**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington, D.C.  20549**

 

**FORM 10-Q**

 

**ý****QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

 

**For the quarterly period ended September 30,2005**

 

**OR**

 

**o****TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

 

**For the transition period from              to              **

 

**Commission file number 0-22149**

 

**EDGEPETROLEUM CORPORATION**

(Exact name of registrantas specified in its charter)

 
| **Delaware**                     | ** ** | **76-0511037**       |
|----------------------------------|------------|----------------------|
| (State or other  jurisdiction of |       | (I.R.S. Employer     |
| incorporation or  organization)  |       | Identification  No.) |

 

**1301Travis, Suite 2000**

**Houston,Texas 77002**

(Address ofprincipal executive offices)

(Zip code)

 

**(713) 654-8960**

(Registrant’s telephonenumber, including area code)

 

Indicate by checkmark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15 (d) ofthe Securities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days.  Yes ý   Noo

 

Indicate by check mark whether the registrant is anaccelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes ý   No o

 

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Exchange Act). Yes o   No ý

 

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

 
| **Class**    | ** ** | **Outstanding at November 7,  2005** | ** ** |
|--------------|------------|-------------------------------------------|------------|
|         |       |                                      |       |
| Common Stock |       | 17,168,376                                |       |

 

 

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**EDGE PETROLEUM CORPORATION**

 

**Table of Contents**

 
| Part I. Financial Information                                                                                                                             |   |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
| Item 1. Financial Statements:                                                                                                                                  |   |
| Consolidated Balance Sheets as of September 30,  2005 and December 31, 2004                                                                          |   |
| Consolidated  Statements of Operations for the Three and Nine Months in the Periods Ended September 30,  2005 and September 30, 2004                 |   |
| Consolidated  Statements of Other Comprehensive Income for the Three and Nine Months in the  Periods Ended September 30, 2005 and September 30, 2004 |   |
| Consolidated  Statements of Cash Flows for the Nine Months in the Periods Ended September 30,  2005 and September 30, 2004                           |   |
| Consolidated Statements of Stockholders’ Equity as of September 30,  2005 and December 31, 2004                                                 |   |
| 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 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

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**PART I. FINANCIALINFORMATION**

 

**Item 1. Financial Statements**

 

**EDGEPETROLEUM CORPORATION**

 

**CONSOLIDATED BALANCE SHEETS**

 
| ** **                                                                                                                                                                                                                                | ** ** | **September 30,  2005** | ** **  | **December 31,  2004** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|-------------|-----------------------------|------------|
| ** **                                                                                                                                                                                                                                | ** ** | **(Unaudited)**              | ** **  | ** **                  | ** ** |
| **ASSETS**                                                                                                                                                                                                                                |       |                         |        |                        |       |
| CURRENT ASSETS:                                                                                                                                                                                                                           |       |                         |        |                        |       |
| Cash and cash equivalents                                                                                                                                                                                                                 |       | $                            | 3,794,728   |                        | $          | 2,267,423 |   |
| Accounts receivable, trade, net of allowance of  $525,248 at September 30, 2005 and December 31, 2004                                                                                                                           |       | 19,049,279                   |        | 12,756,097                  |       |
| Accounts receivable, joint interest owners, net of  allowance of $4,771 and $82,000 at September 30, 2005 and December 31,  2004, respectively                                                                                  |       | 2,085,280                    |        | 5,911,073                   |       |
| Deferred income taxes                                                                                                                                                                                                                     |       | 5,560,897                    |        | 660,223                     |       |
| Derivative financial instruments                                                                                                                                                                                                          |       | —                       |        | 1,824,790                   |       |
| Other current assets                                                                                                                                                                                                                      |       | 9,949,415                    |        | 1,445,923                   |       |
| Total current assets                                                                                                                                                                                                                      |       | 40,439,599                   |        | 24,865,529                  |       |
| PROPERTY AND EQUIPMENT, Net – full cost method of  accounting for oil and natural gas properties (including unproved costs of  $19.9 million and $15.5 million at September 30, 2005 and December 31,  2004, respectively) |       | 202,139,297                  |        | 165,840,345                 |       |
| OTHER ASSETS                                                                                                                                                                                                                              |       | 228,932                      |        | 284,280                     |       |
| TOTAL ASSETS                                                                                                                                                                                                                              |       | $                            | 242,807,828 |                        | $          | 190,990,154 |   |
|                                                                                                                                                                                                                                      |       |                         |        |                        |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                             |       |                         |        |                        |       |
| CURRENT LIABILITIES:                                                                                                                                                                                                                      |       |                         |        |                        |       |
| Accounts payable, trade                                                                                                                                                                                                                   |       | $                            | 3,845,869   |                        | $          | 3,141,235 |   |
| Accrued liabilities                                                                                                                                                                                                                       |       | 18,621,121                   |        | 12,105,694                  |       |
| Asset retirement obligation – current portion                                                                                                                                                                                        |       | 202,248                      |        | 193,647                     |       |
| Derivative financial instruments                                                                                                                                                                                                          |       | 9,331,127                    |        | 468,308                     |       |
| Total current liabilities                                                                                                                                                                                                                 |       | 32,000,365                   |        | 15,908,884                  |       |
| ASSET RETIREMENT OBLIGATION – non-current portion                                                                                                                                                                                    |       | 2,235,973                    |        | 1,995,441                   |       |
| DERIVATIVE FINANCIAL INSTRUMENT                                                                                                                                                                                                           |       | 1,567,768                    |        | —                      |       |
| DEFERRED TAX LIABILITY                                                                                                                                                                                                                    |       | 14,024,199                   |        | 2,618,934                   |       |
| LONG-TERM DEBT                                                                                                                                                                                                                            |       | 20,000,000                   |        | 20,000,000                  |       |
| Total liabilities                                                                                                                                                                                                                         |       | 69,828,305                   |        | 40,523,259                  |       |
| COMMITMENTS AND CONTINGENCIES (NOTE 10)                                                                                                                                                                                                   |       |                         |        |                        |       |
| 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; 17,143,024 and 16,535,901 shares issued and outstanding at September 30,  2005 and December 31, 2004, respectively                                                |       | 171,430                      |        | 165,359                     |       |
| Additional paid-in capital                                                                                                                                                                                                                |       | 137,117,311                  |        | 126,957,059                 |       |
| Retained earnings                                                                                                                                                                                                                         |       | 42,171,421                   |        | 22,095,807                  |       |
| Accumulated other comprehensive income (loss)                                                                                                                                                                                             |       | (6,480,639                   | )           | 1,248,670                   |       |
| Total stockholders’ equity                                                                                                                                                                                                           |       | 172,979,523                  |        | 150,466,895                 |       |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                                                                           |       | $                            | 242,807,828 |                        | $          | 190,990,154 |   |

 

See accompanyingnotes to consolidated financial statements.

 

3

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**EDGE PETROLEUM CORPORATION**

 

**CONSOLIDATED STATEMENTS OFOPERATIONS (Unaudited)**

 
| ** **                                                    | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|---------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                    | ** ** | **2005**                                   | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                    | ** ** | ** **                                 | ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| OIL AND NATURAL GAS REVENUE                                   |       |                                       |       |                                      |       |   |   |   |   |
| Oil and natural gas sales                                     |       | $                                          | 30,979,230 |                                      | $          | 15,181,874 |   | $ | 81,136,206 |   | $ | 47,203,800 |   |
| Loss on hedging and derivatives                               |       | (1,394,503                                 | )          | (1,939,409                                | )          | (2,397,181 | ) | (2,299,274 | ) |
| Total revenue                                                 |       | 29,584,727                                 |       | 13,242,465                                |       | 78,739,025 |   | 44,904,526 |   |
|                                                          |       |                                       |       |                                      |       |   |   |   |   |
| OPERATING EXPENSES:                                           |       |                                       |       |                                      |       |   |   |   |   |
| Oil and natural gas operating expenses                        |       | 2,369,882                                  |       | 1,176,732                                 |       | 6,414,396 |   | 3,601,898 |   |
| Severance and ad valorem taxes                                |       | 1,845,462                                  |       | 891,194                                   |       | 5,496,787 |   | 3,146,116 |   |
| Depletion, depreciation, amortization and accretion           |       | 8,311,284                                  |       | 5,133,452                                 |       | 25,885,911 |   | 15,517,254 |   |
| General and administrative expenses:                          |       |                                       |       |                                      |       |   |   |   |   |
| Deferred compensation – repriced options                 |       | 1,758,848                                  |       | (153,808                                  | )          | 1,930,493 |   | 1,294,677 |   |
| Deferred compensation – restricted stock                 |       | 273,057                                    |       | 143,500                                   |       | 679,401 |   | 354,600 |   |
| Bad debt expense                                              |       | 54,157                                     |       | —                                    |       | 65,157 |   | — |   |
| Other general and administrative expenses                     |       | 2,470,611                                  |       | 1,844,062                                 |       | 7,306,749 |   | 5,476,342 |   |
| Total operating expenses                                      |       | 17,083,301                                 |       | 9,035,132                                 |       | 47,778,894 |   | 29,390,887 |   |
| OPERATING INCOME                                              |       | 12,501,426                                 |       | 4,207,333                                 |       | 30,960,131 |   | 15,513,639 |   |
|                                                          |       |                                       |       |                                      |       |   |   |   |   |
| OTHER INCOME AND EXPENSE:                                     |       |                                       |       |                                      |       |   |   |   |   |
| Interest income                                               |       | 28,384                                     |       | 8,087                                     |       | 84,859 |   | 16,118 |   |
| Interest expense, net of amounts capitalized                  |       | —                                     |       | (22,204                                   | )          | — |   | (241,887 | ) |
| Amortization of deferred loan costs                           |       | (36,480                                    | )          | (35,948                                   | )          | (107,550 | ) | (106,332 | ) |
| INCOME BEFORE INCOME TAXES                                    |       | 12,493,330                                 |       | 4,157,268                                 |       | 30,937,440 |   | 15,181,538 |   |
| INCOME TAX EXPENSE                                            |       | (4,350,758                                 | )          | (1,474,374                                | )          | (10,861,826 | ) | (5,359,327 | ) |
| NET INCOME                                                    |       | $                                          | 8,142,572  |                                      | $          | 2,682,894 |   | $ | 20,075,614 |   | $ | 9,822,211 |   |
|                                                          |       |                                       |       |                                      |       |   |   |   |   |
| BASIC EARNINGS PER SHARE:                                     |       | $                                          | 0.47       |                                      | $          | 0.21 |   | $ | 1.17 |   | $ | 0.76 |   |
| DILUTED EARNINGS PER SHARE:                                   |       | $                                          | 0.45       |                                      | $          | 0.20 |   | $ | 1.13 |   | $ | 0.73 |   |
|                                                          |       |                                       |       |                                      |       |   |   |   |   |
| BASIC WEIGHTED AVERAGE NUMBER OF COMMON SHARES  OUTSTANDING   |       | 17,137,515                                 |       | 12,999,659                                |       | 17,100,374 |   | 12,889,109 |   |
| DILUTED WEIGHTED AVERAGE NUMBER OF COMMON SHARES  OUTSTANDING |       | 17,907,903                                 |       | 13,668,542                                |       | 17,801,874 |   | 13,506,831 |   |

 

See accompanying notes to consolidated financial statements.

 

4

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**EDGEPETROLEUM CORPORATION**

 

**CONSOLIDATEDSTATEMENTS OF OTHER COMPREHENSIVE INCOME (Unaudited)**

 
| ** **                                                                  | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|-----------------------------------------------------------------------------|------------|-------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                  | ** ** | **2005**                                  | ** ** | **2004**                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                        |       |                                      |       |                                     |       |   |   |   |   |
| NET INCOME                                                                  |       | $                                         | 8,142,572  |                                     | $          | 2,682,894 |   | $ | 20,075,614 |   | $ | 9,822,211 |   |
|                                                                        |       |                                      |       |                                     |       |   |   |   |   |
| OTHER COMPREHENSIVE INCOME (LOSS), net of tax:                              |       |                                      |       |                                     |       |   |   |   |   |
|                                                                        |       |                                      |       |                                     |       |   |   |   |   |
| Change in fair value of outstanding hedging and  derivative instruments (1) |       | (6,450,038                                | )          | (578,834                                 | )          | (6,761,546 | ) | (749,887 | ) |
| Reclassification of hedging and derivative losses  (gains) (2)              |       | 35,323                                    |       | 312,332                                  |       | (967,763 | ) | 270,537 |   |
|                                                                        |       |                                      |       |                                     |       |   |   |   |   |
| Other comprehensive income (loss)                                           |       | (6,414,715                                | )          | (266,502                                 | )          | (7,729,309 | ) | (479,350 | ) |
|                                                                        |       |                                      |       |                                     |       |   |   |   |   |
| COMPREHENSIVE INCOME, net of tax                                            |       | $                                         | 1,727,857  |                                     | $          | 2,416,392 |   | $ | 12,346,305 |   | $ | 9,342,861 |   |
|                                                                        |       |                                      |       |                                     |       |   |   |   |   |
|                                                                             |
| (1) Income tax (expense) benefit                                       |       | $                                         | (3,473,098 | )                                        | $          | (311,680 | ) | $ | (3,640,832 | ) | $ | (403,786 | ) |
|                                                                        |       |                                      |       |                                     |       |   |   |   |   |
| (2) Income tax (expense) benefit                                       |       | $                                         | 19,020     |                                     | $          | 168,178 |   | $ | (521,102 | ) | $ | 151,933 |   |

 

See accompanying notes to consolidated financial statements.

 

5

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**EDGE PETROLEUM CORPORATION**

 

**CONSOLIDATED STATEMENTS OF CASHFLOWS (Unaudited)**

 
| ** **                                                                         | ** ** | **Nine Months Ended September 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                         | ** ** | **2005**                                 | ** ** | **2004** | ** ** |
| ** **                                                                         | ** ** | ** **                               | ** ** | ** ** | ** ** |
| **CASH FLOWS FROM OPERATING ACTIVITIES:**                                          | ** ** | ** **                               | ** ** | ** ** | ** ** |
| Net income                                                                         |       | $                                        | 20,075,614 |   | $ | 9,822,211 |   |
| Adjustments to reconcile net income to net cash  provided by operating activities: |       |                                     |       |   |   |
| Loss on the unrealized change in fair value of derivatives                         |       | 364,135                                  |       | 1,254,911 |   |
| Loss on property                                                                   |       | 1,778                                    |       | — |   |
| Deferred income taxes                                                              |       | 10,861,826                               |       | 5,359,327 |   |
| Depletion, depreciation, and amortization                                          |       | 25,784,355                               |       | 15,437,126 |   |
| Amortization of deferred loan costs                                                |       | 107,550                                  |       | 106,332 |   |
| Accretion of asset retirement obligation                                           |       | 101,556                                  |       | 80,128 |   |
| Deferred compensation                                                              |       | 2,609,894                                |       | 1,649,277 |   |
| Bad debt expense                                                                   |       | 65,157                                   |       | — |   |
| Changes in assets and liabilities:                                                 |       |                                     |       |   |   |
| Increase in accounts receivable, trade                                             |       | (6,293,182                               | )          | (3,369,143 | ) |
| (Increase) decrease in accounts receivable, joint  interest owners                 |       | 3,760,636                                |       | (365,326 | ) |
| Increase in other assets                                                           |       | (8,548,215                               | )          | (266,241 | ) |
| Increase (decrease) in accounts payable, trade                                     |       | 704,634                                  |       | (1,610,528 | ) |
| Increase in accrued liabilities                                                    |       | 6,645,591                                |       | 6,344,574 |   |
|                                                                               |       |                                     |       |   |   |
| Net cash provided by operating activities                                          |       | 56,241,329                               |       | 34,442,648 |   |
|                                                                               |       |                                     |       |   |   |
| **CASH FLOWS FROM INVESTING ACTIVITIES:**                                          |       |                                     |       |   |   |
| Oil and natural gas property and equipment additions                               |       | (61,937,508                              | )          | (36,067,116 | ) |
| Proceeds from the sale of oil and natural gas  properties                          |       | —                                   |       | 45,000 |   |
|                                                                               |       |                                     |       |   |   |
| Net cash used in investing activities                                              |       | (61,937,508                              | )          | (36,022,116 | ) |
|                                                                               |       |                                     |       |   |   |
| **CASH FLOWS FROM FINANCING ACTIVITIES:**                                          |       |                                     |       |   |   |
| Borrowings from long-term debt                                                     |       | 13,000,000                               |       | 4,000,000 |   |
| Payments of long-term debt                                                         |       | (13,000,000                              | )          | (3,000,000 | ) |
| Net proceeds from issuance of common stock                                         |       | 7,230,963                                |       | 2,170,357 |   |
| Deferred loan costs                                                                |       | (7,479                                   | )          | (425,364 | ) |
|                                                                               |       |                                     |       |   |   |
| Net cash provided by financing activities                                          |       | 7,223,484                                |       | 2,744,993 |   |
|                                                                               |       |                                     |       |   |   |
| **NET INCREASE IN CASH AND CASH EQUIVALENTS**                                      |       | 1,527,305                                |       | 1,165,525 |   |
| **CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD**                                 |       | 2,267,423                                |       | 1,327,081 |   |
| **CASH AND CASH EQUIVALENTS, END OF PERIOD**                                       |       | $                                        | 3,794,728  |   | $ | 2,492,606 |   |

 

See accompanying notes to consolidated financial statements.

 

6

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**EDGE PETROLEUM CORPORATION**

 

**CONSOLIDATED STATEMENTS OFSTOCKHOLDERS’ EQUITY (Unaudited)**

 
| ** **                                                           | ** ** | **Common Stock** | ** ** | **Additional** | ** ** | **Retained**        | ** ** | **Accumulated  Other  Comprehensive** | ** ** | **Total  Stockholders’** | ** ** |
|----------------------------------------------------------------------|------------|------------------|------------|----------------|------------|---------------------|------------|---------------------------------------|------------|-------------------------------|------------|
| ** **                                                           | ** ** | **Shares**       | ** ** | **Amount**     | ** ** | **Paid-in Capital** | ** ** | **Earnings**                          | ** ** | **Income (Loss)**             | ** ** | **Equity** | ** ** |
| BALANCE, DECEMBER 31, 2004                                      |       | 16,535,901       |       | $              | 165,359    |                | $          | 126,957,059                           |       | $                             | 22,095,807 |   | $ | 1,248,670 |   | $ | 150,466,895 |   |
| Issuance of common stock                                             |       | 607,123          |       | 6,071          |       | 7,355,056           |       | —                                |       | —                        |       | 7,361,127 |   |
| Deferred compensation – restricted stock                        |       | —           |       | —         |       | 679,401             |       | —                                |       | —                        |       | 679,401 |   |
| Deferred compensation - repriced options                             |       | —           |       | —         |       | 1,930,493           |       | —                                |       | —                        |       | 1,930,493 |   |
| Change in valuation of hedging instruments                           |       | —           |       | —         |       | —              |       | —                                |       | (7,729,309                    | )          | (7,729,309 | ) |
| Tax benefit associated with exercise of non-qualified  stock options |       | —           |       | —         |       | 195,302             |       | —                                |       | —                        |       | 195,302 |   |
| Net income                                                           |       | —           |       | —         |       | —              |       | 20,075,614                            |       | —                        |       | 20,075,614 |   |
| BALANCE, SEPTEMBER 30, 2005                                     |       | 17,143,024       |       | $              | 171,430    |                | $          | 137,117,311                           |       | $                             | 42,171,421 |   | $ | (6,480,639 | ) | $ | 172,979,523 |   |

 

See accompanyingnotes to consolidated financial statements.

 

7

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**EDGE PETROLEUM CORPORATION**

 

**NOTES TOTHE CONSOLIDATED FINANCIAL STATEMENTS**

 

**1.**              SUMMARYOF SIGNIFICANT ACCOUNTING POLICIES

 

Thefinancial statements included herein have been prepared by Edge PetroleumCorporation, a Delaware corporation (“we”, “our”, “us” or the “Company”),without audit (with the exception of the balance sheet as of December 31,2004 which has been derived from our Annual Report on Form 10-K for theyear ended December 31, 2004) pursuant to the rules and regulationsof the Securities and Exchange Commission (“SEC”), and reflect all adjustmentswhich are, in the opinion of management, necessary to present a fair statementof the results for the interim periods on a basis consistent with the annualaudited consolidated financial statements. All such adjustments are of a normal recurring nature.  The results of operations for the interimperiods are not necessarily indicative of the results to be expected for anentire year. Certain information, accounting policies and footnote disclosuresnormally included in financial statements prepared in accordance withaccounting principles generally accepted in the United States of America havebeen 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 Form 10-Kfor the year ended December 31, 2004.

 

***Oil and Natural Gas Properties*****-**Investments in oil and natural gas properties areaccounted for using the full-cost method of accounting. The accounting for ourbusiness is subject to special accounting rules that are unique to the oiland gas industry.  There are twoallowable methods of accounting for oil and gas business activities:  the successful-efforts method and thefull-cost method.  There are severalsignificant differences between these methods. Among these differences is that,under the successful-efforts method, costs such as geological and geophysical (“G&G”),exploratory dry holes and delay rentals are expensed as incurred whereas underthe full-cost method these types of charges are capitalized to their respectivefull-cost pool.  In the measurement ofimpairment of oil and gas properties, the successful-efforts method ofaccounting follows the guidance provided in Statement of Financial AccountingStandards (“SFAS”) No. 144, “*Accountingfor the Impairment or Disposal of Long-Lived Assets*,” where thefirst measurement for impairment is to compare the net book value of therelated asset to its undiscounted future cash flows using commodity pricesconsistent with management expectations. The full-cost method follows guidance provided in SEC Regulation S-X Rule 4-10,where impairment is determined by comparing the net book value (full-cost pool)to the future net cash flows discounted at 10 percent using commodity prices ineffect at the end of the reporting period.

 

In accordance with the full-cost method of accounting,all costs associated with the exploration, development and acquisition of oiland natural gas properties, including salaries, benefits and other internalcosts directly attributable to these activities are capitalized within a costcenter.  The Company’s oil and naturalgas properties are located within the United States of America and constituteone cost center. The Company also capitalizes interest expense on borrowedfunds not in excess of the balance of our unproved property balance.  Employee related costs that are directlyattributable to exploration and development activities are also capitalized.  These costs are considered to be direct costsbased on the nature of their function as it relates to the exploration anddevelopment activities.

 

Oil and natural gas properties are amortized based ona unit-of-production method using estimates of proved reserve quantities. Oiland natural gas liquids (“NGLs”) are converted to gas equivalent basis (“Mcfe”)at the rate of one barrel equals six Mcf. Investments in unproved propertiesare not amortized until proved reserves associated with the prospects can bedetermined or until impairment occurs. Oil and natural gas properties include costs of $19.9 million and $15.5million at September 30, 2005 and December 31, 2004, 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 assessment indicate that an unproved property isimpaired, the amount of impairment is added to the proved oil and natural gasproperty costs to be amortized.  Inaccordance with SEC Staff Accounting Bulletin (“SAB”) No. 106, *“Interaction of Statement 143 and the Full CostRules,”*the amortizable base includes estimated future developmentand dismantlement costs, and restoration and abandonment costs, net ofestimated salvage values.

 

8

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In addition, the capitalized costs of oil and naturalgas properties are subject to a “ceiling test,” whereby to the extent that suchcapitalized costs subject to amortization in the full-cost pool (net ofaccumulated depletion, depreciation and amortization, asset retirementobligations and related deferred taxes) 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 andnatural gas properties is not reversible at a later date.  In accordance with SAB No.103, “*Update of Codification of Staff Accounting Bulletins*,”derivative instruments qualifying as cash flow hedges are included in thecomputation of limitation on capitalized costs. The period-end price exceeded the cap price established by two of theCompany’s hedge contracts at September 30, 2005 and thus a $16.5 millionloss was included in the calculation. Impairment of oil and natural gas properties is assessed on a quarterlybasis in conjunction with the Company’s quarterly and annual filings with theSEC.  No impairment related to theceiling test was required during the nine-month periods ended September 30,2005 or 2004.

 

Sales of proved and unproved properties are accountedfor as adjustments of capitalized costs with no gain or loss recognized, unlesssuch adjustments would significantly alter the relationship between capitalizedcosts and proved reserves.

 

***Inventories –***Inventoriesconsist principally of tubular goods and production equipment for wells andfacilities. They are stated at the lower of weighted-average cost or market.

 

***Asset Retirement Obligations –***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 acumulative effect 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.

 

At January 1, 2003,the Company recorded the present value of its future Asset RetirementObligations (“ARO”) for oil and natural gas properties and related equipment.The changes to the ARO during the periods ended September 30, 2005 and2004 are as follows:

 
| ** **                                 | ** ** | **Nine Months Ended September 30,** | ** ** |
|--------------------------------------------|------------|------------------------------------------|------------|
| ** **                                 | ** ** | **2005**                                 | ** ** | **2004** | ** ** |
| ARO, Beginning of Period                   |       | $                                        | 2,189,088  |   | $ | 1,811,995 |   |
| Liabilities incurred in the current period |       | 265,985                                  |       | 233,828 |   |
| Liabilities settled in the current period  |       | (118,408                                 | )          | (123,231 | ) |
| Accretion expense                          |       | 101,556                                  |       | 80,128 |   |
| Revisions                                  |       | —                                   |       | — |   |
| ARO, End of Period                         |       | $                                        | 2,438,221  |   | $ | 2,002,720 |   |
|                                       |       |                                     |       |   |   |
| Current Portion                            |       | $                                        | 202,248    |   | $ | 411,092 |   |
| Long Term Portion                          |       | $                                        | 2,235,973  |   | $ | 1,591,628 |   |

 

Duringthe nine months ended September 30, 2005, ARO liabilities incurred include38 new well obligations and liabilities settled include 17 wells that wereplugged.

 

***Stock-Based Compensation***- The Company accounts for stockcompensation plans under the intrinsic value method of Accounting PrinciplesBoard (“APB”) Opinion No. 25, “*Accountingfor Stock Issued to Employees*.” No compensation expense is recognized for stock options that had anexercise price equal to or greater than the market value of the underlyingcommon stock on the date of grant.  Asallowed by SFAS No. 123,

 

9

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“*Accounting for Stock-Based Compensation*,”the Company has continued to apply APB Opinion No. 25 for purposes ofdetermining net income.  In December 2002,the FASB issued SFAS No. 148, “*Accountingfor Stock-Based Compensation – Transition and Disclosure – an amendment of FASBStatement No. 123”* to provide alternative methods of transitionfor a voluntary change to the fair value based method of accounting forstock-based employee compensation. Additionally, the statement amends the disclosure requirements of SFAS No. 123to require prominent disclosures in both annual and interim financialstatements about the method of accounting for stock-based compensation and theeffect of the method used on reported results.

 

Hadcompensation expense for stock-based compensation been determined based on thefair value at the date of grant, the Company’s net income and earnings pershare would have been as follows:

 
| ** **                                                                                                                           | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                                                                           | ** ** | **2005**                                  | ** ** | **2004**                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net income as reported                                                                                                               |       | $                                         | 8,142,572  |                                     | $          | 2,682,894 |   | $ | 20,075,614 |   | $ | 9,822,211 |   |
| Add:                                                                                                                                 |       |                                      |       |                                     |       |   |   |   |   |
| Stock-based employee compensation expense included  in reported net income, net of related income tax                                |       | 1,320,738                                 |       | (6,700                                   | )          | 1,696,431 |   | 1,072,030 |   |
| Deduct:                                                                                                                              |       |                                      |       |                                     |       |   |   |   |   |
| Total stock-based employee compensation expense  determined under fair value based method for all awards, net of related  income tax |       | (204,617                                  | )          | (106,092                                 | )          | (530,127 | ) | (314,380 | ) |
| Pro forma net income                                                                                                                 |       | $                                         | 9,258,693  |                                     | $          | 2,570,102 |   | $ | 21,241,918 |   | $ | 10,579,861 |   |
|                                                                                                                                 |       |                                      |       |                                     |       |   |   |   |   |
| Earnings Per Share:                                                                                                                  |       |                                      |       |                                     |       |   |   |   |   |
| Basic – as reported                                                                                                             |       | $                                         | 0.47       |                                     | $          | 0.21 |   | $ | 1.17 |   | $ | 0.76 |   |
| Basic – pro forma                                                                                                               |       | $                                         | 0.54       |                                     | $          | 0.20 |   | $ | 1.24 |   | $ | 0.82 |   |
|                                                                                                                                 |       |                                      |       |                                     |       |   |   |   |   |
| Diluted – as reported                                                                                                           |       | $                                         | 0.45       |                                     | $          | 0.20 |   | $ | 1.13 |   | $ | 0.73 |   |
| Diluted – pro forma                                                                                                             |       | $                                         | 0.52       |                                     | $          | 0.19 |   | $ | 1.19 |   | $ | 0.78 |   |

 

As aresult of the re-pricing in May 1999 of certain non-qualified stockoptions granted to our employees and directors in prior years, as well asissuing new options in conjunction with such re-pricing, we became subject tothe reporting requirements of FASB Interpretation No. (“FIN”) 44, “*Accounting for Certain Transactions Involving Stock Compensation*”.FIN 44 requires a company, among other things, to record a non-cash, pre-taxcharge to deferred compensation expense if the market price of such company’scommon stock at the end of a reporting period is greater than the exerciseprice of any re-priced stock options. After the first such adjustment is made, each subsequent period isadjusted upward or downward, and a charge or credit, as applicable, for theperiod is recorded.  Volatility in acompany’s stock price can have a direct impact on the amount of these chargesand credits from period to period, which may affect the comparability ofresults between periods. As of September 30, 2005, we had 159,750 of suchoptions outstanding that were subject to these FIN 44 reportingrequirements. The market price used to calculate the related charge or credit,as applicable, was $26.69 per share at September 30, 2005, as compared to $15.68per share at June 30, 2005, $16.25 per share at March 31, 2005, and$14.66 per share at December 31, 2004. For the third quarter of 2005, werecorded a non-cash, pre-tax charge of $1.8 million, as compared to a non-cash,pre-tax credit of $153,808 for the third quarter of 2004.  For the first nine months of 2005, werecorded a non-cash, pre-tax charge of $1.9 million as compared to a non-cash,pre-tax charge of $1.3 million for the same period in 2004.

 

***Accounting Pronouncements*****–** In December 2004, the FASB issued SFAS No. 123(R),“*Share-Based Payment.*” Thisstatement 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. SFAS No. 123(R) amends the original SFAS No. 123and 95 that had allowed companies to choose between expensing stock options orshowing pro forma disclosure only. This 

 

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statement eliminates the ability to account forshare-based compensation transactions using APB Opinion No. 25. Wecurrently account for our stock-based compensation plans under the principlesprescribed by APB Opinion No. 25. Accordingly, no stock optioncompensation cost is reflected in net income, as all options granted under theplan had an exercise price equal to the market value of the underlying commonstock on the date of grant. The adoption of SFAS No. 123(R) will impactour results of operations, but will have no impact on our overall financialposition. In March 2005, the SEC issued SAB No. 107. Among otherthings, SAB No. 107 provides interpretive guidance related to theinteraction between SFAS No. 123(R) and certain SEC rules andregulations, as well as provides the SEC staff’s views regarding the valuationof share-based payment arrangements for public companies. SFAS No. 123(R)was to become effective as of the beginning of the first interim or annualreporting period that begins after June 15, 2005, but on April 14,2005, the SEC issued press release 2005-57, which amends the compliance date ofSFAS No. 123(R) for fiscal years beginning after June 15, 2005. Weanticipate adopting the provisions of SFAS No. 123(R) in the firstquarter of 2006 using the modified prospective method for transition. Underthis method we will recognize compensation expense for all stock-based awardsgranted or modified on or after July 1, 2005, as well as any previouslygranted awards that are not fully vested as of July 1, 2005. Compensationexpense will be measured based on the fair value of the awards previouslycalculated in developing the pro forma disclosures in accordance with theprovisions of SFAS No. 123 (see Stock-Based Compensation above). TheCompany expects the impact to be immaterial due to the fact that the Companyhas not issued options since April 2004 and there will be a minimal amountof unvested options as of our adoption date. SFAS No. 123(R) also requiresthe benefits of tax deductions in excess of recognized compensation cost bereflected as a financing cash flow, rather than as an operating cash flow ascurrently required.

 

In March 2005, theFASB issued FASB Interpretation No. 47, *Accountingfor Conditional Asset Retirement Obligations, an interpretation of FASBStatement No. 143* (“FIN 47”).  FIN 47 clarifies that theterm, “conditional asset retirement obligation” as used in SFAS No. 143, *Accounting for Asset Retirement Obligations*,refers to a legal obligation to perform an asset retirement activity in whichthe timing and/or method of settlement are conditional upon a future event thatmay or may not be within the control of the entity.  Even thoughuncertainty about the timing and/or method of settlement exists and may beconditional upon a future event, the obligation to perform the asset retirementactivity is unconditional.  Accordingly, an entity is required torecognize a liability for the fair value of a conditional asset retirementobligation if the fair value of the liability can be reasonablyestimated.  Uncertainty about the timing and/or method of settlement of aconditional asset retirement obligation should be factored into the measurementof the liability when sufficient information exists.  The fair value of aliability for the conditional asset retirement obligation should be recognizedwhen incurred generally upon acquisition, construction, or development orthrough the normal operation of the asset.  SFAS No. 143 acknowledgesthat in some cases, sufficient information may not be available to reasonablyestimate the fair value of an asset retirement obligation.  FIN 47 also clarifieswhen an entity would have sufficient information to reasonably estimate thefair value of an asset retirement obligation.  FIN 47 is effective nolater than the end of reporting periods ending after December 15,2005.  Retrospective application for interim financial information ispermitted but is not required.  Early adoption of FIN 47 isencouraged.  The Company is currently evaluating what impact FIN 47 willhave on its financial statements, but at this time, it does not believe thatthe adoption of FIN 47 will have a material effect on the Company’sconsolidated financial position, results of operations or cash flows.

 

In June 2005,the FASB issued SFAS No. 154, *AccountingChanges and Error Corrections*, which changes the requirements forthe accounting for and reporting of a change in accounting principle. It alsoapplies to changes required by an accounting pronouncement in the unusualinstance that the pronouncement does not include specific transitionprovisions. Application is effective for accounting changes and correction oferrors made in fiscal years beginning after December 15, 2005. Earlyadoption is permitted. The adoption of SFAS No. 154 is not expected tohave a material effect on the Company’s consolidated financial position, resultsof operations or cash flows.

 

***Reclassifications***-Certain reclassifications of prior period statements have been made to conformto current reporting practices.

 

**2.****              LONGTERM DEBT**

 

EffectiveDecember 31, 2003, the Company entered into a new amended and restatedcredit facility (the “Credit Facility”) which permits borrowings up to thelesser of (i) the borrowing base or (ii) $100 million.

 

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Borrowingsunder the Credit Facility bear interest at a rate equal to prime plus 0.50% orLIBOR plus 2.25%.  At September 30,2005, the interest rate applied to our outstanding balance was 5.69%.Commitment fees of 0.25% to 0.50% accrue on the unused portion of the borrowingbase, depending on the utilization percentage, and are included as a componentof interest expense. As of September 30, 2005, $20.0 million in borrowingswere outstanding under the Credit Facility.

 

EffectiveDecember 29, 2004, the Credit Facility’s borrowing base was increased from$48.0 million to $65.0 million. The borrowing base under the Credit Facilitywas increased as a result of the south Texas asset acquisition that closed December 29,2004 and drilling activities since the last redetermination. On May 31,2005, the borrowing base was increased from $65.0 million to $70.0 million as aresult of drilling activities since the last redetermination. In addition, thematurity date was extended from December 31, 2006 to December 31,2007 and the interest rate margins were reduced from previous levels.  The Company’s available borrowing capacityunder this facility was $50.0 million at September 30, 2005. The borrowingbase is currently being redetermined in connection with the Company’s recentdrilling activities and the Chapman Ranch Field acquisitions described in Note8.

 

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.  TheCredit Facility also contains the following financial covenants, among others:

 

•                  The EBITDAX to Interest Expense ratiorequires that the ratio of (a) consolidated EBITDAX (defined as EBITDAplus similar non-cash items and exploration and abandonment expenses for suchperiod) of the Company for the four fiscal quarters then ended to (b) theconsolidated interest expense of the Company for the four fiscal quarters thenended, not be less than 3.5 to 1.0.

•                  The Working Capital ratio requiresthat the amount of the Company’s consolidated current assets less itsconsolidated current liabilities, as defined in the agreement, be at least $1.0million. For the purposes of calculating the Working Capital ratio, currentassets are adjusted for unused capacity under credit agreement and derivativefinancial instruments, and current liabilities are adjusted for derivativefinancial instruments and asset retirement 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) as of such fiscal quarter to (b) anamount equal to consolidated EBITDAX for the two quarters then ended times two,not be greater than 3.0 to 1.0.

 

ConsolidatedEBITDAX is a component of negotiated covenants with our lender and is definedhere as part of the Company’s disclosure of its covenant obligations.

 

**3.****              SHELFREGISTRATION STATEMENT**

 

During 2004, the Company filed a $150 million shelf registration statement with the SEC, which became effective in May 2004 and was reduced to approximately $90 million after our 2004 offering (see discussion below). During the second quarter 2005, the Company filed a new registration statement that replaced the prior registration statement and increased the amount of securities registered to $390 million.  Under this shelf registration statement, the Company may issue, from time to time, any combination of debt securities, preferred stock, common stock or warrants in one or more offerings to those persons who agree to purchase our securities. Net proceeds, terms and pricing of the offering of securities issued under the shelf registration statement will be determined at the time of the offerings. The shelf registration statement does not provide assurance that the Company will or could sell any such securities. The Company’s ability to utilize the shelf registration statement for the purpose of issuing, from time to time, any combination of debt securities, preferred stock, common stock or warrants will depend upon, among other things, market conditions and the existence of investors who wish to purchase the Company’s securities at prices acceptable to the Company.

 

TheCompany completed anoffering on December 21, 2004 of 3.5 million shares of its common stockunder the Company’s initial shelf registration statement, which generated netproceeds of $47.8 million, before

 

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directcosts of the offering of $0.6 million. These funds were used to finance the southTexas asset acquisition that closed December 29, 2004 and fund othergeneral corporate purposes. On January 5, 2005, the underwriters exercisedtheir over-allotment option for an additional 525,000 shares of common stock,which generated additional net proceeds of $7.2 million. These funds were usedto reduce outstanding debt. Each of these sales was made under the Company’sinitial shelf registration statement. At September 30, 2005, the Company had $390 million availablefor issuance under its current shelf registration statement.

 

**4.****              EARNINGSPER SHARE**

 

TheCompany accounts for earnings per share in accordance with SFAS No. 128, “*Earnings per Share*,” which establishes therequirements for presenting earnings per share (“EPS”).  SFAS No. 128 requires the presentationof “basic” and “diluted” EPS on the face of the income statement.  Basic earnings per common share amounts arecalculated using the average number of common shares outstanding during eachperiod.  Diluted earnings per commonshare assumes the exercise of all stock options and warrants having exerciseprices less than the average market price of the common stock during the periods,using the treasury stock method.

 

Thefollowing is a reconciliation of the numerators and denominators of basic anddiluted earnings per common share computations, in accordance with SFAS No. 128,for the three-month and nine-month periods ended September 30, 2005 and2004:

 
| ** **                              | ** ** | **Three Months Ended  September 30, 2005** | ** ** | **Three Months Ended  September 30, 2004** | ** ** |
|-----------------------------------------|------------|-------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                              | ** ** | **Income  (Numerator)**                         | ** ** | **Shares  (Denominator)**                       | ** ** | **Per Share  Amount** | ** ** | **Income  (Numerator)** | ** ** | **Shares  (Denominator)** | ** ** | **Per  Share  Amount** | ** ** |
| **Basic EPS**                           |       |                                            |       |                                            |       |   |   |   |   |   |   |   |   |
| Income available to common stockholders |       | $                                               | 8,142,572  |                                            | 17,137,515 |   | $ | 0.47 |   | $ | 2,682,894 |   | 12,999,659 |   | $ | 0.21 |   |
| Effect of dilutive securities:          |       |                                            |       |                                            |       |   |   |   |   |   |   |   |   |
| Restricted stock                        |       | —                                          |       | 212,641                                         |       | (0.01 | ) | — |   | 156,310 |   | — |   |
| Common stock options                    |       | —                                          |       | 557,747                                         |       | (0.01 | ) | — |   | 512,573 |   | (0.01 | ) |
| **Diluted EPS**                         |       |                                            |       |                                            |       |   |   |   |   |   |   |   |   |
| Income available to common stockholders |       | $                                               | 8,142,572  |                                            | 17,907,903 |   | $ | 0.45 |   | $ | 2,682,894 |   | 13,668,542 |   | $ | 0.20 |   |
|                                    |       |                                            |       |                                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| ** **                              | ** ** | **Nine Months Ended  September 30, 2005**  | ** ** | **Nine Months Ended  September 30, 2004**  | ** ** |
| ** **                              | ** ** | **Income  (Numerator)**                         | ** ** | **Shares  (Denominator)**                       | ** ** | **Per Share  Amount** | ** ** | **Income  (Numerator)** | ** ** | **Shares  (Denominator)** | ** ** | **Per  Share  Amount** | ** ** |
| **Basic EPS**                           |       |                                            |       |                                            |       |   |   |   |   |   |   |   |   |
| Income available to common stockholders |       | $                                               | 20,075,614 |                                            | 17,100,374 |   | $ | 1.17 |   | $ | 9,822,211 |   | 12,889,109 |   | $ | 0.76 |   |
| Effect of dilutive securities:          |       |                                            |       |                                            |       |   |   |   |   |   |   |   |   |
| Restricted stock                        |       | —                                          |       | 186,752                                         |       | (0.01 | ) | — |   | 139,223 |   | (0.01 | ) |
| Common stock options                    |       | —                                          |       | 514,748                                         |       | (0.03 | ) | — |   | 478,499 |   | (0.02 | ) |
| **Diluted EPS**                         |       |                                            |       |                                            |       |   |   |   |   |   |   |   |   |
| Income available to common stockholders |       | $                                               | 20,075,614 |                                            | 17,801,874 |   | $ | 1.13 |   | $ | 9,822,211 |   | 13,506,831 |   | $ | 0.73 |   |

 

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**5.****              INCOMETAXES**

 

The Company accounts for income taxes under theprovisions of SFAS No. 109, “*Accountingfor Income Taxes*,” which provides for an asset and liabilityapproach in accounting for income taxes. Under this approach, deferred tax assets and liabilities are recognizedbased on anticipated future tax consequences, using currently enacted tax laws,attributable to temporary differences between the carrying amounts of assetsand liabilities for financial reporting purposes and the amounts calculated forincome tax purposes.

 

The Company is subject to state and federal incometaxes. Although it is currently generating taxable income for financialreporting purposes, the Company is not in a federal income tax paying positionas a result of deducting intangible drilling costs (“IDC”) that reduce taxableincome for income tax purposes and applying NOL carryforwards that offset anyremaining taxable income. Therefore, the Company was not required to pay incometaxes in 2004 or 2003. The Company currently estimates that its effective taxrate for the year ending December 31, 2005 will be approximately 35.1%.  A deferred income tax provision of $10.9million and $5.4 million was recorded for the nine months ended September 30,2005 and 2004, respectively.

 

**6.****              SUPPLEMENTALDISCLOSURE OF NON-CASH INVESTING AND FINANCING ACTIVITIES**

 

TheCompany considers all highly liquid debt instruments purchased with an originalmaturity of three months or less to be cash equivalents. A summary of non-cashinvesting and financing activities for the nine months ended September 30,2005 and 2004 is presented below:

 
| **Description**                                                                                       | ** ** | **Number of  Shares  Issued** | ** ** | **Fair Market  Value** | ** ** |
|-------------------------------------------------------------------------------------------------------|------------|-------------------------------|------------|------------------------|------------|
| **Nine months ended September 30, 2005:**                                                        |       |                          |       |                   |       |
| Shares issued to satisfy restricted stock grants                                                      |       | 55,228                        |       | $                      | 528,272    |   |
| Shares issued to fund the Company’s matching  contribution under the Company’s 401-k plan   |       | 8,295                         |       | $                      | 130,164    |   |
| **Nine months ended September 30, 2004:**                                                        |       |                          |       |                   |       |
| Shares issued to satisfy restricted stock grants                                                      |       | 61,136                        |       | $                      | 384,708    |   |
| Shares issued to fund the Company’s matching  contribution under the Company’s 401 (k) plan |       | 5,785                         |       | $                      | 83,270     |   |

 

For the ninemonths ended September 30, 2005 and 2004, the non-cash portion of AssetRetirement Costs was $147,577 and $110,597, respectively.  A supplemental disclosure of cash flowinformation related to interest for the nine months ended September 30,2005 and 2004 is presented below:

 
| ** **                                                                                                                               | ** ** | **For the Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                                                                               | ** ** | **2005**                                          | ** ** | **2004** | ** ** |
| Cash paid during the period for:                                                                                                         |       |                                              |       |   |   |
| Interest, net of amounts capitalized of $742,924 and  $378,118 for the nine months ended September 30, 2005 and 2004,  respectively |       | $                                                 | —     |   | $ | 241,887 |   |
| Income taxes (See Note 5)                                                                                                                |       | —                                            |       | — |   |
|                                                                                                                                          |            |                                                   |            |  |  |  |  |

 

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**7.****              HEDGINGAND DERIVATIVE ACTIVITIES**

 

Due tothe volatility of oil and natural gas prices, the Company periodically entersinto price-risk management transactions (e.g., swaps, collars and floors) for aportion of its oil and natural gas production to achieve a more predictablecash flow, as well as to reduce exposure from price fluctuations.  While the use of these arrangements limits theCompany’s ability to benefit from increases in the price of oil and naturalgas, it also reduces the Company’s potential exposure to adverse pricemovements.  The Company’s arrangements,to the extent it enters into any, apply to only a portion of its production,provide only partial price protection against declines in oil and natural gasprices and limit the Company’s potential gains from future increases inprices.  None of these instruments areused for trading or speculative purposes. On a quarterly basis, the Company’smanagement sets all of the Company’s price-risk management policies, includingvolumes, 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 Chief ExecutiveOfficer.  The Board of Directors monitorsthe Company’s 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.”* These derivative instruments are intended to hedge ourprice risk and may be considered hedges for economic purposes, but certain ofthese transactions may not qualify for cash flow hedge accounting. Allderivative 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. The Company is currently accounting for itsnatural gas contracts as cash flow hedges of future cash flows from the sale ofnatural gas. For those derivative instrument contracts that either do notqualify for cash flow hedge accounting or the Company does not designate ashedges of future cash flows, the changes in fair value are not deferred throughother comprehensive income, but rather recorded in revenue immediately asunrealized gains or losses. The Company did not apply cash flow hedgeaccounting to its crude oil collars entered into in May/August of 2004 andin August 2005, because although they were economic hedges, they did notqualify for hedge accounting.

 

Forthe nine months ended September 30, 2005 and 2004, the Company included inrevenue realized and unrealized losses of $2.4 million and $2.3 million,respectively, related to its natural gas hedges and oil derivatives. There wasno ineffectiveness recognized during the nine months ended September 30,2005 or 2004.

 
| ** **                                               | ** ** | **Nine Months Ended September 30,** | ** ** |
|----------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                               | ** ** | **2005**                                 | ** ** | **2004** | ** ** |
| Natural gas hedging contract settlements                 |       | $                                        | (809,900   | ) | $ | (222,000 | ) |
| Oil derivative contract settlements                      |       | (1,223,146                               | )          | (410,713 | ) |
| Hedge premium reclassification                           |       | —                                   |       | (411,650 | ) |
| Oil derivative contract unrealized change in fair  value |       | (364,135                                 | )          | (1,254,911 | ) |
| Loss on hedging and derivatives                          |       | $                                        | (2,397,181 | ) | $ | (2,299,274 | ) |

 

15

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The outstandinghedges at September 30, 2005 and December 31, 2004 impacting thebalance sheet were as follows:

 
| ** **              | ** ** | ** **           | ** ** | ** **    | ** ** | ** ** | ** ** | ** **    | ** ** | ** **  | ** ** | **Fair Value of Outstanding Hedging and  Derivative Contracts as of** | ** **  |
|-------------------------|------------|----------------------|------------|---------------|------------|------------|------------|---------------|------------|-------------|------------|-----------------------------------------------------------------------|-------------|
| ** **              | ** ** | ** **           | ** ** | ** **    | ** ** | ** ** | ** ** | **Price**     | ** ** | **Volumes** | ** ** | **September 30,**                                                | ** **  | **December 31,** | ** ** |
| **Transaction  Date**   | ** ** | **Transaction Type** | ** ** | **Beginning** | ** ** | **Ending** | ** ** | **Per Unit**  | ** ** | **Per Day** | ** ** | **2005**                                                              | ** **  | **2004 (4)** | ** ** |
| ***Natural  Gas (1):*** |       |                 |       |          |       |       |       |          |       |        |       |                                                                  |        |   |   |
| 05/04                   |       | Collar               |       | 01/01/2005    |       | 03/31/2005 |       | $5.00-$10.39  |       | 10,000MMbtu |       | $                                                                     | —      |   | $ | 92,703 |   |
| 07/04                   |       | Collar               |       | 04/01/2005    |       | 06/30/2005 |       | $5.00-$7.53   |       | 10,000MMbtu |       | —                                                                |        | 9,162 |   |
| 07/04                   |       | Collar               |       | 07/01/2005    |       | 09/30/2005 |       | $5.00-$7.67   |       | 10,000MMbtu |       | —                                                                |        | (41,210 | ) |
| 10/04                   |       | Collar               |       | 01/01/2005    |       | 12/31/2005 |       | $6.00-$9.52   |       | 10,000MMbtu |       | (2,168,927                                                            | )           | 1,860,375 |   |
| 08/05                   |       | Collar               |       | 01/01/2006    |       | 12/31/2006 |       | $7.00-$10.50  |       | 10,000MMbtu |       | (6,190,758                                                            | )           | — |   |
| 08/05                   |       | Collar               |       | 01/01/2006    |       | 12/31/2006 |       | $7.00-$16.10  |       | 10,000MMbtu |       | (1,610,527                                                            | )           | — |   |
|                    |       |                 |       |          |       |       |       |          |       |        |       |                                                                  |        |   |   |
| ***Crude  Oil (2):***   |       |                 |       |          |       |       |       |          |       |        |       |                                                                  |        |   |   |
| 03/04                   |       | Collar               |       | 04/01/2004    |       | 12/31/2004 |       | $30.00-$35.50 |       | 400Bbl      |       | —                                                                |        | (96,240 | ) |
| 05/04 (08/04) (3)       |       | Collar               |       | 01/01/2005    |       | 12/31/2005 |       | $35.00-$40.00 |       | 200/290Bbl  |       | (920,888                                                              | )           | (468,308 | ) |
| 08/05                   |       | Collar               |       | 01/01/2006    |       | 12/31/2006 |       | $55.00-$80.00 |       | 400Bbl      |       | (7,795                                                                | )           | — |   |
|                    |       |                 |       |          |       |       |       |          |       |        |       | $                                                                     | (10,898,895 | ) | $ | 1,356,482 |   |

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(1)   TheCompany’s current hedging activities for natural gas were entered into on a perMMbtu delivered price basis, using the Houston Ship Channel Index, withsettlement for each calendar month occurring five business days following theexpiration date.

(2)   Hedge accountingis not applied to the Company’s collars on crude oil, which were entered intoon a per barrel delivered price basis, using the West Texas Intermediate Index,with settlement for each calendar month occurring five business days followingthe expiration date. The change in fair value is reflected in net revenue forthe applicable period.

(3)   In August 2004,the Company replaced the contract that was entered into May 2004 with anew contract that changes the volume and pricing terms. The put option is on200 Bbl/D and the call option is on 290 Bbl/D. This transaction was completedat no additional cost to the Company.

(4)   The fair value ofthe Company’s outstanding transactions is presented on the balance sheet bycounterparty. Our counterparties net our positions with them, but we cannotpresent the net of the two counterparty positions because we do not have legalright of offset. Therefore one counterparty is presented in the DerivativeAsset and one is presented in the Derivative Liability at December 31,2004. At December 31, 2004 crude oil collar with a balance of ($468,308)is presented as a liability and the remaining contracts are presented as anasset. All contracts are considered current.

 

**8.****              ACQUISITIONS**

 

ChapmanRanch Field – On September 21, 2005, the Companyexecuted two separate and definitive agreements for the acquisition of (i) thestock of a private company, whose primary asset is ownership of workinginterests in oil and natural gas properties located on the Chapman Ranch Field insouth Texas and (ii) additional working interests in the Chapman RanchField owned by two other private companies for an aggregate cash purchase priceof approximately $62.8 million (of which $35,767,500 is attributable to the stockpurchase and $26,982,500 is attributable to the working interest assetpurchase). The Company expects approximately $10 million of the purchase priceto be allocated to the unproved property category. The purchase price issubject to adjustment for the results of operations between the September 1,2005 effective date and the closing dates, pursuant to closing adjustmentprovisions in the agreements. The properties to be acquired from these entitiesare located in Nueces County, Texas and consist of six producing wells, onewell undergoing completion operations, one well currently drilling and anownership in approximately 1,300 net acres of developed and undevelopedleasehold.

 

The Company has paid the sellers a deposit in theamount of 5% of the applicable purchase price before adjustment (for anaggregate deposit in the amount of $3,137,500 (the “Deposit”)) to be appliedagainst the purchase price payable at the closings. Generally, the Company isentitled to the return of the applicable Deposit upon termination of therelated agreements unless the closing has not occurred (i) in the case ofthe working interest purchase by October 14, 2005 and (ii) in thecase of the stock purchase by November 30, 2005, and if, in each case, therespective agreements are then terminated because of failure to consummate theclosings by such date if at the

 

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time of such termination the respective sellers havefulfilled all of their conditions to closing such that the Company would thenhave been obligated to close the transaction. In addition, the parties haveagreed that either party may terminate the agreements upon the payment to theother party of an amount which is equal to the Deposit related to suchagreement, with no further liability after such termination and payment,provided that, the Company may elect to allow the sellers to retain the Depositin lieu of making such payment.

 

In addition, the Companyhas agreed to pay the sellers an aggregate incremental purchase price of $5.2million (of which $2,964,000 is attributable to the stock purchase and$2,236,000 is attributable to the working interest asset purchase) should theoperator of the properties obtain high-cost gas certification on or before December 31,2005, which would provide for severance tax abatements on the properties. Theoperator of the properties filed for the abatement and the Company was notifiedrecently that a portion of the properties did qualify, and are discussing theorder from the Railroad Commission of Texas with the sellers to determine if itmeets the requirements of the acquisition agreements. The Company plans tofinance the planned acquisitions through borrowings under the unused portion ofits credit facility, which is expected to increase as a result of thesetransactions and other recent activities since the last redetermination. The assetpurchase closed on October 13, 2005 (see Note 9) and the stock purchase isexpected to close on or before November 30, 2005.

 

South Texas - On December 29, 2004, the Companyconsummated the acquisition of interests in certain oil and natural gasproperties located in south Texas from Contango Oil & Gas Company (“Contango”).The final cash purchase price for the acquisition was $40.1 million, which wasadjusted from the original price of $50.0 million for the results of operationsbetween the July 1, 2004 effective date and the December 29, 2004closing date pursuant to the closing adjustment provisions. The Company alsorealized other acquisition costs of approximately $135,200 related toprofessional fees for assistance with the transaction. The purchase price wasfunded from the net proceeds of a public offering of common stock completed December 21,2004 (see Note 3).

 

Thefollowing unaudited pro forma results for the three- and nine-months ended September 30,2004 show the effect on the Company’s consolidated results of operations as if theasset acquisition had occurred on January 1, 2003 and are derived from thepro forma results as reported on Form 8-K/A filed April 5, 2005. Theyare the result of combining the statement of income of Edge with the statementsof revenues and direct operating expenses for the acquired properties adjustedfor (1) the completion of the public offering of common stock to financethe cash purchase price, (2) assumption of ARO liabilities and accretionexpense for the properties acquired, (3) depletion, depreciation andamortization expense applied to the adjusted basis of the properties acquiredusing the purchase method of accounting, and (4) the related income taxeffects of these adjustments based on the applicable statutory rates. Thestatements of revenues and direct operating expenses for the acquired assetsexclude all other historical Contango expenses. As a result, certain estimates and judgments were made in preparing thepro forma adjustments, including as to the incremental expenses associated withthe acquired assets.  The pro forma information includes numerousassumptions, and is not necessarily indicative of future results of operations:

 

| ** **                   | ** ** | **For the Three  Months Ended**                                 | ** ** | **For the Nine  Months Ended** | ** ** |
|------------------------------|------------|-----------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                   | ** ** | **September 30, 2004**                                     | ** ** |
| ** **                   | ** ** | **(unaudited)********(In thousands, except per share amounts)** | ** ** |
| Revenue                      |       | $                                                               | 19,335     |                           | $          | 64,344 |   |
| Net income                   |       | $                                                               | 3,683      |                           | $          | 17,562 |   |
| Net income per common share: |       |                                                            |       |                           |       |
| Basic                        |       | $                                                               | 0.22       |                           | $          | 1.04 |   |
| Diluted                      |       | $                                                               | 0.20       |                           | $          | 1.00 |   |

 

**9.****              SUBSEQUENTEVENTS**

 

On October 13, 2005, the Company consummated theacquisition of certain working interests in oil and natural gas properties onthe Chapman Ranch Field located in Nueces County, Texas owned by two private

 

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companies (see Note 8). The cash purchase price atclosing was $27.0 million (of which $1.4 million was deposited when theagreement was executed (see Note 8) and $25.6 million was paid at closing),which will be adjusted for the results of operations between the September 1,2005 effective date and the October 13, 2005 closing date, pursuant to theclosing adjustment provisions in the Asset Purchase Agreement. The purchaseprice was funded from borrowings under the Company’s current credit facility. TheCompany also incurred a contingent liability for an incremental purchase priceadjustment of $2.2 million should the operator of the properties obtainhigh-cost gas certification, which would provide for severance tax abatementson the properties. The operator of the properties filed for the high-cost gascertification and the Company was notified recently that the properties didqualify. The Company is awaiting the final order from the Railroad Commissionof Texas.

 

**10.****       COMMITMENTSAND CONTINGENCIES**

 

Fromtime to time the Company is a party to various legal proceedings arising in theordinary course of business.  While theoutcome of lawsuits cannot be predicted with certainty, the Company is notcurrently a party to any proceeding that it believes, if determined in a manneradverse to the Company, could have a potential material adverse effect on itsfinancial condition, results of operations or cash flows.

 

During the second quarterof 2004, the Company received notice that its 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 agent maintained that transfers by theparent company to its subsidiaries that the Company classified as intercompanyloans should instead be classified as equity investments in the subsidiary. TheState of Texas originally proposed that the franchise tax liability of thesubsidiaries would be increased by approximately $3.0 million for the four-yearperiod under audit.

 

During the thirdquarter of 2004 the agent reduced the proposed franchise tax deficiencyadjustment to the Company and its subsidiaries to an aggregate of $467,000. Inthe fourth quarter of 2004, there was an informal hearing at the localComptroller’s Office during which the agent indicated he would formally assessthe proposed deficiency.  On March 24,2005, the Company received such deficiency assessment in the amount of$471,482, including penalty and interest. The Company responded on April 21,2005 with a request for a formal redetermination hearing. In July 2005,the Company submitted additional documents and evidence supporting its positionfor the hearing. There has not yet been a formal response from the Comptroller’sOffice on the Company’s request for an administrative hearing. The Companyintends to continue to vigorously contest the assessment through appropriateadministrative levels in the Comptroller’s Office and any other availablemeans.  Due to its intention to continueto vigorously contest the proposed adjustments, the Company has not recognizedany provision for the additional franchise taxes that would result from theproposed deficiency.

 

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**ITEM2.   MANAGEMENT’S DISCUSSION AND ANALYSISOF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

The following is Management’s Discussion andAnalysis (“MD&A”) of significant factors that have affected certain aspectsof our financial position and operating results during the periods included inthe accompanying unaudited condensed consolidated financial statements. Thefollowing MD&A is intended to help the reader understand Edge PetroleumCorporation (“Edge”). Thisdiscussion should be read in conjunction with the accompanying unauditedcondensed consolidated financial statements included elsewhere in this Form 10-Qand with Management’s Discussion and Analysis of Financial Condition andResults of Operations and our audited consolidated financial statementsincluded in our annual report on Form 10-K for the year ended December 31,2004.

 

### **FORWARD LOOKING STATEMENTS**

 

The statements containedin all parts of this document, including, but not limited to, those relating toour outlook, the effects of our acquisitions, our financing plans relatedthereto, including any increase in our credit line, issuance of equity or debt,contribution and any other benefit of an acquisition, our ability to access thecapital markets to raise additional capital, our debt-to-total capital ratio,our drilling plans and the ability to secure drilling rigs to effectuate theseplans, our natural gas and oil production volumes, our 3-D project portfolio,our ability to hedge our risks, our ability to reduce our interest rates,capital expenditures and capital program, future capabilities, the sufficiencyof capital resources and liquidity to support working capital and capitalexpenditure requirements, sufficiency, growth and reinvestment of cash flows,our ability to control the timing of our future exploration and developmentrequirements, use of NOLs, tax rates, the outcome of litigation and audits, theimpact of changes in interest rates on our estimates of asset retirement obligations,production declines, the commodity pricing environment and the state of theeconomy and any other statements regarding future operations, financialresults, business plans, sources of liquidity and cash needs and otherstatements that are not historical facts are forward looking statements.  When used in this document, the words “anticipate,”“estimate,” “expect,” “may,” “project,” “believe,” “budgeted,” “intend,” “plan,”“potential,” “forecast,” “might,” “predict,” “should” and similar expressionsare intended to be among the statements that identify forward lookingstatements.  Such statements involverisks and uncertainties, including, but not limited to, those relating to theresults of and our dependence on our exploratory and development drillingactivities, the volatility of oil and natural gas prices, the need to replacereserves depleted by production, operating risks of oil and natural gasoperations, our dependence on key personnel, our reliance on technologicaldevelopment and possible obsolescence of the technology currently used by us,the significant capital requirements of our exploration and development andtechnology development programs, the potential impact of government regulationsand liability for environmental matters, results of litigation and audits,expansion of our capital budgets, our ability to manage our growth and achieveour business strategy, competition from larger oil and gas companies, theuncertainty of reserve information and future net revenue estimates, hedgingopportunities in the future, property acquisition risks, risks relating toacquisitions and other factors detailed in our Form 10-K and other filingswith the Securities and Exchange Commission (“SEC”).  Should one or more of these risks oruncertainties materialize, or should underlying assumptions prove incorrect,actual outcomes may vary materially from those indicated. All subsequentwritten and oral forward looking statements attributable to the Company or thepersons acting on its behalf are expressly qualified in their entirety by thereference to these risks and uncertainties. The Company undertakes noobligation to publicly update or revise any forward looking statements, whetheras a result of new information, future events or otherwise.

 

## **GENERAL OVERVIEW**

 

Edge PetroleumCorporation is a Houston-based independent energy company that focuses itsexploration, production 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. Our company generates revenues, income and cash flows by producingand marketing oil and natural gas produced from our oil and natural gasproperties. We make significant capital expenditures in our exploration,development, and acquisition activities that allow us to continue generatingrevenue, income and cash flows. In December 2003, we acquired 100 percentof the outstanding stock of Miller

 

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Exploration Company (“Miller”).  The transaction was treated as a tax-freereorganization and accounted for as a purchase business combination. Millercontinues to conduct exploration and development activities as a wholly-ownedsubsidiary of Edge. In December 2004, we acquired substantially all of theoperating assets of Contango Oil & Gas Company (“Contango”) for a cashpurchase price financed by proceeds from a public offering of our common stock.This acquisition is herein referred to as the south Texas asset acquisition.During the third quarter of 2005, we entered into two separate and definitiveagreements to purchase certain oil and natural gas working interests in theChapman Ranch Field from two private companies and the stock of a third privatecompany that also owns interests in this field. One transaction closed on October 13,2005 and we expect the other to close on November 30, 2005.

 

Thisoverview provides our perspective on the individual sections of MD&A, aswell as helpful hints for reading these pages. Our MD&A includes thefollowing sections:

 

•                  **Industryand Economic Factors** – a general description of value drivers of ourbusiness as well as opportunities, challenges and risks related to the oil andgas industry.

 

•                  **Approachto the Business** – additional information regarding our approach andstrategy.

 

•                  **Acquisitionsand Divestitures** - information about significant changes in ourbusiness structure.

 

•                  **Outlook**– additional discussion relating to management’s outlook to the future of ourbusiness.

 

•                  **CriticalAccounting Policies and Estimates** – a discussion of certainaccounting policies that require critical judgments and estimates.

 

•                  **Resultsof Operations** – an analysis of our Company’s consolidated resultsfor the periods presented in our financial statements.

 

•                  **Liquidityand Capital Resources -**an analysis of cash flows, sources and usesof cash, and contractual obligations.

 

•                  **RiskManagement Activities – Derivatives & Hedging -**supplementaryinformation regarding our Company’s price-risk management activities involvingcommodity contracts that are accounted for at fair value.

 

•                  **TaxMatters** – supplementary discussion of income tax matters.

 

•                  **RecentlyIssued Accounting Pronouncements** – a discussion of certainaccounting pronouncements recently issued that may impact our future results.

 

# **Industry and Economic Factors**

 

Inmanaging our business, we must deal with many factors inherent in ourindustry.  First and foremost is thefluctuation of oil and gas prices. Historically, oil and gas markets have been cyclical and volatile withfuture price movements which are difficult to predict.  While our revenues are a function of bothproduction and prices, wide swings in commodity prices have most often had thegreatest impact on our results of operations. We have little ability to predictthose prices or to control them without losing some advantage of the upsidepotential. The oil and gas industry has experienced a high commodity priceenvironment in 2005, which has positively impacted the entire industry as wellas our Company.

 

Ouroperations entail significant complexities. Advanced technologies requiring highly trained personnel are utilized inboth exploration and production.  Evenwhen the technology is properly used, we may still not know conclusively ifhydrocarbons will be present or the rate at which they will be produced.  Exploration is a high-risk activity, oftentimes resulting in no commercially productive reserves being discovered.Moreover, costs associated

 

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with operating within ourindustry are substantial. The recent high commodity price environment has alsoled to increased costs in our industry, which together with increased demandfor rigs, equipment and supplies, have made it difficult at times for us tofurther our growth.

 

Ourbusiness, as with other extractive industries, is a depleting one in which eachgas equivalent produced must be replaced or our business, and a critical sourceof our future liquidity, will shrink.

 

Theoil and gas industry is highly competitive. We compete with major and diversified energy companies, independent oiland gas businesses and individual operators in exploration, production,marketing and acquisition activities.  Inaddition, the industry as a whole competes with other businesses that supplyenergy to industrial and commercial end users.

 

Extensivefederal, state and local regulation of the industry significantly affects ouroperations.  In particular, ouractivities are subject to stringent operational and environmental regulations.  These regulations have increased the costs ofplanning, designing, drilling, installing, operating and abandoning oil and gaswells and related facilities.  Theseregulations may become more demanding in the future.

 

Duringthe third quarter 2005, Hurricanes Rita and Katrina hit the Gulf Coast leavingsignificant destruction in their paths. We were fortunate to avoid substantialdamage or major interruptions in our production or business, but were forced toshut-in several of our larger wells in Mississippi due to the inability of trucksto gain access to haul the crude oil production from the wells. We also wereforced to close our corporate offices for a few days to allow those employeesaffected to evacuate as needed. The hurricanes damaged many of the platforms inthe Gulf of Mexico, as well as numerous onshore facilities related to ourindustry. As a result, both oil and natural gas prices increased in late August andSeptember.

 

# **Approach to the Business**

 

Profitablegrowth of our business will largely depend upon our ability to successfullyfind and develop new proved reserves of oil and natural gas in a cost-effectivemanner.  In order to achieve an overallacceptable rate of growth, we seek to maintain a prudent blend of low, moderateand higher risk exploration and development projects.  We have chosen to seek geologic andgeographic diversification by operating in multiple basins in order to mitigaterisk in our operations. We also attempt to make selected acquisitions of oiland gas properties to augment our growth and provide future drillingopportunities.

 

Weperiodically hedge our exposure to volatile oil and gas prices on a portion ofour production to reduce price risk. As of September 30, 2005, we hadhedge contracts in place covering approximately 23% and 33% of our remainingexpected 2005 natural gas and crude oil production, respectively, andapproximately 35% of total 2006 estimated production on an Mcfe basis, includingthe effect of pending and completed Chapman Ranch Field acquisitions but beforeany other acquisitions that may occur.

 

Implementation of our business approach relies on ourability to fund ongoing exploration and development projects with cash flowprovided by operating activities and external sources of capital. In December 2004,our Board approved a 2005 capital budget of $63 million. At our July 27,2005 Board of Director’s meeting, a budget supplement of $13 million wasapproved, effectively raising our planned capital budget to approximately $76million. At a Board of Directors meeting held on October 27, 2005,approval was given to further increase our capital budget, before acquisitions,by $16.0 million to a total of $92.0 million. The increase is to fund thedrilling of additional wells. After giving effect to the pending acquisitionsof interests in the Chapman Ranch Field and ongoing drilling activities, weexpect our total capital spending program to be approximately $157.0 million in2005. Based upon current expectations for production volumes and commodityprices, we expect to fund the pre-acquisition capital expenditures frominternally generated cash from operating activities. We expect to fund theacquisition with borrowings under our credit facility.

 

Ourlong-term debt balance as of September 30, 2005 was $20.0 million,unchanged from our debt outstanding as of December 31, 2004. As of September 30,2005, our debt to total capital ratio was approximately

 

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10.4%. Currently, ouroutstanding debt balance is $46.0 million, reflecting the closing of the firstof the Chapman Ranch Field acquisitions. During the second quarter of 2005, wetook steps to increase our shelf registration statement capacity to $390million from approximately $90 million (see Note 3 to our consolidatedfinancial statements), which became effective on July 1, 2005. We believewe have the financial flexibility to continue to execute our businessstrategies.

 

**Acquisitions and Divestitures**

 

*Acquisitions –*Acquisitions add meaningfulincremental increases in reserves and production and may range in size fromacquiring a working interest in non-operated producing property to an entirefield or company. Unlike drilling capital, which is planned and budgeted,acquisition capital is neither budgeted nor allocated.  Specific timing of acquisitions cannot bepredicted. Although we consider a wide variety of acquisitions, a significantpart of our growth strategy is expected to be focused toward producing propertyacquisitions, which we believe have exploitable potential.  Because of our financial flexibility, we arepositioned to take advantage of producing property acquisition opportunities asthey may arise. In today’s high price environment, where production isproviding greater cash flow and earnings to most companies, identifying qualityopportunities is difficult. We believe through hard work, technical ability andcreative thinking of our people, we will continue to grow through bothacquisitions and drilling. Any such acquisition could involve the payment by usof a substantial amount of cash or the issuance of a substantial number ofadditional shares or other securities.

 

On September 21,2005, we executed two separate and definitive agreements for the acquisition of(i) the stock of a private company, whose primary asset is ownership of workinginterests in oil and natural gas properties located on the Chapman Ranch Field insouth Texas and (ii) additional working interests owned by two otherprivate companies for an aggregate cash purchase price of approximately $62.8million (of which $35,767,500 is attributable to the stock purchase and$26,982,500 is attributable to the working interest asset purchase). We expectapproximately $10 million of the purchase price to be allocated to the unprovedproperty category. The purchase price is subject to adjustment for the resultsof operations between the September 1, 2005 effective date and the closingdates, pursuant to closing adjustment provisions in the agreements. Theproperties to be acquired from these entities are located in Nueces County,Texas and consist of six non-operated producing wells, one well undergoing completionoperations, and one well currently drilling, as well as an ownership inapproximately 1,300 net acres of developed and undeveloped leasehold.

 

We have paid the sellers a deposit in the amount of 5%of the applicable purchase price before adjustment (for an aggregate deposit inthe amount of $3,137,500 (the “Deposit”)) to be applied against the purchaseprice payable at the closings. Generally, we are entitled to the return of theapplicable Deposit upon termination of the related agreements unless theclosing has not occurred (i) in the case of the working interest purchaseby October 14, 2005 and (ii) in the case of the stock purchase by November 30,2005, and if, in each case, the respective agreements are then terminatedbecause of failure to consummate the closings by such date if at the time ofsuch termination the respective sellers have fulfilled all of their conditionsto closing such that we would then have been obligated to close thetransaction. In addition, the parties have agreed that either party mayterminate the agreements upon the payment to the other party of an amount whichis equal to the Deposit related to such agreement, with no further liabilityafter such termination and payment, provided that, we may elect to allow thesellers to retain the Deposit in lieu of making such payment.

 

In addition, we haveagreed to pay the three sellers an aggregate incremental purchase price of $5.2million (of which $2,964,000 is attributable to the stock purchase and$2,236,000 is attributable to the working interest asset purchase) should theproperties obtain high-cost gas certification on or before December 31,2005, which would provide for severance tax abatements on the properties. Theoperator of the properties filed for the abatement and we were recentlynotified that a portion of the properties did qualify, and are discussing theorder from the Railroad Commission of Texas with the sellers to determine if itmeets the requirements of the acquisition agreements. We plan to finance theplanned acquisitions through borrowings under the unused portion of our credit facility,which is expected to increase as a result of these transactions and other recentactivities since the last redetermination. On October 13, 2005, weconsummated the Chapman Ranch Field asset acquisition. The cash purchase priceat closing was $27.0 million, which will be adjusted for the results ofoperations pursuant to the closing adjustment provisions as described above. Wealso incurred a contingent liability for an incremental

 

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purchase price adjustment of $2.2 million relating tothe incremental purchase price as described above. The stock purchase isexpected to close on or before November 30, 2005.

 

On December 29, 2004we successfully completed the acquisition of oil and natural gas propertieslocated in south Texas for a final adjusted cash purchase price of $40.1million, before other acquisition costs of approximately $135,200. The originalpurchase price of $50 million was subject to adjustment for the results ofoperations between the July 1, 2004 effective date and the December 29,2004 closing date, pursuant to the post-closing adjustments provision. Wefinanced the south Texas asset acquisition with proceeds from a public offeringof our common stock under our then current shelf registration (see Note 3 toour consolidated financial statements). The properties acquired consist of 39non-operated producing wells with working interests ranging from approximately41% to 75% and net revenue interests ranging from 29% to 56%. The addition ofthese properties increased our production and activity levels during 2005.These properties, located primarily in Jim Hogg County, Texas and producingprimarily from the Queen City formation, are in a geographic area that has beenone of our most active and successful areas of focus in recent years. Inaddition to estimated proved reserves, our technical team identified asubstantial number of additional drilling locations on undeveloped acreage withattractive exploitation and exploration potential, therefore, we allocated $6million of the purchase price to the unproved property category, of which allwas categorized as proved at September 30, 2005.

 

*Divestitures -*We regularly review our asset base for the purpose ofidentifying non-core assets, the disposition of which would increase capitalresources available for other activities and create organizational andoperational efficiencies. While we generally do not dispose of assets solelyfor the purpose of reducing debt, such dispositions can have the result offurthering our objective of financial flexibility through reduced debt levels.During the nine months ended September 30, 2005, there were nodivestitures as compared to the first nine months of 2004, during which wedivested oil and natural gas properties in Louisiana and equipment generatingnet proceeds of $45,000.

 

**Outlook**

 

We expectto continue our acquisition program as we seek to further our growth. Duringthe first nine months of 2005, we initiated activities in the Fayetteville Shalein Arkansas and Floyd Shale in Mississippi and Alabama, a new focus for us. Weexpect our drilling program to increase from 49 wells (26.9 net) in 2004 toapproximately 60 to 65 wells (33 to 36 net) in 2005. Our ability to materiallyincrease the number of wells to be drilled beyond our original budget number isheavily dependent upon the timely access to oilfield services, particularlydrilling rigs. The rig situation delayed the drilling of several wells causingdelays in our forecasted growth in production. However, our expected productionvolumes combined with a strong commodity-pricing environment, that ifsustained, as expected for the remainder of the year, is anticipated to producerecord cash flow. We have closed one of the two Chapman Ranch Field acquisitionsand expect the other acquisition to close during the fourth quarter, having animpact on our 2006 operations.

 

Tohelp protect against the possibility that commodity prices do not remain at thecurrent levels, we have entered into several hedges covering approximately 23%of our expected natural gas production and 33% of our expected crude oilproduction streams for the remainder of 2005 to offset the negative impact ofpotential downward price movements. We also put hedges in place during thethird quarter 2005 that cover approximately 38% of our expected natural gasproduction and 35% of our expected crude oil production for 2006, includingproduction expected as a result of both Chapman Ranch Field acquisitions. We mayconsider additional hedging opportunities in the future.

 

Inorder to manage our realized and anticipated growth, we increased our headcountfrom 51 employees as of December 31, 2004 to 58 employees as of September 30,2005 and during the first half of 2005 we expanded our office space, resultingin increased G&A costs for 2005. We expect to continue to add to our stafflevels for the remainder of 2005 in response to past and anticipated growth.

 

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Ouroutlook and the expected results described above are both subject to changebased upon factors that include but are not limited to drilling results,commodity prices, access to capital, the acquisitions market and factorsreferred to in “Forward Looking Statements.”

 

**Critical Accounting Policies andEstimates**

 

The preparation of financial statements in conformitywith generally accepted accounting principles in the United States requiresmanagement to make estimates and assumptions that affect the reported amountsof assets, liabilities, revenues, expenses, contingent assets and liabilitiesand the related disclosures in the accompanying financial statements.  Changes in these estimates and assumptionscould materially affect our financial position, results of operations or cashflows. Management considers an accounting estimate to be critical if:

 

•                  it requires assumptions to be made that were uncertain at the time theestimate was made, and

 

•                  changes in the estimate or different estimates that could have beenselected could have a material impact on our consolidated results of operationsor financial condition.

 

All other significant accounting policies that weemploy are presented in the notes to the consolidated financial statements. Thefollowing discussion presents information about the nature of our most criticalaccounting estimates, our assumptions or approach used and the effects ofhypothetical changes in the material assumptions used to develop each estimate.

 

*Nature of Critical Estimate Item:*Oil & Natural Gas Reserves - Our estimate of proved reserves isbased on the quantities of oil and gas which geological and engineering datademonstrate, with reasonable certainty, to be recoverable in future years fromknown reservoirs under existing economic and operating conditions.  The accuracy of any reserve estimate is afunction of the quality of available data, engineering and geologicalinterpretation, and judgment.  Forexample, we must estimate the amount and timing of future operating costs,severance taxes, development costs and workover costs, all of which may in factvary considerably from actual results. In addition, as prices and cost levelschange from year to year, the economics of producing the reserves may changeand therefore the estimate of proved reserves also may change.  Any significant variance in these assumptionscould materially affect the estimated quantity and value of our reserves.Despite the inherent imprecision in these engineering estimates, our reservesare used throughout our financial statements.

 

*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 oil and gas propertiesrequires a quarterly calculation of a limitation on capitalized costs, oftenreferred to as a full-cost ceiling calculation. The ceiling is the discountedpresent value of our estimated total proved reserves adjusted for taxes and theimpact of hedges on pricing, using a 10% discount rate. To the extent that ourcapitalized costs (net of accumulated depletion and deferred taxes) exceed theceiling, the excess must be written off to expense. Once incurred, thisimpairment of oil and gas properties is not reversible at a later date even ifoil and gas prices increase. No such impairment was required in the nine monthsended September 30, 2005 and 2004. This calculation of our proved reservescould significantly impact our ceiling limitation used in determining whetheran impairment of our capitalized costs is necessary. The ceiling calculationdictates that prices and costs in effect as of the last day of the period aregenerally held constant indefinitely. Therefore, the future net revenuesassociated with the estimated proved reserves are not based on our assessmentof future prices or costs, but rather are based on prices and costs in effectas of the end of the period. Oil and natural gas prices used in the reservevaluation at September 30, 2005 were $66.24 per barrel and $13.92 perMMbtu.

 

24

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*Effect if different assumptionsused:*Units-of-productionmethod to amortize our oil and natural gas properties - A 10% increase or decrease in reserveswould have decreased or increased, respectively, our depletion expense for thequarter by approximately 10%.

 

“Ceiling”limitation test -The most likely factor to contribute to a ceiling test impairment is the priceused to calculate the reserve limitation threshold. A significant reduction inthe prices at a future measurement date could trigger a full-cost ceilingimpairment. At September 30, 2005, we had a cushion (i.e. the excess ofthe ceiling over our capitalized costs) of $314.2 million. A 10% increase ordecrease in prices used would have increased or decreased our cushion byapproximately 22%. Our hedging program would serve to mitigate some of theimpact of any price decline. Two of our hedges impacted the ceiling test thisquarter. If the price was 10% higher, the ceiling would have decreased byapproximately $22.9 million, and had we decreased the price by 10%, the ceilingwould have decreased by approximately $10.7 million. Another likely factor tocontribute to a ceiling test impairment is a revised estimate of reserves. A10% increase or decrease in reserve volume would have increased or decreasedour cushion by approximately 21%.

 

*Nature of Critical Estimate Item:*Unproved Property Impairment****- We have elected to use the full-cost methodto account for our oil and gas activities. Investments in unproved propertiesare not amortized until proved reserves associated with the prospects can bedetermined or until impairment occurs. Unproved properties are evaluated quarterly for impairment on aproperty-by-property basis.  If theresults of an assessment indicate that an unproved property is impaired, theamount of impairment is added to the proved oil and natural gas property coststo be amortized.

 

*Assumptions/Approach Used:*At September 30, 2005, we had $19.9million allocated to unproved property. This allocation is based on theestimation by the technical team of whether the property has potentialattributable reserves. Therefore, the assessment made by our technical team ofthe potential reserves will determine whether costs are moved from the unprovedcategory to the full-cost pool for depletion or whether an impairment is taken.

 

*Effect if different assumptionsused:* A 10%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 quarter ended September 30, 2005.

 

*Nature of Critical Estimate Item:*Asset Retirement Obligations**-**Wehave certain obligations to remove tangible equipment and restore land at theend of oil and gas production operations. Our removal and restoration obligations are primarily associated withplugging and abandoning wells. Previously, the costs associated with thisactivity were capitalized to the full-cost pool and charged to income throughdepletion. We adopted SFAS No. 143, “*Accountingfor Asset Retirement Obligations*” effective January 1, 2003, asdiscussed in Note 1 to our Consolidated Financial Statements.  SFAS No. 143 significantly changed themethod of accruing for costs an entity is legally obligated to incur related tothe retirement of fixed assets (“asset retirement obligations” or “ARO”).  Primarily, the new statement requires us toestimate asset retirement costs for all of our assets, inflation adjust thosecosts to the forecast abandonment date, discount that amount using acredit-adjusted-risk-free rate back to the date we acquired the asset orobligation to retire the asset and record an ARO liability in that amount witha corresponding addition to our asset value. We then accrete the liabilityquarterly using the period-end effective credit-adjusted-risk-free rate. As newwells are drilled or purchased, their initial asset retirement cost andliability is calculated and recorded. Should either the estimated life or theestimated abandonment costs of a property change upon our quarterly review, anew calculation is performed using the same methodology of taking theabandonment cost and inflating it forward to its abandonment date and thendiscounting it back to the present using our credit-adjusted-risk-free rate.The carrying value of the asset retirement obligation is adjusted to the newlycalculated value, with a corresponding offsetting adjustment to the assetretirement cost (included in the full-cost pool); therefore, abandonment costswill almost always approximate the estimate. When wells are sold the relatedliability and asset costs are removed from the balance sheet.

 

*Assumptions/Approach Used:*Estimatingthe future asset removal costs is difficult and requires management to makeestimates and judgments because most of the removal obligations are many yearsin the future and

 

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contractsand regulations often have vague descriptions of what constitutes removal.  Asset removal technologies and costs areconstantly changing, as are regulatory, political, environmental, safety andpublic relations 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, timing of settlement, and changes in thelegal, regulatory, environmental and political environments.

 

*Effect if different assumptionsused:* Since thereare so many variables in estimating AROs, we attempt to limit the impact ofmanagement’s judgment on certain of these variables by using input of qualifiedthird parties. We engage independent engineering firms to evaluate ourproperties 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 move from their current lows, as thecredit-adjusted-risk-free rate is one of the variables used on a quarterlybasis. Our technical team developed a standard cost estimate based onhistorical costs, industry quotes and depth of wells. Unless we expect a well’splugging to be significantly different than a normal abandonment, we use thisestimate. The resulting estimate, after application of a discount factor andsome significant calculations, could differ from actual results, despite allour efforts to make an accurate estimate.

 

*Nature of Critical Estimate Item:*Income Taxes**-**In accordance with the accounting forincome taxes under SFAS No. 109, *Accountingfor Income Taxes,* we have recorded a deferred tax asset andliability to account for the expected future tax benefits and consequences ofevents that have been recognized in our financial statements and our taxreturns. There are several items that result in deferred tax asset andliability impact to the balance sheet, but the largest of which is income taxesand the impact of net operating loss (“NOL”) carryforwards. We routinely assessour ability to use all of our NOL carryforwards that resulted from substantialincome tax deductions, prior year losses and acquisitions. We consider futuretaxable income in making such assessments. If we conclude that it is more likely than not that some portion or allof the deferred tax assets will not be realized under accounting standards, itis reduced by a valuation allowance.

 

*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). The Company is not currentlyrequired to pay any federal income taxes because of the prior generation of NOL’s.

 

*Effect if different assumptionsused:* Our independentpublic accounting firm assists us in applying the numerous and complicated taxlaw requirements. However, despite our attempt to make an accurate estimate,the ultimate utilization of our NOL carryforwards is highly dependent upon ouractual production and the realization of taxable income in future periods. Ifwe estimate that some or all of our NOL carryforwards are more likely than notgoing to expire or otherwise not be utilized to reduce future tax, we wouldrecord a valuation allowance to remove the benefit of those NOL carryforwardsfrom our financial statements.

 

*Nature of Critical Estimate Item:*Derivative & Hedging Activities**-**Due to the instability of oil and naturalgas prices, we may enter into, from time to time, price-risk managementtransactions (e.g., swaps, collars and floors) for a portion of our oil andnatural gas production to achieve a more predictable cash flow, as well as toreduce exposure from commodity price fluctuations. While all of thesetransactions are economic hedges of price risk, different accounting treatmentmay apply depending on if they qualify for cash flow hedge accounting. Inaccordance with SFAS No. 133, all transactions are recorded on the balancesheet at fair value.

 

Hedge Contracts - Weformally assess, both at the hedge’s inception and on an ongoing basis, whetherthe derivatives that are used for hedging are expected to be highly effectivein offsetting changes in cash flows of the hedged transactions.  In the event it is determined that the use ofa particular derivative may not be or has ceased to be effective in pursuing ahedging strategy, hedge accounting is discontinued prospectively. The ongoingmeasurement of effectiveness determines whether the change in fair value isdeferred through other comprehensive income (“OCI”) on the balance sheet orrecorded immediately in revenue on the

 

26

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income statement. Theeffective portion of the changes in the fair value of hedge contracts isrecorded initially in OCI. When the hedged production is sold, the realizedgains and losses on the hedge contracts are removed from OCI and recorded inrevenue. Ineffective portions of the changes in the fair value of the hedgecontracts are recognized in revenue as they occur. While the hedge contract isoutstanding, the ineffective gain or loss may increase or decrease untilsettlement of the contract.

 

DerivativeContracts - For transactions not accounted for using cash flow hedgeaccounting, the change in the fair value of the derivative contract isreflected in revenue immediately, and not deferred through OCI, and there is nomeasurement of effectiveness.

 

*Assumptions/Approach Used:*Estimating the fair values of derivativeinstruments requires complex calculations, including the use of a discountedcash flow technique, estimates of risk and volatility, and subjective judgmentin selecting an appropriate discount rate. In addition, the calculations usefuture market commodity prices, which although posted for trading purposes, aremerely the market consensus of forecasted price trends. The results of the fairvalue calculations cannot be expected to represent exactly the fair value ofour commodity hedges. We currently obtain the fair value of our positions fromour counterparties. Our practice of relying on our counterparties who are morespecialized and knowledgeable in preparing these complex calculations reducesour management’s input.

 

*Effect if different assumptionsused:* At September 30,2005, 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 instrument to increase or decrease byapproximately $1.0 million.

 

# **Results ofOperations**

 

This section includesdiscussion of our results of operations for the three and nine-month periodsended September 30, 2005 as compared to the same periods of the prioryear.  We are an independent energycompany engaged in the exploration, development, acquisition and production ofoil and natural gas.  Our resources andassets are managed and our results reported as one operating segment.  We conduct our operations primarily along theonshore United States Gulf Coast, with our primary emphasis in south Texas,Mississippi, Louisiana, and southeast New Mexico.

 

Our revenue is sensitive to changes in pricesreceived for our products.  A substantialportion of our production is sold at prevailing market prices, which fluctuatein response to many factors that 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 andavailability of alternative fuels could impact worldwide supply, while theeconomy, weather and other factors outside of our control could impact demand.During the third quarter, two large hurricanes impacted the Gulf Coast area,leaving significant damage to platforms in the Gulf and numerous onshorefacilities related to our industry. As a result, both oil and natural gasprices increased. We were fortunate to only experience minor productiondeferrals as a result of these hurricanes.

 

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**Third Quarter 2005 Compared tothe Third Quarter 2004**

 

**Revenue and Production**

 

Total revenueincreased 123% from the third quarter of 2004 to the comparable 2005period.  For the third quarter of 2005and 2004, our product mix contributed the following percentages of revenues andproduction:

 
| ** **                 | ** ** | **REVENUES (1)** | ** ** | **PRODUCTION** | ** ** |
|----------------------------|------------|------------------|------------|----------------|------------|
| ** **                 | ** ** | **2005**         | ** ** | **2004**       | ** ** | **2005** | ** ** | **2004** | ** ** |
| Natural Gas (Mcf)          |       | 83               | %          | 89             | %          | 78 | % | 74 | % |
| Natural gas liquids (Bbls) |       | 4                | %          | 8              | %          | 11 | % | 14 | % |
| Crude oil (Bbl)            |       | 13               | %          | 3              | %          | 11 | % | 12 | % |
|                       |       |             |       |           |       |   |   |   |   |
| Total (Mcfe)               |       | 100              | %          | 100            | %          | 100 | % | 100 | % |

 

----

(1) Includeseffect of hedging and derivative transactions.

 

The followingtable summarizes volume and price information with respect to our oil and gasproduction for the third quarter of 2005 and 2004:

 
| ** **                                  | ** ** | ** **             | ** ** | **2005 Period Compared to 2004 Period** | ** ** |
|---------------------------------------------|------------|------------------------|------------|----------------------------------------------|------------|
| ** **                                  | ** ** | **Three Months Ended** | ** ** | **$**                                        | ** ** | **%** | ** ** |
| ** **                                  | ** ** | **September 30,** | ** ** | **Increase**                                 | ** ** | **Increase** | ** ** |
| ** **                                  | ** ** | **2005**               | ** ** | **2004**                                     | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
| **Production Volumes:**                     |       |                   |       |                                         |       |   |   |   |   |
| Natural gas (Mcf)                           |       | 2,991,548              |       | 2,077,791                                    |       | 913,757 |   | 44 | % |
| Natural gas liquids (Bbls)                  |       | 73,217                 |       | 63,857                                       |       | 9,360 |   | 15 | % |
| Oil and condensate (Bbls)                   |       | 70,029                 |       | 56,415                                       |       | 13,614 |   | 24 | % |
| Natural gas equivalent (Mcfe)               |       | 3,851,024              |       | 2,799,423                                    |       | 1,051,601 |   | 38 | % |
| **Average Sales Price:**                    |       |                   |       |                                         |       |   |   |   |   |
| Natural gas ($ per Mcf)(1)             |       | $                      | 8.54       |                                         | $          | 5.74 |   | $ | 2.80 |   | 49 | % |
| Natural gas liquids ($ per Bbl)        |       | $                      | 17.01      |                                         | $          | 16.27 |   | $ | 0.74 |   | 5 | % |
| Oil and condensate ($ per Bbl)(1)      |       | $                      | 59.89      |                                         | $          | 39.17 |   | $ | 20.72 |   | 53 | % |
| Natural gas equivalent ($ per Mcfe)(1) |       | $                      | 8.04       |                                         | $          | 5.42 |   | $ | 2.62 |   | 48 | % |
| Natural gas equivalent ($ per Mcfe)(2) |       | $                      | 7.68       |                                         | $          | 4.73 |   | $ | 2.95 |   | 62 | % |
| **Operating Revenue:**                      |       |                   |       |                                         |       |   |   |   |   |
| Natural gas (1)                             |       | $                      | 25,540,010 |                                         | $          | 11,933,309 |   | $ | 13,606,701 |   | 114 | % |
| Natural gas liquids                         |       | 1,245,212              |       | 1,038,811                                    |       | 206,401 |   | 20 | % |
| Oil and condensate (1)                      |       | 4,194,008              |       | 2,209,754                                    |       | 1,984,254 |   | 90 | % |
| Loss on hedging and derivatives             |       | (1,394,503             | )          | (1,939,409                                   | )          | 544,906 |   | (28 | )% |
| Total                                       |       | $                      | 29,584,727 |                                         | $          | 13,242,465 |   | $ | 16,342,262 |   | 123 | % |

 

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(1) Excludesthe effect of hedging and derivative transactions.

(2) Includesthe effect of hedging and derivative transactions.

 

Natural gas revenue, excluding hedging activity,increased 114% for the three months ended September 30, 2005 over the sameperiod in 2004 due to significantly higher production and higher realizedprices. Excluding the effect of hedges, the average natural gas sales price forproduction in the three months ended September 30, 2005 was $8.54 per Mcfcompared to $5.74 per Mcf for the same period in 2004.  This increase in average price receivedresulted in increased revenue of approximately $8.4 million (based on currentyear production). Average natural gas production increased 44% from 2.1 Bcfe inthe three months ended September 30, 2004 to 3.0 Bcfe in the comparable2005 period due to production from new wells acquired on December 29, 2004in south Texas, new wells drilled, primarily in our Encinitas, Gato Creek,southeast New Mexico and other acquired properties, partially

 

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offset by natural declines on other properties. The overall increase inproduction compared to the prior year period resulted in an increase in revenueof approximately $5.2 million (based on 2004 comparable period pre-hedgeprices).

 

Revenue from the sale of NGLs increased 20% for thethree months ended September 30, 2005 over the same period in 2004.Production volumes for NGLs increased 15%, from 63.9 MBbls for the three monthsended September 30, 2004 to 73.2 MBbls for the three months ended September 30,2005 due primarily to increased production from new wells at Encinitas and GatoCreek, partially offset by natural declines on other properties. The increasein NGL production increased revenue by approximately $152,300 (based on 2004comparable period average prices). Higher average realized prices for the three months ended September 30,2005 resulted in an increase in revenue of approximately $54,100 (based oncurrent year production).  The averagerealized price for NGLs for the three months ended September 30, 2005 was$17.01 per barrel compared to $16.27 per barrel for the same period in 2004.

 

Revenue from the sale of oil and condensate, excludingderivative activity, increased 90% for the three months ended September 30,2005 as compared to the comparable prior year period in 2004 due to the higherprice environment and increased production. The average realized price for oiland condensate before the derivative losses for the three months ended September 30,2005 was $59.89 per barrel compared to $39.17 per barrel in the same period of2004.  These higher average prices forthe three months ended September 30, 2005 resulted in an increase inrevenue of approximately $1.5 million (based on current year production).  Production volumes increased due primarily toproduction from the south Texas asset acquisition that closed on December 29,2004, as well as new wells drilled on our New Mexico and other acquiredproperties. The increase in oil and condensate production resulted in anincrease in revenue of approximately $0.5 million (based on 2004 comparableperiod average prices).

 

Totalrevenues were reduced by realized and unrealized losses related to our naturalgas hedges and oil derivatives. For the three months ended September 30,2005, we recorded $0.6 million of realized losses on oil derivativessettlements and $0.2 million of unrealized gains representing the change in themark-to-market fair value of our outstanding oil derivative contracts. Thesenet losses account for a $6.11 per barrel decrease in the realized oil pricefor the three months ended September 30, 2005 from $59.89 per barrel to$53.78 per barrel. We did not apply hedge accounting to these transactions (seeNote 7 to our consolidated financial statements).  This compares to $0.3 million of realizedlosses on oil derivatives settlements and $1.4 million of unrealized lossesrepresenting the change in the mark-to-market fair value of our outstanding oilderivative contracts for the three months ended September 31, 2004. Thesenet losses account for a $30.87 per barrel decrease in the realized oil pricefor the three months ended September 30, 2004 from $39.17 per barrel to$8.30 per barrel. We also recorded $1.0 million of settlements, representing adecrease of $0.32 per Mcf, on our natural gas hedges for the three months endedSeptember 30, 2005.  We had nosettlement impact from expiring natural gas hedge contracts for the threemonths ended September 30, 2004, but recognized $0.2 million of thepremium paid for a natural gas hedge entered into in 2003, representing $0.10per Mcf. Should commodity prices move outside the bounds of our collars, itcould materially affect our revenues.

 

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**Costs and Operating Expenses**

 

Thetable below presents a detail of our expenses for the three months ended September 30,2005 and 2004:

 
| ** **                                           | ** ** | ** **             | ** ** | **2005 Period Compared to 2004 Period** | ** ** |
|------------------------------------------------------|------------|------------------------|------------|----------------------------------------------|------------|
| ** **                                           | ** ** | **Three Months Ended** | ** ** | **$**                                        | ** ** | **%** | ** ** |
| ** **                                           | ** ** | **September 30,** | ** ** | **Increase**                                 | ** ** | **Increase** | ** ** |
| ** **                                           | ** ** | **2005**               | ** ** | **2004**                                     | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
|                                                 |       |                   |       |                                         |       |   |   |   |   |
| Oil and natural gas operating expenses               |       | $                      | 2,369,882  |                                         | $          | 1,176,732 |   | $ | 1,193,150 |   | 101 | % |
| Severance and ad valorem taxes                       |       | 1,845,462              |       | 891,194                                      |       | 954,268 |   | 107 | % |
| Depreciation, depletion, amortization and accretion: |       |                   |       |                                         |       |   |   |   |   |
| Oil and gas property and equipment                   |       | 8,209,512              |       | 5,002,010                                    |       | 3,207,502 |   | 64 | % |
| Other assets                                         |       | 67,745                 |       | 103,815                                      |       | (36,070 | ) | (35 | )% |
| ARO accretion                                        |       | 34,027                 |       | 27,627                                       |       | 6,400 |   | 23 | % |
| General and administrative:                          |       |                   |       |                                         |       |   |   |   |   |
| Deferred compensation – repriced options        |       | 1,758,848              |       | (153,808                                     | )          | 1,912,656 |   | 1,244 | % |
| Deferred compensation – restricted stock        |       | 273,057                |       | 143,500                                      |       | 129,557 |   | 90 | % |
| Bad debt expense                                     |       | 54,157                 |       | —                                       |       | 54,157 |   | * |   |
| Other general and administrative                     |       | 2,470,611              |       | 1,844,062                                    |       | 626,549 |   | 34 | % |
|                                                 |       | 17,083,301             |       | 9,035,132                                    |       | 8,048,169 |   | 89 | % |
| Other expense, net                                   |       | 8,096                  |       | 50,065                                       |       | (41,969 | ) | (84 | )% |
| Total                                                |       | $                      | 17,091,397 |                                         | $          | 9,085,197 |   | $ | 8,006,200 |   | 88 | % |

 

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*Not meaningful.

 

Oil and natural gas operating expenses are theday-to-day costs incurred to bring hydrocarbons out of the ground and to themarket, combined with the daily costs incurred to maintain our producing properties.For the three months ended September 30, 2005 these costs on an absolutebasis increased 101% over the same period of 2004. A substantial portion ofthis cost increase can be attributed to our increased production. On an Mcfebasis, costs have increased 48% from $0.42 per Mcfe for the three months ended September 30,2004 to $0.62 per Mcfe for the three months ended September 30, 2005. The December 29,2004 south Texas asset acquisition of producing properties contributed 44% ofthe increase in costs and new wells drilled since September 30, 2004 furtherincreased the costs for the three months ended September 30, 2005 comparedto the prior year. We are experiencing increased costs due to increased demandfor oil field products and services. The oil and natural gas industry tends tobe cyclical in nature and the demand for goods and services of oil fieldcompanies, suppliers and others associated with the industry can put extremepressure on the economic stability and pricing structure within the industry.Typically, as prices for oil and natural gas increase, so do associated costs.When commodity prices decline, associated costs do not necessarily decline atthe same rate.

 

Severanceand ad valorem taxes for the three months ended September 30, 2005increased 107% from the same period of 2004. Severance tax expense for the three months ended September 30, 2005was 106% higher than the comparable prior year period as a result of higherrevenue. Our severance tax expense is levied on our oil and gas revenue dollars(excluding hedging and derivative impact), so if commodity prices remain high,we expect to continue to incur higher severance tax expense. For the threemonths ended September 30, 2005, severance tax expense was approximately 5.3%of revenue subject to severance taxes compared to 5.2% of revenue subject toseverance taxes for the comparable 2004 period. Ad valorem tax expense for thethree months ended September 30, 2005 was impacted by increased accrualsfor the estimated costs related to the addition of the south Texas propertiesacquired on December 29, 2004. On an equivalent basis, severance and advalorem taxes averaged $0.48 per Mcfe and $0.32 per Mcfe for the three monthsended September 30, 2005 and 2004, respectively.

 

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Depletion,depreciation, and amortization (“DD&A”) represents the systematic expensingof capital costs. As a full cost company, we capitalize all costs associatedwith our acquisition, exploration and development efforts, and apportion thesecosts to each unit of production through depletion expense. Other assetsrepresent non-oil and gas assets such as furniture, computers and leaseholdimprovements in our corporate office that are capitalized and apportioned to expenseusing straight line depreciation. Accretion expense is the systematic accretionof future abandonment costs of our properties. For the three months ended September 30,2005, DD&A and accretion expense totaled $8.3 million compared to $5.1million for the same period of 2004. Depletion on our oil and natural gas properties increased 64% for thethree months ended September 30, 2005 compared to the same period of 2004due to an increase in production levels and in the unit-of-production depletionrate from $1.79 per Mcfe for the three months ended September 30, 2004 ascompared to $2.13 per Mcfe in the same period in 2005. The increase indepletion expense from the higher production levels in the three months ended September 30,2005 as compared to the same period of 2004 resulted in an increase in expenseof approximately $1.9 million. The increase in depletion rate for the threemonths ended September 30, 2005 compared to the same period of 2004 addedapproximately $1.3 million in depletion expense. Our depletion rate hasincreased due to increased spending on our drilling program withdisproportionate reserve additions. Depreciation of other assets for the threemonths ended September 30, 2005 decreased 35% compared to the same prioryear period due to several larger depreciable assets that became fullydepreciated by year-end 2004 and are not currently contributing to expense.Accretion expense associated with our asset retirement obligations for thethree months ended September 30, 2005 increased 23% over the same prioryear period for the new obligations incurred from the wells drilled andacquired since September 30, 2004.

 

G&Aexpense includes overhead, payroll and benefits of our corporate staff, costsof maintaining our headquarters, managing our production and developmentoperations and legal compliance. Total G&A for the three months ended September 30,2005 was $4.6 million, an increase of 148% compared to the same prior yearperiod total of $1.8 million. Pursuant to FIN 44 discussed in Note 1 to theconsolidated financial statements, G&A costs include deferred compensationrelated to repriced options, deferred compensation related to restricted stockgrants and other G&A costs. A FIN44 charge of $1.8 million was incurred for the three months ended September 30,2005 compared to a credit of $0.2 million in the same period of 2004. Amortizationrelated to restricted stock awards granted over the past three years totaled $0.3million and $0.1 million, respectively, for the three months ended September 30,2005 and 2004. The increase relates to new grants that have occurred since the September 30,2004. We recorded $54,157 of bad debt expense during the third quarter 2005 toincrease our allowance for doubtful accounts receivable, joint interest owners.We then wrote off approximately $0.1 million of accounts receivable, jointinterest owners, that had been reserved in the past and were now deemeduncollectible.  Other G&A for thethree months ended September 30, 2005, which does not include the deferredcompensation expenses discussed above, totaled $2.5 million, a 34% increasefrom the comparable 2004 period total of $1.8 million. The increase in otherG&A was attributable to higher salaries and benefits, due in part to higherstaffing levels, as well as higher rent expense for additional office space,higher board of director compensation, higher franchise taxes and higherprofessional fees for auditors and lawyers, partially offset by reductions infees paid to consultants for Sarbanes-Oxley implementation. For the threemonths ended September 30, 2005 and 2004, overhead reimbursement feesreduced G&A costs by $24,819 and $49,716, respectively. We capitalizeG&A expense directly related to our acquisition, exploration anddevelopment activities. Capitalized G&A costs further reduced other G&Aby $0.7 million and $0.6 million for the three months ended September 30,2005 and 2004, respectively.  OtherG&A on a unit of production basis for the three months ended September 30,2005 was $0.64 per Mcfe compared to $0.66 per Mcfe for the comparable 2004period.

 

Other expense for the three months ended September 30,2005 excludes interest expense because 100% of our interest expense for thequarter was capitalized as compared to only a portion being capitalized in thesame 2004 period. We incurred higher interest costs for the three months ended September 30,2005 than for the same period of 2004 due to commitment fees for borrowing baseincreases and fees on available funds that is a new charge associated with ourcredit facility in 2005, but we capitalized all of this interest expense as aresult of our unproved property balance exceeding our debt balance.

 

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| ** **                 | ** ** | **For the Three Months Ended  September 30,** | ** ** |
|----------------------------|------------|----------------------------------------------------|------------|
| ** **                 | ** ** | **2005**                                           | ** ** | **2004** | ** ** |
|                       |       |                                               |       |   |   |
| Gross interest             |       | $                                                  | 262,835    |   | $ | 188,843 |   |
| Less: Capitalized interest |       | (262,835                                           | )          | (166,639 | ) |
| Interest expense, net      |       | $                                                  | —     |   | $ | 22,204 |   |
|                       |       |                                               |       |   |   |
| Weighted Average Debt      |       | $                                                  | 14,228,261 |   | $ | 19,000,000 |   |

 

We also recorded amortization of deferred loan costsrelated to our amended credit facility during the three months ended September 30,2005 and 2004, as well as interest income earned on our outstanding daily cashbalances.

 

We are subject to state and federal income taxes andalthough we are currently generating taxable income for financial reportingpurposes, we are not in a federal income tax paying position as a result ofdeducting intangible drilling costs (“IDC”) that reduce our taxable income forincome tax purposes and NOL carryforwards that offset any remaining taxableincome. A deferred income tax provision was recorded for the three months endedSeptember 30, 2005 and 2004 of $4.4 million and $1.5 million,respectively. The increase resulted from higher pre-tax income in 2005 ascompared to 2004.

 

Forthe three months ended September 30, 2005, we had net income of $8.1million, or $0.47 basic earnings per share and $0.45 diluted earnings pershare, as compared to net income of $2.7 million, or $0.21 basic earnings pershare and $0.20 diluted earnings per share in the comparable 2004 period. Basicweighted average shares outstanding increased for the three months ended September 30,2005 over the same period 2004 primarily due to the stock offering completed inDecember 2004 and the related over-allotment exercise in January 2005.We issued a total of 4,025,000 shares in these transactions.

 

**NineMonths Ended September 30, 2005 Compared to the Nine Months Ended September 30,2004**

 

**Revenue and Production**

 

Total revenueincreased 75% from the first nine months of 2004 to the comparable 2005period.  For the nine months ended September 30,2005 and 2004, our product mix contributed the following percentages ofrevenues and production:

 
| ** **                 | ** ** | **REVENUES (1)** | ** ** | **PRODUCTION** | ** ** |
|----------------------------|------------|------------------|------------|----------------|------------|
| ** **                 | ** ** | **2005**         | ** ** | **2004**       | ** ** | **2005** | ** ** | **2004** | ** ** |
| Natural Gas (Mcf)          |       | 82               | %          | 84             | %          | 76 | % | 76 | % |
| Natural gas liquids (Bbls) |       | 5                | %          | 7              | %          | 12 | % | 13 | % |
| Crude oil (Bbl)            |       | 13               | %          | 9              | %          | 12 | % | 11 | % |
|                       |       |             |       |           |       |   |   |   |   |
| Total (Mcfe)               |       | 100              | %          | 100            | %          | 100 | % | 100 | % |

 

----

(1) Includeseffect of hedging and derivative transactions.

 

32

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The followingtable summarizes volume and price information with respect to our oil and gasproduction for the nine-month periods ended September 30, 2005 and 2004:

 
| ** **                                  | ** ** | ** **             | ** ** | **2005 Period Compared  to 2004 Period** | ** ** |
|---------------------------------------------|------------|------------------------|------------|------------------------------------------|------------|
| ** **                                  | ** ** | **Nine Months Ended**  | ** ** | **$**                                    | ** ** | **%** | ** ** |
| ** **                                  | ** ** | **September 30,** | ** ** | **Increase**                             | ** ** | **Increase** | ** ** |
| ** **                                  | ** ** | **2005**               | ** ** | **2004**                                 | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
| **Production  Volumes:**                    |       |                   |       |                                     |       |   |   |   |   |
| Natural gas (Mcf)                           |       | 9,276,710              |       | 6,797,836                                |       | 2,478,874 |   | 36 | % |
| Natural gas liquids (Bbls)                  |       | 240,456                |       | 190,944                                  |       | 49,512 |   | 26 | % |
| Oil and condensate (Bbls)                   |       | 232,623                |       | 156,075                                  |       | 76,548 |   | 49 | % |
| Natural gas equivalent (Mcfe)               |       | 12,115,184             |       | 8,879,950                                |       | 3,235,234 |   | 36 | % |
| **Average Sales Price:**                    |       |                   |       |                                     |       |   |   |   |   |
| Natural gas ($ per Mcf)(1)             |       | $                      | 6.99       |                                     | $          | 5.67 |   | $ | 1.32 |   | 23 | % |
| Natural gas liquids ($ per Bbl)        |       | $                      | 17.22      |                                     | $          | 15.40 |   | $ | 1.82 |   | 12 | % |
| Oil and condensate ($ per Bbl)(1)      |       | $                      | 52.10      |                                     | $          | 36.70 |   | $ | 15.40 |   | 42 | % |
| Natural gas equivalent ($ per Mcfe)(1) |       | $                      | 6.70       |                                     | $          | 5.32 |   | $ | 1.38 |   | 26 | % |
| Natural gas equivalent ($ per Mcfe)(2) |       | $                      | 6.50       |                                     | $          | 5.06 |   | $ | 1.44 |   | 28 | % |
| **Operating Revenue:**                      |       |                   |       |                                     |       |   |   |   |   |
| Natural gas (1)                             |       | $                      | 64,875,582 |                                     | $          | 38,535,571 |   | $ | 26,340,011 |   | 68 | % |
| Natural gas liquids                         |       | 4,140,581              |       | 2,939,992                                |       | 1,200,589 |   | 41 | % |
| Oil and condensate (1)                      |       | 12,120,043             |       | 5,728,237                                |       | 6,391,806 |   | 112 | % |
| Loss on hedging and derivatives             |       | (2,397,181             | )          | (2,299,274                               | )          | (97,907 | ) | 4 | % |
| Total                                       |       | $                      | 78,739,025 |                                     | $          | 44,904,526 |   | $ | 33,834,499 |   | 75 | % |

 

----

(1) Excludesthe effect of hedging and derivative transactions.

(2) Includesthe effect of hedging and derivative transactions.

 

Natural gas revenue, excluding hedging activity,increased 68% for the nine months ended September 30, 2005 over the sameperiod in 2004 due to significantly higher production and higher realizedprices. Average natural gas production increased 36% from 6.8 Bcfe in the ninemonths ended September 30, 2004 to 9.3 Bcfe in the comparable 2005 perioddue to production from new wells acquired on December 29, 2004 in southTexas, new wells drilled, primarily on our Encinitas, Gato Creek, southeast NewMexico and other acquired properties, partially offset by natural declines onother properties. The overall increase in production compared to the prior yearperiod resulted in an increase in revenue of approximately $14.0 million (basedon 2004 comparable period pre-hedge prices).  Excluding the effect of hedges, the averagenatural gas sales price for production in the nine months ended September 30,2005 was $6.99 per Mcf compared to $5.67 per Mcf for the same period in2004.  This increase in average pricereceived resulted in increased revenue of approximately $12.3 million (based oncurrent year production).

 

Revenue from the sale of NGLs increased 41% for the ninemonths ended September 30, 2005 over the same period in 2004. Productionvolumes for NGLs increased 26%, from 190.9 MBbls for the nine months ended September 30,2004 to 240.5 MBbls for the nine months ended September 30, 2005 dueprimarily to increased production from new wells at Encinitas and Gato Creek,partially offset by natural declines on our other properties. The increase inNGL production increased revenue by approximately $0.8 million (based on 2004comparable period average prices). Higher average realized prices for the nine months ended September 30,2005 resulted in an increase in revenue of approximately $0.4 million (based oncurrent year production).  The averagerealized price for NGLs for the nine months ended September 30, 2005 was$17.22 per barrel compared to $15.40 per barrel for the same period in 2004.

 

Revenue from the sale of oil and condensate, excludingderivative activity, increased 112% for the nine months ended September 30,2005 as compared to the comparable prior year period in 2004 due to higherprice environment and increased production. The average realized price for oiland condensate before the derivative losses

 

33

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for the nine months ended September 30, 2005 was $52.10 per barrelcompared to $36.70 per barrel in the same period of 2004.  These higher average prices for the nine monthsended September 30, 2005 resulted in an increase in revenue ofapproximately $3.6 million (based on current year production).  Production volumes for oil and condensateincreased 49% to 232.6 MBbls for the nine months ended September 30, 2005compared to 156.1 MBbls for the same prior year period due primarily toproduction from the south Texas asset acquisition that closed on December 29,2004, as well as new wells drilled on our Miller, Encinitas and Gato Creekproperties. The increase in oil and condensate production resulted in anincrease in revenue of approximately $2.8 million (based on 2004 comparableperiod average prices).

 

Revenueswere reduced by realized and unrealized losses related to our natural gashedges and oil derivatives. For the nine months ended September 30, 2005,we recorded $1.2 million of realized losses on oil derivatives settlements and$0.4 million of unrealized losses representing the change in the mark-to-marketfair value of our outstanding oil derivative contracts. These net lossesaccount for a $6.82 per barrel decrease in the realized oil price for the ninemonths ended September 30, 2005 from $52.10 per barrel to $45.28 perbarrel. We did not apply hedge accounting to these transactions (see Note 7 toour consolidated financial statements). This compares to $0.4 million of realized losses on oil derivativessettlements and $1.3 million of unrealized losses representing the change inthe mark-to-market fair value of our outstanding oil derivative contracts forthe nine months ended September 30, 2004. These net losses account for a$10.67 per barrel decrease in the realized oil price for the nine months ended September 30,2004 from $36.70 per barrel to $26.03 per barrel. We also recorded $0.8 millionof settlements, representing a decrease of $0.09 per Mcf, on our natural gashedges for the nine months ended September 30, 2005.  This compares to $0.2 million of settlementsand recognition of $0.4 million of the premium paid for a natural gas hedgeentered into in 2003, representing an aggregate $0.09 per Mcf decrease in theprice realized during the first nine months of 2004. Should commodity pricesmove outside the bounds of our collars, it could materially affect ourrevenues.

 

**Costs and Operating Expenses**

 

Thetable below presents a detail of our expenses for the nine months ended September 30,2005 and 2004:

 
| ** **                                           | ** ** | ** **             | ** ** | **2005 Period Compared  to 2004 Period** | ** ** |
|------------------------------------------------------|------------|------------------------|------------|------------------------------------------|------------|
| ** **                                           | ** ** | **Nine Months Ended**  | ** ** | **$**                                    | ** ** | **%** | ** ** |
| ** **                                           | ** ** | **September 30,** | ** ** | **Increase**                             | ** ** | **Increase** | ** ** |
| ** **                                           | ** ** | **2005**               | ** ** | **2004**                                 | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
|                                                 |       |                   |       |                                     |       |   |   |   |   |
| Oil and natural gas operating expenses               |       | $                      | 6,414,396  |                                     | $          | 3,601,898 |   | $ | 2,812,498 |   | 78 | % |
| Severance and ad valorem taxes                       |       | 5,496,787              |       | 3,146,116                                |       | 2,350,671 |   | 75 | % |
| Depreciation, depletion, amortization and accretion: |       |                   |       |                                     |       |   |   |   |   |
| Oil and gas property and equipment                   |       | 25,589,349             |       | 15,154,311                               |       | 10,435,038 |   | 69 | % |
| Other assets                                         |       | 195,006                |       | 282,815                                  |       | (87,809 | ) | (31 | )% |
| ARO accretion                                        |       | 101,556                |       | 80,128                                   |       | 21,428 |   | 27 | % |
| General and administrative:                          |       |                   |       |                                     |       |   |   |   |   |
| Deferred compensation – repriced options        |       | 1,930,493              |       | 1,294,677                                |       | 635,816 |   | 49 | % |
| Deferred compensation – restricted stock        |       | 679,401                |       | 354,600                                  |       | 324,801 |   | 92 | % |
| Bad debt expense                                     |       | 65,157                 |       | —                                   |       | 65,157 |   | * |   |
| Other general and administrative                     |       | 7,306,749              |       | 5,476,342                                |       | 1,830,407 |   | 33 | % |
|                                                 |       | 47,778,894             |       | 29,390,887                               |       | 18,388,007 |   | 63 | % |
| Other expense, net                                   |       | 22,691                 |       | 332,101                                  |       | (309,410 | ) | (93 | )% |
| Total                                                |       | $                      | 47,801,585 |                                     | $          | 29,722,988 |   | $ | 18,078,597 |   | 61 | % |

 

----

*Not meaningful

 

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Oil and natural gas operating expenses for the ninemonths ended September 30, 2005 increased 78% over the same period of2004. A significant portion of this cost increase can be attributed to ourincreased production. On a Mcfe basis, costs have increased 29% from $0.41 perMcfe for the nine months ended September 30, 2004 to $0.53 per Mcfe forthe nine months ended September 30, 2005. The December 29, 2004 southTexas asset acquisition of producing properties contributed approximately 44%of the increase in costs and new wells drilled since September 30, 2004 furtherincreased the costs for the nine months ended September 30, 2005 comparedto the prior year.  During the first ninemonths of 2005, we also recognized higher expenses attributable to the fourthquarter 2004 than originally estimated in our year-end accruals for ourEncinitas, Gato Creek and other acquired properties, which equated toapproximately 16% of the increase in costs. We also experienced increased costson our Gato Creek properties for the addition of 10 new wells since September 30,2004, which equates to 21% of the increase. Again, costs are increasing due toincreased demand for oil field products and services. The oil and natural gasindustry tends to be cyclical in nature and the demand for goods and servicesof oil field companies, suppliers and others associated with the industry canput extreme pressure on the economic stability and pricing structure within theindustry. Typically, as prices for oil and natural gas increase, so do allassociated costs. When commodity prices decline, associated costs do notnecessarily decline at the same rate.

 

Severanceand ad valorem taxes for the nine months ended September 30, 2005increased 75% from the same period in 2004. Severance tax expense for the nine months ended September 30, 2005was 67% higher than the comparable prior year period as a result of higherrevenue. Our severance tax expense is levied on our oil and gas revenue dollars(excluding hedging and derivative impact), so if commodity prices remain high,we expect to continue to incur higher severance tax expense. For the ninemonths ended September 30, 2005, severance tax expense was approximately 5.8%of revenue subject to severance taxes compared to 6.0% of revenue subject toseverance taxes for the comparable 2004 period. Ad valorem tax expense for the ninemonths ended September 30, 2005 was impacted by increased accruals for theestimated costs related to the addition of the south Texas properties acquiredon December 29, 2004.  On anequivalent basis, severance and ad valorem taxes averaged $0.45 per Mcfe and$0.35 per Mcfe for the nine months ended September 30, 2005 and 2004,respectively.

 

DD&Aand accretion expense for the nine months ended September 30, 2005 totaled$25.9 million compared to $15.5 million for the nine months ended September 30,2004.  Depletion on our oil and naturalgas properties increased 69% for the nine months ended September 30, 2005compared to the same period of 2004 due to an increase in production levels andin the unit-of-production depletion rate from $1.71 per Mcfe in the nine monthsended September 30, 2004 as compared to $2.11 per Mcfe in the comparable2005 period. The increase in depletion expense from the higher productionlevels in the nine months ended September 30, 2005 as compared to the sameperiod of 2004 resulted in an increase in expense of approximately $5.5million. The increase in depletion rate for the nine month ended September 30,2005 compared to the same prior year period added approximately $4.9 million indepletion expense. Our depletion rate has increased due to increased spendingon our drilling program with disproportionate reserve additions. Depreciation onother assets decreased 31% compared to the nine months ended September 30,2004 due to several larger depreciable assets that became fully depreciated byyear-end 2004 and are not currently contributing to expense. Accretion expenseassociated with our asset retirement obligations for the nine months ended September 30,2005 increased 27% over the same prior year period for the new obligationsincurred from the wells drilled in 2004 and 2005, as well as those south Texasproperties acquired on December 29, 2004.

 

TotalG&A for the nine months ended September 30, 2005 was $10.0 million, anincrease of 40% compared to the prior year nine months total of $7.1 million. A FIN 44 charge of $1.9 million was incurredfor the nine months ended September 30, 2005 compared to $1.3 million inthe same period of 2004. Amortization related to restricted stock awardsgranted over the past three years totaled $0.7 million and $0.4 million,respectively, for the nine months ended September 30, 2005 and 2004. Theincrease relates to new grants that have occurred since September 30,2004. We recorded $65,157 of bad debt expense and wrote off approximately $0.1million in JIB Accounts Receivable deemed uncollectible. Other G&A for the ninemonths ended September 30, 2005, which does not include the deferredcompensation expenses discussed above, totaled $7.3 million, a 33% increasefrom the comparable 2004 period total of $5.5 million. The increase in otherG&A was attributable to higher salaries and benefits, due in part to higherstaffing levels, as well as higher rent expense for additional office space,higher board of director compensation, increased audit and Sarbanes-Oxley 404audit fees, franchise tax expense and costs relating to strategic planning. Forboth the nine months ended September 30, 2005 and 2004, overheadreimbursement fees reduced G&A costs by $0.2 million. Capitalized G&Acosts further reduced other G&A by $2.0

 

35

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million and $1.6 millionfor the nine months ended September 30, 2005 and 2004, respectively.  Other G&A on a unit of production basisfor the nine months ended September 30, 2005 was $0.60 per Mcfe comparedto $0.62 per Mcfe for the comparable 2004 period.

 

Other expense for the nine months ended September 30,2005 excludes interest expense because 100% of our interest expense for the ninemonths ended September 30, 2005 was capitalized as compared to only aportion of interest expense in the same 2004 period. We incurred higherinterest costs for the nine months ended September 30, 2005 than for thesame period of 2004 due to higher commitment fees and higher interest rates,but we capitalized all of our expense as a result of our unproved propertybalance exceeding our outstanding debt balance.

 
| ** **                 | ** ** | **For the Nine Months Ended  September 30,** | ** ** |
|----------------------------|------------|---------------------------------------------------|------------|
| ** **                 | ** ** | **2005**                                          | ** ** | **2004** | ** ** |
|                       |       |                                              |       |   |   |
| Gross interest             |       | $                                                 | 742,924    |   | $ | 620,005 |   |
| Less: Capitalized interest |       | (742,924                                          | )          | (378,118 | ) |
| Interest expense, net      |       | $                                                 | —     |   | $ | 241,887 |   |
|                       |       |                                              |       |   |   |
| Weighted Average Debt      |       | $                                                 | 12,487,179 |   | $ | 19,806,569 |   |

 

We also recorded amortization of deferred loan costsrelated to our amended credit facility during the nine months ended September 30,2005 and 2004, as well as interest income earned on our outstanding daily cashbalances.

 

An income tax provision was recorded for the ninemonths ended September 30, 2005 and 2004 of $10.9 million and $5.4million, respectively. The increase resulted from higher pre-tax income in 2005as compared to 2004.

 

For the ninemonths ended September 30, 2005, we had net income of $20.1 million, or $1.17basic earnings per share and $1.13 diluted earnings per share, as compared tonet income of $9.8 million, or $0.76 basic earnings per share and $0.73 dilutedearnings per share in the comparable 2004 period. Basic weighted average sharesoutstanding increased for the nine months ended September 30, 2005 overthe same period 2004 primarily due to the stock offering completed in December 2004and the related over-allotment exercise in January 2005. We issued a totalof 4,025,000 shares in these transactions.

 

## **Liquidity and CapitalResources**

 

Ourprimary ongoing source of capital is the cash flow generated from our operatingactivities supplemented by borrowings under our credit facility.  Net cash generated from operating activitiesis a function of production volumes, commodity prices (which are inherently volatileand unpredictable), operating efficiency and capital spending. Our business, aswith other extractive industries, is a depleting one in which each gasequivalent unit produced must be replaced or our business, and a criticalsource of our future liquidity, will shrink. Our overall existing productionhas a decline rate of approximately 20% per year.  Less predictable than production declinesfrom our proved reserves is the impact of constantly changing oil and naturalgas prices on cash flows and, therefore capital budgets.  We attempt to mitigate the price risk withour hedging program. Reserves and production volumes are influenced, in part,by the amount of future capital expenditures. In turn, capital expenditures areinfluenced by many factors including drilling results, oil and gas prices,industry conditions, availability and prices of goods and services and theextent to which oil and gas properties are acquired.

 

Ourprimary needs for capital 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 capital expenditures in response to changes in oiland natural gas prices, drilling and acquisition costs, and cash flow. We havehistorically used our credit facility to supplement any deficiencies betweenoperating cash flow and capital expenditures. We typically fund acquisitionsfrom borrowings

 

36

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under our creditfacility, cash flow from operations and sales of common stock. The ChapmanRanch Field acquisitions are expected to be funded with borrowings under our currentcredit facility.

 

Significantchanges to working capital may affect our liquidity in the short term. Theincrease in the derivative instrument liability is indicative of potentialfuture cash settlements on our hedge positions as the months settle. The fair marketvalue of our outstanding hedge and derivative contracts is reflected on thebalance sheet as a liability for the positions with each of our twocounterparties. This hedge and derivative financial instrument is a liability becausethe future strip commodity prices exceed the price caps on our contracts at thebalance sheet date, such that if the contracts were to settle at the balancesheet date we would have significant losses. The fair market value representsthe potential settlement for those contracts if the market prices remainunchanged, but should commodity prices increase or decrease, the fair value ofthose outstanding contracts would change and the settlements at maturity wouldalso change.. When our hedges and derivatives require cash settlement to bepaid by Edge, we are receiving higher cash inflows on the sale of unhedgedproduction at higher prices, therefore the use of those funds would adequatelycover any derivative and hedge payments when they come due.

 

Afterconsidering the impact of these working capital changes and our forecasts offuture results of operations, we believe that cash flows from operatingactivities, as supplemented by borrowings on our credit facility, combined withour ability to control the timing of the majority of our future exploration anddevelopment requirements will provide us with the flexibility and liquidity tomeet our planned capital requirements for 2005. In addition, our creditfacility had $50.0 million available at September 30, 2005 for generalcorporate purposes, exploratory and developmental drilling and acquisitions ofoil and gas properties. On October 12, 2005 we borrowed $26.0 million inorder to fund the first of the Chapman Ranch Field acquisitions that closed on October 13,2005, therefore we now have $46.0 million outstanding under our creditfacility, with $24.0 million available to borrow. Our lender is currentlyredetermining our borrowing base, and we expect it to increase as a result ofthe recently completed Chapman Ranch Field acquisition and our recentsuccessful drilling activities. The maturity date for the credit facility is December 31,2007.

 

During2004 and early 2005, we realized increased cash flows as a result of our publicstock offerings and activity in stock option and warrant exercises. Mostsignificantly were the net proceeds of $47.8 million that we received, beforedirect costs of $0.6 million, from our December 2004 offering of ourcommon stock and the related exercise of the underwriter’s over-allotment optionfor 525,000 additional shares of our common stock, resulting in an additional$7.2 million of net proceeds to us in January 2005. We typically do notrely on proceeds from offerings and the exercise of warrants and stock optionsto sustain our business as they are unpredictable events.

 

We hadcash and cash equivalents at September 30, 2005 of $3.8 million consistingprimarily of short-term money market investments, as compared to $2.3 millionat December 31, 2004.  Workingcapital was $8.4 million as of September 30, 2005, as compared to $9.0million at December 31, 2004. We had $20.0 million outstanding under thecredit facility at September 30, 2005 and December 31, 2004. We paiddown debt early in 2005 with proceeds we received from the exercise of theunderwriter’s over-allotment option (see discussion above), and borrowed againin the fourth quarter 2005 (see discussion above) to fund the first of the ChapmanRanch Field acquisitions.

 

*Net Cash Provided By Operating Activities*

 

Cashflows provided by operating activities were $56.2 million for the nine monthsended September 30, 2005 compared to $34.4 million for the nine monthsended September 30, 2004. The increase in cash flows provided by operatingactivities for the nine months ended September 30, 2005 compared to 2004was primarily due to higher oil and gas production revenue partially offset byhigher operating expense.  Althoughfluctuations in commodity prices have been the primary reason for our short-termchanges in cash flow from operating activities, increased production volumessignificantly impacted us in the past few quarters. In an effort to reduce thevolatility realized on commodity prices, we enter into derivativeinstruments.  Due to inflated crude oil marketpricing, the impact related to the derivatives for the first nine months of2005 has been negative, as the prices have exceeded the highs we originallyexpected. We have realized the benefit of these high prices on our crude oilproduction, but also realized the negative impact from $1.2 million of cashsettlements on our crude oil derivatives. We have also paid $0.8 million of netcash settlements on our natural gas hedges due to the natural gas market pricesrising above our hedge ceilings. Overall, oil and gas production revenueincreased for the nine months ended September 30, 2005 as

 

37

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compared to the sameperiod in 2004 with a 36% increase in production and a 28% increase in theaverage net price received for our production.

 

*Net Cash Used In Investing Activities*

 

Wereinvest a substantial portion of our cash flows from operating activities inour drilling, acquisition, land and geophysical activities.  As a result, we used $61.9 million ininvesting activities during the first nine months of 2005. Capital expendituresof $45.1 million were attributable to our drilling program. In addition todrilling that was in progress at year-end 2004, we drilled 40 gross wellsduring the nine months ended September 30, 2005, all but two of which weresuccessful. Leasehold acquisitions, including seismic data and other geologicaland geophysical expenditures totaled $11.6 million and acquisition coststotaled $4.6 million for the nine months ended September 30, 2005. Theremaining capital expenditures were associated with computer hardware andoffice equipment. During the nine months ended September 30, 2004, we used$36.0 million in investing activities. We incurred capital expenditures of $32.9million attributable to the drilling of 30 gross wells, 23 of which weresuccessful.  Leasehold acquisitions,including seismic data and other geological and geophysical expenditures,totaled $2.6 million and acquisition costs totaled $0.1 million for the ninemonths ended September 30, 2004. The remaining capital expenditures wereassociated with computer hardware and office equipment.  Proceeds from the sale of oil and gasproperties totaled $45,000 during the nine months ended September 30,2004.

 

We currently anticipate our 2005 capital expenditures,before the effect of the Chapman Ranch Field acquisitions, to be in the rangeof $92-$96 million. Approximately $70.7 million is allocated to our expecteddrilling and production activities; $14.3 million is allocated to land, legaland seismic activities; $1.4 million to acquisitions (not including the ChapmanRanch Field acquisitions) and $5.5 million relates to capitalized interest andG&A and other. Based upon current expectations for production volumes andcommodity prices, we expect to fund these capital expenditures from internallygenerated cash from operating activities. We will fund the Chapman Ranch Field acquisitionswith borrowings under our credit facility. We do not explicitly budget foracquisitions; however, we do spend considerable effort evaluating acquisitionopportunities. We typically fund acquisitions through traditional oil and gasreserve-based bank debt and the issuance of common stock and, if required,through additional debt and equity financings and production payment financings.We currently have $46.0 million outstanding under our credit facility, afterborrowing $26.0 million to fund the first of the Chapman Ranch Fieldacquisitions in October 2005. This leaves us with $24.0 million of unusedborrowing capacity under our credit facility, which is currently being redetermined,and $390 million of unused capacity under our current shelf registrationstatement. After giving effect to the Chapman Ranch Field acquisitions and ourongoing drilling activities, we expect our total 2005 capital spending programto be approximately $157 million.

 

*Net Cash Provided By Financing Activities*

 

Cashflows provided by financing activities totaled $7.2 million for the nine monthsended September 30, 2005. We received $7.2 million in proceeds from theissuance of common stock related to the exercise of the over-allotment optionon our December 21, 2004 public offering and stock options exercised inthe first nine months of 2005. Cash flows provided by financing activitiestotaled $2.7 million for the nine months ended September 30, 2004, andincluded net borrowings of $1.0 million under our credit facility, $2.2 millionof net proceeds from the issuance of common stock, less deferred loan costs of$0.4 million associated with amending the credit facility after the Millermerger.

 

Due toour active exploration, development and acquisition activities, we haveexperienced and expect to continue to experience substantial working capitalrequirements. We intend to fund our total projected 2005 capital expenditures,including acquisitions, commitments and working capital requirements throughcash flows from operations and borrowings under our credit facility. We believewe will be able to generate capital resources and liquidity sufficient to fundour capital expenditures and meet such financial obligations as they come due.

 

38

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*Credit Facility*

 

In March 2004,but effective December 31, 2003, the Company entered into a new amendedand restated credit facility (the “Credit Facility”) which permits borrowingsup to the lesser of (i) the borrowing base or (ii) $100 million.  Borrowings under the Credit Facility bearinterest at a rate equal to prime plus 0.50% or LIBOR plus 2.25%. Commitmentfees of 0.25% to 0.50% accrue on the unused portion of the borrowing base,depending on the utilization percentage, and are included as a component ofinterest expense. As of September 30, 2005, $20.0 million in borrowingswere outstanding under the Credit Facility and our interest rate was 5.69%. On June 30,2005, we entered into a short term fixed rate LIBOR agreement, which reducedour interest rates. The Credit Facility matures December 31, 2007 and issecured by substantially all of the Company’s assets.

 

EffectiveDecember 2004, the borrowing base under the Credit Facility was increasedfrom $48.0 million to $65.0 million as a result of the south Texas assetacquisition that closed December 29, 2004 and our drilling activitiessince the last redetermination. On May 31, 2005, the borrowing base wasincreased from $65.0 million to $70.0 million and the maturity date wasextended from December 31, 2006 to December 31, 2007 and the interestrate margins were reduced from previous levels. The borrowing base is currentlybeing redetermined by our lenders. Based on the increase in our borrowing base,our available borrowing capacity at September 30, 2005 was $50.0 million.

 

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 consolidationtransactions. The Credit Facility also prohibits dividends and certaindistributions of cash or properties and certain liens.  The Credit Facility also contains thefollowing financial covenants, among others:

 

•      TheEBITDAX to Interest Expense ratio requires that the ratio of (a) ourconsolidated EBITDAX (defined as EBITDA plus similar non-cash items andexploration and abandonment expenses for such period) for the four fiscalquarters then ended to (b) our consolidated interest expense for the fourfiscal quarters then ended, to not be less than 3.5 to 1.0.

•      TheWorking Capital ratio requires that the amount of our consolidated currentassets less our consolidated current liabilities, as defined in the agreement,be at least $1.0 million. For the purposes of calculating the Working Capitalratio, current assets are adjusted for unused capacity under credit agreementand derivative financial instruments, and current liabilities are adjusted forderivative financial 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 CreditFacility) as of such fiscal quarter to (b) an amount equal to consolidatedEBITDAX for the two quarters then ended times two, not be greater than 3.0 to1.0.

 

ConsolidatedEBITDAX is a component of negotiated covenants with our lender and is definedhere as part of the Company’s disclosure of its covenant obligations.

 

*ShelfRegistration Statement*

 

We filed a $150 million shelf registration statement with the SEC, which became effective in May 2004. During the second quarter 2005, we filed a new registration statement that replaced the prior registration statement and increased the amount of securities registered to $390 million. Under this shelf registration statement, we may issue, from time to time, any combination of debt securities, preferred stock, common stock or warrants for debt securities or equity securities in one or more offerings to those persons who agree to purchase our securities. Net proceeds, terms and pricing of the offering of securities issued under the shelf registration statement will be determined at the time of the offerings. The shelf registration statement does not provide assurance that we will or could sell any such securities. Our ability to utilize our shelf registration statement for the purpose of issuing, from time to time, any combination of debt securities, preferred stock, common stock or warrants for debt securities or equity securities will depend upon, among other things, market conditions and the existence of investors who wish to purchase our securities at prices acceptable to us.

 

39

 

Wecompleted an offering on December 21, 2004 of 3.5 million shares of ourcommon stock under our initial shelf registration statement, which generatednet proceeds to us, before direct costs of the offering, of $47.8 million.These funds were used to finance the south Texas asset acquisition that closedon December 29, 2004 with a final adjusted purchase price of $40.1million, before other acquisition costs, and fund the costs of the offering andother general corporate purposes. On January 5, 2005, the underwritersexercised their over-allotment option for an additional 525,000 shares ofcommon stock, which generated net proceeds to us of $7.2 million. These fundswere used to reduce our outstanding debt. Each of these sales was made underour shelf registration statement. At September 30, 2005, we had $390million remaining for issuance under our new shelf registration statement.

 

*OffBalance Sheet Arrangements*

 

We do not have anyoff balance sheet arrangements.

 

*ContractualCash Obligations*

 

In September 2005,we executed two separate and definitive agreements to purchase 100% of thestock of a private company that owns certain working interests in the ChapmanRanch Field in Nueces County, Texas and additional working interests in thatfield from two other private companies for a cash purchase price, beforeadjustment, of $62.8 million. We will fund those obligations at theirrespective closings with borrowings under our current credit facility. Exceptas mentioned here, there were no other material changes outside the ordinarycourse of our business in lease obligations or other contractual obligationssince December 31, 2004.

 

**RiskManagement Activities – Derivatives & Hedging**

 

Due tothe instability of oil and natural gas prices, we may enter into, from time totime, price-risk management transactions (e.g., swaps, collars and floors) fora portion of our oil and natural gas production to achieve a more predictablecash flow, as well as to reduce exposure from commodity pricefluctuations.  While the use of thesearrangements limit our ability to benefit from increases in the price of oiland natural gas, it also reduces our potential exposure to adverse pricemovements.  Our arrangements, to theextent we enter into any, apply to only a portion of our production, provideonly partial price protection against declines in oil and natural gas pricesand limits our potential gains from future increases in prices. We also useprice-risk management transactions to protect forward pricing as a biddingstrategy with respect to acquisition offers and execution. None of theseinstruments are used for trading purposes. On a quarterly basis, our managementsets all of our price-risk management policies, including volumes, types ofinstruments and counterparties. These policies are implemented by managementthrough the execution of trades by the Chief Financial Officer afterconsultation and concurrence by the Chief Executive Officer. Our Board ofDirectors monitors the Company’s 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.”* These derivative instruments are intended to hedge ourprice risk and may be considered hedges for economic purposes, but certain ofthese transactions may not qualify for special cash flow hedge accounting.Therefore, depending on the type of transaction and the circumstances,different accounting treatment may apply to the timing and location of theincome statement impact, but all derivatives are recorded on the balance sheetat fair value. The following table provides additional information regardingthe Company’s various derivative and hedging transactions that were recorded atfair value on the balance sheet as of September 30, 2005.

 

40

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| Fair value of contracts outstanding at December 31,  2004                          |   | $          | 1,356,482   |   |
|-----------------------------------------------------------------------------------------|--------|------------|-------------|--------|
| Contracts realized or otherwise settled during the  period                              |   | (1,257,235 | )           |
| Fair value of new contracts when entered into during  2005:                             |   |       |        |
| Asset                                                                                   |   | —     |        |
| Liability                                                                               |   | (7,809,080 | )           |
| Changes in fair values attributable to changes in valuation  techniques and assumptions |   | (3,189,062 | )           |
| Other changes in fair values                                                            |   | —     |        |
| Fair values of contracts outstanding at September 30,  2005                        |   | $          | (10,898,895 | )      |

 

The following tabledetails the fair value of our commodity-based derivative and hedging contractsby year of maturity and valuation methodology as of September 30, 2005.

 
| ** **                                          | ** ** | **Fair Value of Contracts at September 30,  2005** | ** ** |
|-----------------------------------------------------|------------|---------------------------------------------------------|------------|
| **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** | ** ** |
| Prices actively quoted:                             |       | $                                                       | —     |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   |
| Prices provided by other external sources:          |       | —                                                  |       | — |   | — |   | — |   | — |   |
| Asset                                               |       |  (9,331,127                                        | )          |  (1,567,768 | ) | — |   | — |   | (10,898,895 | ) |
| Liability                                           |       |                                                    |       |   |   |   |   |   |   |   |   |
| Prices based on models and other valuation methods: |       | —                                                  |       | — |   | — |   | — |   | — |   |
| Total                                               |       | $                                                       | (9,331,127 | ) | $ | (1,567,768 | ) | $ | — |   | $ | — |   | $ | (10,898,895 | ) |

 

**TaxMatters**

 

At December 31,2004, we had cumulative net operating loss carryforwards (“NOLs”) for federalincome tax purposes of approximately $73.9 million that expire beginning 2007through 2022. The estimated NOLs presented herein assume that certain items,primarily intangible drilling costs, have been written off for tax purposes inthe current year. However, we have not made a final determination if an electionwill be made to capitalize all or part of these items for tax purposes in thefuture.

 

**RecentlyIssued Accounting Pronouncements**

 

In December 2004,the FASB issued SFAS No. 123(R), “*Share-BasedPayment.*” This statement requires companies to measure the cost ofemployee services in exchange for an award of equity instruments based on agrant-date fair value of the award (with limited exceptions), and that costmust generally be recognized over the vesting period. SFAS No. 123(R)amends the original SFAS No. 123 and 95 that had allowed companies tochoose between expensing stock options or showing pro forma disclosure only.This statement eliminates the ability to account for share-based compensationtransactions using APB Opinion No. 25. We currently account for ourstock-based compensation plans under the principles prescribed by APB Opinion No. 25.Accordingly, no stock option compensation cost is reflected in net income, asall options granted under the plan had an exercise price equal to the market valueof the underlying common stock on the date of grant. The adoption of SFAS No. 123(R)will impact our results of operations, but will have no impact on our overallfinancial position. In March 2005, the SEC issued SAB No. 107. Amongother things, SAB No. 107 provides interpretive guidance related to theinteraction between SFAS No. 123(R) and certain SEC rules andregulations, as well as provides the SEC staff’s views regarding the valuationof share-based payment arrangements for public companies. SFAS No. 123(R)was to become effective as of the beginning of the first interim or annualreporting period that begins after June 15, 2005, but on April 14,2005, the SEC issued press release 2005-57, which amends the compliance date ofSFAS No. 123(R) until fiscal years beginning after June 15, 2005. Weanticipate adopting the provisions of SFAS No. 123(R) in the firstquarter of 2006 using the modified prospective method for transition. Underthis method we will recognize compensation expense for all stock-based awardsgranted or modified on or after July 1, 2005, as well as any previouslygranted awards that are not fully vested as of July 1, 2005. Compensationexpense will be measured based on the fair value of the awards previouslycalculated in developing the pro forma disclosures in accordance with theprovisions of SFAS No. 123. We expect the impact to be immaterial dueto the fact that the Company has not issued options since April 2004 andthere will only be a minimal amount of unvested options as of our adoptiondate. SFAS No. 123(R)

 

41

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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 ascurrently required.

 

In March 2005, theFASB issued FASB Interpretation No. 47, *Accountingfor Conditional Asset Retirement Obligations, an interpretation of FASBStatement No. 143* (“FIN 47”).  FIN 47 clarifies that theterm, “conditional asset retirement obligation” as used in SFAS No. 143, *Accounting for Asset Retirement Obligations*,refers to a legal obligation to perform an asset retirement activity in whichthe timing and/or method of settlement are conditional upon a future event thatmay or may not be within the control of the entity.  Even thoughuncertainty about the timing and/or method of settlement exists and may beconditional upon a future event, the obligation to perform the asset retirementactivity is unconditional.  Accordingly, an entity is required torecognize a liability for the fair value of a conditional asset retirementobligation if the fair value of the liability can be reasonablyestimated.  Uncertainty about the timing and/or method of settlement of aconditional asset retirement obligation should be factored into the measurementof the liability when sufficient information exists.  The fair value of aliability for the conditional asset retirement obligation should be recognizedwhen incurred generally upon acquisition, construction, or development orthrough the normal operation of the asset.  SFAS No. 143 acknowledgesthat in some cases, sufficient information may not be available to reasonablyestimate the fair value of an asset retirement obligation.  FIN 47 alsoclarifies when an entity would have sufficient information to reasonablyestimate the fair value of an asset retirement obligation.  FIN 47 iseffective no later than the end of reporting periods ending after December 15,2005.  Retrospective application for interim financial information ispermitted but is not required.  Early adoption of FIN 47 isencouraged.  We are currently evaluating what impact FIN 47 will have onour financial statements, but at this time, we do not believe that the adoptionof FIN 47 will have a material effect on our consolidated financial position,results of operations or cash flows.

 

In June 2005,the FASB issued SFAS No. 154, *AccountingChanges and Error Corrections*, which changes the requirements forthe accounting for and reporting of a change in accounting principle. It alsoapplies to changes required by an accounting pronouncement in the unusualinstance that the pronouncement does not include specific transitionprovisions. Application is effective for accounting changes and correction of errorsmade in fiscal years beginning after December 15, 2005. Early adoption ispermitted. The adoption of SFAS No. 154 is not expected to have a materialeffect on our consolidated financial position, results of operations or cashflows.

 

## **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 credit facility, which has afloating interest rate, to finance a portion of our operations. We are notsubject to fair value risk resulting from changes in our floating interestrates.  The use of floating rate debtinstruments provides a benefit due to downward interest rate movements but doesnot limit us to exposure from future increases in interest rates.  Based on the September 30, 2005outstanding borrowings and a floating interest rate of 5.69%, a 10% change ininterest rates would result in an increase or decrease of interest expense ofapproximately $108,600 on an annual 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 2004 and 2005, due to the instabilityof prices and to achieve a more predictable cash flow, we put in place naturalgas and crude oil collars for a portion of our 2005 and estimated 2006production. Please refer to Note 7 to our consolidated financial statements.While the use of these arrangements may limit the benefit to us of increases inthe price of oil and natural gas, it also limits the downside risk of adverseprice movements.  The following is a listof contracts outstanding as of September 30, 2005:

 

42

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| **Transaction  Date** | ** ** | **Transaction  Type** | ** ** | **Beginning** | ** ** | **Ending** | ** ** | **Price  Per Unit** | ** ** | **Volumes Per  Day** | ** ** | **Fair Value  Outstanding as of  September 30,  2005** | ** **  |
|-----------------------|------------|-----------------------|------------|---------------|------------|------------|------------|---------------------|------------|----------------------|------------|-------------------------------------------------------------|-------------|
| ***Natural Gas:***    |       |                  |       |          |       |       |       |                |       |                 |       |                                                        |        |
| 10/04                 |       | Collar                | (1)        | 01/01/05      |       | 12/31/05   |       | $6.00-$9.52         |       | 10,000 MMbtu         |       | (2,168,927                                                  | )           |
| 08/05                 |       | Collar                | (1)        | 01/01/06      |       | 12/31/06   |       | $7.00-$10.50        |       | 10,000 MMbtu         |       | (6,190,758                                                  | )           |
|                  |       |                  |       |          |       |       |       |                |       |                 |       |                                                        |        |
| 08/05                 |       | Collar                | (1)        | 01/01/06      |       | 12/31/06   |       | $7.00-$16.10        |       | 10,000 MMbtu         |       | (1,610,527                                                  | )           |
| ***Crude Oil:***      |       |                  |       |          |       |       |       |                |       |                 |       |                                                        |        |
| 05/04(08/04)          |       | Collar                | (2)(3)     | 01/01/05      |       | 12/31/05   |       | $35.00-$40.00       |       | 200/290 Bbl          |       | (920,888                                                    | )           |
| 08/05                 |       | Collar                | (2)        | 01/01/06      |       | 12/31/06   |       | $55.00-$80.00       |       | 400 Bbl              |       | (7,795                                                      | )           |
|                  |       |                  |       |          |       |       |       |                |       |                 |       |                                                        |        |
|                  |       |                  |       |          |       |       |       |                |       |                 |       | $                                                           | (10,898,895 | ) |
|                       |            |                       |            |               |            |            |            |                     |            |                      |            |                                                             |             |  |

 

----

(1)   TheCompany’s current hedging activities for natural gas were entered into on a perMMbtu delivered price basis, using the Houston Ship Channel Index, withsettlement for each calendar month occurring five business days following theexpiration date.

(2)   Hedge accountingis not applied to the Company’s collars on crude oil, which were entered intoon a per barrel delivered price basis, using the West Texas Intermediate Index,with settlement for each calendar month occurring five business days followingthe expiration date. The change in fair value is reflected in net revenue forthe applicable periods.

(3)   In August 2004,the Company replaced the hedge contract that was outstanding at June 30,2004 with a new contract that changes the volume and pricing terms. The putoption is on 200 Bbl/D and the call option is on 290 Bbl/D. This transactionwas completed at no additional cost to the Company.

 

At September 30,2005, the fair value of the outstanding hedges was a liability of approximately$10.9 million. A 10% change in the commodity price per unit, as long as theprice is either above the ceiling or below the floor price would cause the fairvalue total of the hedge to increase or decrease by approximately $1.0 million.

#####  

##### **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 that evaluation, our Chief ExecutiveOfficer and Chief Financial Officer concluded that our disclosure controls andprocedures were effective as of September 30, 2005 to provide reasonableassurance that information required to be disclosed in our reports filed orsubmitted under the Exchange Act is recorded, processed, summarized andreported within the time periods specified in the SEC’s rules and forms.

 

There has been no change in our internal controls overfinancial reporting that occurred during the three months ended September 30,2005 that has materially affected, or is reasonably likely to materiallyaffect, our internal controls over financial reporting.

 

**PART II - OTHER INFORMATION**

 

**Item 1. - Legal Proceedings**

 

Fromtime to time the Company is a party to various legal proceedings arising in theordinary course of business.  While theoutcome of lawsuits cannot be predicted with certainty, the Company is notcurrently a party to any proceeding that it believes, if determined in a manneradverse to the Company, could have a potential material adverse effect on theCompany’s financial condition, results of operations or cash flows.

 

During the second quarterof 2004, the Company received notice that its 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

 

43

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result in an increased franchise tax liability.  The agent maintained that transfers by theparent company to its subsidiaries that the Company classified as intercompanyloans should instead be classified as equity investments in the subsidiary. TheState of Texas originally proposed that the franchise tax liability of thesubsidiaries would be increased by approximately $3.0 million for the four-yearperiod under audit.

 

During the thirdquarter of 2004, the agent reduced the proposed franchise tax deficiencyadjustment to the Company and its subsidiaries to an aggregate of $467,000. Inthe fourth quarter of 2004, there was an informal hearing at the localComptroller’s Office during which the agent indicated he would formally assessthe proposed deficiency.  On March 24,2005, the Company received such deficiency assessment in the amount of $471,482including penalty and interest. The Company responded on April 21, 2005with a request for a formal redetermination hearing. In July 2005, the Companysubmitted additional documents and evidence supporting its position for thehearing. There has not yet been a formal response from the Comptroller’s Officeon the Company’s request for an administrative hearing. The Company intends tocontinue to vigorously contest the assessment through appropriateadministrative levels in the Comptroller’s Office and any other availablemeans.  Due to its intention to continueto vigorously contest the proposed adjustments, the Company has not recognizedany provision for the additional franchise taxes that would result from theproposed deficiency.

 
| **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**        | None |
| **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 (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. |

 

44

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| 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 3.4 to the Company’s Quarterly Report on  Form 10-Q for the quarterly period ended March 31, 2003).                                                                                                                                                                                                                                                                                                                       |
|       |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| 3.6        | — |   | Second Amendment  to Bylaws of the Company on May 7, 2003 (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).                                                                                                                                                                                                                                                                                                                         |
|       |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| 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 for the lenders(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.                                                                                                                               |
|       |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| 4.3        | — |   | 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)).                                                                                                                                                                                                                                                                          |
|       |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| 4.4        | — |   | 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)).                                                                                                                                                                                                                                               |
|       |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| 4.5        | — |   | 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)).                                                                                                                                                                                                                                               |
|       |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| 4.6        | — |   | 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)).                                                                                                                                                                                                                                                                                                                 |

 

45

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| †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  | — |   | Incentive Plan  of Edge Petroleum Corporation as Amended and Restated Effective as of  June 1, 2004 (Incorporated by reference from exhibit 10.9 to the  Company’s Quarterly Report on Form 10-Q for the quarterly period ended  June 30, 2004).                                                                              |
|        |   |   |                                                                                                                                                                                                                                                                                                                                              |
| †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 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 herein (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, 2004, as  updated in part by the Company’s Current Report on Form 8-K filed  May 4, 2005).                                       |
|        |   |   |                                                                                                                                                                                                                                                                                                                                              |
| †10.13 | — |   | 2005 Bonus Plan for Executive Officers (Incorporated  by reference from the Company’s Current Report on Form 8-K filed  May 4, 2005).                                                                                                                                                                                              |
|        |   |   |                                                                                                                                                                                                                                                                                                                                              |
| †10.14 | — |   | 2004 Bonus Program (Incorporated by reference from  Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on  April 6, 2005).                                                                                                                                                                                        |
|        |   |   |                                                                                                                                                                                                                                                                                                                                              |
| †10.15 | — |   | Salaries and Other Compensation of Executive  Officers (Incorporated by reference from Exhibit 10.13 to the Company’s  Annual Report on Form 10-K for the year ended December 31, 2004, as                                                                                                                                    |

 

46

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|   |   |   | updated in part by Exhibit 10.2 to the  Company’s Current Report on Form 8-K filed on April 6, 2005).                                                                                                                         |
|--------|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |   |                                                                                                                                                                                                                                              |
| *31.1  | — |   | Certification by  John W. Elias, Chief Executive Officer, pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002.                                                                                                                        |
|   |   |   |                                                                                                                                                                                                                                              |
| *31.2  | — |   | Certification by  Michael G. Long, Chief Financial Officer, pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002.                                                                                                                      |
|   |   |   |                                                                                                                                                                                                                                              |
| *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). |

 

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* Filed herewith.

† Denotes management orcompensatory contract, arrangement or agreement.

 

47

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## **SIGNATURES**

 

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

 

 
|   |                   | EDGE PETROLEUM  CORPORATION, |
|--------|------------------------|------------------------------|
|   |                   | A DELAWARE  CORPORATION      |
|   |                   | (REGISTRANT)                 |
|   |                   |                         |
|   |                   |                         |
| Date   | November 9,  2005 |                         | /s/ John W. Elias |   |
|   |                   | John W. Elias                |   |
|   |                   | Chief Executive Officer and  |   |
|   |                   | Chairman of the Board        |   |
|   |                   |                         |   |
|   |                   |                         |   |
| Date   | November 9,  2005 |                         | /s/ Michael G. Long |   |
|   |                   | Michael G. Long              |   |
|   |                   | Executive Vice President and |   |
|   |                   | Chief Financial Officer      |   |

 

48

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# **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. |
|                 |       |       |   |
| 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 3.4 to the Company’s Quarterly Report on  Form 10-Q for the quarterly period ended March 31, 2003). |
|                 |       |       |   |
| 3.6                  | —     |       | Second Amendment  to Bylaws of the Company on May 7, 2003 (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). |
|                 |       |       |   |
| 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 for the lenders (Incorporated  by |

 

49

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|       |   |   | 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. |
|       |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 4.3        | — |   | 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)).                                                                                                                                            |
|       |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 4.4        | — |   | 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)).                                                                                                                 |
|       |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 4.5        | — |   | 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)).                                                                                                                 |
|       |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 4.6        | — |   | 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 | — |   | Incentive Plan  of Edge Petroleum Corporation as Amended and Restated Effective as of  June 1, 2004 (Incorporated by reference from exhibit 10.9 to the  Company’s Quarterly Report on Form 10-Q for the quarterly period ended  June 30, 2004).                                                                                                                                                     |
|       |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                     |
| †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 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 herein (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).                                                                                                                                           |

 

50

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| †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, 2004, as  updated in part by the Company’s Current Report on Form 8-K filed  May 4, 2005).                               |
|        |   |   |                                                                                                                                                                                                                                                                                                                                      |
| †10.13 | — |   | 2005 Bonus Plan for Executive Officers (Incorporated  by reference from the Company’s Current Report on Form 8-K filed  May 4, 2005).                                                                                                                                                                                      |
|        |   |   |                                                                                                                                                                                                                                                                                                                                      |
| †10.14 | — |   | 2004 Bonus Program (Incorporated by reference from  Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on  April 6, 2005).                                                                                                                                                                                |
|        |   |   |                                                                                                                                                                                                                                                                                                                                      |
| †10.15 | — |   | Salaries and  Other Compensation of Executive Officers (Incorporated by reference from  Exhibit 10.13 to the Company’s Annual Report on Form 10-K for the  year ended December 31, 2004, as updated in part by Exhibit 10.2 to  the Company’s Current Report on Form 8-K filed on April 6, 2005). |
|        |   |   |                                                                                                                                                                                                                                                                                                                                      |
| *31.1       | — |   | Certification by  John W. Elias, Chief Executive Officer, pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                |
|        |   |   |                                                                                                                                                                                                                                                                                                                                      |
| *31.2       | — |   | Certification by  Michael G. Long, Chief Financial Officer, pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                              |
|        |   |   |                                                                                                                                                                                                                                                                                                                                      |
| *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 orcompensatory contract, arrangement or agreement.

 

51

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