and Australian Dollar.
Foreign exchange risk currently relates to two escrow accounts held in Australian dollars in the amount of U.S. $16,206,000 at December 31, 2001, and to long-term debt held in Australian dollars in the amount of U.S. $1,190,000 at December 31, 2001. This long-term debt matures in 2025 and has been discounted using an imputed interest rate of nine percent. We also have deferred revenue, a portion of which is denominated in Australian currency. This deferred revenue was U.S. $15,351,000 at December 31, 2001. These restricted funds, long-term debt, and associated discount and deferred revenue are converted to U.S. dollars for financial reporting at the end of every reporting period. To the extent that the conversion results in gains or losses, such gains or losses will be shown in our statements of operations.
We have not purchased futures contracts nor have we purchased or hold any derivative financial instruments.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Our consolidated financial statements, together with the report thereon of Arthur Andersen LLP dated January 18, 2002, are set forth on pages through hereof. See Item 14 for an index to the consolidated financial statements.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED PARTY TRANSACTIONS
The information required by Items 10, 11, 12 and 13 is incorporated herein by reference to our definitive proxy statement for our 2002 annual meeting of stockholders, which will be filed with the Securities and Exchange Commission pursuant to Regulation 14A under the Securities Exchange Act of 1934 within 120 days of December 31, 2001.
Certain information with respect to our executive officers is set forth in Item I of this annual report under the caption "Executive Officers of the Registrant."
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a)(1) Financial Statements
(a)(2) Financial Statement Schedules
All schedules and other statements for which provision is made in the applicable regulations of the Securities and Exchange Commission have been omitted because they are not required under the relevant instructions or are inapplicable.
(a)(3) Exhibits
Exhibits. The following exhibits are filed as part of this Annual Report on Form 10-K:
Exhibit No. Description of Exhibit --- ----------------------
*3.1 Certificate of Incorporation of the Company (incorporated by reference to Annex B to the Proxy Statement of the Company filed with the Securities and Exchange Commission on May 12, 1999).
*3.2 Certificate of Designations of Series A Junior Participating Preferred Stock of the Company dated June 16, 1999 (incorporated by reference to Exhibit 4.5 to the Company's Current Report on Form 8-K filed with the Securities and Exchange Commission on June 17, 1999).
*3.3 Bylaws of the Company (incorporated by reference to Annex C to the Proxy Statement of the Company filed with the Securities and Exchange Commission on May 12, 1999).
*4.1 Amended and Restated Rights Agreement dated as of January 31, 1997 and amended and restated on June 17, 1999 (incorporated by reference to Exhibit 4.4 to the Company's Current Report on Form 8-K filed with the Securities and Exchange Commission on June 17, 1999).
The Company is a party to debt instruments under which the total amount of securities authorized does not exceed 10% of the total assets of the Company and its subsidiaries on a consolidated basis. Pursuant to paragraph 4(iii)(A) of Item 601(b) of Regulation S-K, the Company agrees to furnish a copy of such instruments to the Commission upon request.
*10.1 Form of Master License Agreement of Syntroleum (incorporated by reference to Exhibit 10.9 to the Company's Registration Statement on Form S-4 (Registration No. 333-50253)).
+*10.2 Form of Amended and Restated Indemnification Agreement between Syntroleum and each of its officers and directors (incorporated by reference to Exhibit 10.2 to the Company's Annual Report on Form 10-K for the year ended December 31, 2000)
+*10.3 Syntroleum Corporation 1993 Stock Option and Incentive Plan First Amendment and Restatement (incorporated by reference to Appendix B to the Proxy Statement filed by the Company with the Securities and Exchange Commission on April 18, 2001).
+*10.4 Stock Option Plan for Outside Directors of Syntroleum (incorporated by reference to Appendix F to the Joint Proxy Statement/Prospectus filed by the Company with the Securities and Exchange Commission on July 6, 1998).
*10.5 Master Preferred License Agreement dated September 25, 1996 between Syntroleum and Texaco Natural Gas, Inc. (incorporated by reference to Exhibit 10.22 to the Company's Registration Statement on Form S-4 (Registration No. 333-50253)).
*10.6 Master Preferred License Agreement dated March 7, 1997 between Syntroleum and Marathon Oil Company (incorporated by reference to Exhibit 10.23 to the Company's Registration Statement on Form S-4 (Registration No. 333-50253)).
*10.7 Master Preferred License Agreement dated April 10, 1997 between Syntroleum and Atlantic Richfield Company (incorporated by reference to Exhibit 10.24 to the Company's Registration Statement on Form S-4 (Registration No. 333-50253)).
*10.8 Volume License Agreement dated August 1, 1997 between Syntroleum and YPF International, Ltd. (incorporated by reference to Exhibit 10.25 to the Company's Registration Statement on Form S-4 (Registration No. 333-50253)).
*10.9 Volume License Agreement dated February 4, 1998 between Syntroleum and Kerr-McGee Corporation (incorporated by reference to Exhibit 10.26 to the Company's Registration Statement on Form S-4 (Registration No. 333-50253)).
*10.10 Volume License Agreement dated January 12, 1998 between Syntroleum and Enron Capital & Trade Resources Corp. (incorporated by reference to Exhibit 10.27 to the Company's Registration Statement on Form S-4 (Registration No. 333-50253)).
*10.11 Site License Agreement dated January 12, 1998 between Syntroleum and Syntroleum/Sweetwater Company, L.L.C. (incorporated by reference to Exhibit 10.28 to the Company's Registration Statement on Form S-4 (Registration No. 333-50253)).
+*10.12 SLH Corporation 1997 Stock Incentive Plan (incorporated by reference to Exhibit 10(c) to Amendment No. 1 to the Company's Annual Report on Form 10/A of the Company for the year ended December 31, 1997).
+*10.13 Form of Option Agreement with certain executive officers under the SLH Corporation 1997 Stock Incentive Plan (incorporated by reference to Exhibit 10(e) to Amendment No. 1 to the Company's Annual Report on Form 10K/A for the year ended December 31, 1997).
+*10.14 Form of Option Agreement with directors under the SLH Corporation 1997 Stock Incentive Plan (incorporated by reference to Exhibit 10(f) to Amendment No. 1 to the Company's Annual Report on Form 10K/A for the year ended December 31, 1997).
+*10.15 Form of Consent to Adjustment to Option Agreements called for by Section 2.1(c) of the Agreement and Plan of Merger dated as of March 30, 1998 by and between SLH and Syntroleum (incorporated by reference to Exhibit 10.8 to the Company's Registration Statement on Form S-4 (Registration No. 333-50253)).
*10.16 License Agreement dated April 26, 2000 between Syntroleum Corporation and Ivanhoe Energy Inc. (incorporated by reference to Exhibit 10.1 of the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 2000).
*10.17 License Agreement dated August 2, 2000 between Syntroleum Corporation and Syntroleum Australia Licensing Corporation (incorporated by reference to Exhibit 10.1 of the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 2000).
*10.18 License Agreement dated August 3, 2000 between Syntroleum Australia Licensing Corporation and the Commonwealth of Australia (incorporated by reference to Exhibit 10.2 of the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 2000).
*10.19 A$Loan Agreement dated August 3, 2000 between Syntroleum Australia Credit Corporation and the Commonwealth of Australia (incorporated by reference to Exhibit 10.3 of the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 2000).
*10.20 Deposit Agreement dated August 3, 2000 between Syntroleum Australia Licensing Corporation, the Commonwealth of Australia and Westpac Banking Association (incorporated by reference to Exhibit 10.4 of the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 2000).
*10.21 Deposit Agreement dated August 3, 2000 between Syntroleum Australia Credit Corporation, the Commonwealth of Australia and Westpac Banking Corporation (incorporated by reference to Exhibit 10.5 of the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 2000).
*10.22 Letter Agreement dated August 3, 2000 between Syntroleum Corporation and the Commonwealth of Australia (incorporated by reference to Exhibit 10.6 of the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 2000).
*10.23 Amendment No. 1 to Volume License Agreement dated October 11, 2000 between Syntroleum Corporation and Ivanhoe Energy Inc. (incorporated by reference to Exhibit 10.1 of the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 2000).
+*10.24 Form of Employment Agreement between Syntroleum and its executive officers dated
June 17, 1999 incorporated by reference to Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the period ended June 30, 1999 filed with the Securities and Exchange Commission on August 12, 1999.
+*10.25 Syntroleum Corporation 1993 Stock Option and Incentive Plan First Amendment and Restatement (incorporated by reference to Appendix B to the Company's Proxy Statement filed with the Securities and Exchange Commission on April 18, 2001).
*10.26 Secured Promissory Note dated June 25, 2001 from Mark A. Agee to Syntroleum Corporation (incorporated by reference to Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the period ended June 30, 2001 field with the Securities and Exchange Commission on August 14, 2001).
*10.27 Security and Stock Pledge Agreement dated June 25, 2001 between Mark A. Agee and Syntroleum Corporation (incorporated by reference to Exhibit 10.2 to the Company's Quarterly Report on Form 10-Q for the period ended June 30, 2001 field with the Securities and Exchange Commission on August 14, 2001).
*10.28 Secured Promissory Note dated June 25, 2001 from Kenneth L. Agee to Syntroleum Corporation (incorporated by reference to Exhibit 10.3 to the Company's Quarterly Report on Form 10-Q for the period ended June 30, 2001 field with the Securities and Exchange Commission on August 14, 2001).
*10.29 Security and Stock Pledge Agreement dated June 25, 2001 between Kenneth L. Agee and Syntroleum Corporation (incorporated by reference to Exhibit 10.4 to the Company's Quarterly Report on Form 10-Q for the period ended June 30, 2001 field with the Securities and Exchange Commission on August 14, 2001).
21 Subsidiaries
Syntroleum International Corporation (a Delaware corporation) Syntroleum/Sweetwater Company, L.L.C. (a Delaware limited liability company) Syntroleum Australia Credit Corporation (a Delaware corporation) Syntroleum Australia Licensing Corporation (a Delaware corporation) Syntroleum Sweetwater Holdings Corp. (a Delaware corporation) Syntroleum International Holdings, Ltd. (a Cayman Islands exempted company) Syntroleum Sweetwater Holdings, Ltd. (a Cayman Islands exempted company) Syntroleum Sweetwater Operations, Ltd. (a Cayman Islands exempted company) Syntroleum Peru Holdings Limited (a Cayman Islands exempted company) Scout Development Corporation (a Missouri Corporation) Scout Development Corporation of New Mexico (a Missouri Corporation) BMA Resources, Inc. (a Missouri Corporation) 529 Partners, Ltd. (a Texas limited partnership) Lot Development, Inc. (a Texas Corporation) Carousel Apartment Homes, Inc. (a Georgia Corporation)
23 Consent of Arthur Andersen LLP
- --------------------
* Incorporated by reference as indicated. + Compensatory plan or arrangement.
(b) Reports on Form 8-K
No Current Reports on Form 8-K were filed during the last quarter of the period covered by this Annual Report on Form 10-K.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
SYNTROLEUM CORPORATION
Dated: March 15, 2002 By: /s/ Mark A. Agee ---------------------------------- Mark A. Agee President and Chief Operating Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Board of Directors and Stockholders of Syntroleum Corporation:
We have audited the accompanying consolidated balance sheets of Syntroleum Corporation (a Delaware corporation) and subsidiaries as of December 31, 2001 and 2000, and the related statements of operations, stockholders' equity and cash flows for each of the three years in the period ended December 31, 2001. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Syntroleum Corporation and subsidiaries as of December 31, 2001 and 2000, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2001, in conformity with accounting principles generally accepted in the United States.
ARTHUR ANDERSEN LLP
Tulsa, Oklahoma January 18, 2002
SYNTROLEUM CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (in thousands, except per share data)
The accompanying notes are an integral part of these consolidated balance sheets.
SYNTROLEUM CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands, except per share data)
The accompanying notes are an integral part of these consolidated statements.
SYNTROLEUM CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (in thousands)
The accompanying notes are an integral part of these consolidated statements.
SYNTROLEUM CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands)
The accompanying notes are an integral part of these consolidated statements.
SYNTROLEUM CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
BASIS OF REPORTING
The primary operations of Syntroleum Corporation (together with its predecessors and subsidiaries, the "Company" or "Syntroleum") to date have consisted of the research and development of a proprietary process (the "Syntroleum Process") designed to convert natural gas into synthetic liquid hydrocarbons ("GTL")and activities related to commercialization of the Syntroleum Process. Synthetic liquid hydrocarbons produced by the Syntroleum Process can be further processed into high quality liquid fuels such as diesel, kerosene and naphtha, high quality specialty products such as synthetic lubricants, synthetic drilling fluid, waxes, liquid normal paraffins and certain chemical feedstocks.
The Company's current focus is to further demonstrate the commercial viability of the Syntroleum Process. The Company has sold license agreements to seven oil companies and the Commonwealth of Australia. In addition to operating its own pilot plant in Tulsa, Oklahoma, the Company participated in the operation of a demonstration plant located at ARCO's refinery in Cherry Point, Washington.
OPERATIONS
The construction of GTL plants will require significant capital expenditures. The Company's other efforts to commercialize the Syntroleum Process will also involve significant expenditures. The Company has an effective registration statement for the proposed offering from time to time of shares of the Company's common stock, preferred stock, debt securities, depositary shares or warrants for an aggregate initial offering price of $250,000,000. The Company intends to obtain additional funding through joint ventures, partnerships, license agreements and other strategic alliances, as well as various other financing arrangements. The Company may also seek debt or additional equity financing in the capital markets. In the event such capital resources are not available to the Company, its GTL plant development and other activities may be curtailed.
The Company is developing a commercial-scale specialty products plant to be located in Western Australia known as the Sweetwater plant. Definitive agreements with equity and debt participants in the Sweetwater project and the Company's other capital projects are expected to include conditions to funding, many of which could be outside of its control. If adequate funds are not available, the Company may be required to delay or to eliminate expenditures for the Sweetwater project and its other capital projects, as well as its research and development and other activities or seek to enter into a business combination transaction with another company. The Company could also be forced to license to third parties the rights to commercialize additional products or technologies that it would otherwise seek to develop itself. If the Company obtains additional funds by issuing equity securities, dilution to stockholders may occur. In addition, preferred stock could be issued in the future without stockholder approval and the terms of the preferred stock could include dividend, liquidation, conversion, voting and other rights that are more favorable than the rights of the holders of the Company's common stock. The Company can give no assurance that any of the transactions outlined above will be available to it when needed or on terms acceptable or favorable to the Company.
CONSOLIDATION
The consolidated financial statements include the accounts of the Company and its majority-owned subsidiaries. All significant inter-company accounts and transactions have been eliminated. Investments in affiliated companies of 20% to 50% in which Syntroleum does not have a controlling interest are accounted for by the equity method. Investments in affiliated companies of less than 20% are accounted for by the cost method.
REVENUE RECOGNITION
The Company recognizes revenues from joint development activities as the related expenses are incurred because the contracts provide that revenue is earned as the expenses under the contract are incurred. Substantially all of the Company's joint development revenues during the periods presented have been from joint development activities with several major oil companies (see Note 16). All such joint development activities were pursuant to
joint research and development agreements where the Company expenses its research and development costs as incurred.
The Company recognizes revenue on the sale of license agreements by recording 50% of the license fee deposit as revenue when: (1) the license agreement has been formally executed, (2) the license fee deposit has been paid in cash and (3) the Company has delivered to the licensee the process design package for the licensee's initial licensed plant. Since 50% of the license fee deposit is subject to the Company's indemnity obligation with respect to the performance guarantee on the related plant, the remaining license fee deposit is recorded as deferred revenue in the consolidated balance sheets and will be recognized as revenue in the consolidated statements of operations after the related plant has passed certain performance tests. Option fees, which provide licensees the right to include additional geographic areas in its license agreement territory, are deferred until the earlier of the option being exercised or lapsing. As of December 31, 2001, the Company has deferred all amounts received related to license agreements except for $2 million in license revenue recognized by the Company in 2000 related to an option granted to acquire the right to use the Syntroleum Process in certain additional geographic areas, which lapsed in April 2000.
CASH AND CASH EQUIVALENTS
Cash and cash equivalents consist of cash and highly liquid investments with an original maturity of three months or less.
REAL ESTATE
Real estate sales are recognized when consummated. Profit is recognized using the full accrual method when the down payment, continuing investment, and transfer of risk criteria have been satisfied. Payments received from buyers prior to recording of a sale are recorded as deposits. Real estate rentals and other revenues are accrued in the period earned.
Real estate is valued at lower of cost, including development costs, or market. Development costs that are incurred during the period of development or construction are capitalized. Capitalized costs are charged to expense as properties are sold.
During 2001, the Company sold its partnership interest in the Powder Basin Partnership, which owns a shopping center in Gillette, Wyoming, for a gain of approximately $1.9 million. The Company also sold 125 lots in Houston in 2001 for $2,555,000.
SHORT-TERM INVESTMENTS
Short-term investments consist of U.S. Treasury securities and debt obligations of U.S. Government agencies with original maturities between three and twelve months. Management determines the appropriate classification of these securities at the time of purchase and re-evaluates such designation at each subsequent balance sheet date. At December 31, 2000, the Company's investment portfolio consisted of debt securities classified as trading securities or held-to-maturity presented at amortized cost.
RESEARCH AND DEVELOPMENT
The Company incurs significant costs for research, development and engineering programs. Expenses classified as research and development include salaries and wages, rent, utilities, equipment, engineering and outside testing and analytical work associated with our research, development and engineering programs. These costs are charged to expense when incurred.
INCOME TAXES
Income taxes are accounted for using the asset and liability method of accounting for income taxes. Under this method, deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and of net operating loss carry-forwards. Deferred tax assets and liabilities are measured using the enacted tax rates and laws in effect or that will be in effect when the differences are expected to reverse. The Company records a valuation allowance if it is more likely than not that some portion or all of the deferred tax asset will not be realized.
IMPAIRMENT OF LONG-LIVED ASSETS
The Company follows the provisions of Statement No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of." The Company makes assessments of impairment on a project-by-project basis. The impairment provision is based on the excess of carrying value over fair value. Fair value is defined as the present value of the estimated future net revenues of a project. No impairment provisions were required in 2001, 2000 or 1999.
SEGMENTS
The Company acquired certain real estate assets in the merger with SLH Corporation ("SLH") in 1998, which have since been sold with the exception of the Company's real estate development in Houston, Texas. Management's intent is to complete the development of its remaining real estate in Houston and to continue to liquidate these assets. Management does not intend to acquire additional real estate holdings. The Company's primary operation is to commercialize its proprietary technology. Accordingly, management views the Company as having only one segment.
EARNINGS PER SHARE
The Company applies the provisions of Statement No. 128, "Earnings Per Share." Basic and diluted earnings (losses) per common share were computed by dividing net income (loss) by the weighted average number of shares of common stock outstanding during the reporting period. Options to purchase 3,844,161, 3,114,347 and 2,721,925 shares of common stock at an average exercise price of $10.40, $10.43 and $7.44 were not included in the computation of diluted earnings per share for the years ended December 31, 2001, 2000 and 1999, respectively, as inclusion of such options would be anti-dilutive.
USE OF ESTIMATES
The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
FOREIGN CURRENCY TRANSACTIONS
All of the Company's subsidiaries use the U.S. dollar for their functional currency. Assets and liabilities are translated into U.S. dollars at the rate of exchange in effect at the balance sheet date. Transaction gains and losses that arise from exchange rate fluctuations applicable to transactions denominated in a currency other than the U.S. dollar are included in the results of operations as incurred.
NEW ACCOUNTING PRONOUNCEMENTS
In June 1998, the Financial Accounting Standards Board ("FASB") issued Statement No. 133, "Accounting for Derivative Instruments and Hedging Activities." Statement No. 133 establishes accounting and reporting standards requiring that every derivative instrument (including certain derivative instruments embedded in other contracts) be recorded in the balance sheet as either an asset or liability measured at its fair value. Statement No. 133 requires that changes in the derivative's fair value be recognized currently in earnings unless specific hedge accounting criteria are met. Special accounting for qualifying hedges allows a derivative's gains and losses to offset related results on the hedged item in the income statement. Companies must formally document, designate and assess the effectiveness of transactions that receive hedge accounting treatment. The Company does not purchase futures contracts nor does it hold derivative investments. The Company adopted Statement No. 133 beginning January 1, 2001. The adoption of Statement No.133 had no material effect on the Company's financial statements.
In July 2001, the FASB issued Statement No. 141, "Business Combinations," Statement No. 142, "Goodwill and Other Intangible Assets," and Statement No. 143, "Accounting for Asset Retirement Obligations." Statement No. 141 requires all business combinations initiated after June 30, 2001, to be accounted for using the purchase method of accounting. Under Statement No. 142, goodwill is no longer subject to amortization over its
estimated useful life. Rather, goodwill will be subject to at least an annual assessment for impairment by applying a fair-value-based test. Additionally, an acquired intangible asset should be separately recognized if the benefit of the intangible asset is obtained through contractual or other legal rights, or if the intangible asset can be sold, transferred, licensed, rented, or exchanged, regardless of the acquirer's intent to do so. Under these statements there will be more recognized intangible assets, such as unpatented technology and database content, being separated from goodwill. Those assets will be amortized over their useful lives, other than assets that have an indefinite life. Statement No. 142 is required to be applied starting with fiscal years beginning after December 15, 2001. The Company does not believe the adoption of Statement No. 142 will have a material impact on its financial condition and results of operations.
Statement No. 143 requires entities to record the fair value of a liability for an asset retirement obligation in the period in which it is incurred and a corresponding increase in the carrying amount of the related long-lived asset. Statement No. 143 is effective for fiscal years beginning after June 15, 2002. The Company is currently assessing the impact of Statement No. 143 on its financial condition and results of operations.
In August 2001, the FASB issued Statement No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." Statement No. 144 supercedes the previously issued Statement No. 121, "Accounting for the Impairment of Long-Lived Assets and Long-Lived Assets to be Disposed Of" and addresses financial accounting and reporting for the impairment or disposal of long-lived assets. Statement No. 144 is effective for fiscal years beginning after December 15, 2001. The Company is currently assessing the impact of Statement No. 144 on its financial condition and results of operations. However, the Company does not believe the adoption of Statement No. 144 will have a material impact on its financial condition and results of operations.
2. INVESTMENTS:
At December 31, 2001, the Company had a 4.3% interest in a hotel partnership in Tulsa, Oklahoma having a carrying value of $90,000. The Company also owns a 3.6% investment in a privately held venture capital limited partnership having a carrying value of $476,000 and an investment in a developer of a proprietary bone substitute technology, which has a carrying value of $506,000 at December 31, 2001. These assets were acquired in the Company's merger with SLH.
3. RESTRICTED CASH:
Restricted cash consists of $16,206,000 held in two escrow accounts denominated in Australian dollars and $300,000 pledged to secure a letter of credit, all of which are carried at fair value. The restricted Australian funds are held in the Company's name in a custodian account with a major Australian financial institution and are restricted as to withdrawal (see Notes 7 and 9). These funds are restricted as to use and can only be withdrawn with a valid drawdown notice signed by both the Company and the Commonwealth of Australia after certain conditions have been met related to the Sweetwater project. The Company has sole rights to all interest earned on these escrow balances, except after notice of default by the Company on the related note payable.
4. PROPERTY AND EQUIPMENT:
Property and equipment is stated at cost. When assets are sold or retired, the cost and accumulated depreciation related to those assets are removed from the accounts and any gain or loss is credited or charged to income. Depreciation of property and equipment is computed on the straight-line method over estimated useful lives of three to thirty-nine years. Property and equipment consists of the following:
December 31, ------------------------------- 2001 2000 -------------- -------------- (in thousands) Furniture and office equipment................ $ 3,969 $ 3,341 Buildings..................................... 840 840 Land.......................................... 118 118 Leasehold improvements........................ 368 355 Construction in progress...................... 31,692 28,675 -------------- -------------- 36,987 33,329 Less-accumulated depreciation................. 2,938 2,055 -------------- -------------- $ 34,049 $ 31,274 ============== ==============
5. NOTES RECEIVABLE RELATED TO COMMON STOCK:
During 2001, the Company loaned $300,000 to Kenneth L. Agee, the Company's Chairman and Chief Executive Officer, and $1,295,217 to Mark A. Agee, the Company's President and Chief Operating Officer. The proceeds of these loans were used by the Agees to either reduce or repay margin account loans to the Agees from third parties and thereby avoid the sale by either of the Agees of shares of the Company's common stock to satisfy margin calls as a result of a decline in the market price of the Company's common stock. Each of the loans to the Agees is full recourse, matures in one year, bears interest at the rate of six percent, and is secured by the pledge to the Company by each of the Agees of shares of the Company's common stock, which they own and which have a value (based on the Company's stock price) equal to or greater than two times the outstanding principal and accrued interest of their respective loans.
Notes receivable from the sale of common stock consists of notes receivable from officers for the purchase of common stock in the Company. The notes bear interest at the rate of 6.10%, mature in May 2004, and are secured by the pledge of the Company's common stock.
6. NOTES RECEIVABLE:
In February 2000, the Company sold its parking garage in Reno, Nevada to Fitzgeralds Reno, Inc. The sale price of $3 million was paid by $750,000 in cash and a promissory note in the principal amount of $2,250,000 together with the assumption of the lease payments due under the ground lease. The note bears interest at the rate of 10% per annum and is payable in monthly installments of principal and interest based on a 20 year amortization, with the entire unpaid balance due in 10 years. The note is secured by a deed of trust covering the leasehold estate created by the ground lease on which the garage is located, as well as the parking garage and an assignment of leases. In December 2000, Fitzgeralds Reno, Inc., a Nevada corporation doing business as Fitzgeralds Hotel & Casino Reno, along with several affiliates, filed voluntary petitions for reorganization under Chapter 11 of the United States Bankruptcy Code in the United States Bankruptcy Court, District of Nevada. Fitzgeralds continues to make the monthly payments due on the note and the ground lease and has informed the Company that it intends to assume these obligations and continue making these payments until the sale of the casino and parking garage. The Company's deed of trust contains a "due on sale" provision until the note is paid. After the note is paid, the Company's deed of trust remains in effect to secure Fitzgeralds' performance of its obligations under the ground lease and provides that, in the event of the sale of the parking garage, any assignee of Fitzgeralds must meet certain net worth requirements in order for Fitzgeralds to assign the ground lease.
7. LONG-TERM DEBT:
In August 2000, a wholly-owned subsidiary of the Company entered into a loan agreement with the Commonwealth of Australia under which the Commonwealth will make an unsecured, non-amortizing, interest-free loan to the Company in the amount of AUD $40 million (approximately U.S. $22 million) with a 25-year maturity. Loan proceeds are to be used to support the further development and commercialization of GTL technologies in Australia. Under the terms of the loan agreement, the Company has agreed to conduct a feasibility study on constructing a large-scale GTL fuels plant in Australia. Loan proceeds are to be made available to the Company in three successive advances. Pending satisfaction of certain conditions relating to the financing, construction and completion of the Sweetwater project, proceeds will be held in escrow. Should the conditions not be fully satisfied by August 2004, any loan proceeds remaining in escrow may be returned to the Commonwealth.
During 2000 the Company received the first advance and during 2001 the Company received the second advance of loan proceeds in the amount of AUD $8 million (approximately U.S. $4 million) and AUD $12 million (approximately U.S. $6 million), respectively. These funds were placed in escrow and are being held in Australian currency. Both the restricted funds and the long-term debt have been adjusted to reflect the exchange rates in effect as of the balance sheet date. The long-term amount reflects cash loan proceeds received in escrow from both the 2001 and 2000 distributions, discounted over the remaining term of the loan using an imputed interest rate of nine percent. The difference between the cash proceeds received and the discounted long-term debt has been recorded as a reduction in the cost of the related property and equipment. The long-term debt amount reflected for these proceeds will, excluding the effect of currency exchange rate fluctuations, increase over time as the remaining term of the loan declines.
8. MINORITY INTERESTS:
During 2000, the Company received $2 million from Methanex Corporation towards the cost of the engineering work being performed by a third party for the Sweetwater project. The $2 million contribution was recorded as a reduction in engineering costs for the Sweetwater plant during the second quarter of 2000.
9. LICENSING ACTIVITY:
In August 2000, the Company signed a non-exclusive license agreement with the Commonwealth of Australia, granting the Commonwealth the right to utilize the Syntroleum Process. Under the license agreement, the Commonwealth has paid the Company a license fee in the amount of AUD $30 million (approximately U.S. $17 million), half of which is being held in escrow and will be distributed to the Company upon satisfaction of certain conditions relating to the construction of the Sweetwater project. Should the conditions not be fully satisfied by August 2004, any license proceeds remaining in escrow will be returned to the Commonwealth.
In October 2000, the Company modified its existing volume license agreement with Ivanhoe to a master license agreement. The license agreement, as amended, no longer contains limitations on the volume of synthetic hydrocarbons which may be produced by Ivanhoe under the agreement and enables Ivanhoe to pursue an unlimited number of gas-to-liquids projects around the world.
Also during 2000, the Company recognized $2 million in license revenue reflecting funds previously received by the Company as payment for an option granted to a licensee to acquire the right to use the Syntroleum Process in certain additional geographic areas not included in the original licensed territory. Revenue received upon the grant of this option was deferred until the earlier of the licensee exercising the option or the expiration of the option. The option lapsed in April 2000, resulting in the recognition of the related revenue.
10. PUBLIC OFFERING:
In July 2000, the Company completed the sale of 5,650,000 shares of common stock (including 400,000 shares of common stock pursuant to the exercise of a portion of the underwriter's over-allotment option) pursuant to a public offering at a price to the public of $17.50 per share. The Company received net proceeds of approximately $92 million after the underwriting discount and offering expenses.
The Company has used and intends to continue to use a substantial portion of the net proceeds from the offering to fund a portion of the Sweetwater project construction costs. The Company intends to use any remaining net proceeds to fund costs associated with pilot plant facilities, the development of additional GTL plants, research and development activities, the acquisition of complementary technologies, working capital needs and other general corporate purposes.
11. INCOME TAXES:
The Company has federal income tax net operating loss (NOL) carry-forwards of approximately $89 million at December 31, 2001. In connection with the Company's merger with SLH, the Company obtained NOLs of approximately $17.6 million and capital loss carry-forwards of approximately $4.6 million. These carry-forwards generally begin to expire in 2004.
The Company recognizes the tax benefit of NOL carry-forwards as assets to the extent that management concludes that the realization of the NOL carry-forwards is "more likely than not." Realization of the future tax benefits is dependent on the Company's ability to generate taxable income within the carry-forward period. The Company's management has concluded that, based solely on the criteria of Statement No. 109 "Accounting for Income Taxes" and the historical results of the Company, a valuation allowance should be provided for the entire balance of the net deferred tax asset.
The Company has not recorded an income tax provision or benefit for the years ended December 31, 2001, 2000 and 1999. This differs from the amount of income tax benefit that would result from applying the 35% statutory federal income tax rate to the pretax loss due to the increase in the valuation allowance in each period. The valuation allowance increased by approximately $12,226,000, $11,983,000 and $9,690,000 for the years ended December 31, 2001, 2000 and 1999, respectively. Deferred taxes arise primarily from NOL carry-forwards and the
recognition of revenues and expenses in different periods for financial and tax purposes.
Deferred taxes consist of the following:
During 2001 and 2000, the Company made Australian withholding tax payments in the amount of $472,000 and $2,486,000, respectively, for Australian sourced income. These taxes were withheld by the Commonwealth of Australia upon the Commonwealth's payment of advances under the loan agreement and by the Australian bank upon payments of interest on these monies. Under the Australian tax treaty with the U.S., the payor is required to withhold 10% on Australian sourced revenue and to remit it to the Australian tax authorities.
12. COMMITMENTS:
The Company has entered into various, non-cancelable operating leases for office space, equipment, land and buildings that expire over the next several years. Rental expense was $1,077,000 in 2001, $866,000 in 2000, and $1,246,000 in 1999. Total future minimum lease payments under these agreements as of December 31, 2001 are as follows:
Year Amount --------------------------- (in thousands) 2002 1,032 2003 421 2004 379 2005 364 2006 345 Thereafter 5,508
The Company has entered into employment agreements which provide severance benefits to several key employees. Commitments under these agreements totaled approximately $5,049,000 at December 31, 2001.
The Company's subsidiary, Scout Development Corporation, is subject to contingent obligations under leases and other instruments incurred in connection with real estate activities and other operations. The Company believes that adequate accruals have been made for the contingent liabilities on its financial statements and that none of these are deemed to be material, individually or in the aggregate.
13. FAIR VALUE OF FINANCIAL INSTRUMENTS:
The estimated fair values of the Company's financial instruments at December 31 are summarized as follows:
The fair value of the cash and cash equivalents, restricted cash, short-term investments and accounts receivable approximates cost because of the short-term maturity of these financial instruments. The estimated fair value of the notes receivable were calculated by discounting scheduled cash flows using estimated market discount rates. The investments were acquired in the merger with SLH and, at the time of the merger, were valued at market. No significant changes in the estimated fair value have occurred since the merger.
14. CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS:
At December 31, 2000, all marketable securities were classified as held-to-maturity and trading securities. Held-to-maturity investments were carried at amortized cost and trading securities were carried at fair value. During 2000, no securities classified as held-to-maturity or trading securities were transferred out of held-to-maturity or trading securities. Investments consisted of the following at December 31, 2000 (in thousands):
15. STOCK OPTIONS:
The Company maintains stock option and incentive plans for employees and directors and has reserved 7,125,751 shares of common stock for issuance under the employee and director plans including one percent of the outstanding shares of common stock of the Company as of January 1 of each year (331,367 as of December 31, 2001) for the director plan. Under the terms of the plans, incentive stock options may be issued with an exercise price of not less than 100% of fair market value at the date of grant. Options granted vest at a rate determined by the Compensation Committee of the Company's Board of Directors and are exercisable for varying periods, not to exceed ten years. At December 31, 2001, 1,791,818 shares were available for granting future options.
The number and exercise price of stock options granted are as follows:
The following is a summary of stock options outstanding as of December 31, 2001:
The Company applies the disclosure-only provisions of Statement No. 123, "Accounting for Stock-Based Compensation." Accordingly, no compensation cost has been recognized for the stock option plans. However, pursuant to the requirements of Statement No. 123, the following disclosures are presented to reflect the Company's pro forma net income (loss) for the three years ended December 31, 2001 as if the fair value method of accounting prescribed by Statement No. 123 had been used. Had compensation cost for the Company's stock option plans been determined consistent with the provisions of Statement No. 123, the Company's net income (loss) and income (loss) per share would have increased to the pro forma amounts indicated below:
Because the Statement No. 123 method of accounting has not been applied to options granted prior to January 1, 1995, the resulting pro forma compensation cost may not be representative of that to be expected in future years.
The weighted average per share fair value at date of grant for options granted during 2001, 2000 and 1999 was $6.41, $12.32 and $5.82 per share, respectively. Prior to the Company's merger with SLH on August 7, 1998, the Company was a privately held corporation and used the minimum value method with the following assumptions during 1997: dividend yield of 0%, risk-free interest rate of 5.60% to 6.83%, and expected lives of 5 to 10 years. During 1997 and prior to the merger in 1998, volatility was assumed to be 0%. The fair values of options granted since the merger have been estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions: 2001 2000 1999 --------------------------------------- Expected dividend yield 0% 0% 0% Expected volatility 93% 98% 83% Risk-free interest rate 4.48% 5.78% 5.07% Expected life 5 yrs. 5 yrs. 9.77 yrs.
Subsequent to December 31, 2001, the Company granted 17,745 options to purchase shares of common stock to directors at an average exercise price of $7.10.
16. SIGNIFICANT CUSTOMERS:
Substantially all of the Company's joint development revenue for the three years ended December 31, 2001 was from several major oil companies for joint development work conducted in the Company's research and development facilities and at the pilot plant located at ARCO's Cherry Point Refinery in Cherry Point, Washington and in connection with the conduct of several feasibility studies. The testing in the laboratories under the agreements with ARCO was completed in September 2000. In addition, since 1996 the Company has signed master license agreements with four oil companies and with the Commonwealth of Australia. The Company has also signed volume license agreements with three other oil companies. The license agreements allow the licensees to use the Syntroleum Process in their production of synthetic crude oil and fuels primarily outside of North America. Syntroleum received an aggregate of $36 million and rights to certain technologies in connection with these license agreements. The amounts received under license agreements have been recorded as deferred revenue at December 31, 2001 and 2000, except for $2 million in license revenue recognized by the Company in 2000 related to an option granted to acquire the right to use the Syntroleum Process in certain additional geographic areas which lapsed in April 2000.
Under these license agreements, a licensee obtains the right to use the Syntroleum Process and to acquire catalysts from the Company, secures pricing terms for future site licenses and obtains rights to future improvements to the Syntroleum Process. Generally, the amount of the license fee for site licenses issued under the Company's master and volume license agreements is determined pursuant to a formula based on the discounted present value of the product of (i) the annual maximum design capacity of the plant, (ii) an assumed life of the plant and (iii) the Company's per barrel rate. Initial cash deposits under the Company's license agreement are credited against future site license fees (see Note 1).
The Company is pursuing development of a commercial specialty products plant using the Syntroleum Process to be located in Western Australia. In addition, the Company conducts a portion of its research and development activities through joint development agreements with licensees and other industry partners. The terms of these agreements vary, but generally provide cost sharing arrangements.
17. STOCKHOLDER RIGHTS PLAN:
Each outstanding share of the Company's common stock carries a stock purchase right issued pursuant to a dividend distribution declared by the Company's Board of Directors in March 1997. The rights entitle the holder to buy one-sixth of one one-hundredth of a share of junior preferred stock at a price of $125 per one one-hundredth of a share. Generally, the rights become exercisable ten days after a public announcement that a person or group has acquired, or a tender offer is made for 25% or more of the common stock of the Company. If either of these events occur, each right will entitle the holder (other than a holder owning more than 25% of the outstanding stock) to buy the number of shares of the Company's common stock having a market value two times the exercise price of $125 per share. The rights may be redeemed by the Company for $.01 per right until a person or group has acquired 25% of the Company's stock. The rights expire January 2007.