**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-Q**

 

**x****QUARTERLY REPORT PURSUANT TO SECTION 13 OR15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

 

**Forthe quarterly period ended June 30, 2006**

 

**OR**

 

**o****TRANSITION REPORT PURSUANT TO SECTION 13 OR15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

 

**Forthe transition period from             to              **

 

**Commissionfile number 0-22149**

 

**EDGE PETROLEUM CORPORATION**

(Exact name ofregistrant as specified in its charter)

 

| **Delaware**                                               | ** ** | **76-0511037**       |
|------------------------------------------------------------|------------|----------------------|
| (State  or other jurisdiction of                           |       | (I.R.S.  Employer    |
| incorporation  or organization)                            |       | Identification  No.) |
|                                                       |       |                 |
| **1301  Travis, Suite 2000**                               | ** ** | ** **           |
| **Houston,  Texas**                                        | ** ** | **77002**            |
| (Address of  principal executive offices)                  |       | (Zip code)           |
|                                                       |       |                 |
| **(713) 654-8960**                                         |
| (Registrant’s  telephone number, including area code) |

 

Indicate by checkmark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15 (d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days.

xYes o No

 

Indicate by check mark whether the registrant is a large acceleratedfiler, an accelerated filed, or a non-accelerated filer. See definition of “acceleratedfiler and larger accelerated filer” in Rule 12b-2 of the Exchange Act.:

o Largeaccelerated filer                                    xAccelerated filer                                                             oNon-accelerated filer

 

Indicate by check mark whether the registrant is a shell company (asdefined in Rule 12b-2 of the Exchange Act). oYes x No

 

Indicate the number of shares outstanding of each of the issuer’sclasses of common stock, as of the latest practicable date.

 

| **Class**    | ** ** | **Outstanding at August 7, 2006** | ** ** |
|--------------|------------|-------------------------------------------------------|------------|
|         |       |                                                  |       |
| Common Stock |       | 17,426,989                                            |       |

 

 

----

 

**EDGEPETROLEUM CORPORATION**

 

**Table ofContents**

 
| Part I.  Financial Information                                                                                             |   |
|----------------------------------------------------------------------------------------------------------------------------|--------|
| Item 1. Financial Statements:                                                                                              |   |
| Consolidated Balance Sheets as of  June 30, 2006 and December 31, 2005                                                     |   |
| Consolidated Statements of  Operations for the Three and Six Months Ended June 30, 2006 and June 30, 2005                  |   |
| Consolidated Statements of  Other Comprehensive Income for the Three and Six Months Ended June 30, 2006  and June 30, 2005 |   |
| Consolidated Statements of  Cash Flows for the Six Months Ended June 30, 2006 and June 30, 2005                            |   |
| Consolidated Statement of  Stockholders’ Equity as of June 30, 2006 and December 31, 2005                             |   |
| Notes to the Consolidated  Financial Statements                                                                            |   |
| Item 2. Management’s  Discussion and Analysis of Financial Condition and Results of Operations                        |   |
| Item 3. Qualitative and Quantitative  Disclosures About Market Risk                                                        |   |
| Item 4. Controls  and Procedures                                                                                           |   |
| Part II. Other  Information                                                                                                |   |
| Item 1. Legal  Proceedings                                                                                                 |   |
| Item 1A. Risk Factors                                                                                                      |   |
| Item 2.  Unregistered Sale of Equity Securities and Use of Proceeds                                                        |   |
| Item 3.  Defaults Upon Senior Securities                                                                                   |   |
| Item 4.  Submission of Matters to a Vote of Security Holders                                                               |   |
| Item 5. Other  Information                                                                                                 |   |
| Item 6. Exhibits                                                                                                           |   |
| Signatures                                                                                                                 |   |

 

2

----

 

**PART I. FINANCIAL INFORMATION**

 

**Item 1. Financial Statements**

**EDGEPETROLEUM CORPORATION**

 

**CONSOLIDATED BALANCE SHEETS**

 
| ** **                                                                                                                                                                                                                 | ** ** | **June 30,  2006**                                   | ** ** | **December 31,  2005** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                                                                 | ** ** | **(Unaudited)**                                           | ** ** | ** **                  | ** ** |
| ** **                                                                                                                                                                                                                 | ** ** | **(in thousands, except share data)** | ** ** |
| **ASSETS**                                                                                                                                                                                                                 | * *   | * *                                                  | * *   | * *                    | * *   |
| CURRENT ASSETS:                                                                                                                                                                                                            |       |                                                      |       |                        |       |
| Cash and cash  equivalents                                                                                                                                                                                                 |       | $                                                         | 2,380      |                        | $          | 666 |   |
| Accounts  receivable, trade, net of allowance of $0.5 million at June 30, 2006 and  December 31, 2005                                                                                                                      |       | 16,305                                                    |       | 24,980                      |       |
| Accounts  receivable, joint interest owners, net of allowance of $4,771 at June 30,  2006 and December 31, 2005                                                                                                            |       | 4,358                                                     |       | 2,100                       |       |
| Deferred income  taxes                                                                                                                                                                                                     |       | 2,328                                                     |       | 2,518                       |       |
| Derivative  financial instruments                                                                                                                                                                                          |       | 2,973                                                     |       | —                      |       |
| Other current  assets                                                                                                                                                                                                      |       | 4,868                                                     |       | 6,437                       |       |
| Total current  assets                                                                                                                                                                                                      |       | 33,212                                                    |       | 36,701                      |       |
| PROPERTY AND  EQUIPMENT, net – full cost method of accounting for oil and natural gas  properties (including unproved costs of $35.7 million and $36.9 million at  June 30, 2006 and December 31, 2005, respectively) |       | 341,665                                                   |       | 306,456                     |       |
| OTHER ASSETS                                                                                                                                                                                                               |       | 175                                                       |       | 223                         |       |
| TOTAL ASSETS                                                                                                                                                                                                               |       | $                                                         | 375,052    |                        | $          | 343,380 |   |
|                                                                                                                                                                                                                       |       |                                                      |       |                        |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                             |       |                                                      |       |                        |       |
| CURRENT  LIABILITIES:                                                                                                                                                                                                      |       |                                                      |       |                        |       |
| Accounts  payable, trade                                                                                                                                                                                                   |       | $                                                         | 2,512      |                        | $          | 5,571 |   |
| Accrued  liabilities                                                                                                                                                                                                       |       | 10,947                                                    |       | 17,894                      |       |
| Accrued interest  payable                                                                                                                                                                                                  |       | 623                                                       |       | 17                          |       |
| Asset retirement  obligation – current portion                                                                                                                                                                        |       | 166                                                       |       | 203                         |       |
| Derivative  financial instruments                                                                                                                                                                                          |       | —                                                    |       | 2,479                       |       |
| Total current  liabilities                                                                                                                                                                                                 |       | 14,248                                                    |       | 26,164                      |       |
| ASSET RETIREMENT  OBLIGATION – long-term portion                                                                                                                                                                      |       | 2,848                                                     |       | 2,564                       |       |
| DEFERRED TAX  LIABILITY                                                                                                                                                                                                    |       | 45,051                                                    |       | 37,897                      |       |
| LONG-TERM DEBT                                                                                                                                                                                                             |       | 105,000                                                   |       | 85,000                      |       |
| Total  liabilities                                                                                                                                                                                                         |       | 167,147                                                   |       | 151,625                     |       |
|                                                                                                                                                                                                                       |       |                                                      |       |                        |       |
| COMMITMENTS AND CONTINGENCIES  (NOTE 9)                                                                                                                                                                                    |       |                                                      |       |                        |       |
| STOCKHOLDERS’  EQUITY                                                                                                                                                                                                 |       |                                                      |       |                        |       |
| Preferred stock,  $0.01 par value; 5,000,000 shares authorized; none issued and outstanding                                                                                                                                |       | —                                                    |       | —                      |       |
| Common stock,  $0.01 par value; 60,000,000 shares authorized; 17,379,426 and 17,216,776  shares issued and outstanding at June 30, 2006 and December 31, 2005,  respectively                                               |       | 174                                                       |       | 172                         |       |
| Additional  paid-in capital                                                                                                                                                                                                |       | 139,590                                                   |       | 137,842                     |       |
| Retained  earnings                                                                                                                                                                                                         |       | 68,141                                                    |       | 55,454                      |       |
| Accumulated  other comprehensive loss                                                                                                                                                                                      |       | —                                                    |       | (1,713                      | )          |
| Total  stockholders’ equity                                                                                                                                                                                           |       | 207,905                                                   |       | 191,755                     |       |
| TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                                                           |       | $                                                         | 375,052    |                        | $          | 343,380 |   |

 

See accompanying notes toconsolidated financial statements.

 

3

----

 

**EDGEPETROLEUM CORPORATION**

 

**CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)**

 
| ** **                                                    | ** ** | **Three Months Ended June 30,**                   | ** ** | **Six Months Ended June 30,** | ** ** |
|---------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                    | ** ** | **2006**                                                              | ** ** | **2005**                                          | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                    | ** ** | **(in thousands, except per share amounts)** | ** ** |
| OIL AND NATURAL  GAS REVENUE                                  | * *   | * *                                                              | * *   | * *                                          | * *   | * * | * * | * * | * * |
| Oil and natural  gas sales                                    |       | $                                                                     | 31,199     |                                              | $          | 26,228 |   | $ | 64,094 |   | $ | 50,157 |   |
| Gain (loss) on  hedging and derivatives                       |       | 2,679                                                                 |       | (18                                               | )          | 4,778 |   | (1,003 | ) |
| Total revenue                                                 |       | 33,878                                                                |       | 26,210                                            |       | 68,872 |   | 49,154 |   |
|                                                          |       |                                                                  |       |                                              |       |   |   |   |   |
| OPERATING  EXPENSES:                                          |       |                                                                  |       |                                              |       |   |   |   |   |
| Oil and natural  gas operating expenses                       |       | 2,260                                                                 |       | 1,802                                             |       | 4,449 |   | 4,044 |   |
| Severance and ad  valorem taxes                               |       | 2,236                                                                 |       | 1,785                                             |       | 4,825 |   | 3,651 |   |
| Depletion,  depreciation, amortization and accretion          |       | 16,545                                                                |       | 8,939                                             |       | 32,338 |   | 17,575 |   |
| General and  administrative expenses:                         |       |                                                                  |       |                                              |       |   |   |   |   |
| Deferred  compensation – repriced options                |       | (296                                                                  | )          | (90                                               | )          | (267 | ) | 172 |   |
| Deferred  compensation – restricted stock                |       | 522                                                                   |       | 262                                               |       | 858 |   | 406 |   |
| Deferred  compensation – stock option expense            |       | —                                                                |       | —                                            |       | 42 |   | — |   |
| Bad debt expense                                              |       | —                                                                |       | —                                            |       | — |   | 11 |   |
| Other general  and administrative expenses                    |       | 3,122                                                                 |       | 2,357                                             |       | 5,839 |   | 4,836 |   |
| Total operating  expenses                                     |       | 24,389                                                                |       | 15,055                                            |       | 48,084 |   | 30,695 |   |
| OPERATING INCOME                                              |       | 9,489                                                                 |       | 11,155                                            |       | 20,788 |   | 18,459 |   |
|                                                          |       |                                                                  |       |                                              |       |   |   |   |   |
| OTHER INCOME AND  EXPENSE:                                    |       |                                                                  |       |                                              |       |   |   |   |   |
| Interest income                                               |       | 32                                                                    |       | 24                                                |       | 70 |   | 56 |   |
| Interest  expense, net of amounts capitalized                 |       | (545                                                                  | )          | —                                            |       | (1,213 | ) | — |   |
| Amortization of  deferred loan costs                          |       | (41                                                                   | )          | (36                                               | )          | (83 | ) | (71 | ) |
| INCOME BEFORE  INCOME TAXES                                   |       | 8,935                                                                 |       | 11,143                                            |       | 19,562 |   | 18,444 |   |
| INCOME TAX  EXPENSE                                           |       | (3,140                                                                | )          | (3,934                                            | )          | (6,875 | ) | (6,511 | ) |
| NET INCOME                                                    |       | $                                                                     | 5,795      |                                              | $          | 7,209 |   | $ | 12,687 |   | $ | 11,933 |   |
|                                                          |       |                                                                  |       |                                              |       |   |   |   |   |
| BASIC EARNINGS  PER SHARE                                     |       | $                                                                     | 0.33       |                                              | $          | 0.42 |   | $ | 0.73 |   | $ | 0.70 |   |
| DILUTED EARNINGS  PER SHARE                                   |       | $                                                                     | 0.32       |                                              | $          | 0.40 |   | $ | 0.70 |   | $ | 0.67 |   |
|                                                          |       |                                                                  |       |                                              |       |   |   |   |   |
| BASIC WEIGHTED  AVERAGE NUMBER OF COMMON SHARES OUTSTANDING   |       | 17,372                                                                |       | 17,120                                            |       | 17,306 |   | 17,081 |   |
| DILUTED WEIGHTED  AVERAGE NUMBER OF COMMON SHARES OUTSTANDING |       | 18,105                                                                |       | 17,796                                            |       | 18,043 |   | 17,745 |   |

 

See accompanyingnotes to consolidated financial statements.

 

4

----

 

**EDGE PETROLEUM CORPORATION**

**CONSOLIDATED STATEMENTS OF OTHER COMPREHENSIVE INCOME(Unaudited)**

 
| ** **                                                                  | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|-----------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                  | ** ** | **2006**                                            | ** ** | **2005**                                          | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                                  | ** ** | **(in thousands)**                                  | ** ** |
| NET INCOME                                                                  |       | $                                                   | 5,795      |                                              | $          | 7,209 |   | $ | 12,687 |   | $ | 11,933 |   |
|                                                                        |       |                                                |       |                                              |       |   |   |   |   |
| OTHER COMPREHENSIVE  INCOME (LOSS), net of tax:                             |       |                                                |       |                                              |       |   |   |   |   |
| Change in fair  value of outstanding hedging and derivative instruments (1) |       | —                                              |       | 541                                               |       | — |   | (648 | ) |
| Reclassification  of hedging and derivative losses (gains) (2)              |       | —                                              |       | 143                                               |       | — |   | (667 | ) |
| Other  comprehensive income (loss)                                          |       | —                                              |       | 684                                               |       | — |   | (1,315 | ) |
| COMPREHENSIVE  INCOME                                                       |       | $                                                   | 5,795      |                                              | $          | 7,893 |   | $ | 12,687 |   | $ | 10,618 |   |
|                                                                        |       |                                                |       |                                              |       |   |   |   |   |
|                                                                             |
| (1) net of  income taxes of                                                 |       | $                                                   | —     |                                              | $          | 291 |   | $ | — |   | $ | (349 | ) |
| (2) net of  income taxes of                                                 |       | $                                                   | —     |                                              | $          | 77 |   | $ | — |   | $ | (359 | ) |

 

See accompanyingnotes to the consolidated financial statements**.**

 

5

----

 

**EDGEPETROLEUM CORPORATION**

 

**CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)**

 
| ** **                                                                         | ** ** | **Six Months Ended June 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                         | ** ** | **2006**                                          | ** ** | **2005** | ** ** |
| ** **                                                                         | ** ** | **(in thousands)**                           | ** ** |
| **CASH  FLOWS FROM OPERATING ACTIVITIES:**                                         | * *   | * *                                          | * *   | * * | * * |
| Net income                                                                         |       | $                                                 | 12,687     |   | $ | 11,933 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                                              |       |   |   |
| Unrealized  (gain) loss on the fair value of derivatives                           |       | (2,817                                            | )          | 554 |   |
| Loss on property                                                                   |       | —                                            |       | 2 |   |
| Deferred income  taxes                                                             |       | 6,875                                             |       | 6,511 |   |
| Depletion,  depreciation, amortization and accretion                               |       | 32,338                                            |       | 17,575 |   |
| Amortization of  deferred loan costs                                               |       | 83                                                |       | 71 |   |
| Deferred  compensation                                                             |       | 633                                               |       | 578 |   |
| Bad debt expense                                                                   |       | —                                            |       | 11 |   |
| Changes in  assets and liabilities:                                                |       |                                              |       |   |   |
| Decrease  (increase) in accounts receivable, trade                                 |       | 8,675                                             |       | (1,230 | ) |
| Decrease  (increase) in accounts receivable, joint interest owners                 |       | (2,258                                            | )          | 3,341 |   |
| Increase in  other assets                                                          |       | (627                                              | )          | (1,755 | ) |
| Decrease in  accounts payable, trade                                               |       | (3,058                                            | )          | (2,119 | ) |
| Decrease in  accrued liabilities                                                   |       | (6,766                                            | )          | (1,732 | ) |
| Increase in  accrued interest payable                                              |       | 605                                               |       | — |   |
| Net cash  provided by operating activities                                         |       | 46,370                                            |       | 33,740 |   |
|                                                                               |       |                                              |       |   |   |
| **CASH  FLOWS FROM INVESTING ACTIVITIES:**                                         |       |                                              |       |   |   |
| Oil and natural  gas property and equipment additions                              |       | (67,897                                           | )          | (34,037 | ) |
| Decrease in  drilling advances                                                     |       | 2,071                                             |       | — |   |
| Proceeds from  the sale of oil and natural gas properties                          |       | 600                                               |       | — |   |
| Net cash used in  investing activities                                             |       | (65,226                                           | )          | (34,037 | ) |
|                                                                               |       |                                              |       |   |   |
| **CASH  FLOWS FROM FINANCING ACTIVITIES:**                                         |       |                                              |       |   |   |
| Borrowings from  long-term debt                                                    |       | 28,000                                            |       | 3,000 |   |
| Payments of  long-term debt                                                        |       | (8,000                                            | )          | (10,000 | ) |
| Net proceeds  from issuance of common stock                                        |       | 576                                               |       | 7,210 |   |
| Deferred loan  costs                                                               |       | (6                                                | )          | — |   |
| Net cash  provided by financing activities                                         |       | 20,570                                            |       | 210 |   |
|                                                                               |       |                                              |       |   |   |
| **NET  INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS**                          |       | 1,714                                             |       | (87 | ) |
| **CASH  AND CASH EQUIVALENTS, BEGINNING OF PERIOD**                                |       | 666                                               |       | 2,267 |   |
| **CASH  AND CASH EQUIVALENTS, END OF PERIOD**                                      |       | $                                                 | 2,380      |   | $ | 2,180 |   |

 

See accompanyingnotes to consolidated financial statements.

 

6

----

 

**EDGEPETROLEUM CORPORATION**

 

**CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY (Unaudited)**

 
| ** **                                                           | ** ** | **Common Stock** | ** ** | **Additional** | ** ** | **Retained**             | ** ** | **Accumulated  Other  Comprehensive** | ** ** | **Total  Stockholders’** | ** ** |
|----------------------------------------------------------------------|------------|-----------------------|------------|----------------|------------|--------------------------|------------|---------------------------------------|------------|-------------------------------|------------|
| ** **                                                           | ** ** | **Shares**            | ** ** | **Amount**     | ** ** | **Paid-in Capital** | ** ** | **Earnings**                          | ** ** | **Income (Loss)**        | ** ** | **Equity** | ** ** |
| ** **                                                           | ** ** | **(in  thousands)**   | ** ** |
| BALANCE, DECEMBER  31, 2005                                          |       | 17,217                |       | $              | 172        |                     | $          | 137,842                               |       | $                             | 55,454     |   | $ | (1,713 | ) | $ | 191,755 |   |
| Issuance of  common stock                                            |       | 162                   |       | 2              |       | 712                      |       | —                                |       | —                        |       | 714 |   |
| Deferred  compensation – restricted stock                       |       | —                |       | —         |       | 858                      |       | —                                |       | —                        |       | 858 |   |
| Deferred  compensation - repriced options                            |       | —                |       | —         |       | (267                     | )          | —                                |       | —                        |       | (267 | ) |
| Deferred  compensation - stock option expense                        |       | —                |       | —         |       | 42                       |       | —                                |       | —                        |       | 42 |   |
| Change in  valuation of hedging instruments                          |       | —                |       | —         |       | —                   |       | —                                |       | 1,713                         |       | 1,713 |   |
| Tax benefit  associated with exercise of non-qualified stock options |       | —                |       | —         |       | 403                      |       | —                                |       | —                        |       | 403 |   |
| Net income                                                           |       | —                |       | —         |       | —                   |       | 12,687                                |       | —                        |       | 12,687 |   |
| BALANCE, JUNE 30,  2006                                              |       | 17,379                |       | $              | 174        |                     | $          | 139,590                               |       | $                             | 68,141     |   | $ | — |   | $ | 207,905 |   |

 

See accompanying notes toconsolidated financial statements.

 

7

----

 

**EDGEPETROLEUM CORPORATION**

 

**NOTESTO THE CONSOLIDATED FINANCIAL STATEMENTS**

 

**1.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

 

The financial statementsincluded herein have been prepared by Edge Petroleum Corporation, a Delawarecorporation (“we”, “our”, “us” or the “Company”), without audit pursuant to therules and regulations of the Securities and Exchange Commission (“SEC”), andreflect all adjustments which are, in the opinion of management, necessary topresent a fair statement of the results for the interim periods on a basisconsistent with the annual audited consolidated financial statements. All suchadjustments are of a normal recurring nature. The results of operations for theinterim periods are not necessarily indicative of the results to be expectedfor an entire year. Certain information, accounting policies and footnotedisclosures normally included in financial statements prepared in accordancewith accounting principles generally accepted in the United States of Americahave been omitted pursuant to such rules and regulations, although we believethat the disclosures are adequate to make the information presented notmisleading. These financial statements should be read in conjunction with ouraudited consolidated financial statements included in our Annual Report on Form10-K for the year ended December 31, 2005.

 

***Oil and Natural Gas Properties* -**Investments in oil and natural gasproperties are accounted for using the full-cost method of accounting. Theaccounting for our business is subject to special accounting rules that areunique to the oil and gas industry. There are two allowable methods ofaccounting for oil and gas business activities: the successful-efforts method and the full-cost method. There areseveral significant differences between these methods. Among these differencesis that, under the successful-efforts method, costs such as geological andgeophysical (“G&G”), exploratory dry holes and delay rentals are expensedas incurred whereas under the full-cost method these types of charges arecapitalized to their respective full-cost pool. In the measurement ofimpairment of oil and gas properties, the successful-efforts method of accountingfollows the guidance provided in Statement of Financial Accounting Standards (“SFAS”)No. 144, *Accounting for the Impairment orDisposal of Long-Lived Assets*, where the first measurement forimpairment is to compare the net book value of the related asset to itsundiscounted future cash flows using commodity prices consistent withmanagement expectations. The full-cost method follows guidance provided in SECRegulation S-X Rule 4-10, where impairment is determined by comparing the netbook value of the full-cost pool to the future net cash flows discounted at 10percent using commodity prices in effect at the end of the reporting period.

 

The Company utilizes thefull-cost method of accounting for oil and natural gas properties. Inaccordance with the full-cost method of accounting, all costs associated withthe exploration, development and acquisition of oil and natural gas properties,including salaries, benefits and other internal costs directly attributable tothese activities are capitalized within a cost center. The Company’s oil andnatural gas properties are located within the United States of America andconstitute one cost center. The Company also capitalizes a portion of interestexpense on borrowed funds. Employee related costs that are directlyattributable to exploration and development activities are also capitalized. Thesecosts are considered to be direct costs based on the nature of their functionas it relates to the exploration and development activities.

 

Oil and natural gasproperties are amortized based on a unit-of-production method using estimatesof proved reserve quantities. Oil and natural gas liquids (“NGL”s) areconverted to gas equivalent basis (“Mcfe”) at the rate of one barrel equals sixMcf. In accordance with SEC Staff Accounting Bulletin (“SAB”) No. 106, *Interaction of Statement 143 and the Full Cost Rules,*the amortizable base includes estimated future development anddismantlement costs, and restoration and abandonment costs, net of estimatedsalvage values. Investments in unproved properties are not amortized untilproved reserves associated with the prospects can be determined or untilimpairment occurs. Oil and natural gas properties include costs of $35.7million and $36.9 million at June 30, 2006 and December 31, 2005, respectively,related to unproved property, which were excluded from capitalized costs beingamortized. Unproved properties are evaluated quarterly, and as needed, forimpairment on a property-by-property basis. If the results of an assessmentindicate that an unproved property is impaired, the amount of impairment isadded to the proved oil and natural gas property costs to be amortized.

 

8

----

 

In addition, thecapitalized costs of oil and natural gas properties are subject to a “ceilingtest,” whereby to the extent that such capitalized costs subject toamortization in the full-cost pool (net of accumulated depletion, depreciationand amortization, and related tax effects) exceed the present value (using a 10%discount rate) of estimated future net after-tax cash flows from proved oil andnatural gas reserves, such excess costs are charged to expense. Once incurred,an impairment of oil and natural gas properties is not reversible at a laterdate. In accordance with SAB No.103, *Updateof Codification of Staff Accounting Bulletins*, derivativeinstruments qualifying as cash flow hedges are to be included in thecomputation of limitation on capitalized costs. As of June 30, 2006, theCompany was not applying cash flow hedge accounting to any derivative contracts(see Note 7), therefore the ceiling test at June 30, 2006 was not impacted. Impairmentof oil and natural gas properties is assessed on a quarterly basis inconjunction with the Company’s quarterly and annual SEC filings. No ceilingtest impairment was required during the three- or six-month periods ended June30, 2006 or 2005.

 

Sales of proved andunproved properties are accounted for as adjustments of capitalized costs withno gain or loss recognized, unless such adjustments would significantly alterthe relationship between capitalized costs and proved reserves.

 

***Inventories–***Inventories consist principally of tubular goods andproduction equipment for wells and facilities. They are stated at the lower ofweighted-average cost or market.

 

***Asset RetirementObligations –***The Company records a liability for legalobligations associated with the retirement of tangible long-lived assets in theperiod in which they are incurred in accordance with SFAS No. 143, *Accounting for Asset Retirement Obligations.*The Company adopted this policy effective January 1, 2003, using a cumulativeeffect approach to recognize transition amounts for asset retirementobligations, asset retirement costs and accumulated accretion and depletion.Under this method, when liabilities for dismantlement and abandonment costs,excluding salvage values, are initially recorded, the carrying amount of therelated oil and gas properties is increased. Accretion of the liability isrecognized each period using the interest method of allocation, and thecapitalized cost is depleted over the useful life of the related asset. Thechanges to the Asset Retirement Obligations (“ARO”) for oil and natural gasproperties and related equipment during the periods ended June 30, 2006 and 2005are as follows:

 
| ** **                                  | ** ** | **Six Months Ended June 30,** | ** ** |
|---------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                  | ** ** | **2006**                                          | ** ** | **2005** | ** ** |
| ** **                                  | ** ** | **(in thousands)**                           | ** ** |
| ARO, Beginning  of Period                   |       | $                                                 | 2,767      |   | $ | 2,189 |   |
| Liabilities  incurred in the current period |       | 287                                               |       | 139 |   |
| Liabilities  settled in the current period  |       | (129                                              | )          | (98 | ) |
| Accretion  expense                          |       | 89                                                |       | 68 |   |
| Revisions                                   |       | —                                            |       | — |   |
| ARO, End of  Period                         |       | $                                                 | 3,014      |   | $ | 2,298 |   |
|                                        |       |                                              |       |   |   |
| Current Portion                             |       | $                                                 | 166        |   | $ | 197 |   |
| Long Term  Portion                          |       | $                                                 | 2,848      |   | $ | 2,101 |   |

 

During the six monthsended June 30, 2006, ARO liabilities incurred include 29 new well obligationsand liabilities settled include eight wells that were plugged and eleven thatwere sold.

 

***Stock-BasedCompensation***– On January 1, 2006, the Company adoptedSFAS No. 123(R), *Share-Based Payment.*This statement requires companies to measure the cost of employee services inexchange for an award of equity instruments based on a grant-date fair value ofthe award (with limited exceptions), and that cost must generally be recognizedover the vesting period for the award. Prior to the adoption of SFAS No.123(R), this accounting treatment was optional with pro forma disclosuresrequired. SFAS No. 123(R) amends the original SFAS No. 123 and SFAS No. 148 thathad allowed companies to choose between expensing stock options or showing pro

 

9

----

 

forma disclosure only. This statement also eliminated the ability toaccount for share-based compensation transactions using Accounting PrinciplesBoard (“APB”) Opinion No. 25, *Accounting forStock Issued to Employees*, which allowed companies to exclude stockoption compensation cost from net income when all options granted had exerciseprices equal to the market value of the underlying common stock on the dates ofgrant. The Company adopted SFAS No. 123(R) using the modified prospectivemethod for transition and the impact is reflected in “Deferred compensation –stock option expense” in the Company’s results of operations. Under this methodthe Company recognizes compensation expense for all stock-based awards grantedor modified on or after July 1, 2005, as well as any previously grantedawards that were not fully vested as of July 1, 2005. Compensation expensewill be measured based on the fair value of the awards previously calculated indeveloping the pro forma disclosures in accordance with the provisions ofSFAS No. 123, *Accounting forStock-Based Compensation*. The Company expects the future impact onpreviously granted options to be immaterial due to the fact that it has notissued stock options since April 2004. SFAS No. 123(R) also requires thebenefits of tax deductions in excess of recognized compensation cost bereflected as a financing cash flow, rather than as an operating cash flow as previouslyrequired.

 

The Company previouslyaccounted for stock compensation plans under the intrinsic value method of APBOpinion No. 25, in which no compensation expense was recognized for stockoptions that had an exercise price equal to or greater than the market value ofthe underlying common stock on the date of grant. Had the Company applied theprovisions of SFAS No. 123(R) on January 1, 2005, the Company’s pro forma netincome and earnings per share would have been as follows:

 
| ** **                                                                                                    | ** ** | **Three Months Ended  June 30, 2005**             | ** ** | **Six Months Ended  June 30, 2005** | ** ** |
|---------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                                                    | ** ** | **(in thousands, except per share amounts)** | ** ** |
| Net income as  reported                                                                                       |       | $                                                                     | 7,209      |                                                    | $          | 11,933 |   |
| Deduct:                                                                                                       |       |                                                                  |       |                                                    |       |
| Stock based  employee compensation expense included in reported net income, net of related  income tax        |       | 112                                                                   |       | 376                                                     |       |
| Add:                                                                                                          |       |                                                                  |       |                                                    |       |
| Total stock  based employee compensation expense determined under SFAS No. 123(R), net of  related income tax |       | (201                                                                  | )          | (326                                                    | )          |
| Pro forma net  income                                                                                         |       | $                                                                     | 7,120      |                                                    | $          | 11,983 |   |
|                                                                                                          |       |                                                                  |       |                                                    |       |
| Earnings Per  Share:                                                                                          |       |                                                                  |       |                                                    |       |
| Basic – as  reported                                                                                     |       | $                                                                     | 0.42       |                                                    | $          | 0.70 |   |
| Basic – pro  forma                                                                                       |       | $                                                                     | 0.42       |                                                    | $          | 0.70 |   |
|                                                                                                          |       |                                                                  |       |                                                    |       |
| Diluted – as  reported                                                                                   |       | $                                                                     | 0.40       |                                                    | $          | 0.67 |   |
| Diluted – pro  forma                                                                                     |       | $                                                                     | 0.40       |                                                    | $          | 0.68 |   |

 

The Company is alsosubject to reporting requirements of Financial Accounting Standards Board (“FASB”)Interpretation No. (“FIN”) 44, *Accounting for Certain**Transactions involving Stock Compensation*that requires a non-cash charge to deferred compensation expense if the marketprice of the Company’s common stock at the end of a reporting period is greaterthan the exercise price of certain stock options. After the first suchadjustment is made, each subsequent period is adjusted upward or downward tothe extent that the market price exceeds the exercise price of the options. Thecharge is related to non-qualified stock options granted to employees anddirectors in prior years and re-priced in May 1999, as well as certain optionsnewly issued in conjunction with the repricing. For the second quarter of 2006,we recorded a non-cash, pre-tax credit of $0.3 million, as compared to anon-cash, pre-tax credit of $90,259 for the second quarter of 2005. For thefirst half of 2006, we recorded a non-cash, pre-tax credit of $0.3 million ascompared to a charge of approximately $0.2 million for the same period in 2005.

 

***Accounting Pronouncements***– InDecember 2004, the FASB issued SFAS No. 153, *Exchanges ofNonmonetary Assets, an amendment of APB Opinion No. 29*. SFASNo. 153 is based on the principle that exchanges of nonmonetary assetsshould be measured based on the fair value of the assets exchanged. APB OpinionNo. 29,

 

10

----

 

*Accounting for Nonmonetary Transactions*,provided an exception to its basic measurement principle (fair value) forexchanges of similar productive assets. Under APB Opinion No. 29, anexchange of a productive asset for a similar productive asset was based on therecorded amount of the asset relinquished. SFAS No. 153 eliminates theexception for nonmonetary exchanges of similar productive assets and replacesit with a general exception for exchanges of nonmonetary assets that do nothave commercial substance. Nonmonetary exchange has commercial substance if thefuture cash flows of the entity are expected to change significantly as aresult of the exchange. SFAS No. 153 is effective for fiscal periodsbeginning after June 15, 2005. The adoption of SFAS No. 153 is not expected tohave a material effect on the Company’s consolidated financial position,results of operations or cash flows.

 

In March 2005, the FASBissued FIN 47, *Accounting for ConditionalAsset Retirement Obligations, an interpretation of FASB Statement No. 143*. FIN 47 clarifies that the term, “conditional asset retirement obligation” asused in SFAS No. 143, *Accounting for AssetRetirement Obligations*, refers to a legal obligation to perform anasset retirement activity in which the timing and/or method of settlement areconditional upon a future event that may or may not be within the control ofthe entity.  Even though uncertainty about the timing and/or method ofsettlement exists and may be conditional upon a future event, the obligation toperform the asset retirement activity is unconditional.  Accordingly, anentity is required to recognize a liability for the fair value of a conditionalasset retirement obligation if the fair value of the liability can bereasonably estimated.  Uncertainty about the timing and/or method ofsettlement of a conditional asset retirement obligation should be factored intothe measurement of the liability when sufficient information exists.  Thefair value of a liability for the conditional asset retirement obligationshould be recognized when incurred generally upon acquisition, construction, ordevelopment or through the normal operation of the asset.  SFAS No. 143acknowledges that in some cases, sufficient information may not be available toreasonably estimate the fair value of an asset retirement obligation.  FIN47 also clarifies when an entity would have sufficient information toreasonably estimate the fair value of an asset retirement obligation.  FIN47 is effective for fiscal years ending after December 15, 2005. Retrospective application for interim financial information is permitted but isnot required.  The adoption of FIN 47 is not expected to have a materialeffect on the Company’s consolidated financial position, results of operationsor cash flows.

 

In June 2005, the FASBissued SFAS No. 154, *Accounting Changes andError Corrections*, *a replacement ofAccounting Principles Board (“APB”) Opinion No. 20 and FASB StatementNo. 3,*which changes the requirements for the accounting forand reporting of a change in accounting principle. It also applies to changesrequired by an accounting pronouncement in the unusual instance that thepronouncement does not include specific transition provisions. Application iseffective for accounting changes and correction of errors made in fiscal yearsbeginning after December 15, 2005. The adoption of SFAS No. 154 is not expectedto have a material effect on the Company’s consolidated financial position,results of operations or cash flows.

 

In February 2006, theFASB issued SFAS No. 155, *Accounting for CertainHybrid Financial Instruments,*which improves financial reporting byeliminating the exemption from applying SFAS No. 133 to interests insecuritized financial assets so that similar instruments are accounted forsimilarly regardless of the form of the instruments and allows a preparer toelect fair value measurement at acquisition, at issuance, or when a previouslyrecognized financial instrument is subject to a remeasurement (new basis)event, on an instrument-by-instrument basis, in cases in which a derivativewould otherwise have to be bifurcated. Providing a fair value measurementelection also results in more financial instruments being measured at what theFASB regards as the most relevant attribute for financial instruments, fairvalue. SFAS No. 155 is effective for all financial instruments acquired orissued after the beginning of an entity’s first fiscal year that begins afterSeptember 15, 2006. The Company is currently evaluating the impact of thisstandard on its financial position, results of operations and cash flows.

 

In March 2006, theFASB issued SFAS No. 156, *Accounting for Servicingof Financial Assets*, which requires all separately recognized servicingassets and servicing liabilities be initially measured at fair value. SFAS No.156 permits, but does not require, the subsequent measurement of servicingassets and servicing liabilities at fair value. Adoption is required as of thebeginning of the first fiscal year that begins after September 15, 2006.Early adoption is permitted. The adoption of SFAS No. 156 is not expected tohave a material effect on our consolidated financial position, results ofoperations or cash flows.

 

InJune 2006, the FASB issued FIN 48, *Accounting for Uncertaintyin Income Taxes, an Interpretation of FASB Statement No. 109*,which clarifies the accounting for uncertainty in income taxes recognized inaccordance with SFAS No. 109, *Accounting for IncomeTaxes*. FIN 48 prescribes a benefit recognition model with atwo-step

 

11

----

 

approach, a more-likely-than-not recognition criterion and ameasurement attribute that measures the position as the largest amount of taxbenefit that is greater than 50% likely of being ultimately realized uponultimate settlement. If it is not more likely than not that the benefit will besustained on its technical merits, no benefit will be recorded. FIN 48also requires that the amount of interest expense to be recognized related touncertain tax positions be computed by applying the applicable statutory rateof interest to the difference between the tax position recognized in accordancewith FIN 48 and the amount previously taken or expected to be taken in atax return. The change in net assets as a result of applying this pronouncementwill be considered a change in accounting principle with the cumulative effectof the change treated as an offsetting adjustment to the opening balance ofretained earnings or goodwill, if allowed under existing accounting standards,in the period of transition. FIN 48 is effective as of January 1,2007 and the Company is currently assessing the impact that FIN 48 willhave on its financial statements.

 

***Reclassifications***- Certainreclassifications of prior period statements have been made to conform tocurrent reporting practices.

 

**2.   LONG TERM DEBT**

 

On November 30, 2005, theCompany amended its Third Amended and Restated Credit Agreement (the “CreditFacility”), which it had originally entered into in March 2004 (effectiveDecember 31, 2003) and previously amended on May 31, 2005. The Credit Facilitypermits borrowings up to the lesser of (i) the borrowing base and (ii) $150.0million. Effective November 30, 2005, the Credit Facility’s borrowing base wasincreased from $70.0 million to $110.0 million. The borrowing base under theCredit Facility was increased as a result of the Chapman Ranch Fieldacquisitions and the Company’s drilling activities since the last redetermination.Effective May 25, 2006, the Credit Facility’s borrowing base was increased from$110.0 million to $115.0 million as a result of the Company’s recent drillingactivities. The Company’s available borrowing capacity under this facility was$10.0 million at June 30, 2006.

 

The Credit Facilitymatures December 31, 2007 and is secured by substantially all of the Company’sassets. Borrowings under the Credit Facility bear interest at rates that arevariable based on the percentage usage of the facility. Borrowings can be at Primeplus a margin of 0% to 0.25% or at Libor plus a margin of 1.75% to 2.125% . Outstandingavailability will bear interest rates of 0.25% to 0.50% based on utilizationlevels. At June 30, 2006 the interest rates applied to the Company’soutstanding Prime and Libor borrowings were 8.500% and 7.235%. As of June 30,2006, $105.0 million in total borrowings were outstanding under the CreditFacility.

 

The Credit Facilityprovides for certain restrictions, including but not limited to, limitations onadditional borrowings, sales of oil and natural gas properties or othercollateral, and engaging in merger or consolidation transactions. The CreditFacility also prohibits dividends and certain distributions of cash orproperties and certain liens. The Credit Facility also contains the followingfinancial covenants, among others:

 

•                  TheEBITDAX to Interest Expense ratio requires that the ratio of (a) consolidatedEBITDAX (defined as EBITDA plus similar non-cash items and exploration andabandonment expenses for such period) of the Company for the four fiscalquarters then ended to (b) the consolidated interest expense of the Company forthe four fiscal quarters then ended, not be less than 3.5 to 1.0.

 

•                  TheWorking Capital ratio requires that the amount of the Company’s consolidatedcurrent assets less its consolidated current liabilities, as defined in theCredit Facility Agreement, be at least $1.0 million. For the purposes ofcalculating the Working Capital ratio, the total of current assets is adjustedfor unused capacity under the Credit Facility Agreement, and derivativefinancial instruments and the total of current liabilities is adjusted for thecurrent portion of indebtedness under the Credit Facility Agreement, derivativefinancial instruments and asset retirement obligations.

 

•                  TheMaximum Leverage ratio requires that the ratio, as of the last day of anyfiscal quarter, of (a) Total Indebtedness (as defined in the Credit FacilityAgreement) as of such fiscal quarter to (b) an

 

12

----

 

amount equal toconsolidated EBITDAX for the two quarters then ended times two, not be greaterthan 3.0 to 1.0.

 

Consolidated EBITDAX is acomponent of negotiated covenants with our lender and is presented here as partof the Company’s disclosure of its covenant obligations.

 

**3.   SHELF REGISTRATION STATEMENT**

 

During the second quarter2005, the Company filed a registration statement with the SEC which registeredofferings up to $390 million of any combination of debt securities, preferredstock, common stock or warrants for debt securities or equity securities of theCompany. Net proceeds, terms and pricing of the offering of securities issuedunder the shelf registration statement will be determined at the time of theofferings. The shelf registration statement does not provide assurance that theCompany will or could sell any such securities. The Company’s ability toutilize the shelf registration statement for the purpose of issuing, from timeto time, any combination of debt securities, preferred stock, common stock orwarrants will depend upon, among other things, market conditions and theexistence of investors who wish to purchase the Company’s securities at pricesacceptable to the Company. At June 30, 2006, the Company had $390 millionavailable for issuance under its 2005 shelf registration statement.

 

**4.   EARNINGS PER SHARE**

 

The Company accounts forearnings per share in accordance with SFAS No. 128, *Earnings per Share*, which establishes the requirements for presentingearnings per share (“EPS”). SFAS No. 128 requires the presentation of “basic”and “diluted” EPS on the face of the income statement. Basic earnings percommon share amounts are calculated using the weighted average number of commonshares outstanding during each period. Diluted earnings per common shareassumes the exercise of all stock options and warrants having exercise pricesless than the average market price of the common stock during the periods,using the treasury stock method.

 

The following is areconciliation of the numerators and denominators of basic and diluted earningsper common share computations, in accordance with SFAS No. 128, for thethree-month and six-month periods ended June 30, 2006 and 2005:

 
| ** **                               | ** ** | **Three Months Ended June 30, 2006**         | ** ** | **Three Months Ended June 30, 2005** | ** ** |
|------------------------------------------|------------|-----------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                               | ** ** | **Income**                                                            | ** ** | **Shares**                                                    | ** ** | **Per Share  Amount** | ** ** | **Income** | ** ** | **Shares** | ** ** | **Per  Share  Amount** | ** ** |
| ** **                               | ** ** | **(Numerator)**                                                       | ** ** | **(Denominator)**                                             | ** ** | ** ** | ** ** | **(Numerator)** | ** ** | **(Denominator)** | ** ** | ** ** | ** ** |
| ** **                               | ** ** | **(in thousands, except per share amounts)** | ** ** |
| **Basic  EPS**                           | * *   | * *                                                              | * *   | * *                                                      | * *   | * * | * * | * * | * * | * * | * * | * * | * * |
| Income available  to common stockholders |       | $                                                                     | 5,795      |                                                          | 17,372     |   | $ | 0.33 |   | $ | 7,209 |   | 17,120 |   | $ | 0.42 |   |
| Effect of  dilutive securities:          |       |                                                                  |       |                                                          |       |   |   |   |   |   |   |   |   |
| Restricted stock                         |       | —                                                                |       | 254                                                           |       | (0.00 | ) | — |   | 197 |   | (0.01 | ) |
| Common stock  options                    |       | —                                                                |       | 479                                                           |       | (0.01 | ) | — |   | 479 |   | (0.01 | ) |
| **Diluted  EPS**                         |       |                                                                  |       |                                                          |       |   |   |   |   |   |   |   |   |
| Income available  to common stockholders |       | $                                                                     | 5,795      |                                                          | 18,105     |   | $ | 0.32 |   | $ | 7,209 |   | 17,796 |   | $ | 0.40 |   |

 

13

----

 
| ** **                               | ** ** | **Six Months Ended June 30, 2006**           | ** ** | **Six Months Ended June 30, 2005** | ** ** |
|------------------------------------------|------------|-----------------------------------------------------------------------|------------|-------------------------------------------------------------|------------|
| ** **                               | ** ** | **Income**                                                            | ** ** | **Shares**                                                  | ** ** | **Per Share  Amount** | ** ** | **Income** | ** ** | **Shares** | ** ** | **Per  Share  Amount** | ** ** |
| ** **                               | ** ** | **(Numerator)**                                                       | ** ** | **(Denominator)**                                           | ** ** | ** ** | ** ** | **(Numerator)** | ** ** | **(Denominator)** | ** ** | ** ** | ** ** |
| ** **                               | ** ** | **(in thousands, except per share amounts)** | ** ** |
| **Basic  EPS**                           | * *   | * *                                                              | * *   | * *                                                    | * *   | * * | * * | * * | * * | * * | * * | * * | * * |
| Income available  to common stockholders |       | $                                                                     | 12,687     |                                                        | 17,306     |   | $ | 0.73 |   | $ | 11,933 |   | 17,081 |   | $ | 0.70 |   |
| Effect of  dilutive securities:          |       |                                                                  |       |                                                        |       |   |   |   |   |   |   |   |   |
| Restricted stock                         |       | —                                                                |       | 238                                                         |       | (0.01 | ) | — |   | 174 |   | (0.01 | ) |
| Common stock  options                    |       | —                                                                |       | 499                                                         |       | (0.02 | ) | — |   | 490 |   | (0.02 | ) |
| **Diluted  EPS**                         |       |                                                                  |       |                                                        |       |   |   |   |   |   |   |   |   |
| Income available  to common stockholders |       | $                                                                     | 12,687     |                                                        | 18,043     |   | $ | 0.70 |   | $ | 11,933 |   | 17,745 |   | $ | 0.67 |   |

 

**5.   INCOME TAXES**

 

The Company accounts forincome taxes under the provisions of SFAS No. 109, *Accounting for Income Taxes*, which provides for an asset andliability approach in accounting for income taxes. Under this approach,deferred tax assets and liabilities are recognized based on anticipated futuretax consequences, using currently enacted tax laws, attributable to temporarydifferences between the carrying amounts of assets and liabilities forfinancial reporting purposes and the amounts calculated for income taxpurposes.

 

The Company currentlyestimates that its effective tax rate for the year ending December 31, 2006 willbe approximately 35.15%. A provision for income taxes of $6.9 million (35.1% ofpre-tax income) and $6.5 million (35.3% of pre-tax income) was reported for thesix months ended June 30, 2006 and 2005, respectively. Our income taxprovisions are primarily non-cash as we continue to utilize existing netoperating loss carryforwards generated from drilling activity and currentlyanticipate that we will pay only federal alternative minimum tax in 2006. TheCompany was required to pay federal alternative minimum taxes in the fourthquarter of 2005.

 

**6.   SUPPLEMENTAL DISCLOSURE OF CASH FLOWINFORMATION AND NON-CASH INVESTING AND FINANCING ACTIVITIES**

 

The Company considers allhighly liquid debt instruments purchased with an original maturity of threemonths or less to be cash equivalents. A summary of non-cash investing andfinancing activities for the six months ended June 30, 2006 and 2005 ispresented below:

 
| **Description**                                                                                      | ** ** | **Number of  Shares  Issued** | ** ** | **Fair Market  Value** | ** ** |
|------------------------------------------------------------------------------------------------------|------------|------------------------------------|------------|-----------------------------|------------|
| ** **                                                                                           | ** ** | **(in thousands)**            | ** ** |
| **Six  months ended June 30, 2006:**                                                                 |       |                               |       |                        |       |
| Shares issued to  satisfy restricted stock grants                                                    |       | 73                                 |       | $                           | 911        |   |
| Shares issued to  fund the Company’s matching contribution under the Company’s 401(k) plan |       | 5                                  |       | $                           | 138        |   |
| **Six  months ended June 30, 2005:**                                                                 |       |                               |       |                        |       |
| Shares issued to  satisfy restricted stock grants                                                    |       | 48                                 |       | $                           | 482        |   |
| Shares issued to  fund the Company’s matching contribution under the Company’s 401(k) plan |       | 4                                  |       | $                           | 62         |   |

 

14

----

 

Forthe six months ended June 30, 2006 and 2005, the non-cash portion of AssetRetirement Costs was $158,031 and $40,964, respectively. A supplementaldisclosure of cash flow information for the six months ended June 30, 2006 and 2005is presented below:

 
| ** **                                 | ** ** | **For the Six Months Ended  June 30,** | ** ** |
|--------------------------------------------|------------|-----------------------------------------------------------------|------------|
| ** **                                 | ** ** | **2006**                                                        | ** ** | **2005** | ** ** |
| ** **                                 | ** ** | **(in thousands)**                                              | ** ** |
| Cash paid during  the period for:          |       |                                                            |       |   |   |
| Interest                                   |       | $                                                               | 2,959      |   | $ | 480 |   |
| Federal  alternative minimum tax payments* |       | 94                                                              |       | — |   |
|                                            |            |                                                                 |            |  |  |  |  |

 

----

*During 2005 the Company paid Federal alternative minimum taxes only in thefourth quarter.

 

**7.   HEDGING AND DERIVATIVE ACTIVITIES**

 

Due to the volatility ofoil and natural gas prices, the Company periodically enters into price-riskmanagement transactions (e.g., swaps, collars and floors) for a portion of itsoil and natural gas production to achieve a more predictable cash flow, as wellas to reduce exposure from price fluctuations. While the use of thesearrangements may limit the Company’s ability to benefit from increases in theprice of oil and natural gas, it also reduces the Company’s potential exposureto adverse price movements. The Company’s arrangements, to the extent it entersinto any, apply to only a portion of its production and provide only partialprice protection against declines in oil and natural gas prices. None of theseinstruments are used for trading purposes. On a quarterly basis, the Company’smanagement reviews all of the Company’s price-risk management policies,including volumes, types of instruments and counterparties. These policies areimplemented by management through the execution of trades by the ChiefFinancial Officer after consultation and concurrence by the President andChairman of the Board. The Board of Directors continuously monitors the Company’spolicies and trades.

 

All of these price-riskmanagement transactions are considered derivative instruments and accounted forin accordance with SFAS No. 133, *Accountingfor Derivative Instruments and Hedging Activities* (as amended)*.* These derivative instruments are intended to hedge theCompany’s price risk and may be considered hedges for economic purposes, butcertain of these transactions may not qualify for cash flow hedge accounting.All derivative instrument contracts are recorded on the balance sheet at fairvalue. For those derivative instrument contracts that qualify for cash flowhedge accounting, the effective portion of the changes in the fair value of thecontracts is recorded in other comprehensive income and the ineffective portionof the changes in the fair value of the contracts is recorded in revenue asthey occur. While the contract is outstanding, the ineffective gain or loss mayincrease or decrease until settlement of the contract depending on the fairvalue at the measurement dates. When the hedged production is sold, therealized gains and losses on the contracts are removed from other comprehensiveincome and recorded in revenue.

 

During the first quarterof 2006, the Company determined that the cash flow hedge accounting treatment previouslyapplied to its natural gas contracts should be discontinued due to projected changesin the 2006 physical production volumes hedged and to give the Company moreflexibility in how it markets its physical production. The Company is currentlyaccounting for all contracts using mark-to-market accounting treatment, thereforethe changes in fair value are not deferred through other comprehensive income,but rather recorded in revenue immediately as unrealized gains or losses. Goingforward, the Company will continue to evaluate the terms of new contractsentered into to determine whether cash flow hedge accounting treatment ormark-to-market accounting treatment will be applied. In the past, the Companyhas used mark-to-market accounting treatment for its crude oil contracts and cashflow hedge accounting treatment for its natural gas contracts, thereforeunrealized gains and losses on the change in fair value of natural gascontracts between periods may not be comparable.

 

For the six months ended June30, 2006 and 2005, the Company included in total revenue the following realizedand unrealized gains and losses:

 

15

----

 
| ** **                                          | ** ** | **Six Months Ended June 30,** | ** ** |
|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                          | ** ** | **2006**                                          | ** ** | **2005** | ** ** |
| ** **                                          | ** ** | **(in thousands)**                           | ** ** |
| Natural gas  collar realized settlements            |       | $                                                 | 1,961      |   | $ | 156 |   |
| Crude oil collar  realized settlements              |       | —                                            |       | (605 | ) |
| Natural gas  collar unrealized change in fair value |       | 3,124                                             |       | — |   |
| Crude oil collar  unrealized change in fair value   |       | (307                                              | )          | (554 | ) |
| Gain (loss) on  hedging and derivatives             |       | $                                                 | 4,778      |   | $ | (1,003 | ) |

 

The fairvalue of outstanding hedging and derivative contracts at June 30, 2006 andDecember 31, 2005 reflected on the balance sheet were as follows: 

 
| ** **                | ** ** | ** **                | ** ** | ** **    | ** ** | ** ** | ** ** | **Price**         | ** ** | **Volumes**      | ** ** | **Fair Value of Outstanding Contracts as of** | ** ** |
|---------------------------|------------|---------------------------|------------|---------------|------------|------------|------------|-------------------|------------|------------------|------------|-----------------------------------------------------------------------------|------------|
| **Transaction Date** | ** ** | **Transaction Type** | ** ** | **Beginning** | ** ** | **Ending** | ** ** | **Per Unit** | ** ** | **Per Day** | ** ** | **June 30, 2006**                                                 | ** ** | **December 31, 2005** | ** ** |
| ** **                | ** ** | ** **                | ** ** | ** **    | ** ** | ** ** | ** ** | ** **        | ** ** | ** **       | ** ** | **(in  thousands****)**                                                     | ** ** |
| ***Natural  Gas (1):***   | * *   | * *                  | * *   | * *      | * *   | * *   | * *   | * *          | * *   | * *         | * *   | * *                                                                    | * *   | * * | * * |
| 08/05                     |       | Natural Gas Collar        |       | 01/01/2006    |       | 12/31/2006 |       | $7.00-$10.50      |       | 10,000MMbtu      |       | $                                                                           | 1,460      |   | $ | (2,498 | ) |
| 08/05                     |       | Natural Gas Collar        |       | 01/01/2006    |       | 12/31/2006 |       | $7.00-$16.10      |       | 10,000MMbtu      |       | 1,664                                                                       |       | (137 | ) |
| ***Crude  Oil (2):***     |       |                      |       |          |       |       |       |              |       |             |       |                                                                        |       |   |   |
| 08/05                     |       | Crude Oil Collar          |       | 01/01/2006    |       | 12/31/2006 |       | $55.00-$80.00     |       | 400Bbl           |       | (151                                                                        | )          | 156 |   |
|                      |       |                      |       |          |       |       |       |              |       |             |       |                                                                        |       |   |   |
|                      |       |                      |       |          |       |       |       |              |       |             |       | $                                                                           | 2,973      |   | $ | (2,479 | ) |

 

----

(1)   The Company’s current natural gas collars wereentered into on a per MMbtu delivered price basis, using the Houston ShipChannel Index, with settlement for each calendar month occurring five businessdays following the expiration date. During 2005, cash flow hedge accounting wasapplied to these contracts, which was then discontinued in 2006. During 2006,mark-to-market accounting treatment will be applied to these contracts and thechange in fair value is reflected in total revenue during the year.

 

(2)   Cash flow hedge accounting is not applied tothe Company’s crude oil collars, which were entered into on a per barreldelivered price basis, using the West Texas Intermediate Light Sweet Crude Oil Index,with settlement for each calendar month occurring five business days followingthe expiration date. Mark-to-market accounting treatment is applied to thesecontracts and the change in fair value is reflected in total revenue during theyear.

 

Derivativecontracts entered into after June 30, 2006 were as follows: 

 
| ** **           | ** ** | ** **           | ** ** | **Effective Dates** | ** ** | ** ** | ** ** | **Volume Per**          | ** ** |
|----------------------|------------|----------------------|------------|--------------------------|------------|------------|------------|------------------------------|------------|
| **Transaction Date** | ** ** | **Transaction Type** | ** ** | **Beginning**            | ** ** | **Ending** | ** ** | **Price Per Unit** | ** ** | **Day** | ** ** |
| 08/06                |       | Natural Gas  Collar  | (1)        | 01/01/07                 |       | 12/31/07   |       | $7.50-$11.50                 |       | 5,000 MMbtu |   |
| 08/06                |       | Crude Oil Collar     | (2)        | 01/01/07                 |       | 12/31/07   |       | $70.00-$87.50                |       | 400 Bbl |   |

 

----

(1)   The Company’s new natural gas collar wasentered into on a per MMbtu delivered price basis, using the Houston ShipChannel Index, with settlement for each calendar month occurring five businessdays following the expiration date. Mark-to-market accounting treatment will beapplied to this contract and the change in fair value will be reflected intotal revenue.

 

(2)   The Company’s new crude oil collar was enteredinto on a per barrel delivered price basis, using the West Texas IntermediateLight Sweet Crude Oil Index, with settlement for each calendar month occurringfive business days following the expiration date. Mark-to-market accountingtreatment will be applied to this contract and the change in fair value will bereflected in total revenue.

 

**8.   ACQUISITIONS & DIVESTITURES**

 

On October 13, 2005, theCompany consummated the acquisition of working interests in oil and natural gasproperties located on the Chapman Ranch Field in Nueces County, Texas. Thefinal cash purchase price was $28.0 million, including the incremental purchaseprice and the results of operations between the September 1, 2005 effectivedate and the October 13, 2005 closing date, pursuant to the closing adjustmentprovisions of the relevant agreement. On November 30, 2005, the Company alsoconsummated the acquisition of the stock of a private company, Cinco EnergyCorporation (“Cinco”), whose primary asset is ownership of working interests inoil and natural gas properties located on the Chapman Ranch Field. Thepreliminarily adjusted cash purchase price of $47.3

 

16

----

 

million was adjusted from the base purchase price of $35.8 million for,among other things, working capital as of September 1, 2005 and an incrementalpurchase price, pursuant to the closing provisions of the relevant agreement.The Company financed the acquisitions through borrowings under its creditfacility, the borrowing base of which increased in connection with thesetransactions and other recent activities since the last redetermination.

 

Thefollowing unaudited pro forma results for 2005 show the effect on the Company’sconsolidated results of operations as if the Cinco transaction had occurred onJanuary 1, 2005. The pro forma results are the result of combining thestatement of income for the Company with the statement of income for Cincoadjusted for (1) assumption of ARO liabilities and accretion expense for theproperties acquired, (2) depletion expense applied to the adjusted basis of theproperties acquired using the purchase method of accounting, (3) conversion ofCinco from the successful efforts method of accounting to the full cost method,(4) interest expense on added borrowings necessary to finance the acquisitionand (5) the related income tax effects of these adjustments based on theapplicable statutory rates. The pro forma information is based upon numerousassumptions, and is not necessarily indicative of future results of operations:

 

| ** **                    | ** ** | **For the Three  Months Ended**                        | ** ** | **For the Six  Months Ended** | ** ** |
|-------------------------------|------------|-----------------------------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                    | ** ** | **June 30, 2005**                                           | ** ** |
| ** **                    | ** ** | **(unaudited)**                                                       | ** ** |
| ** **                    | ** ** | **(in thousands, except per share amounts)** | ** ** |
| Revenue                       |       | $                                                                     | 28,673     |                                         | $          | 53,384 |   |
| Net income                    |       | $                                                                     | 7,155      |                                         | $          | 12,258 |   |
| Net income per  common share: |       |                                                                  |       |                                         |       |
| Basic                         |       | $                                                                     | 0.42       |                                         | $          | 0.72 |   |
| Diluted                       |       | $                                                                     | 0.40       |                                         | $          | 0.69 |   |

 

OnApril 25, 2006, the Company consummated the divestiture of its Buckeyeproperties located in Live Oak County, Texas for a base sale price of $600,000.The sale price will be adjusted for results of operations between the March 1,2006 effective date of the agreement and the April 25, 2006 closing date, witha post closing adjustment to be finalized in August 2006.

 

**9.   COMMITMENTS AND CONTINGENCIES**

 

From time to time theCompany is a party to various legal proceedings arising in the ordinary courseof business. While the outcome of lawsuits cannot be predicted with certainty,the Company is not currently a party to any proceeding that it believes, ifdetermined in a manner adverse to the Company, could have a material adverseeffect on its financial condition, results of operations or cash flows, exceptas set forth below.

 

**TexasComptroller Audit** - During the second quarter of 2004,the Company received notice that a subsidiary’s franchise tax returns for theState of Texas would be audited for the tax years 1999 through 2002. Afterreviewing documents submitted, the agent representing the Office of theComptroller of the State of Texas proposed adjustments to the calculation thatwould result in an increased franchise tax liability.  The agentmaintained that transfers by the Company to its subsidiary, that had been classifiedas intercompany loans, should instead be classified as equity investments inthe subsidiary. The State of Texas originally proposed that the franchise taxliability of the subsidiaries would be increased by approximately $3.0 millionfor the four-year period under audit.

 

During the third quarterof 2004, the agent reduced the proposed franchise tax deficiency adjustment againstthe subsidiary to an aggregate amount of $467,000. In the fourth quarter of2004, there was an informal hearing at the local Comptroller’s Office duringwhich the agent indicated he would formally assess the proposeddeficiency.  On March 24, 2005, we received a deficiency assessmentin the amount of $471,482 including penalty and interest. The Company respondedon April 21, 2005 with a request for a formal redetermination hearing. On

 

17

----

 

February 14, 2006, a Hearings Attorney for the Texas Comptroller ofPublic Accounts issued a Position Letter reaffirming the auditor’s assessment,and rejecting our arguments as set forth in the April 21, 2005 request forredetermination.  On February 24, 2006, the Company filed a motion toset the matter for oral hearing before an Administrative Law Judge. The hearinghas been set for October 19, 2006. The Company intends to continue tovigorously contest the assessment through appropriate administrativeproceedings at the Comptroller’s Office and by any other available means. Due to its belief that it does not owe any additional franchise tax for theperiod in question and its intention to continue to vigorously contest theproposed adjustments, the Company has not recognized any provision for theadditional franchise taxes that would result from the proposed deficiency. 

 

**Wadeand Joyce Montet, et al., v. Edge Petroleum Corp of Texas, et al., consolidatedwith Rolland L. Broussard, et al., v. Edge Petroleum Corp of Texas, et al.**- This is a consolidated suit, filed in state court in Vermilion Parish,Louisiana in September 2003. Plaintiffs are mineral/royalty owners under theNorcen-Broussard No. 1 and 2 wells, Marg Tex Reservoir C, Sand Unit A (Edge’sold Bayou Vermilion Prospect).  They claim the operator at the time,Norcen Explorer, now Anadarko, failed to “block squeeze” the sections of theNo. 2 well, as a prudent operator, according to their allegations, would havedone, to protect the gas reservoir from being flooded with water from adjacentunderground formations. Plaintiffs further allege Norcen was negligent in notcreating a field-wide unit to protect their interests. Plaintiffs have named theCompany and other working interest owners in the leases as defendants,including Norcen Explorer’s successors in interest, Anadarko. Plaintiffs originallysought unspecified damages for lost royalties and damages due to allegeddevaluation of their mineral and property interests, plus interest and attorneys’fees. In early 2005, the Company filed a motion for summary judgment in thecase asserting, among other defenses, that:  (i) there has been no breachof contract, (ii) there is no express or implied duty imposed on us to blocksqueeze the well or form a field-wide unit, (iii) the units were properlyformed by the Conservation Commissioner in accordance with the statutory schemein Louisiana, (iv) plaintiffs’ claims are barred by limitations, and (v) otherdefenses. Along with the other defendants, the Company also filed a specialpreemptory challenge of no cause of action under the leases and the LouisianaMineral Code for failure to exhaust administrative remedies and due to lack ofa demand. In May and June 2005, the court ruled against us on the motion forsummary judgment and the preemptory challenges. Of the 18.75% after-payoutworking interest that was originally reserved in the leases, the Company owneda 2.8% working interest at the time of the alleged acts or omissions. OnSeptember 6, 2005, the Company was granted leave by the court to file a third-partydemand to join the other working interest owners who hold the remainder of the18.75% working interest as third-party defendants in this case, and thosepleadings have been served on the parties. These third-parties consist, for themost part, of partnerships that are directly or indirectly controlled by JohnSfondrini, a director of the Company, and hold an aggregate 14.72% workinginterest. Vincent Andrews, also a director of the Company, owns a minorityinterest in the corporate general partner of one of the partnerships. Thesepartnerships were among the third party defendants that the Company has soughtto join in the case, and these partnerships have for the most part filedanswers denying any liability to the Company. The Company participated for its2.8% share of the well costs and revenues for the Broussard No. 2 well, as didthe other defendants for their share, including the third-party defendantpartnerships who participated for 14.7%. The Company strongly believes theparties should only be liable for their proportionate share of any damagesaward should a finding of liability occur in the case. The Company intends tovigorously contest the plaintiffs’ claims.

 

As of the date of thisreport, it is not possible to determine what, if any, the Company’s exposuremight be in this matter. The plaintiffs’ expert witness, in his December 2005deposition, offered his theory that plaintiffs’ gross damages are in the rangeof $19 to $20 million. That number is based on his theory that the allegedfailure to block squeeze the well resulted in the under-production of gas worth$300 million. Plaintiffs’ royalty share of that figure yields the $19 to $22million range of alleged damages. Based on the expert’s testimony, damagesattributable to the full 18.75% interest would be in the range of $3.75 milliongross or net to our 2.8% share would be in the range of $560,000 (excludinginterest and attorneys’ fees). Along with the other defendants, the Companyhired its own expert witnesses who have refuted these claims, particularly theexpert’s assertions that failure to block squeeze the well caused any damagesto the reservoir. The deposition of a Norcen engineer who prepared thecompletion plan for the Broussard No. 2 well and supervised the completionoperations, taken in April 2006, confirms the testimony of the defense expertsas to why the well was not block squeezed. The plaintiffs have also retained adamages expert who has given a report that the damages in this case are in therange of $30 million, excluding interest and attorneys’ fees. The Company’s shareof that amount based on the full 18.75% would be in the range of $5.6 millionand net to our 2.8% share would be in the range of $840,000. 

 

18

----

 

The Company participated in mediation of this lawsuit on July 18, 2006but the parties failed to reach an agreement. Therefore, this case is expectedto proceed to trial on August 28, 2006. On July 31, 2006 the Judge granted theDefendant groups’ motion for partial summary dismissing plaintiffs’ tort-basedclaims. Also on the same date, the Judge granted the Defendant groups’ motionfor partial summary judgment seeking to deny the plaintiffs an award ofattorneys fees and also to dismiss any claim of plaintiffs that defendants hadan obligation to form a field-wide unit, but denied the defendants’ motion toexclude evidence of pre-suit damages based on failure of plaintiffs to givenotice of their claims as required by the Louisiana Mineral Code and alsodenied defendants’ motion in limine to exclude testimony of plaintiffs’ expertwitness.

 

The Company may haveinsurance coverage for all or part of this claim up to the policy limits of $1million per occurrence and $2 million in the aggregate. A claim was submittedto Mid-Continent Casualty Company, our casualty carrier, who is currentlyproviding a defense under a reservation of rights letter. However, on July 3,2006, Mid-Continent filed a suit for declaratory judgment against us in federaldistrict court in Houston, Texas seeking to determine whether it has a duty toindemnify Edge and certain other defendants for this loss under the policies atissue. Mid-Continent has asked the court to declare they have no obligation toindemnify the Company and the third-party defendants based on certain technicaldefinitions under the policies and the fact that the plaintiffs’ claims arebased on alleged breaches of contract. The Company intends to dispute thecoverage issues with Mid-Continent and file an answer and counterclaim forbreach of contract.

 

The Company believes thatultimately it should only be liable for its 2.8% share of any damage awardunless a co-party defendant, including any of the third-party defendants,cannot satisfy their share of any final judgment or settlement amount or arefound not to be liable to the Company on its third-party demand. In that event,the Company could be held responsible for more than its 2.8% share. The Companyintends to continue to vigorously contest this suit on the case in chief andits third-party demands against the partnerships, and has not established anyreserve with respect to these claims.

 

**DavidBlake, et al. v. Edge Petroleum Corporation** – OnSeptember 19, 2005, David Blake and David Blake, Trustee of the David and NitaBlake 1992 Children’s Trust filed suit against the Company in state districtcourt in Goliad County, Texas alleging breach of contract for failure andrefusal to transfer overriding royalty interests to plaintiffs in at least fiveleases in Goliad County, Texas and failure and refusal to pay monies to Blakepursuant to such overriding royalty interests for wells completed on theleases. The plaintiff seeks relief of (1) specific performance of the allegedagreement, including granting of overriding royalty interests by the Company toBlake; (2) monetary damages for failure to grant the overriding royaltyinterests; (3) exemplary damages for his claims of business disparagement andslander; (4) monetary damages for tortuous interference; and (5) attorneys’fees and court costs. Venue of the case was transferred to Harris County byagreement of the litigants. The Company has served Plaintiffs with discoveryand has filed a counterclaim and an amended counterclaim joining variousrelated entities that are controlled by Plaintiffs. In addition, Plaintiffshave filed an amended complaint alleging claims of slander of title and tortuousinterference related to its alleged right to receive an overriding royaltyinterest from a third party. Plaintiffs currently have on file an amendedmotion for summary judgment, to which the Company will be filing a response. Thismotion is expected to be heard by late summer. The Company has respondedaggressively to this lawsuit, and believes it has meritorious defenses andcounterclaims.

 

19

----

 

**ITEM 2. MANAGEMENT’S DISCUSSION ANDANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

The following is Management’s Discussion and Analysis (“MD&A”) ofsignificant factors that have affected certain aspects of our financialposition and operating results during the periods included in the accompanyingunaudited condensed consolidated financial statements. The followingMD&A is intended to help the reader understand Edge Petroleum Corporation (“Edge”).This discussion should be read inconjunction with the accompanying unaudited condensed consolidated financialstatements included elsewhere in this Form 10-Q and with Management’sDiscussion and Analysis of Financial Condition and Results of Operations andour audited consolidated financial statements included in our annual report onForm 10-K for the year ended December 31, 2005 (2005 Annual Report).

 

### **FORWARD LOOKING STATEMENTS**

###  

Certain of the statementscontained in all parts of this document, including, but not limited to, thoserelating to our drilling plans (including scheduled and budgeted wells), the effectof changes in strategy and business discipline, future tax matters, our 3-Dproject portfolio, future general and administrative expenses on a per unit ofproduction basis, changes in wells operated and reserves, future growth andexpansion, future exploration, future seismic data (including timing andresults), expansion of operation, our ability to generate additional prospects,our review of outside prospects and acquisitions, additional reserves andreserve increases, our ability to replace production and manage our asset base,enhancement of visualization and interpretation strengths, expansion andimprovement of capabilities, integration of new technology into operations,credit facilities, redetermination of our borrowing base, attraction of newmembers to the technical team, future compensation programs, new focus on coreareas, new prospects and drilling locations, new alliances, future capitalexpenditures (or funding thereof) and working capital, sufficiency of futureworking capital, borrowings and capital resources and liquidity, projectedrates of return, retained earnings and dividend policies, projected cash flowsfrom operations, future commodity price environment, expectation or timing ofreaching payout, the outcome, effects or timing of any legal proceedings orcontingencies, the impact of any change in accounting policies on our financialstatements, the number, timing or results of any wells, the plans for timing,interpretation and results of new or existing seismic surveys or seismic data,future production or reserves, future acquisition of leases, lease options orother land rights, any other statements regarding future operations, financialresults, opportunities, growth, business plans and strategy and otherstatements that are not historical facts are forward-looking statements. Theseforward-looking statements reflect our current view of future events andfinancial performance. When used in this document, the words “budgeted,” “anticipate,”“estimate,” “expect,” “may,” “project,” “believe,” “intend,” “plan,” “potential,”“forecast,” “might,” “predict,” “should” and similar expressions are intendedto be among the expressions that identify forward-looking statements. Theseforward-looking statements speak only as of their dates and should not beunduly relied upon. We undertake no obligation to publicly update or revise anyforward-looking statement, whether as a result of new information, futureevents, or otherwise. Such statements involve risks and uncertainties,including, but not limited to, those set forth under “ITEM 1A. RISK FACTORS” ofour 2005 Annual Report and other factors detailed in this document and ourother filings with the Securities and Exchange Commission (the “SEC”). Shouldone or more of these risks or uncertainties materialize, or should underlyingassumptions prove incorrect, actual outcomes may vary materially from thoseindicated. All subsequent written and oral forward-looking statementsattributable to us or to persons acting on our behalf are expressly qualifiedin their entirety by reference to these risks and uncertainties.

 

## **GENERAL OVERVIEW**

## ** **

Edge is aHouston-based independent energy company that focuses its exploration, development,production, acquisition and marketing activities in selected onshore basins ofthe United States. In late 1998, we undertook a top-level management change andbegan a shift in strategy from pure exploration, which focused more on prospectgeneration, to our current strategy which focuses on a balanced program ofexploration, exploitation and development and acquisition of oil and gasproperties. We generate revenues, income and cash flows by producing andmarketing oil and natural gas produced from our oil and natural gas properties.We make significant capital expenditures in our exploration, development, andproduction activities that allow us to continue generating revenue, income andcash flows. We have also spent considerable efforts on acquisitions, includingboth corporate and asset acquisitions, that have contributed to our growth in recentyears.

 

20

----

 

This overview providesour perspective on the individual sections of MD&A. Our MD&A includesthe following sections:

 

•                  **Industry and Economic Factors** – a generaldescription of value drivers of our business as well as opportunities,challenges and risks related to the oil and gas industry.

 

•                  **Approach to the Business** – additionalinformation regarding our approach and strategy.

 

•                  **Acquisitions and Divestitures** – informationabout significant changes in our business structure.

 

•                  **Outlook** – additional discussion relating tomanagement’s outlook to the future of our business.

 

•                  **Critical Accounting Policies and Estimates**– a discussion of certain accounting policies that require critical judgmentsand estimates.

 

•                  **Results of Operations** – an analysis of ourconsolidated results for the periods presented in our financial statements.

 

•                  **Liquidity and Capital Resources**–****an analysis of cash flows, sources anduses of cash, and contractual obligations.

 

•                  **Risk Management Activities – Derivatives & Hedging**–****supplementaryinformation regarding our price-risk management activities involving commoditycontracts.

 

•                  **Tax Matters** – supplementary discussion ofincome tax matters.

 

•                  **Recently Issued Accounting Pronouncements** –a discussion of certain recently issued accounting pronouncements that mayimpact our future results.

 

# **Industry and Economic Factors**

 

In managing our business,we must deal with many factors inherent in our industry. First and foremost isthe fluctuation of oil and gas prices. Historically, oil and gas markets havebeen volatile, which makes price movements difficult to predict. While ourrevenues are a function of both production and prices, wide swings in commodityprices have most often had the greatest impact on our results of operations. Wehave little ability to predict those prices or to control them without losingsome advantage of the upside potential.

 

Our operations entailsignificant complexities. Advanced technologies requiring highly trainedpersonnel are utilized in both exploration and production. Even when thetechnology is properly used, we may still not know conclusively if hydrocarbonswill be present or the rate at which they will be produced. Exploration is ahigh-risk activity, often times resulting in no commercially productivereserves being discovered. Moreover, costs associated with operating within ourindustry are substantial. The high commodity price environment in late 2005 ledto increased costs in our industry, which together with increased demand forrigs, equipment, supplies and services, have made it difficult at times for usto further our growth, and make timely execution of our planned activitiesdifficult.

 

Our business, as withother extractive businesses, is a depleting one in which each gas equivalentproduced must be replaced or our asset base and capacity to generate revenuesin the future, will shrink.

 

The oil and gas industryis highly competitive. We compete with major and diversified energy companies,independent oil and gas businesses and individual operators in exploration,production, marketing and acquisition activities. In addition, the industry asa whole competes with other businesses that supply energy to industrial and commercialend users.

 

21

----

 

Extensive federal, stateand local regulation of the industry significantly affects our operations. Inparticular, our activities are subject to stringent operational and environmentalregulations. These regulations have increased the costs of planning, designing,drilling, installing, operating and abandoning oil and gas wells and relatedfacilities. These regulations may become more demanding in the future.

 

# **Approach to the Business**

 

Profitable growth of ourbusiness will largely depend upon our ability to successfully find and developnew proved reserves of oil and natural gas in a cost-effective manner. In orderto achieve an overall acceptable rate of growth, we seek to maintain a prudentblend of low, moderate and higher risk exploration and development projects. Wehave chosen to seek geologic and geographic diversification by operating inmultiple basins in order to mitigate risk in our operations. We also attempt tomake selected acquisitions of oil and gas properties to augment our growth andprovide future drilling opportunities.

 

We periodically hedge ourexposure to volatile oil and gas prices on a portion of our production toreduce price risk. As of June 30, 2006, we had derivative contracts in placecovering approximately 50% and 42% of our remaining expected 2006 natural gasand crude oil production, respectively, and approximately 46% of total 2006estimated production on an Mcfe basis, but before any other acquisitions thatmay occur.

 

Implementation of ourbusiness approach relies on our ability to fund ongoing exploration anddevelopment projects with cash flow provided by operating activities andexternal sources of capital. During the first quarter of 2006, our Boardapproved a revised 2006 capital budget of $98 million. Based upon currentexpectations for production volumes and commodity prices, we expect to fund thosecapital expenditures from internally generated cash from operating activities.We do not typically include acquisitions in our budgeted capital expenditures,but expect to fund those with either borrowings under our Credit Facility (asdefined below), proceeds from offerings of common stock or other securitiesunder our shelf registration statement or other sources.

 

Our long-term debtbalance as of June 30, 2006 was $105.0 million and our debt to total capitalratio was approximately 33.6%. During the second quarter of 2005, we took stepsto increase our shelf registration statement capacity to $390 million fromapproximately $90 million (see Note 3 to our consolidated financialstatements), which became effective on July 1, 2005. We believe we have thefinancial flexibility to continue to execute our business strategies.

 

**Acquisitions and Divestitures**

 

*Acquisitions -*We have becomeincreasingly active in acquisitions in recent years. We have looked toacquisitions to enable us to achieve our growth objectives and we expectacquisitions will continue to play a significant role in our future plans forgrowth. Acquisitions add meaningful incremental increases in reserves andproduction and may range in size from acquiring a working interest innon-operated producing property to an entire field or company. Unlike drillingcapital, which is planned and budgeted, acquisition capital is neither budgetednor allocated. Specific timing of acquisitions cannot be predicted. Although weconsider a wide variety of acquisitions, a significant part of our growthstrategy is expected to be focused toward producing property acquisitions,which we believe have exploitable potential. Because of our financialflexibility, we are positioned to take advantage of producing propertyacquisition opportunities as they may arise. In today’s high price environment,where production is providing greater cash flow and earnings to most companies,identifying quality opportunities is difficult. We believe through hard work,technical ability and creative thinking of our people, we will continue to growthrough both acquisitions and drilling. Any such acquisition could involve thepayment by us of a substantial amount of cash or the issuance of a substantialnumber of additional shares or other securities.

 

During the fourth quarterof 2005, we completed two acquisitions including (i) the stock of a privatecompany, whose primary asset is ownership of working interests in oil andnatural gas properties located on the Chapman Ranch Field in south Texas and(ii) additional working interests in the Chapman Ranch Field owned by two otherprivate companies for an aggregate cash purchase price of approximately $62.8million (of which $35.8

 

22

----

 

was attributable to the stock purchase and $27.0 was attributable tothe working interest asset purchase). Pursuant to closing adjustment provisionsin the agreements, the purchase price was subject to adjustment for the resultsof operations between the September 1, 2005 effective date and the closingdates and an incremental purchase price related to the operator of theproperties obtaining high-cost gas certification. The stock purchase wasadjusted to $47.3 million and the asset purchase was adjusted to $28.0 million.The properties acquired from these entities are located in Nueces County, Texasand consisted of six producing wells, one well undergoing completionoperations, one well drilling and an ownership in approximately 1,300 net acresof developed and undeveloped leasehold.

 

*Divestitures -*We regularly reviewour asset base for the purpose of identifying non-core assets, the dispositionof which would increase capital resources available for other activities andcreate organizational and operational efficiencies. While we generally do notdispose of assets solely for the purpose of reducing debt, such dispositionscan have the result of furthering our objective of financial flexibilitythrough reduced debt levels. During the six months ended June 30, 2006, we soldour Buckeye properties in Live Oak County, Texas for a base sale price of$600,000. The divestiture closed on April 25, 2006 and the base sale price willbe adjusted for results of operations between the March 1, 2006 effective date ofthe agreement and the closing date, with a post closing adjustment to befinalized in August 2006.

 

**Outlook**

 

•                       Duringthe six months ended June 30, 2006, a total of 35 wells were drilled with 28apparent successes, for an overall success rate of 80%.

 

•                       Weexpect to drill between 55 and 60 wells (32 and 35 net, respectively) in 2006and we estimate capital spending for the year to be approximately$98 million. Our ability to materially increase the number of wells to bedrilled beyond the prior year or our budgeted number is heavily dependent uponthe timely access to oilfield services, particularly drilling rigs. Theshortage of available rigs in 2005 delayed the drilling of several wells,slowing our growth in production. We have seen some moderation in the tightservice sector since early this year. We will continue to monitor the situationand look for opportunities to increase our production and reserves.

 

•                       Drillingactivities in the Fayetteville Shale play were initiated during the secondquarter and we expect to continue to participate through the remainder of 2006.

 

•                       Weexpect to continue to spend considerable effort in 2006 on acquisitions, as weseek to further our growth.

 

•                       Ourexpected production volumes, including the addition of the Chapman Ranch Fieldproperties, combined with the current commodity-pricing environment, isanticipated to produce another year of record cash flow from operatingactivities.

 

•                       Tohelp protect against the possibility of downward commodity price movements, wehave several derivatives in place to hedge a portion of our expected remaining naturalgas and crude oil production streams for 2006 and 2007. While there has been norealized impact from our oil hedges, our gas hedges have contributed $2.0million to our cash flows thus far in 2006. We discontinued cash flow hedgeaccounting treatment on our natural gas collars, so all of our derivativetransactions are now accounted for using mark-to-market accounting treatment(see Note 7 to our consolidated financial statements).

 

•                       Weexpect to modestly add to our staff levels in 2006 both as a result of recentgrowth and anticipated future growth.

 

Our outlook and the expected results described aboveare both subject to change based upon factors that include but are not limitedto drilling results, commodity prices, access to capital, the acquisitionsmarket and factors referred to in “Forward Looking Statements.”

 

**CriticalAccounting Policies and Estimates**

 

The preparation offinancial statements in conformity with generally accepted accountingprinciples in the United States requires management to make estimates andassumptions that affect the reported amounts of assets,

 

23

----

 

liabilities, revenues, expenses, contingent assets and liabilities andthe related disclosures in the accompanying financial statements. Changes inthese estimates and assumptions could materially affect our financial position,results of operations or cash flows. Management considers an accountingestimate to be critical if:

 

•                  itrequires assumptions to be made that were uncertain at the time the estimatewas made, and

 

•                  changesin the estimate or different estimates that could have been selected could havea material impact on our consolidated results of operations or financialcondition.

 

All other significantaccounting policies that we employ are presented in the notes to theconsolidated financial statements. The following discussion presentsinformation about the nature of our most critical accounting estimates, ourassumptions or approach used and the effects of hypothetical changes in thematerial assumptions used to develop each estimate.

 

*Nature of Critical Estimate Item:*Oiland Natural Gas Reserves - Our estimate of proved reserves is based on thequantities of oil and gas which geological and engineering data demonstrate,with reasonable certainty, to be recoverable in future years from knownreservoirs under existing economic and operating conditions. The accuracy ofany reserve estimate is a function of the quality of available data,engineering and geological interpretation, and judgment. For example, we mustestimate the amount and timing of future operating costs, severance taxes,development costs, and workover costs, all of which may in fact varyconsiderably from actual results. In addition, as prices and cost levels changefrom year to year, the economics of producing the reserves may change andtherefore the estimate of proved reserves also may change. Any significantvariance in these assumptions could materially affect the estimated quantityand value of our reserves. Despite the inherent imprecision in theseengineering estimates, our reserves are used throughout our financialstatements.

 

*Assumptions/Approach Used:*Units-of-productionmethod to amortize our oil and natural gas properties - The quantity ofreserves could significantly impact our depletion expense. Any reduction inproved reserves without a corresponding reduction in capitalized costs willincrease the depletion rate.

 

“Ceiling” Test  – The full-cost method of accounting for oiland gas properties requires a quarterly calculation of a limitation oncapitalized costs, often referred to as a full-cost ceiling calculation. Theceiling is the discounted present value of our estimated total proved reservesadjusted for taxes and the impact of cash flow hedges on pricing, using a 10%discount rate. To the extent that our capitalized costs (net of accumulateddepletion and deferred taxes) exceed the ceiling, the excess must be writtenoff to expense. Once incurred, this impairment of oil and gas properties is notreversible at a later date even if oil and gas prices increase. No suchimpairment was required in the six months ended June 30, 2006 or 2005. Thiscalculation of our proved reserves could significantly impact our ceilinglimitation used in determining whether an impairment of our capitalized costsis necessary. The ceiling calculation dictates that prices and costs in effectas of the last day of the period are generally held constant indefinitely.Therefore, the future net revenues associated with the estimated provedreserves are not based on our assessment of future prices or costs, but ratherare based on prices and costs in effect as of the end of the period. Oil andnatural gas prices used in the reserve valuation at June 30, 2006 were $70.00per barrel and $6.09 per MMbtu.

 

*Effect if Different Assumptions Used:*Units-of-productionmethod to amortize our oil and natural gas properties - A 10% increase ordecrease in reserves would have decreased or increased, respectively, ourdepletion expense for the year by approximately 10%.

 

“Ceiling”limitation test  – Themost likely factor to contribute to a ceiling test impairment is the price usedto calculate the reserve limitation threshold. A significant reduction in theprices at a future measurement date could trigger a full-cost ceilingimpairment. At June 30, 2006, we had a cushion (i.e., the excess of the ceilingover our capitalized costs) of $22.0 million. A 10% increase or decrease inprices used would have increased or decreased our cushion by approximately 120%,which would have resulted in an impairment of approximately $3.7 million at 10%lower prices. Our hedging program would serve to mitigate some of

 

24

----

 

the impact of any pricedecline. Since we no longer apply cash flow hedge accounting to our derivativecontracts, there is no impact to the ceiling test. Had we applied cash flowhedge accounting to our outstanding derivatives there would have been an impactto our ceiling test from both an increase and decrease in prices since bothprices fell below our natural gas collar floors of $7.00 per Mcf. Anotherlikely factor to contribute to a ceiling test impairment is a revised estimateof reserve volume. A 10% increase or decrease in reserve volume would haveincreased or decreased our cushion by approximately 85%.

 

*Nature of Critical Estimate Item:*UnprovedProperty Impairment****- We haveelected to use the full-cost method to account for our oil and gas activities.Investments in unproved properties are not amortized until proved reservesassociated with the prospects can be determined or until impairment occurs. Unprovedproperties are evaluated quarterly for impairment on a property-by-propertybasis. If the results of an assessment indicate that an unproved property isimpaired, the amount of impairment is added to the proved oil and natural gasproperty costs to be amortized.

 

*Assumptions/Approach Used:*At June 30,2006, we had $35.7 million allocated to unproved property. This allocation isbased on our estimation of whether the property has potential attributablereserves. Therefore, our assessment of the potential reserves will determinewhether costs are moved from the unproved category to the full-cost pool fordepletion or whether an impairment is taken.

 

*Effect if Different Assumptions Used:* A10% increase or decrease in the unproved property balance (i.e., transfer tofull-cost pool) would have increased or decreased our depletion expense byapproximately 1% for the three months ended June 30, 2006.

 

*Nature of Critical Estimate Item:*AssetRetirement Obligations**-**Wehave certain obligations to remove tangible equipment and restore land at theend of oil and gas production operations. Our removal and restorationobligations are primarily associated with plugging and abandoning wells. Priorto January 1, 2003, the costs associated with this activity were capitalized tothe full-cost pool and charged to income through depletion. We adoptedStatement of Financial Accounting Standards (“SFAS”) No. 143, *Accounting for Asset Retirement Obligations*effective January 1, 2003, as discussed in Note 1 to our Consolidated FinancialStatements. SFAS No. 143 significantly changed the method of accruing for costsan entity is legally obligated to incur related to the retirement of fixedassets (“asset retirement obligations” or “ARO”). Primarily, SFAS No. 143requires us to estimate asset retirement costs for all of our assets, adjustthose costs for inflation to the forecast abandonment date, discount thatamount using a credit-adjusted-risk-free rate back to the date we acquired theasset or obligation to retire the asset and record an ARO liability in thatamount with a corresponding addition to our asset value. When new obligationsare incurred, i.e. a new well drilled or acquired, we add a layer to the AROliability. We then accrete the liability layers quarterly using the applicableperiod-end effective credit-adjusted-risk-free rates for each layer. Shouldeither the estimated life or the estimated abandonment costs of a property changeupon our quarterly review, a new calculation is performed using the samemethodology of taking the abandonment cost and inflating it forward to itsabandonment date and then discounting it back to the present using ourcredit-adjusted-risk-free rate. The carrying value of the asset retirementobligation is adjusted to the newly calculated value, with a correspondingoffsetting adjustment to the asset retirement cost (included in the full-costpool); therefore, abandonment costs will almost always approximate theestimate. When well obligations are relieved by sale of the property orplugging and abandoning the well, the related liability and asset costs areremoved from our balance sheet.

 

*Assumptions/Approach Used:*Estimating thefuture asset removal costs is difficult and requires management to makeestimates and judgments because most of the removal obligations are many yearsin the future and contracts and regulations often have vague descriptions ofwhat constitutes removal. Asset removal technologies and costs are constantlychanging, as are regulatory, political, environmental, safety and publicrelations considerations. Inherent in the estimate of the present valuecalculation of our AROs are numerous assumptions and judgments including theultimate settlement amounts, inflation factors,credit-adjusted-risk-free-rates,

 

25

----

 

timing of settlement, andchanges in the legal, regulatory, environmental and political environments.

 

*Effect if Different Assumptions Used:*Since there are so many variables in estimating AROs, we attempt to limit theimpact of management’s judgment on certain of these variables by using input ofqualified third parties. We engage independent engineering firms to evaluateour properties annually. We use the remaining estimated useful life from theyear-end reserve reports by our independent reserve engineers in estimatingwhen abandonment could be expected for each property. We utilize a three-yearaverage rate for inflation to diminish any significant volatility that may bepresent in the short term. We expect to see our calculations impactedsignificantly if interest rates continue to rise, as thecredit-adjusted-risk-free rate is one of the variables used on a quarterlybasis. We have developed a standard cost estimate based on historical costs,industry quotes and depth of wells. Unless we expect a well’s plugging to besignificantly different than a normal abandonment, we use this estimate. Theresulting estimate, after application of a discount factor and some significantcalculations, could differ from actual results, despite all our efforts to makean accurate estimate.

 

*Nature of Critical Estimate Item:*IncomeTaxes**-**In accordance with theaccounting for income taxes under SFAS No. 109, *Accounting for Income Taxes,* we have recorded a deferred taxasset and liability to account for the expected future tax benefits andconsequences of events that have been recognized in our financial statementsand our tax returns. There are several items that result in deferred tax assetand liability impact to the balance sheet, but the largest of which is incometaxes and the impact of net operating loss (“NOL”) carryforwards. We routinelyassess our ability to use all of our NOL carryforwards that resulted fromsubstantial income tax deductions, prior year losses and acquisitions. Weconsider future taxable income in making such assessments. If we conclude thatit is more likely than not that some portion or all of the deferred tax assetswill not be realized under accounting standards, it is reduced by a valuationallowance.

 

*Assumptions/ApproachUsed:*Numerousjudgments and assumptions are inherent in the determination of future taxableincome, including factors such as future operating conditions (particularly asrelated to prevailing oil and gas prices). We are not currently required to payany federal income taxes because of the prior generation of  NOL carryforwards.

 

*Effect if Different Assumptions Used:* Wehave engaged an independent public accounting firm to assist us in applying thenumerous and complicated tax law requirements. However, despite our attempt tomake an accurate estimate, the ultimate utilization of our NOL carryforwards ishighly dependent upon our actual production and the realization of taxableincome in future periods. If we estimate that some or all of our NOLcarryforwards are more likely than not going to expire or otherwise not beutilized to reduce future tax, we would record a valuation allowance to removethe benefit of those NOL carryforwards from our financial statements.

 

*Nature of Critical Estimate Item:*Derivativeand Hedging Activities**-**Dueto the instability of oil and natural gas prices, we may enter into, from timeto time, price-risk management transactions (e.g., swaps, collars and floors)for a portion of our oil and natural gas production to achieve a morepredictable cash flow, as well as to reduce exposure from commodity pricefluctuations. While all of these transactions are economic hedges of pricerisk, different accounting treatment may apply depending on if they qualify forcash flow hedge accounting. In accordance with SFAS No. 133, *Accounting for Derivative Instruments and HedgingActivities (as amended),*all transactions are recorded on thebalance sheet at fair value.

 

HedgeContracts - We formally assess, both at the hedge’s inception and on an ongoingbasis, whether the derivatives that are used for hedging are expected to behighly effective in offsetting changes in cash flows of the hedged transactions.The ongoing measurement of effectiveness determines whether the change in fairvalue is deferred through Other Comprehensive Income (“OCI”) on the balancesheet or recorded immediately in revenue on the income statement. The effectiveportion of the changes in the fair value of hedge contracts is recordedinitially in OCI. When the hedged production is sold, the realized gains and

 

26

----

 

losseson the hedge contracts are removed from OCI and recorded in revenue.Ineffective portions of the changes in the fair value of the hedge contractsare recognized in revenue as they occur. While the hedge contract isoutstanding, the fair value may increase or decrease until settlement of thecontract. In the event it is determined that the use of a particular derivativemay not be or has ceased to be effective in pursuing a hedging strategy, hedgeaccounting is discontinued prospectively. During the first quarter of 2006, wediscontinued cash flow hedge accounting treatment applied to our natural gascontracts due to projected changes in the 2006 physical production volumeshedged and to give us flexibility in how we market our physical production. Therefore,all contracts are utilizing mark-to-market accounting treatment at June 30,2006, as discussed below.

 

Derivative Contracts -For transactions not accounted for using cash flow hedge accounting, the changein the fair value of the derivative contract is reflected in revenueimmediately, and not deferred through OCI, and there is no measurement ofeffectiveness.

 

*Assumptions/Approach Used:*Estimating thefair values of derivative instruments requires complex calculations, includingthe use of a discounted cash flow technique, estimates of risk and volatility,and subjective judgment in selecting an appropriate discount rate. In addition,the calculations use future market commodity prices, which although posted fortrading purposes, are merely the market consensus of forecasted price trends.The results of the fair value calculations cannot be expected to representexactly the fair value of our commodity derivatives. We currently obtain thefair value of our positions from our counterparties. Our practice of relying onour counterparties who are more specialized and knowledgeable in preparingthese complex calculations reduces our management’s input. It also approximatesthe fair value of the contracts as that would be the cost to us to terminate acontract at that point in time. Due to the fact that we apply mark-to-marketaccounting treatment, the offset to the balance sheet asset or liability, orthe change in fair value of the contracts, is included in revenue on the incomestatement rather than in OCI on the balance sheet.

 

*Effect if Different Assumptions Used:* At June30, 2006, a 10% change in the commodity price per unit, as long as the price iseither above the ceiling or below the floor price, would cause the fair valuetotal of our derivative financial instruments to increase or decrease byapproximately $0.3 million. Had we applied cash flow hedge accounting treatmentto all of our derivative contracts outstanding at June 30, 2006, net incomewould have been $10.9 million.

 

# **Results of Operations**

 

This section includes discussion of our results ofoperations for the three-month and six-month periods ended June 30, 2006 ascompared to the same periods of the prior year. We are an independent energycompany engaged in the exploration, development, acquisition and production ofoil and natural gas. Our resources and assets are managed and our resultsreported as one operating segment. We conduct our operations primarily alongthe onshore United States Gulf Coast, with our emphasis in south Texas,Louisiana, Mississippi and southeast New Mexico. We completed two acquisitionsin the fourth quarter of 2005, which impacted revenues, production and costsfor the first half of 2006 and, due to timing, may affect the comparability ofperiods presented.

 

27

----

 

**Second Quarter2006 Compared to the Second Quarter 2005**

 

**Revenueand Production**

 

Total revenue increased 29% from the second quarter of2005 to the comparable 2006 period. For the three months ended June 30,2006 and 2005, our product mix contributed the following percentages ofrevenues and production volumes:

 
| ** **               | ** ** | **REVENUES (1)**                               | ** ** | **PRODUCTION VOLUMES  (MCFE)** | ** ** |
|--------------------------|------------|-----------------------------------------------------|------------|-------------------------------------|------------|
| ** **               | ** ** | **Three months ended June 30,** | ** ** |
| ** **               | ** ** | **2006**                                            | ** ** | **2005**                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| Natural gas              |       | 79                                                  | %          | 80                                  | %          | 80 | % | 76 | % |
| Natural gas liquids      |       | 4                                                   | %          | 5                                   | %          | 9 | % | 12 | % |
| Crude oil and condensate |       | 17                                                  | %          | 15                                  | %          | 11 | % | 12 | % |
|                     |       |                                                |       |                                |       |   |   |   |   |
| Total                    |       | 100                                                 | %          | 100                                 | %          | 100 | % | 100 | % |

 

----

(1) Includes effect of hedging and derivativetransactions.

 

The following table summarizes volume and priceinformation with respect to our oil and gas production for the three monthsended June 30, 2006 and 2005:

 
| ** **                                   | ** ** | ** **                                                                                            | ** ** | ** **      | ** ** | **2006 Period Compared  to 2005 Period** | ** ** |
|----------------------------------------------|------------|-------------------------------------------------------------------------------------------------------|------------|-----------------|------------|--------------------------------------------------------------|------------|
| ** **                                   | ** ** | **Three Months Ended  June 30,**                                                       | ** ** | **$  Increase** | ** ** | **%  Increase**                                              | ** ** |
| ** **                                   | ** ** | **2006**                                                                                              | ** ** | **2005**        | ** ** | **(Decrease)**                                               | ** ** | **(Decrease)** | ** ** |
| ** **                                   | ** ** | **(in thousands, except per Bbl/Mcf/Mcfe prices and percentages)** | ** ** |
| **Production Volumes:**                      | * *   | * *                                                                                              |       |            |       |                                                         |       |   |   |
| Natural gas (MMcf)                           |       | 3,578                                                                                                 |       | 3,083           |       | 495                                                          |       | 16 | % |
| Natural gas liquids (MBbls)                  |       | 65                                                                                                    |       | 83              |       | (18                                                          | )          | (22 | )% |
| Crude oil and condensate (MBbls)             |       | 85                                                                                                    |       | 80              |       | 5                                                            |       | 6 | % |
| Natural gas equivalent (MMcfe)               |       | 4,478                                                                                                 |       | 4,059           |       | 419                                                          |       | 10 | % |
| **Average Sales Price(1):**                  |       |                                                                                                  |       |            |       |                                                         |       |   |   |
| Natural gas ($ per Mcf)(2)              |       | $                                                                                                     | 6.68       |            | $          | 6.76                                                         |       | $ | (0.08 | ) | (1 | )% |
| Natural gas liquids ($ per Bbl)         |       | 23.14                                                                                                 |       | 17.15           |       | 5.99                                                         |       | 35 | % |
| Crude oil and condensate ($ per Bbl)(2) |       | 68.65                                                                                                 |       | 49.78           |       | 18.87                                                        |       | 38 | % |
| Natural gas equivalent ($ per Mcfe)(2)  |       | 6.97                                                                                                  |       | 6.46            |       | 0.51                                                         |       | 8 | % |
| Natural gas equivalent ($ per Mcfe)(3)  |       | 7.57                                                                                                  |       | 6.46            |       | 1.11                                                         |       | 17 | % |
| **Operating Revenue:**                       |       |                                                                                                  |       |            |       |                                                         |       |   |   |
| Natural gas (2)                              |       | $                                                                                                     | 23,881     |            | $          | 20,840                                                       |       | $ | 3,041 |   | 15 | % |
| Natural gas liquids                          |       | 1,512                                                                                                 |       | 1,426           |       | 86                                                           |       | 6 | % |
| Crude oil and condensate (2)                 |       | 5,806                                                                                                 |       | 3,962           |       | 1,844                                                        |       | 47 | % |
| Gain (loss) on hedging and derivatives       |       | 2,679                                                                                                 |       | (18             | )          | 2,697                                                        |       |   | * |
| Total revenue                                |       | $                                                                                                     | 33,878     |            | $          | 26,210                                                       |       | $ | 7,668 |   | 29 | % |

 

----

(1) Pricesare calculated based on whole numbers, not rounded numbers.

(2) Excludesthe effect of hedging and derivative transactions.

(3) Includesthe effect of hedging and derivative transactions.

*            Notmeaningful

 

28

----

 

**Average Sales Price****-** For the three months ended June 30, 2006,average sales prices, excluding hedging and derivatives activity, exceededthose for the same prior year period for natural gas liquids, crude oil andcondensate, but not for natural gas. Oursales revenue is sensitive to the volatility of commodity prices. A substantial portion of our production issold at prevailing market prices, which fluctuate in response to many factorsthat are outside of our control. Imbalances in the supply and demand for oiland natural gas can have a dramatic effect on the prices we receive for ourproduction. Political instability and availability of alternative fuels couldimpact worldwide supply, while the economy, weather and other factors outsideof our control could impact demand.

 

**Natural gas revenue** - For the three months ended June 30,2006, natural gas revenue, excluding hedging and derivative activity, increased15% over the same period in 2005 due to 16% higher production volumes partiallyoffset by 1% lower prices. The overall increase in production compared to theprior year period resulted in an increase in revenue of approximately $3.3million (based on 2005 comparable period pre-hedge prices), which was theresult of production from new wells drilled on our Queen City project and theChapman Ranch Field properties acquired in the fourth quarter of 2005,partially offset by declines on our older properties, including Encinitas, GatoCreek and Miller. The decrease in average price received resulted in decreasedrevenue of approximately $0.3 million (based on current period production).

 

**Natural gas liquids (“NGL”)revenue**- Forthe three months ended June 30, 2006, NGL revenue increased 6% over thesame period in 2005 due to an increase in prices realized, partially offset bylower production. This price increase resulted in an increase in revenue ofapproximately $0.4 million (based on current period production). NGL volumes werelower during the three months ended June 30, 2006 as compared to the sameperiod in 2005 as a result of declining production at our Encinitas, Gato Creekand Louisiana properties. The decrease in NGL production decreased revenue byapproximately $0.3 million (based on 2005 comparable period average prices).

 

**Crude oil and condensate revenue**- For the three months ended June 30,2006, oil and condensate sales revenue, excluding hedging and derivativeactivity, increased 47% from the comparable period in 2005, largely due to thesignificant increase in crude oil prices. The increased average realized pricefor oil and condensate for the three months ended June 30, 2006 resultedin an increase in revenue of approximately $1.6 million (based on current periodproduction). Production volumes for oil and condensate increased slightly forthe three months ended June 30, 2006 compared to the same prior yearperiod due primarily to new wells drilled on our Queen City and southeast NewMexico projects, as well as from the Chapman Ranch Field properties acquired inthe fourth quarter of 2005. These increases were partially offset by declineson our Miller, Encinitas and Gato Creek properties. The increase in oil andcondensate production resulted in an increase in revenue of approximately $0.2 million(based on 2005 comparable period pre-hedge prices).

 

**Hedging and derivatives**— For the three months ended June 30,2006 we recorded a net gain on hedging and derivative contracts as compared toa net loss in the same period in 2005. During the first quarter of 2006 wediscontinued cash flow hedge accounting treatment applied to our natural gascollars, due to projected changes in 2006 physical production volumes hedgedand to give us more flexibility to determine into which market we wish to sellour physical production (which had previously been restricted by the fact that cashflow hedge accounting treatment requires a certain relationship between thehedge terms and the physical sale terms to exist). This change in accountingtreatment affects the comparability of the periods (see Note 7 to ourconsolidated financial statements) because the change in fair market value ofthe natural gas hedge contracts in 2005 was deferred through OCI on the balancesheet rather than presented in total revenue on the income statement aspresented in 2006. The volume and price contract terms vary from period toperiod and therefore interact differently with the changing pricing environment.While we are unable to predict the market prices, we enter into contracts thatwe expect will protect us in the event of significant downturns in the market,which has proven to be a benefit to us in the first half of 2006 with decliningnatural gas prices resulting in cash settlement inflows from our hedgecounterparties to offset the lower prices received for our physical production.The following table summarizes the various components of the total gain (loss)on hedging and derivatives for the three months ended June 30, 2006 and2005 and the impact each component had on our realized prices.

 

29

----

 
| ** **                                                                       | ** ** | **Three Months Ended June 30,**                 | ** ** |
|----------------------------------------------------------------------------------|------------|---------------------------------------------------------------------|------------|
| ** **                                                                       | ** ** | **2006**                                                            | ** ** | **2005** | ** ** |
| ** **                                                                       | ** ** | **$**                                                               | ** ** | **$ per unit (1)** | ** ** | **$** | ** ** | **$ per unit(1)** | ** ** |
| ** **                                                                       | ** ** | **(in thousands, except per unit prices)** | ** ** |
|                                                                             |       |                                                                |       |   |   |   |   |   |   |
| Natural gas contract settlements (Mcf)                                           |       | $                                                                   | 1,642      |   | $ | 0.46 |   | $ | — |   | $ | — |   |
|                                                                             |       |                                                                |       |   |   |   |   |   |   |
| Crude oil contract settlements (Bbl)                                             |       | —                                                              |       | — |   | (346 | ) | (4.36 | ) |
|                                                                             |       |                                                                |       |   |   |   |   |   |   |
| Mark-to-market unrealized change in fair value of  gas derivative contract (Mcf) |       | 1,114                                                               |       | 0.31 |   | — |   | — |   |
|                                                                             |       |                                                                |       |   |   |   |   |   |   |
| Mark-to-market reversal of prior period unrealized  change in fair value (Bbl)   |       | (44                                                                 | )          | (0.52 | ) | 125 |   | 1.58 |   |
|                                                                             |       |                                                                |       |   |   |   |   |   |   |
| Mark-to-market unrealized change in fair value of  oil derivative contract (Bbl) |       | (33                                                                 | )          | (0.38 | ) | 203 |   | 2.56 |   |
|                                                                             |       |                                                                |       |   |   |   |   |   |   |
| Gain (loss) on hedging and derivatives (Mcfe)                                    |       | $                                                                   | 2,679      |   | $ | 0.61 |   | $ | (18 | ) | $ | (0.00 | ) |

 

----

(1) Pricesper unit are calculated based on whole numbers, not rounded numbers.

 

Should natural gas pricescontinue to decrease from the high levels of late 2005 and early 2006, thiscould materially affect our revenues that are not hedged.

 

**Costsand Operating Expenses**

 

Thetable below details our expenses for the three months ended June 30, 2006and 2005.

 
| ** **                                           | ** ** | ** **                                            | ** ** | ** **      | ** ** | **2006 Period Compared  to 2005 Period** | ** ** |
|------------------------------------------------------|------------|-------------------------------------------------------|------------|-----------------|------------|--------------------------------------------------------------|------------|
| ** **                                           | ** ** | **Three Months Ended  June 30,**       | ** ** | **$  Increase** | ** ** | **%  Increase**                                              | ** ** |
| ** **                                           | ** ** | **2006**                                              | ** ** | **2005**        | ** ** | **(Decrease)**                                               | ** ** | **(Decrease)** | ** ** |
| ** **                                           | ** ** | **(in thousands, except percentages)** | ** ** |
| Oil and natural gas operating expenses               |       | $                                                     | 2,260      |            | $          | 1,802                                                        |       | $ | 458 |   | 25 | % |
| Severance and ad valorem taxes                       |       | 2,236                                                 |       | 1,785           |       | 451                                                          |       | 25 | % |
| Depletion, depreciation, amortization and accretion: |       |                                                  |       |            |       |                                                         |       |   |   |
| Oil and gas property and equipment                   |       | 16,339                                                |       | 8,840           |       | 7,499                                                        |       | 85 | % |
| Other assets                                         |       | 160                                                   |       | 65              |       | 95                                                           |       | 146 | % |
| ARO accretion                                        |       | 46                                                    |       | 34              |       | 12                                                           |       | 35 | % |
| General and administrative expenses:                 |       |                                                  |       |            |       |                                                         |       |   |   |
| Deferred compensation – repriced options        |       | (296                                                  | )          | (90             | )          | (206                                                         | )          | 229 | % |
| Deferred compensation – restricted stock        |       | 522                                                   |       | 262             |       | 260                                                          |       | 99 | % |
| Other general and administrative                     |       | 3,122                                                 |       | 2,357           |       | 765                                                          |       | 32 | % |
|                                                 |       | 24,389                                                |       | 15,055          |       | 9,334                                                        |       | 62 | % |
| Other income and expense, net                        |       | 554                                                   |       | 12              |       | 542                                                          |       |   | * |
| Total                                                |       | $                                                     | 24,943     |            | $          | 15,067                                                       |       | $ | 9,876 |   | 66 | % |

 

----

* Notmeaningful

 

30

----

 

**Oil and natural gas operatingexpenses** -  For the three months ended June 30, 2006 operatingexpenses increased 25% from the same period of 2005. While we have experiencedsome impact from the tight field services market in 2006, the majority of theincrease is the result of higher activity levels. We experienced increased costsas a result of adding properties, specifically the newly acquired Chapman RanchField properties and new wells drilled at Gato Creek, southeast New Mexico andin Jim Hogg County, Texas. Average oil and natural gas operating expenses were $0.50per Mcfe and $0.44 per Mcfe for the three months ended June 30, 2006 and2005, respectively.

 

**Severance and ad valorem taxes**  — For the three months ended June 30,2006, severance and ad valorem taxes increased 25% from the second quarter of2005. Our severance tax expense is levied on our oil and gas revenue (excludinghedging and derivative impact). Although our revenues increased for thequarter, severance tax expense decreased due to severance tax abatement refundswe received during the quarter, which effectively lowered our realized ratefrom 6.04% of revenue for the three months ended June 30, 2005 to approximately5.03% in the same period of 2006. Ad valorem tax expense for the second quarterof 2006 was impacted by increased accruals for the estimated costs related tothe addition of the Chapman Ranch Field properties acquired in the fourthquarter 2005 and increases in estimated costs from the taxing authorities. Onan equivalent basis, severance and ad valorem taxes averaged $0.50 per Mcfe and$0.44 per Mcfe for the three months ended June 30, 2006 and 2005,respectively.

 

**Depletion, depreciation, and amortization (“DD&A”)and accretion**-  DD&Aand accretion expense for the three months ended June 30, 2006 totaled $16.5million compared to $8.9 million for the same period in 2005. Depletion on ouroil and natural gas properties continues to increase due to increases in ourunit-of-production depletion rate as well as increased production volumes. Thedepletion rate increased from $2.18 per Mcfe in the second quarter 2005 to $3.65per Mcfe in the second quarter of 2006, adding approximately $6.6 million indepletion expense. Our rate has increased due to increased spending on ourdrilling program with disproportionately lower  reserve additions. One example of thisincludes the Chapman Ranch Field acquisitions which added $0.52 per Mcfe to thedepletion rate in the fourth quarter of 2005. Since the first quarter of 2006,the rate increased $0.02 per Mcfe. The increase in depletion expense from thehigher production levels in the second quarter of 2006 as compared to the sameperiod of 2005 resulted in an increase in expense of approximately $0.9 million.Depreciation of furniture and fixtures for the second quarter of 2006 includesadditional expense related to certain assets that were deemed to be fullydepreciated, thus speeding up the depreciation and amortization expense taken. Accretionexpense associated with our asset retirement obligations for the three monthsended June 30, 2006 increased 35% over the second quarter of 2005 for thenew obligations incurred from the wells drilled since June 30, 2005 and theaddition of properties acquired in the fourth quarter of 2005.

 

**Total G&A** - For thethree months ended June 30, 2006, total G&A was $3.3 million, an increaseof 32% compared to the prior year second quarter total of $2.5 million. TotalG&A includes deferred compensation related to repriced options pursuant toFIN 44 discussed in Note 1 to the consolidated financial statements, deferredcompensation related to stock option expense pursuant to the adoption of SFAS No. 123(R)discussed in Note 1, deferred compensation related to restricted stock grantsand other G&A costs. Stock options repriced pursuant to FIN 44 resulted in a credit in the secondquarters of 2006 and 2005. A substantial portion of the outstanding repricedoptions have been exercised since the second quarter of 2005, leaving only62,000 remaining so we expect the impact from these options to diminish in thefuture, unless there was a substantial change to our stock price that impactedthe calculation of this amount. Upon adoption of SFAS No. 123(R) in thefirst quarter of 2006, we recorded $41,738 in compensation expense for stockoptions that had not vested as of adoption of SFAS No. 123(R). Thoseoptions have since vested and there was no additional expense associated withthe adoption of SFAS No. 123(R) recorded in the second quarter of 2006. Wedo not expect any future impact to result from our adoption of SFAS No. 123(R),as we discontinued issuing stock options in 2004. There was no comparable expensein the same prior year period because we were applying APB Opinion No. 25,which allowed us to exclude expense related to stock options (see Note 1 to theconsolidated financial statements). Amortization related to restrictedstock awards granted over the past three years has increased due to new grantsthat have occurred since the second quarter of 2005. Other G&A for thethree months ended June 30, 2006, which does not include the deferredcompensation expenses discussed above, increased 32% from the comparable 2005period. The increase in other G&A was attributable to higher salaries andbenefits, due to adding ten employees since June 30, 2005, as well ashigher rent expense for additional office space, franchise tax expense, andlegal costs for pending litigation. These increases were partially offset bydecreases in regulatory fees, Board of Director compensation costs, and costsincurred in 2005 for strategic planning. For the three months ended June 30,2006 and 2005, overhead reimbursement fees 

 

31

----

 

reducing G&A costs werecomparable. Capitalized G&A costs further reduced other G&A by $0.9 millionand $0.7 million for the three months ended June 30, 2006 and 2005,respectively. Other G&A on a unit of production basis for the three monthsended June 30, 2006 was $0.70 per Mcfe compared to $0.58 per Mcfe for thecomparable 2005 period.

 

**Other income and expense** - During the three months ended June 30,2006, our other income and expense increased from a negligible amount in thecomparable 2005 period, primarily due to an increase in gross interest expense,which was partially offset by an increase interest income and capitalizedinterest. For the second quarter of 2006, 72% of our gross interest expense wascapitalized as compared to 100% in the same 2005 period. We calculate theamount of interest we can capitalize based on the comparison of our unprovedproperty costs and our weighted average debt balance. In 2005, our debt waslower than the unproved property balance, whereas the 2006 weighted averagedebt balance exceeds the unproved property balance. We also incurred higher grossinterest costs for the three months ended June 30, 2006 than for the sameperiod of 2005 due to higher outstanding debt balances.

 
| ** **                 | ** ** | **Three Months Ended June 30,** | ** ** |
|----------------------------|------------|-----------------------------------------------------|------------|
| ** **                 | ** ** | **2006**                                            | ** ** | **2005** | ** ** |
| ** **                 | ** ** | **(in thousands)**                             | ** ** |
| Gross interest expense     |       | $                                                   | 1,974      |   | $ | 256 |   |
| Less: Capitalized interest |       | (1,429                                              | )          | (256 | ) |
| Interest expense, net      |       | $                                                   | 545        |   | $ | — |   |
|                       |       |                                                |       |   |   |
| Weighted Average Debt      |       | $                                                   | 105,253    |   | $ | 11,187 |   |

 

We also recordedamortization of deferred loan costs related to our Credit Facility and interestincome earned on our outstanding daily cash balances during the three monthsended June 30, 2006 and 2005, both of which were comparable amounts.

 

**Income tax expense** - An income tax provision was recordedfor the three months ended June 30, 2006 and 2005 of $3.1 million and $3.9million, respectively. The decrease resulted from lower pre-tax income in 2006as compared to 2005. There has not been a substantial change to our effectiveincome tax rate.

 

**Earnings per share** - For thethree months ended June 30, 2006, earnings per share decreased incomparison to the same period in 2005, mainly as a result of decreased netincome. Basic weighted average shares outstanding for the three months ended June 30,2006 increased approximately 1% as compared to the same 2005 period primarilydue to the exercise of stock options throughout the interim periods.

 

**Six Months Ended June 30, 2006 Compared tothe Six Months Ended June 30, 2005**

 

**Revenueand Production**

 

Total revenue increased 40% from the first six months of2005 to the comparable 2006 period. For the six months ended June 30, 2006and 2005, our product mix contributed the following percentages of revenues andproduction volumes:

 
| ** **               | ** ** | **REVENUES****(1)**                               | ** ** | **PRODUCTION VOLUMES  (MCFE)** | ** ** |
|--------------------------|------------|---------------------------------------------------|------------|-------------------------------------|------------|
| ** **               | ** ** | **Six Months Ended June 30,** | ** ** |
| ** **               | ** ** | **2006**                                          | ** ** | **2005**                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| Natural gas              |       | 80                                                | %          | 80                                  | %          | 80 | % | 76 | % |
| Natural gas liquids      |       | 4                                                 | %          | 6                                   | %          | 9 | % | 12 | % |
| Crude oil and condensate |       | 16                                                | %          | 14                                  | %          | 11 | % | 12 | % |
|                     |       |                                              |       |                                |       |   |   |   |   |
| Total                    |       | 100                                               | %          | 100                                 | %          | 100 | % | 100 | % |

 

----

(1) Includes effect of hedging and derivative transactions.

 

32

----

 

The following table summarizes volume and priceinformation with respect to our oil and gas production for the six months endedJune 30, 2006 and 2005:

 
| ** **                                   | ** ** | ** **                                                                                            | ** ** | ** **      | ** ** | **2006 Period Compared  to 2005 Period** | ** ** |
|----------------------------------------------|------------|-------------------------------------------------------------------------------------------------------|------------|-----------------|------------|--------------------------------------------------------------|------------|
| ** **                                   | ** ** | **Six Months Ended  June 30,**                                                         | ** ** | **$  Increase** | ** ** | **%  Increase**                                              | ** ** |
| ** **                                   | ** ** | **2006**                                                                                              | ** ** | **2005**        | ** ** | **(Decrease)**                                               | ** ** | **(Decrease)** | ** ** |
| ** **                                   | ** ** | **(in thousands, except per Bbl/Mcf/Mcfe prices and percentages)** | ** ** |
| **Production Volumes:**                      |       |                                                                                                  |       |            |       |                                                         |       |   |   |
| Natural gas (MMcf)                           |       | 7,007                                                                                                 |       | 6,285           |       | 722                                                          |       | 11 | % |
| Natural gas liquids (MBbls)                  |       | 126                                                                                                   |       | 167             |       | (41                                                          | )          | (25 | )% |
| Crude oil and condensate (MBbls)             |       | 172                                                                                                   |       | 163             |       | 9                                                            |       | 6 | % |
| Natural gas equivalent (MMcfe)               |       | 8,792                                                                                                 |       | 8,264           |       | 528                                                          |       | 6 | % |
| **Average Sales Price****(1):**              |       |                                                                                                  |       |            |       |                                                         |       |   |   |
| Natural gas ($ per Mcf)(2)              |       | $                                                                                                     | 7.19       |            | $          | 6.26                                                         |       | $ | 0.93 |   | 15 | % |
| Natural gas liquids ($ per Bbl)         |       | 21.90                                                                                                 |       | 17.31           |       | 4.59                                                         |       | 27 | % |
| Crude oil and condensate ($ per Bbl)(2) |       | 64.02                                                                                                 |       | 48.75           |       | 15.27                                                        |       | 31 | % |
| Natural gas equivalent ($ per Mcfe)(2)  |       | 7.29                                                                                                  |       | 6.07            |       | 1.22                                                         |       | 20 | % |
| Natural gas equivalent ($ per Mcfe)(3)  |       | 7.83                                                                                                  |       | 5.95            |       | 1.88                                                         |       | 32 | % |
| **Operating Revenue:**                       |       |                                                                                                  |       |            |       |                                                         |       |   |   |
| Natural gas (2)                              |       | $                                                                                                     | 50,354     |            | $          | 39,336                                                       |       | $ | 11,018 |   | 28 | % |
| Natural gas liquids                          |       | 2,757                                                                                                 |       | 2,895           |       | (138                                                         | )          | (5 | )% |
| Crude oil and condensate (2)                 |       | 10,983                                                                                                |       | 7,926           |       | 3,057                                                        |       | 39 | % |
| Gain (loss) on hedging and derivatives       |       | 4,778                                                                                                 |       | (1,003          | )          | 5,781                                                        |       | (576 | )% |
| Total revenue                                |       | $                                                                                                     | 68,872     |            | $          | 49,154                                                       |       | $ | 19,718 |   | 40 | % |

 

----

(1) Prices arecalculated based on whole numbers, not rounded numbers.

(2) Excludesthe effect of hedging and derivative transactions.

(3) Includesthe effect of hedging and derivative transactions.

 

**Average Sales Price**– For the six months ended June 30,2006, average sales prices, excluding hedging and derivatives activity, exceededthose for the same prior year period for all commodities.

 

**Natural gas revenue** - For the first half of 2006, naturalgas revenue, excluding hedging and derivative activity, increased 28% over thesame period in 2005, due to higher realized prices and production volumes. Theaverage price increase resulted in increased revenue of approximately $6.5million (based on current period production). The increase in productionvolumes compared to the prior year period resulted in an increase in revenue ofapproximately $4.5 million (based on 2005 comparable period pre-hedge prices).The increased volumes came from production from new wells drilled on our QueenCity project and the Chapman Ranch Field properties acquired in the fourthquarter of 2005, partially offset by declines in production from our olderproperties, including Encinitas, Gato Creek and Miller.

 

**NGL revenue**- For the six months ended June 30,2006, NGL sales revenue decreased 5% over the same period in 2005 as a resultof decreased production volumes. NGL production volumes declined at ourEncinitas, Gato Creek and Louisiana properties, leading to decreased revenue ofapproximately $0.7 million (based on 2005 comparable period average prices).Higher average realized prices for the six months ended June 30, 2006partially offset the decline in revenue from lower volumes and resulted in anincrease in revenue of approximately $0.6 million (based on current periodproduction).

 

**Crude oil and condensate revenue**- For the six months ended June 30,2006, oil and condensate sales revenue, excluding hedging and derivativeactivity, increased 39% as compared to the same period in 2005, due to 

 

33

----

 

both higher priceenvironment and production volumes. The higher average prices for the first halfof 2006 resulted in an increase in revenue of approximately $2.6 million (basedon current period production). Production volumes for oil and condensateincreased 6% for the six months ended June 30, 2006 compared to the sameprior year period due primarily to new wells drilled on our Queen City andsoutheast New Mexico projects, as well as from the Chapman Ranch Fieldproperties acquired in the fourth quarter of 2005. These increases werepartially offset by declines in production from our Miller, Encinitas and GatoCreek properties. The overall increase in oil and condensate productionresulted in an increase in revenue of approximately $0.4 million (based on 2005comparable period pre-hedge prices).

 

**Hedging and derivatives****–** For the six months ended June 30, 2006, werecorded a net gain on hedging and derivative contracts as compared to a netloss in the same period in 2005. The change in accounting treatment applied toour derivative contracts affects the comparability of the periods (see Note 7to our consolidated financial statements) because the change in fair marketvalue of the natural gas hedge contracts in 2005 was deferred through OCI onthe balance sheet rather than presented in total revenue on the incomestatement as in 2006. In addition, we have different contract terms in 2006than in 2005, which interact differently with the changing pricing environment.In the first half of 2006, the falling natural gas price has negativelyimpacted our physical sales, but the portion we had hedged was protected bythose contracts in place this year. The following table summarizes the variouscomponents of the total gain (loss) on hedging and derivatives for the six monthsended June 30, 2006 and 2005 and the impact each component had on ourrealized prices.

 
| ** **                                                                       | ** ** | **Six Months Ended June 30,**                   | ** ** |
|----------------------------------------------------------------------------------|------------|---------------------------------------------------------------------|------------|
| ** **                                                                       | ** ** | **2006**                                                            | ** ** | **2005** | ** ** |
| ** **                                                                       | ** ** | **$**                                                               | ** ** | **$ per unit (1)** | ** ** | **$** | ** ** | **$ per unit(1)** | ** ** |
| ** **                                                                       | ** ** | **(in thousands, except per unit prices)** | ** ** |
|                                                                             |       |                                                                |       |   |   |   |   |   |   |
| Natural gas contract settlements (Mcf)                                           |       | $                                                                   | 1,961      |   | $ | 0.28 |   | $ | 156 |   | $ | 0.02 |   |
|                                                                             |       |                                                                |       |   |   |   |   |   |   |
| Crude oil contract settlements (Bbl)                                             |       | —                                                              |       | — |   | (605 | ) | (3.72 | ) |
|                                                                             |       |                                                                |       |   |   |   |   |   |   |
| Mark-to-market unrealized change in fair value of  gas derivative contract (Mcf) |       | 3,124                                                               |       | 0.45 |   | — |   | — |   |
|                                                                             |       |                                                                |       |   |   |   |   |   |   |
| Mark-to-market reversal of prior period unrealized  change in fair value (Bbl)   |       | (62                                                                 | )          | (0.36 | ) | 335 |   | 2.06 |   |
|                                                                             |       |                                                                |       |   |   |   |   |   |   |
| Mark-to-market unrealized change in fair value of  oil derivative contract (Bbl) |       | (245                                                                | )          | (1.43 | ) | (889 | ) | (5.47 | ) |
|                                                                             |       |                                                                |       |   |   |   |   |   |   |
| Gain (loss) on hedging and derivatives (Mcfe)                                    |       | $                                                                   | 4,778      |   | $ | 0.54 |   | $ | (1,003 | ) | $ | (0.12 | ) |

 

----

(1) Pricesper unit are calculated based on whole numbers, not rounded numbers.

 

Should natural gas pricescontinue to decrease from the high levels of late 2005 and early 2006, thiscould materially affect our revenues that are not hedged.

 

34

----

 

**Costsand Operating Expenses**

 

Thetable below details our expenses for the six months ended June 30, 2006and 2005.

 
| ** **                                           | ** ** | ** **                                            | ** ** | ** **      | ** ** | **2006 Period Compared  to 2005 Period** | ** ** |
|------------------------------------------------------|------------|-------------------------------------------------------|------------|-----------------|------------|--------------------------------------------------------------|------------|
| ** **                                           | ** ** | **Six Months Ended  June 30,**         | ** ** | **$  Increase** | ** ** | **%  Increase**                                              | ** ** |
| ** **                                           | ** ** | **2006**                                              | ** ** | **2005**        | ** ** | **(Decrease)**                                               | ** ** | **(Decrease)** | ** ** |
| ** **                                           | ** ** | **(in thousands, except percentages)** | ** ** |
| Oil and natural gas operating expenses               |       | $                                                     | 4,449      |            | $          | 4,044                                                        |       | $ | 405 |   | 10 | % |
| Severance and ad valorem taxes                       |       | 4,825                                                 |       | 3,651           |       | 1,174                                                        |       | 32 | % |
| Depletion, depreciation, amortization and accretion: |       |                                                  |       |            |       |                                                         |       |   |   |
| Oil and gas property and equipment                   |       | 32,015                                                |       | 17,380          |       | 14,635                                                       |       | 84 | % |
| Other assets                                         |       | 234                                                   |       | 127             |       | 107                                                          |       | 84 | % |
| ARO accretion                                        |       | 89                                                    |       | 68              |       | 21                                                           |       | 31 | % |
| General and administrative expenses:                 |       |                                                  |       |            |       |                                                         |       |   |   |
| Deferred compensation – repriced options        |       | (267                                                  | )          | 172             |       | (439                                                         | )          | (255 | )% |
| Deferred compensation – restricted stock        |       | 858                                                   |       | 406             |       | 452                                                          |       | 111 | % |
| Deferred compensation – stock option expense    |       | 42                                                    |       | —          |       | 42                                                           |       |   | * |
| Bad debt expense                                     |       | —                                                |       | 11              |       | (11                                                          | )          |   | * |
| Other general and administrative                     |       | 5,839                                                 |       | 4,836           |       | 1,003                                                        |       | 21 | % |
|                                                 |       | 48,084                                                |       | 30,695          |       | 17,389                                                       |       | 57 | % |
| Other income and expense, net                        |       | 1,226                                                 |       | 15              |       | 1,211                                                        |       |   | * |
| Total                                                |       | $                                                     | 49,310     |            | $          | 30,710                                                       |       | $ | 18,600 |   | 61 | % |

 

----

* Notmeaningful

 

**Oil and natural gas operatingexpenses**-  For the six months ended June 30,2006, operating expenses increased from the same period of 2005. We experiencedincreases in costs for the newly acquired Chapman Ranch Field properties andnew wells drilled at Gato Creek, southeast New Mexico and Jim Hogg County,Texas. Average oil and natural gas operating expenses were $0.51 per Mcfe and $0.49per Mcfe for the six months ended June 30, 2006 and 2005, respectively.

 

**Severance and ad valorem taxes**  — For the six months ended June 30,2006, severance and ad valorem taxes increased 32% from the first half of 2005.Our severance tax expense is levied on our oil and gas revenue dollars(excluding hedging and derivative impact), and typically increases as revenuesincrease. We experienced 13% higher severance tax expense as compared to 2005.This increase resulted from the addition of the Chapman Ranch Field propertiesacquired in late 2005. Although they contributed to the overall increase, theChapman Ranch Field properties receive a very low rate due to severance taxabatements. We also received refunds for prior periods during the secondquarter of 2006 related to these properties. For the six months ended June 30,2006, severance tax expense was approximately 5.41% of revenue subject toseverance taxes compared to 6.13% of revenue subject to severance taxes for thecomparable 2005 period. Ad valorem tax expense for the first half of 2006 wasimpacted by increased accruals for the estimated costs related to the additionof the Chapman Ranch Field properties acquired in the fourth quarter 2005 andincreases in estimated costs from the taxing authorities. On an equivalentbasis, severance and ad valorem taxes averaged $0.55 per Mcfe and $0.44 perMcfe for the six months ended June 30, 2006 and 2005, respectively.

 

**DD&A and accretion**-  For the six months ended June 30, 2006, DD&Aand accretion expense totaled $32.3 million compared to $17.6 million for the sameperiod in 2005. Depletion on our oil and natural gas properties increased 84%for the first half of 2006 compared to the same period of 2005 due to anincrease in our 

 

35

----

 

unit-of-productiondepletion rate and production levels. The depletion rate increased from $2.10per Mcfe in the first half of 2005 to $3.64 per Mcfe in the first half of 2006,adding approximately $13.5 million in depletion expense. Our rate has increaseddue to increased spending on our drilling program with disproportionately lowerreserve additions. One significant example of disproportionate additions to theamortizable base includes the Chapman Ranch Field acquisitions which added$0.52 per Mcfe to the depletion rate in the fourth quarter of 2005. Theincrease in depletion expense from the higher production levels in the first halfof 2006 as compared to the same period of 2005 resulted in an increase inexpense of approximately $1.1 million. Depreciation of furniture and fixturesincreased 84% compared to the prior year first half due to additional expensetaken on assets deemed to be fully depreciated at the end of June 2006.Accretion expense associated with our asset retirement obligations for the six monthsended June 30, 2006 increased 31% over the first half of 2005 for the newobligations incurred from the wells drilled in 2005 and the addition ofproperties acquired in the fourth quarter of 2005.

 

**Total G&A** - For the six monthsended June 30, 2006, total G&A was $6.5 million, an increase of 19%compared to the same prior year period total of $5.4 million. The applicationof FIN 44 to repriced options resultedin a credit in the first half of 2006 as compared to a charge in the first halfof 2005. Since June 30, 2005, 61% of the outstanding repriced options havebeen exercised, leaving only 62,000 at June 30, 2006. We expect the impactof FIN 44 from these options to diminish going forward, unless our stock priceincreases substantially. Upon adoption of SFAS No. 123(R) in the firstquarter of 2006, we recorded $41,738 in compensation expense for stock optionsthat had not vested as of adoption of SFAS No. 123(R). Those options havesince vested and we do not expect any future impact to result from our adoptionof SFAS No. 123(R), as we discontinued issuing stock options in 2004. Amortizationrelated to restricted stock awards granted over the past three years hasincreased due to new grants that have occurred since June 30, 2005. Werecorded $11,000 of bad debt expense in the first half of 2005 related toseveral unpaid joint interest billings receivable and none in 2006. OtherG&A for the six months ended June 30, 2006, which does not include thedeferred compensation expenses discussed above, increased 21% from thecomparable 2005 period. The increase in other G&A was attributable tohigher salaries and benefits, due to adding ten employees since June 30,2005, as well as higher rent expense for additional office and storage space, parkingcosts for added employees, director and officer liability insurance, franchisetax expense, and legal costs for pending litigation. These increases werepartially offset by decreases in regulatory fees, Sarbanes-Oxley consultingfees, and costs incurred in 2005 for Board of Director compensation and strategicplanning meetings. For the six months ended June 30, 2006 and 2005,overhead reimbursement fees reducing G&A costs increased 56% in 2006 ascompared to 2005 as a result of increasing our operated properties. CapitalizedG&A costs further reduced other G&A costs by $1.6 million and $1.4million for the six months ended June 30, 2006 and 2005, respectively. OtherG&A on a unit of production basis for the six months ended June 30,2006 was $0.66 per Mcfe compared to $0.59 per Mcfe for the comparable 2005period.

 

**Other income and expense** - During the six months ended June 30,2006, other income and expense increased from a negligible amount in thecomparable 2005 period, primarily due to an increase in gross interest expense,which was partially offset by increases in interest income and capitalizedinterest. For the first half of 2006, 66% of our interest expense wascapitalized as compared to 100% being capitalized in the same 2005 period. We alsoincurred higher interest costs for the six months ended June 30, 2006 thanfor the same period of 2005 due to higher outstanding debt balances.

 

| ** **                 | ** ** | **For the Six Months Ended June 30,** | ** ** |
|----------------------------|------------|---------------------------------------------------------------------|------------|
| ** **                 | ** ** | **2006**                                                            | ** ** | **2005** | ** ** |
| ** **                 | ** ** | **(in thousands)**                                             | ** ** |
| Gross interest expense     |       | $                                                                   | 3,582      |   | $ | 480 |   |
| Less: Capitalized interest |       | (2,369                                                              | )          | (480 | ) |
| Interest expense, net      |       | $                                                                   | 1,213      |   | $ | — |   |
|                       |       |                                                                |       |   |   |
| Weighted Average Debt      |       | $                                                                   | 99,359     |   | $ | 11,602 |   |

 

We also recordedamortization of deferred loan costs related to our Credit Facility and interestincome earned on our outstanding daily cash balances during the six monthsended June 30, 2006 and 2005, both of which were comparable amounts.

 

36

----

 

**Income tax expense** - An income tax provision was recordedfor the six months ended June 30, 2006 and 2005 of $6.9 million and $6.5million, respectively. The increase resulted from higher pre-tax income in 2006as compared to 2005. There have not been substantial changes to our effectiveincome tax rate.

 

**Earnings per share** - For the first half of 2006, earningsper share increased in comparison to the same period in 2005 mainly as a resultof increased net income, partially offset by an increased number of shares.Basic weighted average shares outstanding for the six months ended June 30,2006 increased approximately 1% as compared to the same 2005 period primarilydue to the exercise of stock options throughout the interim periods.

 

## **Liquidity and CapitalResources**

## ** **

Ourprimary ongoing source of capital is the cash flow generated from our operatingactivities supplemented by borrowings under our Credit Facility. Net cashgenerated from operating activities is a function of production volumes andcommodity prices, both of which are inherently volatile and unpredictable, aswell as operating efficiency and capital spending. Our business, as with otherextractive businesses, is a depleting one in which each gas equivalent unitproduced must be replaced or our asset base and capacity to generate revenuesin the future will shrink. Our overall expected future production decline isestimated to be approximately 22% per year. Less predictable than productiondeclines from our proved reserves is the impact of constantly changing oil andnatural gas prices on cash flows and, therefore capital budgets. We attempt tomitigate the price risk with our hedging program. Reserves and productionvolumes are influenced, in part, by the amount of future capital expenditures.In turn, capital expenditures are influenced by many factors including drillingresults, oil and gas prices, industry conditions, prices, availability of goodsand services and the extent to which oil and gas properties are acquired.

 

Ourprimary cash requirements are for exploration, development and acquisition ofoil and gas properties, and the repayment of principal and interest onoutstanding debt. We attempt to fund our exploration and development activitiesprimarily through internally generated cash flows and budget capitalexpenditures based on projected cash flows. We routinely adjust capitalexpenditures in response to changes in oil and natural gas prices, drilling andacquisition costs, and cash flow. We have historically used our Credit Facilityto supplement any deficiencies between operating cash flow and capitalexpenditures. We typically have funded acquisitions from borrowings under our CreditFacility, cash flow from operations and sales of common stock.

 

Significantchanges to working capital may affect our liquidity in the short term. Thechange in our derivative instrument from a liability at December 31, 2005to an asset at June 30, 2006 is indicative of potential future cash receiptson our derivative positions, which are scheduled to settle in the comingmonths. The fair value of our outstanding derivative contracts, reflected in thederivative financial instrument on the balance sheet, is an asset because theprice floors on our contracts exceed the future strip commodity prices at thebalance sheet date, such that if the contracts were to settle at the balancesheet date we would have gains. The fair market value represents the potentialsettlement for those contracts if the market prices remain unchanged, butshould commodity prices increase or decrease, the fair value of thoseoutstanding contracts would change and the settlements at maturity would alsochange. When our hedges and derivatives require us to pay a cash settlement, weare receiving higher cash inflows on the sale of unhedged production at higherprices, providing us with funds which would adequately cover any settlementswhen they come due.

 

We had $105.0 million outstanding under our Credit Facilityat June 30, 2006. Our Credit Facility matures on December 31, 2007. Wehave received significant funds through equity transactions in the past, includingthrough offerings of our common stock and the exercise of warrants and stockoptions. We typically do not, however, rely on proceeds from the exercise ofwarrants and stock options to sustain our business as the timing of theirexercise is unpredictable.

 

After considering theimpact of these working capital changes and our forecasts of future results ofoperations, we believe that cash flows from operating activities, assupplemented by borrowings on our Credit Facility, combined with our ability tocontrol the timing of certain of our future exploration and developmentrequirements, will provide us with the flexibility and liquidity to meet ourplanned capital requirements for 2006. In addition, our Credit Facility had $10.0million available at June 30, 2006.

 

37

----

 

We had cash and cashequivalents at June 30, 2006 of $2.4 million consisting primarily ofshort-term money market investments, as compared to $0.7 million at December 31,2005. Working capital was $19.0 million as of June 30, 2006, as comparedto $10.5 million at December 31, 2005. Our sources and uses of cash wereas follows:

 
| ** **                                  | ** ** | **For the Six Months Ended June 30,** | ** ** |
|---------------------------------------------|------------|---------------------------------------------------------------------|------------|
| ** **                                  | ** ** | **2006**                                                            | ** ** | **2005** | ** ** |
| ** **                                  | ** ** | **(in thousands)**                                             | ** ** |
| *Net Cash Provided By Operating Activities* |       | $                                                                   | 46,370     |   | $ | 33,740 |   |
| * *                                    |       |                                                                |       |   |   |
| *Net Cash Used In Investing Activities*     |       | (65,226                                                             | )          | (34,037 | ) |
| * *                                    |       |                                                                |       |   |   |
| *Net Cash Provided by Financing Activities* |       | 20,570                                                              |       | 210 |   |
|                                             |            |                                                                     |            |  |  |  |  |

 

**Net Cash Provided ByOperating Activities***-*The increase in cash flows provided by operating activities for the sixmonths ended June 30, 2006 compared to 2005 was primarily due to higheroil and gas production revenue partially offset by higher operating expenses. Althoughfluctuations in commodity prices have been the primary reason for ourshort-term changes in cash flow from operating activities, increased productionvolumes significantly impacted us in the past few quarters. In an effort toreduce the volatility realized on commodity prices, we enter into derivativeinstruments. Although we have seen declines in natural gas prices sinceyear-end 2005, we have realized cash settlements from our derivatives to offseta portion of those price declines. Overall, oil and gas production revenueincreased for the six months ended June 30, 2006 as compared to the sameperiod in 2005 with a 32% increase in the average net price received for ourproduction and a 6% increase in production volumes.

 

**Net Cash Used InInvesting Activities***-*Wereinvest a substantial portion of our cash flows from operating activities inour drilling, acquisition, land and geophysical activities. Capitalexpenditures of $60.1 million were attributable to our drilling and operating program.In addition to drilling that was in progress at year-end 2005, we drilled 35 grosswells during the six months ended June 30, 2006, all but seven of whichwere apparent successes. Leasehold acquisitions, including seismic data andother geological and geophysical expenditures totaled $7.7 million for the six monthsended June 30, 2006. The remaining capital expenditures were associatedwith computer hardware and office equipment and other miscellaneous capitalcharges. Proceeds from the sale of oil and gas properties totaled $0.6 millionduring the six months ended June 30, 2006, which represents thedivestiture of our Buckeye properties which closed in April 2006. Duringthe first six months of 2005, capital expenditures of $27.7 million wereattributable to our drilling program. In addition to drilling that was inprogress at year-end 2004, we drilled 22 gross wells during the six monthsended June 30, 2005, all but one of which was successful. Leaseholdacquisitions, including seismic data and other geological and geophysicalexpenditures totaled $4.6 million and acquisition costs totaled $1.4 millionfor the six months ended June 30, 2005. The remaining capital expenditureswere associated with computer hardware and office equipment.

 

Dueto our active exploration, development and acquisition activities, we haveexperienced and expect to continue to experience substantial working capitalrequirements. We currently anticipate capital expenditures in 2006 to beapproximately $98.0 million. Approximately $78.0 million is allocated to ourexpected drilling and production activities; $12.0 million is allocated toland, legal and seismic activities; and $8.0 million relates to capitalizedinterest, G&A and other. We intend to fund our total projected 2006 capitalexpenditures, and other commitments and working capital requirements, with cashflow from operations and, to the extent necessary, other sources. Should therebe a change in our pricing or production assumptions, we believe that we havesufficient financial flexibility from other financing sources to meet ourfinancial obligations as they come due, and we would recommend to our Board anadjustment to our capital expenditures program accordingly so as to avoidunnecessary incremental borrowings that may be needed for acquisitions. Wedo not explicitly budget for acquisitions; however, we do expect to spendconsiderable effort evaluating acquisition opportunities. We expect to fundacquisitions through traditional reserve-based bank debt and/or the issuance ofequity and, if required, through additional debt and equity financings.

 

**Net Cash Provided By FinancingActivities***-*Duringthe six months ended June 30, 2006 our net borrowings under our CreditFacility (as defined below) were $20.0 million due to the accelerated timing ofour drilling schedule. We received $0.6 million in proceeds from stock optionsexercised in the first six months of 2006. 

 

38

----

 

For the six months ended June 30,2005, we received $7.2 million in proceeds from the issuance of common stockrelated to the exercise of the over-allotment option on our December 21,2004 public offering of common stock and stock options exercised in the firstsix months of 2005. These were partially offset by net repayments of $7.0million under our Credit Facility.

 

Weutilize our Credit Facility to supplement timing differences in our projectedcash inflows and outflows and smaller acquisitions. We also have $390 millionavailable under our current shelf registration statement for largeracquisitions. We believe we will be able to generate capital resources andliquidity sufficient meet our financial obligations as they come due.

 

*Credit Facility*

 

On November 30,2005, we amended our Third Amended and Restated Credit Agreement (the “CreditFacility”), which we had originally entered into in March 2004 (effective December 31,2003) and previously amended on May 31, 2005. The Credit Facility permitsborrowings up to the lesser of (i) the borrowing base and (ii) $150.0million. Effective November 30, 2005, the borrowing base under the CreditFacility was increased from $70.0 million to $110.0 million as a result of theChapman Ranch Field acquisitions and our drilling activities since the lastredetermination. The borrowing base was redetermined by the lender in May 2006and increased to $115.0 million as a result of recent drilling activities. Basedon the increase, our available borrowing capacity at June 30, 2006 was$10.0 million.

 

TheCredit Facility matures December 31, 2007 and is secured by substantiallyall of our assets. Borrowings under the Credit Facility bear interest at ratesthat are variable based on the percentage usage of the facility. Borrowings canbe at Prime plus a margin of up to 0.25% or at Libor plus a margin of 1.75% to2.125%. As of June 30, 2006, our interest rates on our outstanding primeand Libor borrowings were 8.500% and 7.235%. As of June 30, 2006, $105.0million in total borrowings were outstanding under the Credit Facility.

 

TheCredit Facility provides for certain restrictions, including but not limitedto, limitations on additional borrowings, sales of oil and natural gasproperties or other collateral, and engaging in merger or consolidation transactions.The Credit Facility also prohibits dividends and certain distributions of cashor properties and certain liens. The Credit Facility also contains thefollowing financial covenants, among others:

 

•                  The EBITDAX to Interest Expense ratiorequires that the ratio of (a) our consolidated EBITDAX (defined as EBITDAplus similar non-cash items and exploration and abandonment expenses for suchperiod) for the four fiscal quarters then ended to (b) our consolidatedinterest expense for the four fiscal quarters then ended, to not be less than3.5 to 1.0.

•                  The Working Capital ratio requiresthat the amount of our consolidated current assets less our consolidatedcurrent liabilities, as defined in the Credit Facility Agreement, be at least$1.0 million. For the purposes of calculating the Working Capital ratio, thetotal of current assets is adjusted for unused capacity under the CreditFacility Agreement, and derivative financial instruments and the total ofcurrent liabilities is adjusted for the current portion of indebtedness underthe Credit Facility Agreement, derivative financial instruments and assetretirement obligations.

•                  The Maximum Leverage ratio requiresthat the ratio, as of the last day of any fiscal quarter, of (a) TotalIndebtedness (as defined in the Credit Facility Agreement) as of such fiscalquarter to (b) an amount equal to consolidated EBITDAX for the twoquarters then ended times two, not be greater than 3.0 to 1.0.

 

ConsolidatedEBITDAX is a component of negotiated covenants with our lenders and ispresented here as disclosure of our covenant obligations.

 

39

----

 

*ShelfRegistration Statement*

 

During the second quarter 2005, we filed aregistration statement with the SEC which registered offerings of up to $390million of any combination of debt securities, preferred stock, common stock orwarrants for debt securities or equity securities of the Company. Net proceeds,terms and pricing of the offering of securities issued under the shelf registrationstatement will be determined at the time of the offerings. The shelfregistration statement does not provide assurance that we will or could sellany such securities. Our ability to utilize our shelf registration statementfor the purpose of issuing, from time to time, any combination of debtsecurities, preferred stock, common stock or warrants for debt securities orequity securities will depend upon, among other things, market conditions andthe existence of investors who wish to purchase our securities at pricesacceptable to us. In connection with the filing of the 2005 registrationstatement, we deregistered the remaining shares then available for sale underour earlier $150 million shelf registration statement filed in 2004. At June 30,2006, we had $390 million remaining for issuance under our 2005 shelfregistration statement.

 

*OffBalance Sheet Arrangements*

 

We currently do not haveany off balance sheet arrangements.

 

**RiskManagement Activities – Derivatives & Hedging**

 

Due tothe volatility of oil and natural gas prices, we periodically enter intoprice-risk management transactions (e.g., swaps, collars and floors) for aportion of our oil and natural gas production to achieve a more predictablecash flow, as well as to reduce exposure from commodity price fluctuations. Whilethe use of these arrangements limits our ability to benefit from increases inthe price of oil and natural gas, it also reduces our potential exposure toadverse price movements. Our arrangements, to the extent we enter into any,apply to only a portion of our production, provide only partial priceprotection against declines in oil and natural gas prices and limit ourpotential gains from future increases in prices. None of these instruments areused for trading purposes. On a quarterly basis, our management reviews all ofour price-risk management policies, including volumes, types of instruments andcounterparties. These policies are implemented by management through theexecution of trades by the Chief Financial Officer after consultation andconcurrence by the President and Chairman of the Board. Our Board of Directorsmonitors our price-risk management policies and trades.

 

All ofthese price-risk management transactions are considered derivative instrumentsand accounted for in accordance with SFAS No. 133, *Accounting for Derivative Instruments and HedgingActivities*(as amended)*.* These derivative instruments areintended to hedge our price risk and may be considered hedges for economicpurposes. There are two types of accounting treatments for derivatives, (i) mark-to-marketaccounting and (ii) cash flow hedge accounting. For discussion of theseaccounting treatments, see Note 7 to our consolidated financial statements. Wepreviously applied cash flow hedge accounting treatment to our natural gas derivativesand mark-to-market accounting treatment to our crude oil derivatives. Duringthe first quarter of 2006, we discontinued cash flow hedge accounting treatmentapplied to our natural gas derivatives. Therefore, all derivatives are recordedon the balance sheet at fair value and the changes in fair value are presentedin total revenue on the income statement, rather than deferred through OCI onthe balance sheet. The following table provides additional informationregarding our various derivative transactions that were recorded at fair valueon the balance sheet as of June 30, 2006.

 
| ** **                                                                              | ** ** | **(in thousands)** | ** ** |
|-----------------------------------------------------------------------------------------|------------|-------------------------|------------|
| Fair value of contracts outstanding at December 31,  2005                          |       | $                       | (2,479     | ) |
| Contracts realized or otherwise settled during the  period                              |       | 1,961                   |       |
| Fair value of new contracts when entered into during  2006:                             |       |                    |       |
| Asset                                                                                   |       | —                  |       |
| Liability                                                                               |       | —                  |       |
| Changes in fair values attributable to changes in  valuation techniques and assumptions |       | —                  |       |
| Other changes in fair values                                                            |       | 3,491                   |       |
| Fair values of contracts outstanding at June 30,  2006                             |       | $                       | 2,973      |   |

 

40

----

 

The following tabledetails the fair value of our commodity-based derivative contracts by year ofmaturity and valuation methodology as of June 30, 2006.

 
| ** **                                          | ** ** | **Fair Value of Contracts at June 30, 2006** | ** ** |
|-----------------------------------------------------|------------|---------------------------------------------------------------------------------|------------|
| **Source of Fair Value**             | ** ** | **Maturity less  than 1 year**                                   | ** ** | **Maturity 1-3  years** | ** ** | **Maturity 4-  5 years** | ** ** | **Maturity in  excess of 5  years** | ** ** | **Total fair  value** | ** ** |
| ** **                                          | ** ** | **(in thousands)**                                                         | ** ** |
| Prices actively quoted:                             |       | —                                                                          |       | — |   | — |   | — |   | — |   |
| Prices provided by other external sources:          |       |                                                                            |       |   |   |   |   |   |   |   |   |
| Asset                                               |       | 2,973                                                                           |       | — |   | — |   | — |   | 2,973 |   |
| Liability                                           |       | —                                                                          |       | — |   | — |   | — |   | — |   |
| Prices based on models and other valuation methods: |       | —                                                                          |       | — |   | — |   | — |   | — |   |
| Total                                               |       | $                                                                               | 2,973      |   | $ | — |   | $ | — |   | $ | — |   | $ | 2,973 |   |
|                                                     |            |                                                                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**TaxMatters**

 

At June 30,2006, we had cumulative net operating loss carryforwards (“NOLs”) for federalincome tax purposes of approximately $57.3 million. The estimated NOLspresented herein assume that certain items, primarily intangible drillingcosts, have been written off for tax purposes in the current year. However, wehave not made a final determination if an election will be made to capitalizeall or part of these items for tax purposes in the future.

 

**Recently Issued AccountingPronouncements**

 

In December 2004,the Financial Accounting Standards Board (“FASB”) issued SFAS No. 153, *Exchanges of Nonmonetary Assets, an amendment of APB Opinion No. 29*.SFAS No. 153 is based on the principle that exchanges of nonmonetaryassets should be measured based on the fair value of the assets exchanged. APBOpinion No. 29, *Accounting for NonmonetaryTransactions*, provided an exception to its basic measurementprinciple (fair value) for exchanges of similar productive assets. Under APBOpinion No. 29, an exchange of a productive asset for a similar productiveasset was based on the recorded amount of the asset relinquished. SFAS No. 153eliminates the exception for nonmonetary exchanges of similar productive assetsand replaces it with a general exception for exchanges of nonmonetary assetsthat do not have commercial substance. Nonmonetary exchange has commercialsubstance if the future cash flows of the entity are expected to changesignificantly as a result of the exchange. SFAS No. 153 is effective forfiscal periods beginning after June 15, 2005. The adoption of SFAS No. 153is not expected to have a material effect on our consolidated financialposition, results of operations or cash flows.

 

In March 2005,the FASB issued FIN 47, *Accounting forConditional Asset Retirement Obligations, an interpretation of FASB Statement No. 143*.FIN 47 clarifies that the term, “conditional asset retirement obligation” asused in SFAS No. 143, *Accounting forAsset Retirement Obligations*, refers to a legal obligation to perform anasset retirement activity in which the timing and/or method of settlement areconditional upon a future event that may or may not be within thecontrol of the entity. Even though uncertainty about the timing and/or methodof settlement exists and may be conditional upon a future event, theobligation to perform the asset retirement activity is unconditional. Accordingly,an entity is required to recognize a liability for the fair value of aconditional asset retirement obligation if the fair value of the liability canbe reasonably estimated. Uncertainty about the timing and/or method ofsettlement of a conditional asset retirement obligation should be factored intothe measurement of the liability when sufficient information exists. The fairvalue of a liability for the conditional asset retirement obligation should berecognized when incurred generally upon acquisition, construction, ordevelopment or through the normal operation of the asset. SFAS No. 143acknowledges that in some cases, sufficient information may not be availableto reasonably estimate the fair value of an asset retirement obligation. FIN 47also clarifies when an entity would have sufficient information to reasonablyestimate the fair value of an asset retirement obligation. FIN 47 is effectivefor fiscal years ending after December 15, 2005. Retrospective applicationfor interim financial information is permitted but is not required. Theadoption of FIN 47 is not expected to have a material effect on ourconsolidated financial position, results of operations or cash flows.

 

41

----

 

In June 2005,the FASB issued SFAS No. 154, *AccountingChanges and Error Corrections*, *a replacement ofAccounting Principles Board (“APB”) Opinion No. 20 and FASB Statement No. 3,*which changes the requirements for the accounting for and reportingof a change in accounting principle. It also applies to changes required by anaccounting pronouncement in the unusual instance that the pronouncement doesnot include specific transition provisions. Application is effective foraccounting changes and correction of errors made in fiscal years beginningafter December 15, 2005. The adoption of SFAS No. 154 is not expectedto have a material effect on our consolidated financial position, results ofoperations or cash flows.

 

In February 2006,the FASB issued SFAS No. 155, *Accounting for CertainHybrid Financial Instruments,*which improves financial reporting byeliminating the exemption from applying SFAS No. 133 to interests insecuritized financial assets so that similar instruments are accounted forsimilarly regardless of the form of the instruments and allows a preparerto elect fair value measurement at acquisition, at issuance, or when apreviously recognized financial instrument is subject to a remeasurement (newbasis) event, on an instrument-by-instrument basis, in cases in which aderivative would otherwise have to be bifurcated. Providing a fair valuemeasurement election also results in more financial instruments being measuredat what the FASB regards as the most relevant attribute for financialinstruments, fair value. SFAS No. 155 is effective for all financialinstruments acquired or issued after the beginning of an entity’s first fiscalyear that begins after September 15, 2006. We are currently evaluating theimpact of this standard on our financial position, results of operations andcash flows.

 

In March 2006,the FASB issued SFAS No. 156, *Accounting for Servicingof Financial Assets*, which requires all separately recognized servicingassets and servicing liabilities be initially measured at fair value. SFAS No. 156permits, but does not require, the subsequent measurement of servicing assetsand servicing liabilities at fair value. Adoption is required as of thebeginning of the first fiscal year that begins after September 15, 2006.Early adoption is permitted. The adoption of SFAS No. 156 is not expectedto have a material effect on our consolidated financial position, results ofoperations or cash flows.

 

In June 2006, the FASB issued FIN 48, *Accounting for Uncertainty in Income Taxes, an Interpretation of FASBStatement No. 109*, which clarifies the accounting foruncertainty in income taxes recognized in accordance with SFAS No. 109,*Accounting for Income Taxes*. FIN 48prescribes a benefit recognition model with a two-step approach, amore-likely-than-not recognition criterion and a measurement attribute thatmeasures the position as the largest amount of tax benefit that is greater than50% likely of being ultimately realized upon ultimate settlement. If it is notmore likely than not that the benefit will be sustained on its technicalmerits, no benefit will be recorded. FIN 48 also requires that the amountof interest expense to be recognized related to uncertain tax positions becomputed by applying the applicable statutory rate of interest to thedifference between the tax position recognized in accordance with FIN 48and the amount previously taken or expected to be taken in a tax return. Thechange in net assets as a result of applying this pronouncement will beconsidered a change in accounting principle with the cumulative effect of thechange treated as an offsetting adjustment to the opening balance of retainedearnings or goodwill, if allowed under existing accounting standards, in theperiod of transition. FIN 48 is effective as of January 1, 2007 andwe are currently assessing the impact that FIN 48 will have on ourfinancial statements.

 

***ITEM 3. QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK***

 

We are exposed to marketrisk from changes in interest rates and commodity prices. We use a CreditFacility with a floating interest rate. We are not subject to fair value riskresulting from changes in our floating interest rates. The use of floating ratedebt instruments provides a benefit due to downward interest rate movements butdoes not limit us to exposure from future increases in interest rates. Based onthe June 30, 2006 outstanding borrowings and interest rates of 8.500% and 7.235%applied to various borrowings, a 10% change in interest rates would result inan increase or decrease of interest expense of approximately $0.7 million on anannual basis.

 

In thenormal course of business we enter into hedging transactions, includingcommodity price collars, swaps and floors to mitigate our exposure to commodityprice movements, but not for trading or speculative purposes. During 2005, weput in place several natural gas and crude oil collars for a portion of our 2006production to achieve a more predictable cash flow. Please refer to Note 7 toour consolidated financial statements. While the 

 

42

----

 

use of these arrangementsmay limit the benefit to us of increases in the price of oil and naturalgas, it also limits the downside risk of adverse price movements. The followingis a list of contracts outstanding as of June 30, 2006:

 
| **Transaction  Date**  | ** ** | **Transaction  Type** | ** ** | **Beginning** | ** ** | **Ending** | ** ** | **Price  Per Unit** | ** ** | **Volumes Per  Day** | ** ** | **Fair Value  Outstanding as of  June 30, 2006** | ** ** |
|------------------------|------------|-----------------------|------------|---------------|------------|------------|------------|--------------------------|------------|---------------------------|------------|---------------------------------------------------------------------------|------------|
| ** **             | ** ** | ** **            | ** ** | ** **    | ** ** | ** ** | ** ** | ** **               | ** ** | ** **                | ** ** | **(in thousands)**                                                   | ** ** |
| ***Natural Gas (1):*** | * *   | * *              | * *   | * *      | * *   | * *   | * *   | * *                 | * *   | * *                  | * *   | * *                                                                  | * *   |
| 08/05                  |       | Collar                |       | 01/01/06      |       | 12/31/06   |       | $7.00-$10.50             |       | 10,000 MMbtu              |       | $                                                                         | 1,460      |   |
|                   |       |                  |       |          |       |       |       |                     |       |                      |       |                                                                      |       |
| 08/05                  |       | Collar                |       | 01/01/06      |       | 12/31/06   |       | $7.00-$16.10             |       | 10,000 MMbtu              |       | 1,664                                                                     |       |
|                   |       |                  |       |          |       |       |       |                     |       |                      |       |                                                                      |       |
| ***Crude Oil (2):***   |       |                  |       |          |       |       |       |                     |       |                      |       |                                                                      |       |
| 08/05                  |       | Collar                |       | 01/01/06      |       | 12/31/06   |       | $55.00-$80.00            |       | 400 Bbl                   |       | (151                                                                      | )          |
|                   |       |                  |       |          |       |       |       |                     |       |                      |       |                                                                      |       |
|                   |       |                  |       |          |       |       |       |                     |       |                      |       | $                                                                         | 2,973      |   |

 

----

(1)   Our current natural gas collars were enteredinto on a per MMbtu delivered price basis, using the Houston Ship Channel Index,with settlement for each calendar month occurring five business days followingthe expiration date. During 2005, cash flow hedge accounting was applied tothese contracts, which was then discontinued in 2006. During 2006,mark-to-market accounting treatment  hasbeen applied to these contracts and the change in fair value is reflected intotal revenue during the year.

 

(2)   Cash flow hedge accounting is not applied to ourcrude oil collars, which were entered into on a per barrel delivered pricebasis, using the West Texas Intermediate Light Sweet Crude Oil Index, withsettlement for each calendar month occurring five business days following theexpiration date. Mark-to-market accounting treatment is applied to thesecontracts and the change in fair value is reflected in total revenue during theyear.

 

At June 30, 2006,the fair value of the outstanding derivatives was an asset of approximately $3.0million. A 10% change in the commodity price per unit, as long as the price iseither above the ceiling or below the floor price, would cause the fair valuetotal of the hedge to increase or decrease by approximately $0.3 million.

 

In August 2006,we entered into the following additional derivative contracts: 

 
| ** **                | ** ** | ** **                | ** ** | **Effective Dates** | ** ** | ** ** | ** ** | **Volume Per**     | ** ** |
|---------------------------|------------|---------------------------|------------|--------------------------|------------|------------|------------|--------------------|------------|
| **Transaction Date** | ** ** | **Transaction Type** | ** ** | **Beginning**            | ** ** | **Ending** | ** ** | **Price Per Unit** | ** ** | **Day** | ** ** |
| 08/06                     |       | Natural Gas Collar        | (1)        | 01/01/07                 |       | 12/31/07   |       | $7.50-$11.50       |       | 5,000 MMbtu |   |
| 08/06                     |       | Crude Oil Collar          | (2)        | 01/01/07                 |       | 12/31/07   |       | $70.00-$87.50      |       | 400 Bbl |   |

 

----

(1)   The Company’s new natural gas collar wasentered into on a per MMbtu delivered price basis, using the Houston ShipChannel Index, with settlement for each calendar month occurring five businessdays following the expiration date. Mark-to-market accounting treatment will beapplied to this contract and the change in fair value will be reflected intotal revenue.

 

(2)   The Company’s new crude oil collar was enteredinto on a per barrel delivered price basis, using the West Texas IntermediateLight Sweet Crude Oil Index, with settlement for each calendar month occurringfive business days following the expiration date. Mark-to-market accountingtreatment will be applied to this contract and the change in fair value will bereflected in total revenue.

 

##### ***ITEM 4. CONTROLS AND PROCEDURES***

#####  

In accordance with Exchange Act Rules 13a-15 and15d-15, we carried out an evaluation, under the supervision and with theparticipation of management, including our Chief Executive Officer and ChiefFinancial Officer, of the effectiveness of our disclosure controls andprocedures as of the end of the period covered by this report. Based on thatevaluation, our Chief Executive Officer and Chief Financial Officer concludedthat our disclosure controls and procedures were effective as of June 30,2006 to provide reasonable assurance that information required to be disclosedin our reports filed or submitted under the Exchange Act is recorded,processed, summarized and reported within the time periods specified in the SEC’srules and forms.

 

There has been no change in our internal controls overfinancial reporting that occurred during the three months ended June 30,2006 that has materially affected, or is reasonably likely to materiallyaffect, our internal controls over financial reporting.

 

43

----

 

**PART II- OTHER INFORMATION**

 

**Item 1 -Legal Proceedings**

 

Fromtime to time we are a party to various legal proceedings arising in theordinary course of business. While the outcome of lawsuits cannot be predictedwith certainty, we are not currently a party to any proceeding that we believe,if determined in a manner adverse to the Company, could have a material adverseeffect on our financial condition, results of operations or cash flows, exceptas set forth below.

 

**Texas Comptroller Audit** - During thesecond quarter of 2004, we received notice that a subsidiary’s franchise taxreturns for the State of Texas would be audited for the tax years 1999 through2002. After reviewing documents submitted, the agent representing the Office ofthe Comptroller of the State of Texas proposed adjustments to the calculationthat would result in an increased franchise tax liability. The agent maintainedthat transfers by us to this subsidiary, which we had classified asintercompany loans, should instead be classified as equity investments in thesubsidiary. The State of Texas originally proposed that the franchise taxliability of the subsidiaries would be increased by approximately $3.0 millionfor the four-year period under audit.

 

Duringthe third quarter of 2004, the agent reduced the proposed franchise taxdeficiency adjustment against the subsidiary to an aggregate amount of$467,000. In the fourth quarter of 2004, there was an informal hearing at thelocal Comptroller’s Office during which the agent indicated he would formallyassess the proposed deficiency. On March 24, 2005, we received a deficiencyassessment in the amount of $471,482 including penalty and interest. Weresponded on April 21, 2005 with a request for a formal redeterminationhearing. On February 14, 2006, a Hearings Attorney for the TexasComptroller of Public Accounts issued a Position Letter reaffirming the auditor’sassessment, and rejecting our arguments as set forth in the April 21, 2005request for redetermination. On February 24, 2006, we filed a motion toset the matter for oral hearing before an Administrative Law Judge. The hearinghas been set for October 19, 2006. We intend to continue to vigorouslycontest the assessment through appropriate administrative proceedings at theComptroller’s Office and by any other available means. Due to our belief thatwe do not owe any additional franchise tax for the period in question and ourintention to continue to vigorously contest the proposed adjustments, we havenot recognized any provision for the additional franchise taxes that wouldresult from the proposed deficiency.

 

**Wade andJoyce Montet, et al., v. Edge Petroleum Corp of Texas, et al., consolidatedwith Rolland L. Broussard, et al., v. Edge Petroleum Corp of Texas, et al****.** - This is a consolidated suit, filed instate court in Vermilion Parish, Louisiana in September 2003. Plaintiffsare mineral/royalty owners under the Norcen-Broussard No. 1 and 2 wells,Marg Tex Reservoir C, Sand Unit A (Edge’s old Bayou Vermilion Prospect). Theyclaim the operator at the time, Norcen Explorer, now Anadarko, failed to “blocksqueeze” the sections of the No. 2 well, as a prudent operator, accordingto their allegations, would have done, to protect the gas reservoir from beingflooded with water from adjacent underground formations. Plaintiffs furtherallege Norcen was negligent in not creating a field-wide unit to protect theirinterests. Plaintiffs have named us and other working interest owners in theleases as defendants, including Norcen Explorer’s successors in interest,Anadarko. Plaintiffs originally sought unspecified damages for lost royaltiesand damages due to alleged devaluation of their mineral and property interests,plus interest and attorneys’ fees. In early 2005, we filed a motion for summaryjudgment in the case asserting, among other defenses, that:  (i) therehas been no breach of contract, (ii) there is no express or implied dutyimposed on us to block squeeze the well or form a field-wide unit, (iii) theunits were properly formed by the Conservation Commissioner in accordance withthe statutory scheme in Louisiana, (iv) plaintiffs’ claims are barred bylimitations, and (v) other defenses. Along with the other defendants, wealso filed a special preemptory challenge of no cause of action under theleases and the Louisiana Mineral Code for failure to exhaust administrativeremedies and due to lack of a demand. In May and June 2005, the courtruled against us on the motion for summary judgment and the preemptory challenges.Of the 18.75% after-payout working interest that we originally reserved in theleases, we owned a 2.8% working interest at the time of the alleged acts oromissions. On September 6, 2005, we were granted leave by the court tofile a third-party demand to join the other working interest owners who holdthe remainder of the 18.75% working interest as third-party defendants in thiscase, and those pleadings have been served on the parties. These third-parties consist,for the most part, of partnerships that are directly or indirectly controlledby John Sfondrini, a director of the Company, and hold an aggregate 14.7%working interest. Vincent Andrews, also a director of the Company, owns aminority interest in the corporate general partner of one of the partnerships.These partnerships 

 

44

----

 

were among the third party defendants that we havesought to join in the case and these partnerships have for the most part filedanswers denying any liability to us. We participated for our 2.8% share of thewell costs and revenues for the Broussard No. 2 well, as did the otherdefendants for their share, including the third-party defendant partnershipswho participated for 14.7%. We strongly believe the parties should only beliable for their proportionate share of any damages award should a finding ofliability occur in the case. We intend to vigorously contest the plaintiffs’claims.

 

As ofthe date of this report, it is not possible to determine what, if any, ourexposure might be in this matter. The plaintiffs’ expert witness, in his December 2005deposition, offered his theory that plaintiffs’ gross damages are in the rangeof $19 to $20 million. That number is based on his theory that the allegedfailure to block squeeze the well resulted in the under-production of gas worth$300 million. Plaintiffs’ royalty share of that figure yields the $19 to $22million range of alleged damages. Based on the expert’s testimony, damagesattributable to the full 18.75% interest would be in the range of $3.75 milliongross or net to our 2.8% share would be in the range of $560,000 (excludinginterest and attorneys’ fees). Along with the other defendants, we hired ourown expert witnesses who have refuted these claims, particularly the expert’sassertions that failure to block squeeze the well caused any damages to thereservoir. The deposition of a Norcen engineer who prepared the completion planfor the Broussard No. 2 well and supervised the completion operations,taken in April 2006, confirms the testimony of the defense experts as towhy the well was not block squeezed. The plaintiffs have also retained adamages expert who has given a report that the damages in this case are in therange of $30 million, excluding interest and attorneys’ fees. Our share of thatamount based on the full 18.75% would be in the range of $5.6 million and net toour 2.8% share would be in the range of $840,000. We participated in mediationof this lawsuit on July 18, 2006 but the parties failed to reach anagreement. Therefore, this case is expected to proceed to trial on August 28,2006. On July 31, 2006 the Judge granted the Defendant groups’ motion forpartial summary dismissing plaintiffs’ tort-based claims. Also on the samedate, the Judge granted the Defendant groups’ motion for partial summaryjudgment seeking to deny the plaintiffs an award of attorneys fees and also todismiss any claim of plaintiffs that defendants had an obligation to form afield-wide unit, but denied the defendants’ motion to exclude evidence ofpre-suit damages based on failure of plaintiffs to give notice of their claimsas required by the Louisiana Mineral Code and also denied defendants’ motion inlimine to exclude testimony of plaintiffs’ expert witness.

 

We may have insurance coverage for all or part ofthis claim up to the policy limits of $1 million per occurrence and $2 millionin the aggregate. A claim was submitted to Mid-Continent Casualty Company, ourcasualty carrier, who is currently providing a defense under a reservation ofrights letter.  However, on July 3,2006, Mid-Continent filed a suit for declaratory judgment against us in federaldistrict court in Houston, Texas seeking to determine whether it has a duty toindemnify us and certain other defendants for this loss under the policies atissue. Mid-Continent has asked the court to declare they have no obligation toindemnify us and the third-party defendants based on certain technicaldefinitions under the policies and the fact that the plaintiffs’ claims are basedon alleged breaches of contract. We intend to dispute the coverage issues withMid-Continent and file an answer and counterclaim for breach of contract.

 

We believe that ultimately we should only be liablefor our 2.8% share of any damage award unless a co-party defendant, includingany of the third-party defendants, cannot satisfy their share of any finaljudgment or settlement amount or are found not to be liable to us on ourthird-party demand. In that event, we could be held responsible for more than our2.8% share. We intend to continue to vigorously contest this suit on the casein chief and our third-party demands against the partnerships, and we have notestablished any reserve with respect to these claims.

 

**David Blake, et al. v. Edge Petroleum Corporation**— On September 19, 2005, David Blake and David Blake, Trustee of the Davidand Nita Blake 1992 Children’s Trust filed suit against us in state districtcourt in Goliad County, Texas alleging breach of contract for failure andrefusal to transfer overriding royalty interests to plaintiffs in at least fiveleases in Goliad County, Texas and failure and refusal to pay monies to Blakepursuant to such overriding royalty interests for wells completed on theleases. The plaintiff seeks relief of (1) specific performance of thealleged agreement, including granting of overriding royalty interests by theCompany to Blake; (2) monetary damages for failure to grant the overridingroyalty interests; (3) exemplary damages for his claims of businessdisparagement and slander; (4) monetary damages for tortuous interference;and (5) attorneys’ fees and court costs. Venue of the case was transferredto Harris County by agreement of the litigants. We have served Plaintiffs withdiscovery and has filed a counterclaim and an amended counterclaim joiningvarious related entities that are controlled by Plaintiffs. In addition,Plaintiffs have filed an amended complaint alleging claims of slander of titleand tortuous interference related to its alleged right to receive an overridingroyalty interest from a third party. Plaintiffs currently have on file anamended motion for summary judgment, to which we will be filing a 

 

45

----

 

response. This motion isexpected to be heard by late summer. We have responded aggressively to thislawsuit, and believes it has meritorious defenses and counterclaims.

 

 **Item 1A – Risk Factors**

 

In addition to the other information set forth in thisreport, you should carefully consider the factors discussed in Part I, “Item1A. Risk Factors” in our 2005 Annual Report, which could materially affect ourbusiness, financial condition or future results. The risks described in our 2005Annual Report are not the only risks facing our Company. Additional risks anduncertainties not currently known to us or that we currently deem to beimmaterial also may materially adversely affect our business, financialcondition and/or operating results.

 

**Item 2 -Unregistered Sale of Equity Securities and Use of Proceeds**                None

 

**Item 3 -Defaults Upon Senior Securities**                    None

 

**Item 4 -Submission of Matters to a Vote of Security Holders**

 

Our stockholders voted onthe following matters at the Annual Meeting of Shareholders on June 7,2006:

 
| ** **                                                                                                                                        | ** ** | **For**    | ** ** | **Against** | ** ** | **Withheld** | ** ** | **Abstain** | ** ** | **Broker  Non Votes** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|------------|-------------|------------|--------------|------------|-------------|------------|----------------------------|------------|
| (A) Election of Directors:                                                                                                                   |       |       |       |        |       |         |       |        |       |                       |       |
| Thurmon M. Andress                                                                                                                                |       | 14,953,913 |       | —      |       | 1,214,352    |       | —      |       | —                     |       |
| John W. Elias                                                                                                                                     |       | 15,454,612 |       | —      |       | 713,653      |       | —      |       | —                     |       |
| John Sfondrini                                                                                                                                    |       | 12,371,333 |       | —      |       | 3,796,932    |       | —      |       | —                     |       |
| (B) Approval of the Incentive Plan, including  an amendment to increase the number of shares reserved for issuance under the  Incentive Plan |       | 8,113,818  |       | 1,342,397   |       | —       |       | 891,580     |       | 5,820,470                  |       |
| (C) Approval of the Appointment of BDO Seidman  LLP as Independent Registered Public Accounting Firm                                         |       | 15,998,235 |       | 154,433     |       | —       |       | 15,597      |       | —                     |       |

 

Inaddition to the election of the directors indicated above, the followingdirectors continued as directors following the meeting: Vincent S. Andrews,Jonathan M. Clarkson, Michael A. Creel, Stanley S. Raphael, Robert W. Shower andDavid F. Work.

 

**Item 5 -Other Information**                None

 

**Item 6 -Exhibits**

 

The following exhibitsare filed as part of this report:

 

# **INDEX TO EXHIBITS**

# ** **

| **Exhibit No.** | ** ** | ** ** | ** **                                                                                                                                                                                                                                                                                                             |
|----------------------|------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                 |       |       |                                                                                                                                                                                                                                                                                                                   |
| 2.1                  | —     |       | Amended and  Restated Combination Agreement by and among (i) Edge Group II Limited  Partnership, (ii) Gulfedge Limited Partnership, (iii) Edge Group  Partnership, (iv) Edge Petroleum Corporation, (v) Edge Mergeco, Inc.  and (vi) the Company, dated as of January 13, 1997 |

 

46

----

 
|   |   |   | (Incorporated by  reference from exhibit 2.1 to the Company’s Registration Statement on Form S-4  (Registration No. 333-17269)).                                                                                                                                                                                                                                                                                                                                                                                                                    |
|--------|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 2.2    | — |   | Agreement and  Plan of Merger dated as of May 28, 2003 among Edge Petroleum  Corporation, Edge Delaware Sub Inc. and Miller Exploration Company (“Miller”)  (Incorporated by reference from Annex A to the Joint Proxy  Statement/Prospectus contained in the Company’s Registration Statement on Form S-4/A  filed on October 31, 2003 (Registration No. 333-106484)).                                                                                                                                                              |
|   |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 2.3    | — |   | Asset Purchase  Agreement by and among Contango STEP, L.P., Contango Oil & Gas  Company, Edge Petroleum Exploration Company and Edge Petroleum Corporation  dated October 7, 2004 (Incorporated by reference from exhibit 2.1  to the Company’s Current Report on Form 8-K filed October 12,  2004).                                                                                                                                                                                                                                  |
|   |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 2.4    | — |   | Purchase and  Sale Agreement, dated as of September 21, 2005 among Pearl Energy  Partners, Ltd., and Cibola Exploration Partners, L.P., as Sellers; and Edge  Petroleum Exploration Company as Buyer and Edge Petroleum Corporation as  Guarantor (Incorporated by reference from exhibit 2.01 to the Company’s  Current Report on Form 8-K filed October 19, 2005).                                                                                                                                                                           |
|   |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 2.5    | — |   | Stock Purchase Agreement by and among Jon L. Glass,  Craig D. Pollard, Leigh T. Prieto, Yorktown Energy Partners V, L.P., Yorktown  Energy Partners VI, L.P., Cinco Energy Corporation, and Edge Petroleum  Exploration Company and Edge Petroleum Corporation dated September 21,  2005 (Incorporated by reference from exhibit 2.5 to the Company’s  Quarterly Report on Form 10-Q for the quarterly period ended September 30,  2005).                                                                                                      |
|   |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 2.6    | — |   | Letter Agreement  dated November 18, 2005 by and among Edge Petroleum Exploration Company,  Cinco Energy Corporation and Sellers (Incorporated by reference from exhibit 2.02  to the Company’s Current Report on Form 8-K filed December 6,  2005). Pursuant to Item 601(b)(2) of Regulation S-K, the Company had  omitted certain Schedules to the Letter Agreement (all of which are listed  therein) from this Exhibit 2.6. It hereby agrees to furnish a  supplemental copy of any such omitted item to the SEC on its request. |
|   |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 3.1    | — |   | Restated  Certificate of Incorporation of the Company effective January 27, 1997  (Incorporated by reference from exhibit 3.1 to the Company’s Current  Report on Form 8-K filed April 29, 2005).                                                                                                                                                                                                                                                                                                                                              |
|   |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 3.2    | — |   | Certificate of  Amendment to the Restated Certificate of Incorporation of the Company  effective January 31, 1997 (Incorporated by reference from exhibit 3.2  to the Company’s Current Report on Form 8-K filed April 29, 2005).                                                                                                                                                                                                                                                                                                              |
|   |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 3.3    | — |   | Certificate of  Amendment to the Restated Certificate of Incorporation of the Company  effective April 27, 2005 (Incorporated by reference from exhibit 3.3  to the Company’s Current Report on Form 8-K filed April 29, 2005).                                                                                                                                                                                                                                                                                                                |
|   |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 3.4    | — |   | Bylaws of the  Company (Incorporated by Reference from exhibit 3.3 to the Company’s  Quarterly Report on Form 10-Q for the quarterly period ended September 30,  1999).                                                                                                                                                                                                                                                                                                                                                                             |
|   |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 3.5    | — |   | First Amendment  to Bylaws of the Company on September 28, 1999 (Incorporated by  Reference from exhibit 3.2 to the Company’s Quarterly Report on Form 10-Q  for the quarterly period ended September 30, 1999).                                                                                                                                                                                                                                                                                                                               |
|   |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 3.6    | — |   | Second Amendment  to Bylaws of the Company on May 7, 2003 (Incorporated by reference from exhibit 3.4  to the Company’s Quarterly Report on Form 10-Q for the quarterly period  ended March 31, 2003).                                                                                                                                                                                                                                                                                                                                         |
|   |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 4.1    | — |   | Third Amended  and Restated Credit Agreement dated December 31, 2003 among Edge  Petroleum Corporation, Edge Petroleum Exploration Company, Edge Petroleum  Operating Company, Inc., Miller Oil Corporation and Miller Exploration  Company, as borrowers, the lenders thereto and Union                                                                                                                                                                                                                                                                      |

 

47

----

 
|        |   |   | Bank of  California, N.A., a national banking association, as Agent (Incorporated by  reference from Exhibit 4.1 to the Company’s Quarterly Report on Form 10-Q  for the quarterly period ended March 31, 2004).                                                                                                                                                                                                                                                                                                                                                              |
|-------------|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|        |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 4.2         | — |   | Agreement and Amendment No. 1 to Third Amended  and Restated Credit Agreement dated May 31, 2005 among Edge Petroleum Corporation,  Edge Petroleum Exploration Company, Edge Petroleum Operating Company, Inc.,  Miller Exploration Company and Miller Oil Corporation, as borrowers, the  lenders thereto and Union Bank of California, N.A., a national banking  association, as agent for the lenders (Incorporated by reference from Exhibit 4.2  to the Company’s Quarterly Report on Form 10-Q for the quarterly period  ended June 30, 2005).           |
|        |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 4.3         | — |   | Agreement and  Amendment No. 2 to the Third Amended and Restated Credit Agreement dated  November 30, 2005 among Edge Petroleum Corporation, Edge Petroleum  Exploration Company, Edge Petroleum Operating Company, Inc., Miller Oil  Corporation, Miller Exploration Company, and Cinco Energy Corporation, as  borrowers, the lenders thereto and Union Bank of California, N.A., a national  banking association, as Agent (Incorporated by reference from exhibit 4.3  to the Company’s Annual Report on Form 10-K for the year ended December 31,  2005). |
|        |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 4.4         | — |   | Miller  Exploration Company Stock Option and Restricted Stock Plan of 1997  (Incorporated by reference from exhibit 10.1(a) to Miller  Exploration Company’s Annual Report on Form 10-K for the year ended December 31,  1997 (File No. 000-23431)).                                                                                                                                                                                                                                                                                                                |
|        |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 4.5         | — |   | Amendment No. 1  to the Miller Exploration Company Stock Option and Restricted Stock Plan of  1997 (Incorporated by reference to Exhibit 4.2 from Miller Exploration  Company’s Registration Statement on Form S-8 filed on April 11,  2001 (Registration No. 333-58678)).                                                                                                                                                                                                                                                                                          |
|        |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 4.6         | — |   | Amendment No. 2  to the Miller Exploration Company Stock Option and Restricted Stock Plan of  1997 (Incorporated by reference from Exhibit 4.3 to Miller Exploration  Company’s Registration Statement on Form S-8 filed on April 11,  2001 (Registration No. 333-58678)).                                                                                                                                                                                                                                                                                          |
|        |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 4.7         | — |   | Form of  Miller Stock Option Agreement (Incorporated by reference from exhibit 10.1(b) to  Miller Exploration Company’s Annual Report on Form 10-K for the year  ended December 31, 1997 (File No. 000-23431)).                                                                                                                                                                                                                                                                                                                                                |
|        |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| †10.1  | — |   | Form of  Indemnification Agreement between the Company and each of its directors  (Incorporated by reference from exhibit 10.7 to the Company’s  Registration Statement on Form S-4 (Registration No. 333-17269)).                                                                                                                                                                                                                                                                                                                                                       |
|        |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| †10.2  | — |   | Stock Option  Plan of Edge Petroleum Corporation, a Texas corporation (Incorporated by reference  from exhibit 10.13 to the Company’s Registration Statement on Form S-4  (Registration No. 333-17269)).                                                                                                                                                                                                                                                                                                                                                                      |
|        |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| †10.3  | — |   | Employment  Agreement dated as of November 16, 1998, by and between the Company and  John W. Elias (Incorporated by reference from 10.12 to the Company’s Annual  Report on Form 10-K for the year ended December 31, 1998).                                                                                                                                                                                                                                                                                                                                                  |
|        |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| *†10.4 | — |   | Amended and  Restated Incentive Plan of Edge Petroleum Corporation as Amended and Restated  Effective as of August 1, 2006.                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
|        |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| †10.5  | — |   | Edge Petroleum Corporation  Incentive Plan “Standard Non-Qualified Stock Option Agreement” by and between  Edge Petroleum Corporation and the Officers named therein (Incorporated by  reference from exhibit 10.2 to the Company’s Quarterly Report on Form 10-Q  for the quarterly period ended September 30, 1999).                                                                                                                                                                                                                                              |
|        |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| †10.6  | — |   | Edge Petroleum  Corporation Incentive Plan “Director Non-Qualified Stock Option Agreement” by  and between Edge Petroleum Corporation and the Directors named therein  (Incorporated by reference                                                                                                                                                                                                                                                                                                                                                                                       |

 

48

----

 
|        |   |   | from exhibit 10.3  to the Company’s Quarterly Report on Form 10-Q for the quarterly period  ended September 30, 1999).                                                                                                                                              |
|-------------|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|        |   |   |                                                                                                                                                                                                                                                                                    |
| †10.7  | — |   | Severance  Agreements by and between Edge Petroleum Corporation and the Officers of the  Company named therein (Incorporated by reference from exhibit 10.4 to  the Company’s Quarterly Report on Form 10-Q for the quarterly period  ended September 30, 1999).    |
|        |   |   |                                                                                                                                                                                                                                                                                    |
| †10.8  | — |   | Form of Director’s Restricted Stock Award  Agreement under the Incentive Plan of Edge Petroleum Corporation  (Incorporated by reference from exhibit 10.12 to the Company’s Quarterly  Report on Form 10-Q for the quarterly period ended June 30, 2004). |
|        |   |   |                                                                                                                                                                                                                                                                                    |
| †10.9  | — |   | Form of  Employee Restricted Stock Award Agreement under the Incentive Plan of Edge  Petroleum Corporation (Incorporated by reference from exhibit 10.15 to  the Company’s Quarterly Report on Form 10-Q/A for the quarterly period  ended March 31, 1999).    |
|        |   |   |                                                                                                                                                                                                                                                                                    |
| †10.10 | — |   | Edge Petroleum  Corporation Amended and Restated Elias Stock Incentive Plan. (Incorporated by  reference from exhibit 4.5 to the Company’s Registration Statement on Form S-8  filed May 30, 2001 (Registration No. 333-61890)).                               |
|        |   |   |                                                                                                                                                                                                                                                                                    |
| †10.11 | — |   | Form of  Edge Petroleum Corporation John W. Elias Non-Qualified Stock Option Agreement  (Incorporated by reference from exhibit 4.6 to the Company’s  Registration Statement on Form S-8 filed May 30, 2001 (Registration  No. 333-61890)).               |
|        |   |   |                                                                                                                                                                                                                                                                                    |
| †10.12 | — |   | Summary of Compensation of Non-Employee Directors  (Incorporated by reference from Exhibit 10.12 to the Company’s Annual  Report on Form 10-K for the year ended December 31, 2005).                                                                                |
|        |   |   |                                                                                                                                                                                                                                                                                    |
| †10.13 | — |   | 2005 Bonus Plan for Executive Officers (Incorporated  by reference from Exhibit 10.12 to the Company’s Annual Report on Form 10-K  for the year ended December 31, 2005).                                                                                           |
|        |   |   |                                                                                                                                                                                                                                                                                    |
| †10.14 | — |   | 2004 Bonus Program (Incorporated by reference from Exhibit 10.12  to the Company’s Annual Report on Form 10-K for the year ended December 31,  2005).                                                                                                               |
|        |   |   |                                                                                                                                                                                                                                                                                    |
| *31.1       | — |   | Certification by John W. Elias, Chief Executive Officer,  pursuant to Rule 13a-14(a) or Rule 15d-14(a) under the  Securities Exchange Act of 1934.                                                                                                                  |
|        |   |   |                                                                                                                                                                                                                                                                                    |
| *31.2       | — |   | Certification by Michael G. Long, Chief Financial  Officer, pursuant to Rule 13a-14(a) or Rule 15d-14(a) under  the Securities Exchange Act of 1934.                                                                                                                |
|        |   |   |                                                                                                                                                                                                                                                                                    |
| *32.1       | — |   | Certification by  John W. Elias, Chief Executive Officer, pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002 (Subsections (a) and (b) of Section 1350,  Chapter 63 of Title 18, United States Code).                                                        |
|        |   |   |                                                                                                                                                                                                                                                                                    |
| *32.2       | — |   | Certification by  Michael G. Long, Chief Financial and Accounting Officer, pursuant to Section 906  of the Sarbanes-Oxley Act of 2002 (Subsections (a) and (b) of Section 1350,  Chapter 63 of Title 18, United States Code).                                       |

 

----

* Filed herewith.

†Denotes management or compensatory contract, arrangement or agreement.

 

49

----

 

## **SIGNATURES**

## ** **

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.

 

 
|                                                         | EDGE PETROLEUM  CORPORATION,           |
|--------------------------------------------------------------|----------------------------------------|
|                                                         | A DELAWARE  CORPORATION                |
|                                                         | (REGISTRANT)                           |
|                                                         |                                   |
|                                                         |                                   |
|                                                         |                                   |
| Date      August 8,  2006 |                                   | /s/ John W. Elias |   |
|                                                         | John W. Elias                          |   |
|                                                         | President, Chief Executive Officer and |   |
|                                                         | Chairman of the Board                  |   |
|                                                         |                                   |   |
|                                                         |                                   |   |
| Date      August 8,  2006 |                                   | /s/ Michael G. Long |   |
|                                                         | Michael G. Long                        |   |
|                                                         | Executive Vice President and           |   |
|                                                         | Chief Financial Officer                |   |

 

50

----

 

# **INDEX TO EXHIBITS**

# ** **

| **Exhibit No.** |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
|----------------------|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.1                  | — |   | Amended and  Restated Combination Agreement by and among (i) Edge Group II Limited  Partnership, (ii) Gulfedge Limited Partnership, (iii) Edge Group  Partnership, (iv) Edge Petroleum Corporation, (v) Edge Mergeco, Inc.  and (vi) the Company, dated as of January 13, 1997 (Incorporated by  reference from exhibit 2.1 to the Company’s Registration Statement on Form S-4  (Registration No. 333-17269)).                                                                                             |
|                 |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 2.2                  | — |   | Agreement and  Plan of Merger dated as of May 28, 2003 among Edge Petroleum  Corporation, Edge Delaware Sub Inc. and Miller Exploration Company (“Miller”)  (Incorporated by reference from Annex A to the Joint Proxy  Statement/Prospectus contained in the Company’s Registration Statement on Form S-4/A  filed on October 31, 2003 (Registration No. 333-106484)).                                                                                                                                                              |
|                 |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 2.3                  | — |   | Asset Purchase  Agreement by and among Contango STEP, L.P., Contango Oil & Gas  Company, Edge Petroleum Exploration Company and Edge Petroleum Corporation  dated October 7, 2004 (Incorporated by reference from exhibit 2.1  to the Company’s Current Report on Form 8-K filed October 12,  2004).                                                                                                                                                                                                                                  |
|                 |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 2.4                  | — |   | Purchase and  Sale Agreement, dated as of September 21, 2005 among Pearl Energy  Partners, Ltd., and Cibola Exploration Partners, L.P., as Sellers; and Edge  Petroleum Exploration Company as Buyer and Edge Petroleum Corporation as  Guarantor (Incorporated by reference from exhibit 2.01 to the Company’s  Current Report on Form 8-K filed October 19, 2005).                                                                                                                                                                           |
|                 |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 2.5                  | — |   | Stock Purchase Agreement by and among Jon L. Glass,  Craig D. Pollard, Leigh T. Prieto, Yorktown Energy Partners V, L.P., Yorktown  Energy Partners VI, L.P., Cinco Energy Corporation, and Edge Petroleum  Exploration Company and Edge Petroleum Corporation dated September 21,  2005 (Incorporated by reference from exhibit 2.5 to the Company’s  Quarterly Report on Form 10-Q for the quarterly period ended September 30,  2005).                                                                                                      |
|                 |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 2.6                  | — |   | Letter Agreement  dated November 18, 2005 by and among Edge Petroleum Exploration Company,  Cinco Energy Corporation and Sellers (Incorporated by reference from exhibit 2.02  to the Company’s Current Report on Form 8-K filed December 6,  2005). Pursuant to Item 601(b)(2) of Regulation S-K, the Company had  omitted certain Schedules to the Letter Agreement (all of which are listed  therein) from this Exhibit 2.6. It hereby agrees to furnish a  supplemental copy of any such omitted item to the SEC on its request. |
|                 |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 3.1                  | — |   | Restated  Certificate of Incorporation of the Company effective January 27, 1997  (Incorporated by reference from exhibit 3.1 to the Company’s Current  Report on Form 8-K filed April 29, 2005).                                                                                                                                                                                                                                                                                                                                              |
|                 |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 3.2                  | — |   | Certificate of  Amendment to the Restated Certificate of Incorporation of the Company  effective January 31, 1997 (Incorporated by reference from exhibit 3.2  to the Company’s Current Report on Form 8-K filed April 29, 2005).                                                                                                                                                                                                                                                                                                              |
|                 |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 3.3                  | — |   | Certificate of  Amendment to the Restated Certificate of Incorporation of the Company  effective April 27, 2005 (Incorporated by reference from exhibit 3.3  to the Company’s Current Report on Form 8-K filed April 29, 2005).                                                                                                                                                                                                                                                                                                                |
|                 |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 3.4                  | — |   | Bylaws of the  Company (Incorporated by Reference from exhibit 3.3 to the Company’s  Quarterly Report on  Form 10-Q for the quarterly period ended September 30, 1999).                                                                                                                                                                                                                                                                                                                                                                             |
|                 |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 3.5                  | — |   | First Amendment  to Bylaws of the Company on September 28, 1999 (Incorporated by  Reference from exhibit 3.2 to the Company’s Quarterly Report on Form 10-Q  for the quarterly period ended September 30, 1999).                                                                                                                                                                                                                                                                                                                               |
|                 |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 3.6                  | — |   | Second Amendment  to Bylaws of the Company on May 7, 2003 (Incorporated by reference from exhibit 3.4  to the Company’s Quarterly Report on Form 10-Q for the quarterly period  ended March 31, 2003).                                                                                                                                                                                                                                                                                                                                         |

 

51

----

 
| 4.1         | — |   | Third Amended  and Restated Credit Agreement dated December 31, 2003 among Edge  Petroleum Corporation, Edge Petroleum Exploration Company, Edge Petroleum  Operating Company, Inc., Miller Oil Corporation and Miller Exploration  Company, as borrowers, the lenders thereto and Union Bank of California,  N.A., a national banking association, as Agent (Incorporated by reference  from Exhibit 4.1 to the Company’s Quarterly Report on Form 10-Q for  the quarterly period ended March 31, 2004).                                                           |
|-------------|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|        |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 4.2         | — |   | Agreement and Amendment No. 1 to Third Amended  and Restated Credit Agreement dated May 31, 2005 among Edge Petroleum  Corporation, Edge Petroleum Exploration Company, Edge Petroleum Operating  Company, Inc., Miller Exploration Company and Miller Oil Corporation, as  borrowers, the lenders thereto and Union Bank of California, N.A., a national  banking association, as agent for the lenders (Incorporated by reference from  Exhibit 4.2 to the Company’s Quarterly Report on Form 10-Q for the  quarterly period ended June 30, 2005).           |
|        |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 4.3         | — |   | Agreement and  Amendment No. 2 to the Third Amended and Restated Credit Agreement dated  November 30, 2005 among Edge Petroleum Corporation, Edge Petroleum  Exploration Company, Edge Petroleum Operating Company, Inc., Miller Oil  Corporation, Miller Exploration Company, and Cinco Energy Corporation, as  borrowers, the lenders thereto and Union Bank of California, N.A., a national  banking association, as Agent (Incorporated by reference from exhibit 4.3  to the Company’s Annual Report on Form 10-K for the year ended December 31,  2005). |
|        |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 4.4         | — |   | Miller  Exploration Company Stock Option and Restricted Stock Plan of 1997  (Incorporated by reference from exhibit 10.1(a) to Miller  Exploration Company’s Annual Report on Form 10-K for the year ended December 31,  1997 (File No. 000-23431)).                                                                                                                                                                                                                                                                                                                |
|        |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 4.5         | — |   | Amendment No. 1  to the Miller Exploration Company Stock Option and Restricted Stock Plan of  1997 (Incorporated by reference to Exhibit 4.2 from Miller Exploration  Company’s Registration Statement on Form S-8 filed on April 11,  2001 (Registration No. 333-58678)).                                                                                                                                                                                                                                                                                          |
|        |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 4.6         | — |   | Amendment No. 2  to the Miller Exploration Company Stock Option and Restricted Stock Plan of 1997  (Incorporated by reference from Exhibit 4.3 to Miller Exploration  Company’s Registration Statement on Form S-8 filed on April 11,  2001 (Registration No. 333-58678)).                                                                                                                                                                                                                                                                                          |
|        |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 4.7         | — |   | Form of  Miller Stock Option Agreement (Incorporated by reference from exhibit 10.1(b) to  Miller Exploration Company’s Annual Report on Form 10-K for the year  ended December 31, 1997 (File No. 000-23431)).                                                                                                                                                                                                                                                                                                                                                |
|        |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| †10.1  | — |   | Form of  Indemnification Agreement between the Company and each of its directors  (Incorporated by reference from exhibit 10.7 to the Company’s  Registration Statement on Form S-4 (Registration No. 333-17269)).                                                                                                                                                                                                                                                                                                                                                       |
|        |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| †10.2  | — |   | Stock Option  Plan of Edge Petroleum Corporation, a Texas corporation (Incorporated by  reference from exhibit 10.13 to the Company’s Registration Statement on Form S-4  (Registration No. 333-17269)).                                                                                                                                                                                                                                                                                                                                                                      |
|        |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| †10.3  | — |   | Employment  Agreement dated as of November 16, 1998, by and between the Company and  John W. Elias (Incorporated by reference from 10.12 to the Company’s Annual  Report on Form 10-K for the year ended December 31, 1998).                                                                                                                                                                                                                                                                                                                                                  |
|        |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| *†10.4 | — |   | Amended and  Restated Incentive Plan of Edge Petroleum Corporation as Amended and Restated  Effective as of August 1, 2006.                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
|        |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| †10.5  | — |   | Edge Petroleum  Corporation Incentive Plan “Standard Non-Qualified Stock Option Agreement” by  and between Edge Petroleum Corporation and the Officers named therein  (Incorporated by reference from exhibit 10.2 to the Company’s Quarterly  Report on Form 10-Q for the quarterly period ended September 30,  1999).                                                                                                                                                                                                                                             |

 

52

----

 
| †10.6  | — |   | Edge Petroleum  Corporation Incentive Plan “Director Non-Qualified Stock Option Agreement” by  and between Edge Petroleum Corporation and the Directors named therein  (Incorporated by reference from exhibit 10.3 to the Company’s Quarterly  Report on Form 10-Q for the quarterly period ended September 30,  1999). |
|-------------|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|        |   |   |                                                                                                                                                                                                                                                                                                                                                   |
| †10.7  | — |   | Severance  Agreements by and between Edge Petroleum Corporation and the Officers of the  Company named therein (Incorporated by reference from exhibit 10.4 to  the Company’s Quarterly Report on Form 10-Q for the quarterly period  ended September 30, 1999).                                                                   |
|        |   |   |                                                                                                                                                                                                                                                                                                                                                   |
| †10.8  | — |   | Form of Director’s Restricted Stock Award  Agreement under the Incentive Plan of Edge Petroleum Corporation  (Incorporated by reference from exhibit 10.12 to the Company’s Quarterly  Report on Form 10-Q for the quarterly period ended June 30, 2004).                                                                |
|        |   |   |                                                                                                                                                                                                                                                                                                                                                   |
| †10.9  | — |   | Form of  Employee Restricted Stock Award Agreement under the Incentive Plan of Edge  Petroleum Corporation (Incorporated by reference from exhibit 10.15 to  the Company’s Quarterly Report on Form 10-Q/A for the quarterly period  ended March 31, 1999).                                                                   |
|        |   |   |                                                                                                                                                                                                                                                                                                                                                   |
| †10.10 | — |   | Edge Petroleum  Corporation Amended and Restated Elias Stock Incentive Plan. (Incorporated by  reference from exhibit 4.5 to the Company’s Registration Statement on Form S-8  filed May 30, 2001 (Registration No. 333-61890)).                                                                                              |
|        |   |   |                                                                                                                                                                                                                                                                                                                                                   |
| †10.11 | — |   | Form of  Edge Petroleum Corporation John W. Elias Non-Qualified Stock Option Agreement  (Incorporated by reference from exhibit 4.6 to the Company’s  Registration Statement on Form S-8 filed May 30, 2001 (Registration  No. 333-61890)).                                                                              |
|        |   |   |                                                                                                                                                                                                                                                                                                                                                   |
| †10.12 | — |   | Summary of Compensation of Non-Employee Directors  (Incorporated by reference from Exhibit 10.12 to the Company’s Annual  Report on Form 10-K for the year ended December 31, 2005).                                                                                                                                               |
|        |   |   |                                                                                                                                                                                                                                                                                                                                                   |
| †10.13 | — |   | 2005 Bonus Plan for Executive Officers (Incorporated  by reference from Exhibit 10.12 to the Company’s Annual Report on Form 10-K  for the year ended December 31, 2005).                                                                                                                                                          |
|        |   |   |                                                                                                                                                                                                                                                                                                                                                   |
| †10.14 | — |   | 2004 Bonus Program (Incorporated by reference from Exhibit 10.12  to the Company’s Annual Report on Form 10-K for the year ended December 31,  2005).                                                                                                                                                                              |
|        |   |   |                                                                                                                                                                                                                                                                                                                                                   |
| *31.1       | — |   | Certification by John W. Elias, Chief Executive  Officer, pursuant to Rule 13a-14(a) or Rule 15d-14(a) under  the Securities Exchange Act of 1934.                                                                                                                                                                                 |
|        |   |   |                                                                                                                                                                                                                                                                                                                                                   |
| *31.2       | — |   | Certification by Michael G. Long, Chief Financial  Officer, pursuant to Rule 13a-14(a) or Rule 15d-14(a) under  the Securities Exchange Act of 1934.                                                                                                                                                                               |
|        |   |   |                                                                                                                                                                                                                                                                                                                                                   |
| *32.1       | — |   | Certification by  John W. Elias, Chief Executive Officer, pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002 (Subsections (a) and (b) of Section 1350,  Chapter 63 of Title 18, United States Code).                                                                                                                       |
|        |   |   |                                                                                                                                                                                                                                                                                                                                                   |
| *32.2       | — |   | Certification by  Michael G. Long, Chief Financial and Accounting Officer, pursuant to Section 906  of the Sarbanes-Oxley Act of 2002 (Subsections (a) and (b) of Section 1350,  Chapter 63 of Title 18, United States Code).                                                                                                      |

 

----

* Filed herewith.

†Denotes management or compensatory contract, arrangement or agreement.

 

53

----