** **

** **

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-Q**

 

**ý****QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE**

**SECURITIES EXCHANGE ACT OF 1934**

 

**For the quarterly period ended September 30, 2004**

** **

**OR**

 

o**TRANSITION REPORT PURSUANT TOSECTION 13 OR 15(d) OF THE**

**SECURITIES EXCHANGE ACT OF 1934**

** **

**For the transition period from               to                **

** **

**Commission file number 0-22149**

 

**EDGE PETROLEUM CORPORATION**

(Exact name of registrant as specified in its charter)

 

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

 

 

**Travis Tower**

**1301 Travis, Suite 2000**

**Houston, Texas 77002**

(Address of principal executive offices)

(Zip code)

 

**(713) 654-8960**

(Registrant’s telephone number, including area code)

 

 

 

Indicateby checkmark whether the registrant (1) has filed all reports required to befiled by Section 13 or 15 (d) of the Securities Exchange Act of 1934during the preceding 12 months (or for such shorter period that the registrantwas required to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.   Yes ý   No o

 

Indicateby check mark whether the registrant is an accelerated filer (as defined in Rule12b-2 of the Exchange Act).   Yes o   No ý

 

Indicatethe number of shares outstanding of each of the issuer’s classes of commonstock, as of the latest practicable date.

 
| **Class**    | ** ** | **Outstanding at November 10, 2004** | ** ** |
|--------------|------------|--------------------------------------|------------|
| Common Stock |       | 13,025,568                           |       |

 

 

 

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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, 2004 and December 31, 2003                                                                  |   |       |
| Consolidated  Statements of Operations for each of the Three and Nine Months in the Periods  Ended September 30, 2004 and September 30, 2003 |   |       |
| Consolidated  Statements of Cash Flows for each of the Nine Months in the Periods Ended  September 30, 2004 and September 30, 2003           |   |       |
| Consolidated  Statements of Stockholders’ Equity as of September 30, 2004 and December 31,  2003                                        |   |       |
| Notes to  the Consolidated Financial Statements                                                                                              |   |       |
| Item  2. Managements 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. FINANCIAL INFORMATION**

** **

**Item 1. Financial Statements**

** **

**EDGE PETROLEUM CORPORATION**

**CONSOLIDATED BALANCE SHEETS**

 
| ** **                                                                                                                                                                                                                   | ** ** | **September 30, 2004** | ** **  | **December 31, 2003** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|-------------|-----------------------|------------|
| ** **                                                                                                                                                                                                                   | ** ** | **(Unaudited)**        | ** **  | ** **            | ** ** |
| **ASSETS**                                                                                                                                                                                                                   |       |                   |        |                  |       |
|                                                                                                                                                                                                                         |       |                   |        |                  |       |
| CURRENT ASSETS:                                                                                                                                                                                                              |       |                   |        |                  |       |
| Cash and cash equivalents                                                                                                                                                                                                    |       | $                      | 2,492,606   |                  | $          | 1,327,081 |   |
| Accounts receivable, trade, net of allowance of $525,248 at September  30, 2004 and December 31, 2003                                                                                                                        |       | 12,670,527             |        | 8,889,734             |       |
| Accounts receivable, joint interest owners, net of allowance of  $82,000 at September 30, 2004 and December 31, 2003                                                                                                         |       | 2,163,203              |        | 1,797,877             |       |
| Deferred tax asset                                                                                                                                                                                                           |       | 1,390,345              |        | 1,138,492             |       |
| Derivative financial instruments                                                                                                                                                                                             |       | —                 |        | 120,801               |       |
| Other current assets                                                                                                                                                                                                         |       | 1,453,228              |        | 1,186,987             |       |
| Total current assets                                                                                                                                                                                                         |       | 20,169,909             |        | 14,460,972            |       |
| PROPERTY AND EQUIPMENT, Net — full-cost method of accounting for oil  and natural gas properties (including unproved costs of $9.1 million and $5.0  million at September 30, 2004 and December 31, 2003, respectively) |       | 124,407,453            |        | 97,980,757            |       |
| DEFERRED TAX ASSET                                                                                                                                                                                                           |       | 789,612                |        | 5,570,137             |       |
| OTHER ASSETS                                                                                                                                                                                                                 |       | 319,032                |        | —                |       |
| TOTAL ASSETS                                                                                                                                                                                                                 |       | $                      | 145,686,006 |                  | $          | 118,011,866 |   |
|                                                                                                                                                                                                                         |       |                   |        |                  |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                |       |                   |        |                  |       |
|                                                                                                                                                                                                                         |       |                   |        |                  |       |
| CURRENT LIABILITIES:                                                                                                                                                                                                         |       |                   |        |                  |       |
| Accounts payable, trade                                                                                                                                                                                                      |       | $                      | 122,407     |                  | $          | 1,732,935 |   |
| Accrued liabilities                                                                                                                                                                                                          |       | 23,761,443             |        | 11,456,036            |       |
| Asset retirement obligation                                                                                                                                                                                                  |       | 411,092                |        | 323,513               |       |
| Derivative financial instruments                                                                                                                                                                                             |       | 2,159,880              |        | —                |       |
| Total current liabilities                                                                                                                                                                                                    |       | 26,454,822             |        | 13,512,484            |       |
|                                                                                                                                                                                                                         |       |                   |        |                  |       |
| ASSET RETIREMENT OBLIGATION                                                                                                                                                                                                  |       | 1,591,628              |        | 1,488,482             |       |
|                                                                                                                                                                                                                         |       |                   |        |                  |       |
| DERIVATIVE FINANCIAL INSTRUMENTS                                                                                                                                                                                             |       | 117,083                |        | —                |       |
|                                                                                                                                                                                                                         |       |                   |        |                  |       |
| LONG-TERM DEBT                                                                                                                                                                                                               |       | 22,000,000             |        | 21,000,000            |       |
| Total liabilities                                                                                                                                                                                                            |       | 50,163,533             |        | 36,000,966            |       |
| COMMITMENTS AND CONTINGENCIES (See 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; 25,000,000 shares authorized;  13,012,740 and 12,581,032 shares issued and outstanding at September 30, 2004  and December 31, 2003, respectively                                             |       | 130,127                |        | 125,810               |       |
| Additional paid-in capital                                                                                                                                                                                                   |       | 79,639,744             |        | 75,282,007            |       |
| Retained earnings                                                                                                                                                                                                            |       | 16,595,426             |        | 6,966,557             |       |
| Accumulated other comprehensive loss                                                                                                                                                                                         |       | (842,824               | )           | (363,474              | )          |
| Total stockholders’ equity                                                                                                                                                                                              |       | 95,522,473             |        | 82,010,900            |       |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                                                              |       | $                      | 145,686,006 |                  | $          | 118,011,866 |   |
|                                                                                                                                                                                                                              |            |                        |             |                       |            |  |  |  |

 

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,** | ** ** |
|------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                               | ** ** | **2004**                                  | ** ** | **2003**                                 | ** ** | **2004** | ** ** | **2003** | ** ** |
| OIL AND NATURAL GAS REVENUE:                                                             |       |                                      |       |                                     |       |   |   |   |   |
| Oil and natural gas sales                                                                |       | $                                         | 15,181,874 |                                     | $          | 9,719,008 |   | $ | 47,203,800 |   | $ | 27,888,053 |   |
| Loss on hedging and derivatives                                                          |       | (1,939,409                                | )          | (824,470                                 | )          | (2,299,274 | ) | (4,160,350 | ) |
| Total revenue                                                                            |       | 13,242,465                                |       | 8,894,538                                |       | 44,904,526 |   | 23,727,703 |   |
| OPERATING EXPENSES:                                                                      |       |                                      |       |                                     |       |   |   |   |   |
| Lease operating expenses                                                                 |       | 1,176,732                                 |       | 597,550                                  |       | 3,601,898 |   | 1,743,352 |   |
| Severance and ad valorem taxes                                                           |       | 891,194                                   |       | 561,787                                  |       | 3,146,116 |   | 1,602,846 |   |
| Depletion, depreciation, amortization and accretion                                      |       | 5,446,446                                 |       | 3,727,034                                |       | 15,830,248 |   | 9,334,243 |   |
| General and administrative expenses:                                                     |       |                                      |       |                                     |       |   |   |   |   |
| Deferred compensation — repriced options                                            |       | (153,808                                  | )          | —                                   |       | 1,294,677 |   | — |   |
| Deferred compensation — restricted stock                                            |       | 143,500                                   |       | 93,604                                   |       | 354,600 |   | 270,043 |   |
| Other general and administrative expenses                                                |       | 1,844,062                                 |       | 1,157,259                                |       | 5,476,342 |   | 3,844,277 |   |
| Total operating expenses                                                                 |       | 9,348,126                                 |       | 6,137,234                                |       | 29,703,881 |   | 16,794,761 |   |
| OPERATING INCOME                                                                         |       | 3,894,339                                 |       | 2,757,304                                |       | 15,200,645 |   | 6,932,942 |   |
|                                                                                     |       |                                      |       |                                     |       |   |   |   |   |
| OTHER INCOME AND EXPENSE:                                                                |       |                                      |       |                                     |       |   |   |   |   |
| Interest income                                                                          |       | 8,087                                     |       | 8,292                                    |       | 16,118 |   | 13,440 |   |
| Interest expense, net of amounts capitalized                                             |       | (22,204                                   | )          | (128,651                                 | )          | (241,887 | ) | (470,086 | ) |
| Amortization of deferred loan costs                                                      |       | (35,948                                   | )          | —                                   |       | (106,332 | ) | — |   |
| INCOME BEFORE INCOME TAXES AND CUMULATIVE EFFECT OF ACCOUNTING CHANGE                    |       | 3,844,274                                 |       | 2,636,945                                |       | 14,868,544 |   | 6,476,296 |   |
| INCOME TAX EXPENSE                                                                       |       | (1,354,722                                | )          | (946,109                                 | )          | (5,239,675 | ) | (2,313,302 | ) |
| INCOME BEFORE CUMULATIVE EFFECT OF ACCOUNTING CHANGE                                     |       | 2,489,552                                 |       | 1,690,836                                |       | 9,628,869 |   | 4,162,994 |   |
| CUMULATIVE EFFECT OF ACCOUNTING CHANGE                                                   |       | —                                    |       | —                                   |       | — |   | (357,825 | ) |
| NET INCOME                                                                               |       | 2,489,552                                 |       | 1,690,836                                |       | 9,628,869 |   | 3,805,169 |   |
| OTHER COMPREHENSIVE INCOME (LOSS), net of taxes:                                         |       |                                      |       |                                     |       |   |   |   |   |
| Unrealized hedge fair value gain (loss)                                                  |       | (578,834                                  | )          | 1,000,658                                |       | (749,887 | ) | 120,140 |   |
| Reclassification to earnings of realized (gain) loss upon settlement  of hedge contracts |       | 312,332                                   |       | 171,792                                  |       | 270,537 |   | 637,958 |   |
| Other comprehensive income (loss)                                                        |       | (266,502                                  | )          | 1,172,450                                |       | (479,350 | ) | 758,098 |   |
| COMPREHENSIVE INCOME                                                                     |       | $                                         | 2,223,050  |                                     | $          | 2,863,286 |   | $ | 9,149,519 |   | $ | 4,563,267 |   |
| BASIC EARNINGS PER SHARE:                                                                |       |                                      |       |                                     |       |   |   |   |   |
| Income before cumulative effect of accounting change                                     |       | $                                         | 0.19       |                                     | $          | 0.18 |   | $ | 0.75 |   | $ | 0.44 |   |
| Cumulative effect of accounting change                                                   |       | —                                    |       | —                                   |       | — |   | (0.04 | ) |
| Net income per share                                                                     |       | $                                         | 0.19       |                                     | $          | 0.18 |   | $ | 0.75 |   | $ | 0.40 |   |
| DILUTED EARNINGS PER SHARE:                                                              |       |                                      |       |                                     |       |   |   |   |   |
| Income before cumulative effect of accounting change                                     |       | $                                         | 0.18       |                                     | $          | 0.17 |   | $ | 0.71 |   | $ | 0.43 |   |
| Cumulative effect of accounting change                                                   |       | —                                    |       | —                                   |       | — |   | (0.04 | ) |
| Net income per share                                                                     |       | $                                         | 0.18       |                                     | $          | 0.17 |   | $ | 0.71 |   | $ | 0.39 |   |
| BASIC WEIGHTED AVERAGE NUMBER OF COMMON SHARES OUTSTANDING                               |       | 12,999,659                                |       | 9,523,648                                |       | 12,889,109 |   | 9,488,896 |   |
| DILUTED WEIGHTED AVERAGE NUMBER OF COMMON SHARES OUTSTANDING                             |       | 13,668,542                                |       | 9,869,379                                |       | 13,506,831 |   | 9,697,890 |   |
|                                                                                          |            |                                           |            |                                          |            |  |  |  |  |  |  |  |  |  |  |

 

See accompanyingnotes to consolidated financial statements.

 

4

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**EDGE PETROLEUM CORPORATION**

**CONSOLIDATED STATEMENTS OF CASHFLOWS (Unaudited)**

 
| ** **                                                                         | ** ** | **Nine Months Ended September 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                         | ** ** | **2004**                                 | ** ** | **2003** | ** ** |
| **CASH FLOWS FROM OPERATING ACTIVITIES:**                                          |       |                                     |       |   |   |
| Net income                                                                         |       | $                                        | 9,628,869  |   | $ | 3,805,169 |   |
| Adjustments to reconcile net income to net cash provided by operating  activities: |       |                                     |       |   |   |
| Cumulative effect of accounting change                                             |       | —                                   |       | 357,825 |   |
| Loss on the fair value of derivatives                                              |       | 1,254,911                                |       | — |   |
| Deferred income taxes                                                              |       | 5,239,675                                |       | 2,313,302 |   |
| Depletion, depreciation, amortization and accretion                                |       | 15,830,248                               |       | 9,334,243 |   |
| Amortization of deferred loan costs                                                |       | 106,332                                  |       | — |   |
| Deferred compensation                                                              |       | 1,649,277                                |       | 270,043 |   |
| Changes in assets and liabilities:                                                 |       |                                     |       |   |   |
| Increase in accounts receivable, trade                                             |       | (3,369,143                               | )          | (2,915,624 | ) |
| Increase in accounts receivable, joint interest owners                             |       | (365,326                                 | )          | (96,698 | ) |
| Increase in other assets                                                           |       | (266,241                                 | )          | (343,368 | ) |
| Decrease in accounts payable, trade                                                |       | (1,610,528                               | )          | (312,119 | ) |
| Increase in accrued liabilities                                                    |       | 12,388,677                               |       | 3,879,236 |   |
| Increase in accrued interest payable                                               |       | —                                   |       | 5,448 |   |
| Net cash provided by operating activities                                          |       | 40,486,751                               |       | 16,297,457 |   |
|                                                                               |       |                                     |       |   |   |
| **CASH FLOWS FROM INVESTING ACTIVITIES:**                                          |       |                                     |       |   |   |
| Oil and natural gas property and equipment additions                               |       | (42,111,219                              | )          | (25,531,943 | ) |
| Proceeds from the sale of oil and natural gas properties                           |       | 45,000                                   |       | 330,096 |   |
| Net cash used in investing activities                                              |       | (42,066,219                              | )          | (25,201,847 | ) |
|                                                                               |       |                                     |       |   |   |
| **CASH FLOWS FROM FINANCING ACTIVITIES:**                                          |       |                                     |       |   |   |
| Borrowings from long-term debt                                                     |       | 4,000,000                                |       | 10,700,000 |   |
| Payments of long-term debt                                                         |       | (3,000,000                               | )          | (1,200,000 | ) |
| Net proceeds from issuance of common stock                                         |       | 2,170,357                                |       | 84,603 |   |
| Deferred loan costs                                                                |       | (425,364                                 | )          | — |   |
| Net cash provided by financing activities                                          |       | 2,744,993                                |       | 9,584,603 |   |
| **NET INCREASE IN CASH AND CASH EQUIVALENTS**                                      |       | 1,165,525                                |       | 680,213 |   |
| ** **                                                                         |       |                                     |       |   |   |
| **CASH AND CASH EQUIVALENTS, BEGINNING OF PERIO**D                                 |       | 1,327,081                                |       | 2,568,176 |   |
| **CASH AND CASH EQUIVALENTS, END OF PERIOD**                                       |       | $                                        | 2,492,606  |   | $ | 3,248,389 |   |
|                                                                                    |            |                                          |            |  |  |  |  |  |

 

See accompanyingnotes to consolidated financial statements.

 

5

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**EDGE PETROLEUM CORPORATION**

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

 
| ** **                                                           | ** ** | ** **       | ** ** | ** **  | ** ** | ** **     | ** ** | ** **        | ** ** | **Accumulated**        | ** ** | ** ** | ** ** |
|----------------------------------------------------------------------|------------|------------------|------------|-------------|------------|----------------|------------|-------------------|------------|------------------------|------------|------------|------------|
| ** **                                                           | ** ** | ** **       | ** ** | ** **  | ** ** | **Additional** | ** ** | ** **        | ** ** | **Other**              | ** ** | **Total**  | ** ** |
| ** **                                                           | ** ** | **Common Stock** | ** ** | **Paid-in** | ** ** | **Retained**   | ** ** | **Comprehensive** | ** ** | **Stockholders’** | ** ** |
| ** **                                                           | ** ** | **Shares**       | ** ** | **Amount**  | ** ** | **Capital**    | ** ** | **Earnings**      | ** ** | **Loss**               | ** ** | **Equity** | ** ** |
| BALANCE,  DECEMBER 31, 2003                                     |       | 12,581,032       |       | $           | 125,810    |           | $          | 75,282,007        |       | $                      | 6,966,557  |       | $          | (363,474 | ) | $ | 82,010,900 |   |
| Issuance of  common stock                                            |       | 431,708          |       | 4,317       |       | 2,249,310      |       | —            |       | —                 |       | 2,253,627  |       |
| Deferred  compensation — restricted stock                  |       | —           |       | —      |       | 354,600        |       | —            |       | —                 |       | 354,600    |       |
| Deferred  compensation — repriced options                  |       | —           |       | —      |       | 1,294,677      |       | —            |       | —                 |       | 1,294,677  |       |
| Change in  valuation of hedging instruments                          |       | —           |       | —      |       | —         |       | —            |       | (479,350               | )          | (479,350   | )          |
| Tax benefit  associated with exercise of non-qualified stock options |       | —           |       | —      |       | 459,150        |       | —            |       | —                 |       | 459,150    |       |
| Net income                                                           |       | —           |       | —      |       | —         |       | 9,628,869         |       | —                 |       | 9,628,869  |       |
| BALANCE, September 30,  2004                                    |       | 13,012,740       |       | $           | 130,127    |           | $          | 79,639,744        |       | $                      | 16,595,426 |       | $          | (842,824 | ) | $ | 95,522,473 |   |

 

See accompanyingnotes to consolidated financial statements.

 

6

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**EDGE PETROLEUM CORPORATION**

**NOTES TO THE CONSOLIDATEDFINANCIAL STATEMENTS**

 

**1.     SUMMARYOF SIGNIFICANT ACCOUNTING POLICIES**

 

The financial statements includedherein have been prepared by Edge Petroleum Corporation, a Delaware corporation(“we”, “our”, “us” or the “Company”), without audit pursuant to the rules andregulations of the Securities and Exchange Commission (“SEC”), and reflect alladjustments which are, in the opinion of management, necessary to present afair statement of the results for the interim periods on a basis consistentwith the annual audited consolidated financial statements.  All such adjustments are of a normalrecurring nature.  The results ofoperations for the interim periods are not necessarily indicative of theresults to be expected for an entire 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 believe thatthe disclosures are adequate to make the information presented not misleading.These financial statements should be read in conjunction with our auditedconsolidated financial statements included in our Annual Report on Form 10-Kfor the year ended December 31, 2003 and each of our quarterly reports on Form10-Q for the corresponding prior 2004 quarterly periods. 

 

***Oil and Natural GasProperties —*****Investments in oil and natural gasproperties are accounted for using the full-cost method of accounting. Theaccounting for our business is subject to special accounting rules that areunique to the oil and gas industry. There are two allowable methods of accounting for oil and gas businessactivities:  the successful-efforts methodand the full-cost method.  There areseveral significant differences between these methods. Among these differencesis that, under the successful-efforts method, costs such as geological andgeophysical (“G&G”), exploratory dry holes and delay rentals are expensedas incurred whereas under the full-cost method these types of charges arecapitalized to their respective full-cost pool. In the measurement of impairment of oil and gas properties, thesuccessful-efforts method of accounting follows the guidance provided inStatement of Financial Accounting Standards (“SFAS”) No. 144, “*Accounting for the Impairment or Disposal of Long-Lived Assets*,”where the first measurement for impairment is to compare the net book value ofthe related asset to its undiscounted future cash flows using commodity pricesconsistent with management expectations. The full-cost method follows guidance provided in SEC Regulation S-XRule 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 usingcommodity prices in effect at the end of the reporting period. 

 

In accordance with the full-costmethod of accounting, all costs associated with the exploration, developmentand acquisition of oil and natural gas properties, including salaries, benefitsand other internal costs directly attributable to these activities arecapitalized within a cost center.  TheCompany’s oil and natural gas properties are located within the United Statesof America and constitute one cost center. The Company also capitalizes aportion of interest expense on borrowed funds. Employee related costs that are directly attributable to exploration anddevelopment activities are also capitalized. These costs are considered to be direct costs based on the nature oftheir function as it relates to the exploration and development activities. 

 

Oil and natural gas properties areamortized based on a unit-of-production method using estimates of provedreserve quantities.  Investments inunproved properties are not amortized until proved reserves associated with theprospects can be determined or until impairment occurs.  Oil and natural gas properties include costsof $9.1 million and $5.0 million at September 30, 2004 and December 31, 2003,respectively, related to unproved property, which were excluded fromcapitalized costs being amortized. Unproved properties are evaluated quarterly,and as needed, for impairment on a property-by-property basis.  If the results of an assessment indicate thatan unproved property is impaired, the amount of impairment is added to theproved oil and natural gas property costs to be amortized.  In accordance with SEC Staff AccountingBulletin (“SAB”) No. 106, “*Interaction of Statement143 and the Full Cost Rules*,” the amortizable base includesestimated future development and dismantlement costs, and restoration andabandonment costs, net of estimated salvage values.

 

In addition, the capitalized costsof oil and natural gas properties are subject to a “ceiling test,” whereby tothe extent that such capitalized costs subject to amortization in the full-costpool (net of accumulated depletion,

 

7

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depreciation and amortization, asset retirement obligationsand related deferred taxes) exceed the present value (using a 10% discount rate)of estimated future net after-tax cash flows from proved oil and natural gasreserves, 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 was between the cap and floor established by theCompany’s hedge contracts at September 30, 2004 and thus no impact was includedin the calculation.  Impairment of oiland natural gas properties is assessed on a quarterly basis in conjunction withthe Company’s quarterly and annual filings with the SEC.  No impairment related to the ceiling test wasrequired during the nine-month periods ended September 30, 2004 or2003.  

 

Sales of proved and unprovedproperties are accounted for as adjustments of capitalized costs with no gainor loss recognized, unless such adjustments would significantly alter therelationship between capitalized costs and proved reserves. 

 

In March 2004, the Emerging IssuesTask Force (“EITF”) reached a consensus that mineral rights, as defined in EITFIssue No. 04-2, “*Whether Mineral Rights Are Tangible orIntangible Assets*,” are tangible assets and that they should beremoved as examples of intangible assets in SFAS Nos. 141, “*Business Combinations*,” and SFAS No. 142, “*Goodwill and Other Intangible Assets*.” The FinancialAccounting Standards Board (“FASB”) has recently ratified this consensus anddirected the FASB staff to amend SFAS Nos. 141 and 142 through the issuance ofFASB Staff Positions (“FSP”) Nos. FAS 141-1 and FAS 142-1, “*Interaction of FASB Statements No. 141, Business Combinations, andNo. 142, Goodwill and Other Intangible Assets, and EITF Issue No. 04-2,“Whether Mineral Rights Are Tangible or Intangible Assets.*”  In addition, FSP FAS 142-2, “*Application of FASB Statement No. 142, Goodwill and Other IntangibleAssets, to Oil- and Gas-Producing Entities*” confirms that SFASNo. 142 does not change the balance sheet classification or disclosures ofmineral rights of oil and gas producing enterprises. Historically, we haveincluded the costs of such mineral rights as tangible assets, which isconsistent with the EITF’s consensus. As such, EITF 04-2 and the related FSPshave not affected our consolidated financial statements. 

 

***Asset RetirementObligations —*****The Company records a liability forlegal obligations associated with the retirement of tangible long-lived assetsin the period in which they are incurred in accordance with SFAS No. 143,“*Accounting for Asset Retirement Obligations*”.The Company adopted this policy effective January 1, 2003, using a cumulativeeffect approach to recognize transition amounts for asset retirementobligations, asset retirement costs and accumulated accretion and depletion.Under this method, when liabilities for dismantlement and abandonment costs,excluding salvage values, are initially recorded, the carrying amount of therelated oil and gas properties is increased. Accretion of the liability isrecognized each period using the interest method of allocation, and thecapitalized cost is depleted over the useful life of the related asset. 

 

At January 1, 2003, the Companyrecorded the present value of its future Asset Retirement Obligations (“ARO”)for oil and natural gas properties and related equipment. The cumulative effectof the adoption of SFAS No. 143 and the change in accounting principle was acharge to net income during the first quarter of 2003 of $357,825, net of taxesof $192,675. The changes to the ARO during the periods ended September 30, 2004and 2003 are as follows: 

 
| ** **                                 | ** ** | **Nine Months Ended September 30,** | ** ** |
|--------------------------------------------|------------|-------------------------------------|------------|
| ** **                                 | ** ** | **2004**                            | ** ** | **2003** | ** ** |
| ARO, Beginning of Period                   |       | $                                   | 1,811,995  |   | $ | 942,736 |   |
| Liabilities incurred in the current period |       | 233,828                             |       | 504,292 |   |
| Liabilities settled in the current period  |       | (123,231                            | )          | (64,443 | ) |
| Accretion expense                          |       | 80,128                              |       | 44,652 |   |
| Revisions                                  |       | —                              |       | (9,714 | ) |
| ARO, End of Period                         |       | $                                   | 2,002,720  |   | $ | 1,417,523 |   |
| Current Portion                            |       | $                                   | 411,092    |   | $ | 96,249 |   |
| Long Term Portion                          |       | $                                   | 1,591,628  |   | $ | 1,321,274 |   |
|                                            |            |                                     |            |  |  |  |  |  |  |

 

 

8

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ARO liabilities incurred during thenine months ended September 30, 2004 include 28 new well obligations.Liabilities settled during the nine months ended September 30, 2004 includednine wells that were plugged and one well that was sold. 

 

***Stock-BasedCompensation —*****The Company accounts for stockcompensation plans under the intrinsic value method of Accounting PrinciplesBoard (“APB”) Opinion No. 25, “*Accounting for StockIssued to Employees.*”  Nocompensation expense is recognized for stock options that had an exercise priceequal to or greater than the market value of the underlying common stock on thedate of grant.  As allowed by SFASNo. 123, “*Accounting for Stock-Based Compensation*,”the Company has continued to apply APB Opinion No. 25 for purposes ofdetermining net income.  In December2002, the FASB issued SFAS No. 148, “*Accounting for Stock-BasedCompensation — Transition and Disclosure — an amendment of FASB StatementNo  123*” to provide alternative methods of transition for avoluntary change to the fair value based method of accounting for stock-basedemployee compensation.  Additionally, thestatement amends the disclosure requirements of SFAS No. 123 to requireprominent disclosures in both annual and interim financial statements about themethod of accounting for stock-based compensation and the effect of the methodused on reported results.

 

Had compensation expense forstock-based compensation been determined based on the fair value at the date ofgrant, the Company’s net income and earnings per share would have been asfollows: 

 
| ** **                                                                                                                          | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                                                                          | ** ** | **2004**                                   | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net income as reported                                                                                                              |       | $                                          | 2,489,552  |                                      | $          | 1,690,836 |   | $ | 9,628,869 |   | $ | 3,805,169 |   |
| Add:                                                                                                                                |       |                                       |       |                                      |       |   |   |   |   |
| Stock-based employee compensation expense included in reported net  income, net of related income tax                               |       | (6,700                                     | )          | —                                    |       | 1,072,030 |   | — |   |
| Deduct:                                                                                                                             |       |                                       |       |                                      |       |   |   |   |   |
| Total stock-based employee compensation expense determined under fair  value based method for all awards, net of related income tax |       | (106,092                                   | )          | (53,769                                   | )          | (314,380 | ) | (168,030 | ) |
| Pro forma net income                                                                                                                |       | $                                          | 2,376,760  |                                      | $          | 1,637,067 |   | $ | 10,386,519 |   | $ | 3,637,139 |   |
|                                                                                                                                |       |                                       |       |                                      |       |   |   |   |   |
| Earnings Per Share:                                                                                                                 |       |                                       |       |                                      |       |   |   |   |   |
| Basic — as reported                                                                                                            |       | $                                          | 0.19       |                                      | $          | 0.18 |   | $ | 0.75 |   | $ | 0.40 |   |
| Basic — pro forma                                                                                                              |       | $                                          | 0.18       |                                      | $          | 0.17 |   | $ | 0.81 |   | $ | 0.38 |   |
|                                                                                                                                |       |                                       |       |                                      |       |   |   |   |   |
| Diluted — as reported                                                                                                          |       | $                                          | 0.18       |                                      | $          | 0.17 |   | $ | 0.71 |   | $ | 0.39 |   |
| Diluted — pro forma                                                                                                            |       | $                                          | 0.17       |                                      | $          | 0.17 |   | $ | 0.77 |   | $ | 0.38 |   |
|                                                                                                                                     |            |                                            |            |                                           |            |  |  |  |  |  |  |  |  |  |  |

 

The Company is also subject toreporting requirements of FASB Interpretation No. (“FIN”) 44, “*Accounting for Certain Transactions involving Stock Compensation*”that requires a non-cash charge to deferred compensation expense if the marketprice of the Company’s common stock at the end of a reporting period is greaterthan the exercise price of certain stock options.  After the first such adjustment is made, eachsubsequent period is adjusted upward or downward to the extent that the marketprice exceeds the exercise price of the options.  The charge is related to non-qualified stockoptions granted to employees and directors in prior years and re-priced in May1999, as well as certain options newly issued in conjunction with therepricing. A pre-tax charge of $1.3 

 

9

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million was required for the nine months ended September 30,2004.  No charge related to FIN 44 wasrequired during the nine-month period ended September 30, 2003. 

 

***AccountingPronouncements —*** In March 2004, the FASB issued anexposure draft entitled “*Share-Based Payment, anAmendment of FASB Statement No. 123 and 95*.”  This proposed statement addresses theaccounting for share-based payment transactions in which an enterprise receivesemployee services in exchange for (a) equity instruments of the enterprise or(b) liabilities that are based on the fair value of the enterprise’s equityinstruments or that may be settled by the issuance of such equityinstruments.  The proposed statementwould eliminate the ability to account for share-based compensationtransactions using APB Opinion No. 25 and generally would require instead thatsuch transactions be accounted for using a fair-value-based method.  The FASB continued deliberations throughoutthe third quarter and expects to issue a final statement in the fourth quarterof 2004. As proposed, this statement would be effective for the Company onJanuary 1, 2005.  We are currentlyevaluating the impact that may result from adoption of this proposed statement.

 

In September 2004, the SEC issuedSAB No. 106 regarding the application of SFAS No. 143 by oil and gas producingentities that follow the full cost accounting method. SAB No. 106, effective inthe fourth quarter of 2004, states that after adoption of SFAS No. 143, thefuture cash outflows associated with settling asset retirement obligations thathave been accrued on the balance sheet should be excluded from the presentvalue of estimated future net cash flows used for the full cost ceiling testcalculation. It also confirms that the estimated dismantlement and abandonmentcosts, net of estimated salvage values, should be included in amortizable baseused in computing unit-of-production depletion. This standard will also requirecompanies to disclose in the accounting impact of SFAS No. 143 on their oil andgas producing activities, including the calculation of the ceiling test anddepreciation, depletion and amortization. The Company currently does not expectthe adoption of SAB No. 106 in the fourth quarter of 2004 to have any materialimpact on its financial statements, nor does it expect adoption to have amaterial effect on the results of the ceiling test calculation.

 

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

 

**2.     LONGTERM DEBT**

 

Effective December 31, 2003, theCompany entered into a new amended and restated credit facility (the “CreditFacility”) which permits borrowings up to the lesser of (i) the borrowing baseor (ii) $100 million.  Borrowings underthe Credit Facility bear interest at a rate equal to prime plus 0.50% or LIBORplus 2.25%.  At September 30, 2004, theinterest rate applied to our outstanding balance was 4.06%. As of September 30,2004, $22.0 million in borrowings were outstanding under the CreditFacility.  The Credit Facility maturesDecember 31, 2006 and is secured by substantially all of the Company’sassets.  

 

Effective June 8, 2004, theborrowing base under the Credit Facility was increased to $45.0 million from$40.0 million; primarily as a result of our drilling activities since the lastredetermination. At September 30, 2004, the Company’s available borrowingcapacity under this facility was $23.0 million. 

 

Effective November 1, 2004, theCredit Facility’s borrowing base was increased from $45.0 million to $48.0million.  

 

The Credit Facility provides forcertain restrictions, including but not limited to, limitations on additionalborrowings, sales of oil and natural gas properties or other collateral, andengaging in merger or consolidation transactions. The Credit Facility alsoprohibits dividends and certain distributions of cash or properties and certainliens.  The Credit Facility also containsthe following financial covenants, among others:

•                  The EBITDAXto Interest Expense ratio requires that the ratio of (a) consolidated EBITDAX(defined as EBITDA plus similar non-cash items and exploration and abandonmentexpenses for such period) of the Company for the four fiscal quarters thenended to (b) the consolidated interest expense of the Company for the fourfiscal quarters then ended, not be less than 3.5 to 1.0.

 

 

10

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•                  The WorkingCapital ratio requires that the amount of the Company’s consolidated currentassets less its consolidated current liabilities, as defined in the agreement,be at least $1.0 million.

•                  The MaximumLeverage ratio requires that the ratio, as of the last day of any fiscalquarter, of (a) Total Indebtedness (as defined in the Credit Facility) as ofsuch fiscal quarter to (b) an amount equal to consolidated EBITDAX for the twoquarters then ended times two, not be greater than 3.0 to 1.0.

 

Consolidated EBITDAX is a componentof negotiated covenants with our lender and is presented here as part of theCompany’s disclosure of its covenant obligations.  

 

**3.     SHELFREGISTRATION STATEMENT**

 

The Company filed a $150 million shelfregistration statement, which became effective in May 2004. Under the shelfregistration statement, the Company may issue, from time to time, anycombination of debt securities, preferred stock, common stock or warrants fordebt securities or equity securities in one or more offerings to those personswho agree to purchase our securities. At September 30, 2004, the Company had$150 million remaining for issuance under the shelf registration. Our abilityto utilize the shelf registration statement will depend upon, among otherthings, market conditions and the existence of investors who wish to purchaseour securities at prices and terms acceptable to us. 

 

**4.     EARNINGSPER SHARE**

 

The Company accounts for earningsper share in accordance with SFAS No. 128, “*Earnings per Share*,”which establishes the requirements for presenting earnings per share(“EPS”).  SFAS No. 128 requires thepresentation of “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 option and warrants having exerciseprices less than the average market price of the common stock during theperiods, using the treasury stock method. 

 

The following is a reconciliation ofthe numerators and denominators of basic and diluted earnings per common sharecomputations, in accordance with SFAS No. 128, for the three-month andnine-month periods ended September 30, 2004 and 2003: 

 
| ** **                              | ** ** | **Three Months Ended September 30, 2004** | ** ** | **Three Months Ended September 30, 2003** | ** ** |
|-----------------------------------------|------------|------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                              | ** ** | **Income  (Numerator)**                        | ** ** | **Shares  (Denominator)**                      | ** ** | **Per Share  Amount** | ** ** | **Income  (Numerator)** | ** ** | **Shares  (Denominator)** | ** ** | **Per Share  Amount** | ** ** |
| **Basic EPS**                           |       |                                           |       |                                           |       |   |   |   |   |   |   |   |   |
| Income available to common stockholders |       | $                                              | 2,489,552  |                                           | 12,999,659 |   | $ | 0.19 |   | $ | 1,690,836 |   | 9,523,648 |   | $ | 0.18 |   |
| Effect of dilutive securities:          |       |                                           |       |                                           |       |   |   |   |   |   |   |   |   |
| Restricted stock                        |       | —                                         |       | 156,310                                        |       | — |   | — |   | 112,451 |   | — |   |
| Common stock options                    |       |                                           |       | 512,573                                        |       | (0.01 | ) |   |   | 183,756 |   | (0.01 | ) |
| Warrants                                |       | —                                         |       | —                                         |       | — |   | — |   | 49,524 |   | — |   |
| **Diluted EPS**                         |       |                                           |       |                                           |       |   |   |   |   |   |   |   |   |
| Income available to common stockholders |       | $                                              | 2,489,552  |                                           | 13,668,542 |   | $ | 0.18 |   | $ | 1,690,836 |   | 9,869,379 |   | $ | 0.17 |   |

 

 

11

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| ** **                              | ** ** | **Nine Months Ended September 30, 2004** | ** ** | **Nine Months Ended September 30, 2003** | ** ** |
|-----------------------------------------|------------|-----------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                              | ** ** | **Income  (Numerator)**                       | ** ** | **Shares  (Denominator)**                     | ** ** | **Per Share  Amount** | ** ** | **Income  (Numerator)** | ** ** | **Shares  (Denominator)** | ** ** | **Per Share  Amount** | ** ** |
| **Basic EPS**                           |       |                                          |       |                                          |       |   |   |   |   |   |   |   |   |
| Income available to common stockholders |       | $                                             | 9,628,869  |                                          | 12,889,109 |   | $ | 0.75 |   | $ | 3,805,169 |   | 9,488,896 |   | $ | 0.40 |   |
| Effect of dilutive securities:          |       |                                          |       |                                          |       |   |   |   |   |   |   |   |   |
| Restricted stock                        |       | —                                        |       | 139,223                                       |       | (0.01 | ) | — |   | 104,912 |   | (0.01 | ) |
| Common stock options                    |       | —                                        |       | 478,499                                       |       | (0.03 | ) | — |   | 104,082 |   | — |   |
| **Diluted EPS**                         |       |                                          |       |                                          |       |   |   |   |   |   |   |   |   |
| Income available to common stockholders |       | $                                             | 9,628,869  |                                          | 13,506,831 |   | $ | 0.71 |   | $ | 3,805,169 |   | 9,697,890 |   | $ | 0.39 |   |
|                                         |            |                                               |            |                                               |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

 

**5.     INCOMETAXES**

 

The Company accounts for incometaxes under the provisions 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 currently estimates thatits effective tax rate for the year ending December 31, 2004 will beapproximately 35.2%.  A provision forincome taxes of $5.2 million and $2.3 million was reported for the nine monthsended September 30, 2004 and 2003, respectively. The Company was not requiredto pay income taxes in 2003 or 2002 because of the utilization of net operatingloss carryforwards. 

 

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

 

The Company considers all highlyliquid debt instruments purchased with an original maturity of three months orless to be cash equivalents. A summary of non-cash investing and financingactivities for the nine months ended September 30, 2004 and 2003 is presentedbelow: 

 
| **Description**                                                                                     | ** ** | **Number of Shares Issued** | ** ** | **Fair Market Value** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|-----------------------|------------|
| **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     |   |
| **Nine months ended September 30, 2003:**                                                           |       |                        |       |                  |       |
| Shares issued to satisfy restricted stock grants                                                    |       | 73,962                      |       | $                     | 390,238    |   |
| Shares issued to fund the Company’s matching contribution under the  Company’s 401-k plan |       | 11,785                      |       | $                     | 51,451     |   |
|                                                                                                     |            |                             |            |                       |            |  |  |  |

 

For the nine months ended September30, 2004 and 2003, the non-cash portion of Asset Retirement Costs was $110,597and $1,165,428, respectively.  Asupplemental disclosure of cash flow information for the nine months endedSeptember 30, 2004 and 2003 is presented below: 

 

 

12

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| ** **                           | ** ** | **For the Nine Months   Ended September 30,** | ** ** |
|--------------------------------------|------------|-----------------------------------------------|------------|
| ** **                           | ** ** | **2004**                                      | ** ** | **2003** | ** ** |
| Cash paid during the period for:     |       |                                          |       |   |   |
| Interest, net of amounts capitalized |       | $                                             | 241,887    |   | $ | 336,939 |   |
|                                      |            |                                               |            |  |  |  |  |

 

Interest paid for the nine monthsended September 30, 2004 and 2003 excludes amounts capitalized of $378,118 and$189,697, respectively. The Company was not required to pay income taxes in2003 or 2002.

 

**7.     HEDGINGAND DERIVATIVE ACTIVITIES**

 

Due to the volatility of oil andnatural gas prices, the Company periodically enters into price-risk managementtransactions (e.g., swaps, collars and floors) for a portion of its oil andnatural gas production to achieve a more predictable cash flow, as well as toreduce exposure from price fluctuations. While the use of these arrangements limits the Company’s ability tobenefit from increases in the price of oil and natural gas, it also reduces theCompany’s potential exposure to adverse price movements.  The Company’s arrangements, to the extent itenters into any, apply to only a portion of its production, provide onlypartial price protection against declines in oil and natural gas prices andlimit the Company’s potential gains from future increases in prices.  None of these instruments are used fortrading purposes. On a quarterly basis, the Company’s management sets all ofthe Company’s 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 after consultationand concurrence by the President and Chairman of the Board.  The Board of Directors continuously monitorsthe Company’s policies and trades.

 

All of these price-risk managementtransactions are considered derivative instruments and accounted for in accordancewith SFAS No. 133, “*Accounting for DerivativeInstruments and Hedging Activities*”. These derivative instrumentsare intended to hedge our price risk and may be considered hedges for economicpurposes, but certain of these transactions may not qualify for cash flow hedgeaccounting. All derivative instrument contracts are recorded on the balancesheet at fair value. For those derivative instrument contracts that qualify forcash flow hedge accounting, the effective portion of the changes in the fairvalue of the contracts is recorded in other comprehensive income and the ineffectiveportion of the changes in the fair value of the contracts is recorded inrevenue as they occur. While the contract is outstanding, the ineffective gainor loss may increase or decrease until settlement of the contract depending onthe fair value at the measurement dates. When the hedged production is sold,the realized gains and losses on the contracts are removed from othercomprehensive income and recorded in revenue. The Company is currentlyaccounting for its natural gas contracts as cash flow hedges of future cashflows from the sale of natural gas. For those derivative instrument contractsthat either do not qualify for cash flow hedge accounting or the Company doesnot designate as hedges of future cash flows, the changes in fair value are notdeferred through other comprehensive income, but rather recorded in revenueimmediately as unrealized gains or losses. The Company did not apply cash flowhedge accounting to its crude oil collars entered into in March and May/Augustof 2004, because although they were economic hedges, they did not qualify forhedge accounting.

 

For the nine months ended September30, 2004 and 2003, the Company included in revenue realized and unrealizedlosses of $2.3 million and $4.2 million, respectively, related to its naturalgas hedges and oil derivatives. There was no ineffectiveness recognized duringthe nine months ended September 30, 2004 or 2003. 

 
| ** **                                              | ** ** | **Nine Months Ended September 30,** | ** ** |
|---------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                              | ** ** | **2004**                                 | ** ** | **2003** | ** ** |
| Natural gas hedging contract settlements                |       | $                                        | (222,000   | ) | $ | (4,160,350 | ) |
| Oil derivative contract settlements                     |       | (410,713                                 | )          | — |   |
| Hedge premium reclassification                          |       | (411,650                                 | )          | — |   |
| Oil derivative contract unrealized change in fair value |       | (1,254,911                               | )          | — |   |
| Loss on hedging and derivatives                         |       | $                                        | (2,299,274 | ) | $ | (4,160,350 | ) |
|                                                         |            |                                          |            |  |  |  |  |  |

 

 

13

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A portion of the oil collar thatextends into the fourth quarter of 2005 was classified as long term and theremaining contracts were classified as current based on the maturity of thecontracts. The outstanding derivatives and hedges at September 30, 2004 andDecember 31, 2003 impacting the balance sheet were as follows: 

 
| ** **          | ** ** | ** **         | ** ** | ** ** | ** ** | ** **        | ** ** | ** **        | ** ** | ** **    | ** ** | ** **  | ** ** | **Unrealized Hedging Gains (Losses)** | ** ** |
|---------------------|------------|--------------------|------------|------------|------------|-------------------|------------|-------------------|------------|---------------|------------|-------------|------------|---------------------------------------|------------|
| ** **          | ** ** | ** **         | ** ** | ** ** | ** ** | ** **        | ** ** | ** **        | ** ** | ** **    | ** ** | **Volumes** | ** ** | **As of**                             | ** ** |
| **Transaction**     | ** ** | **Transaction**    | ** ** | ** ** | ** ** | ** **        | ** ** | ** **        | ** ** | **Price**     | ** ** | **Per**     | ** ** | **September 30,**                | ** ** | **December 31,** | ** ** |
| **Date**            | ** ** | **Type**           | ** ** | ** ** | ** ** | **Beginning**     | ** ** | **Ending**        | ** ** | **Per Unit**  | ** ** | **Day**     | ** ** | **2004**                              | ** ** | **2003** | ** ** |
| ***Natural  Gas***: |       |               |       |       |       |              |       |              |       |          |       |        |       |                                  |       |   |   |
| 12/03               |       | Natural Gas Collar |       | (1)        |       | 01/01/04          |       | 03/31/04          |       | $4.50-$7.05   |       | 5,000       |       | $                                     | —     |   | $ | 37,688 |   |
| 08/03               |       | Natural Gas Collar |       | (1)(2)     |       | 040/1/04          |       | 09/30/04          |       | $4.50-$6.00   |       | 10,000      |       | —                                |       | 42,996 |   |
| 08/03               |       | Natural Gas Collar |       | (1)(2)     |       | 01/01/04 10/01/04 |       | 03/31/04 12/31/04 |       | $4.50-$7.00   |       | 10,000      |       | (346,634                              | )          | 40,117 |   |
| 02/04               |       | Natural Gas Collar |       | (1)        |       | 04/01/04          |       | 09/30/04          |       | $4.50-$6.20   |       | 5,000       |       | —                                |       | — |   |
| 03/04               |       | Natural Gas Collar |       | (1)        |       | 10/01/04          |       | 12/31/04          |       | $4.50-$7.25   |       | 5,000       |       | (138,163                              | )          | — |   |
| 05/04               |       | Natural Gas Collar |       | (1)        |       | 01/01/05          |       | 03/31/05          |       | $5.00-$10.39  |       | 10,000      |       | (212,843                              | )          | — |   |
| 07/04               |       | Natural Gas Collar |       | (1)        |       | 04/01/05          |       | 06/30/05          |       | $5.00-$7.53   |       | 10,000      |       | (166,387                              | )          | — |   |
| 07/04               |       | Natural Gas Collar |       | (1)        |       | 07/01/05          |       | 09/30/05          |       | $5.00-$7.67   |       | 10,000      |       | (158,025                              | )          | — |   |
|                |       |               |       |       |       |              |       |              |       |          |       |        |       |                                  |       |   |   |   |
| ***Crude  Oil:***   |       |               |       |       |       |              |       |              |       |          |       |        |       |                                  |       |   |   |
| 03/04               |       | Crude Oil Collar   |       | (3)        |       | 04/01/04          |       | 12/31/04          |       | $30.00-$35.50 |       | 400         |       | (620,428                              | )          | — |   |
| 05/04 (08/04)       |       | Crude Oil Collar   |       | (3)(4)     |       | 01/01/05          |       | 12/31/05          |       | $35.00-$40.00 |       | 200/290     |       | (634,483                              | )          | — |   |
|                |       |               |       |       |       |              |       |              |       |          |       |        |       | $                                     | (2,276,963 | )  | $ | 120,801 |   |
|                     |            |                    |            |            |            |                   |            |                   |            |               |            |             |            |                                       |            |  |  |  |  |  |  |

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(1)        The Company’s current hedgingactivities for natural gas were entered into on a per MMbtu delivered pricebasis, using the Houston Ship Channel Index, with settlement for each calendarmonth occurring five business days following the expiration date.

 

(2)          This contract was entered into at acost of $686,250.

 

(3)          Hedge accounting is not applied tothe Company’s collars on crude oil, which were entered into on a per barreldelivered price basis, using the West Texas Intermediate Index, with settlementfor each calendar month occurring five business days following the expirationdate. The change in fair value is reflected in net revenue for the nine monthsended September 30, 2004.

 

(4)          In August 2004, the Company replacedthe contract that was outstanding at June 30, 2004 with a new contract thatchanges the volume and pricing terms. The put option is on 200 Bbl/D and thecall option is on 290 Bbl/D. This transaction was completed at no additionalcost to the Company.

 

Hedges entered into after September30, 2004 were as follows: 

 
| ** **           | ** ** | ** **          | ** ** | **Effective Dates** | ** ** | ** ** | ** ** | ** **         | ** ** |
|----------------------|------------|---------------------|------------|---------------------|------------|------------|------------|--------------------|------------|
| **Transaction Date** | ** ** | **Hedge Type**      | ** ** | **Beginning**       | ** ** | **Ending** | ** ** | **Price Per Unit** | ** ** | **Volumes Per Day** | ** ** |
| 10/04                |       | Natural  Gas Collar | (1)        | 1/1/05              |       | 12/31/05   |       | $6.00-$9.52        |       | 10,000  MMBTU |   |

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(1)          The Company’s current hedgingactivities for natural gas were entered into on a per MMbtu delivered pricebasis, Houston Ship Channel Index, with settlement for each calendar monthoccurring five business days following the expiration date.

 

**8.     MILLEREXPLORATION COMPANY MERGER**

 

On December 4, 2003, Edge acquired100% of the outstanding common stock of Miller Exploration Company (“Miller”)in a transaction pursuant to which Miller became a wholly-owned subsidiary ofEdge. The acquisition of Miller was accounted for using the purchase method ofaccounting. 

 

The following unaudited pro formafinancial information has been prepared to present the combined results of Edgeand Miller for the nine months ended September 30, 2003, as if the merger hadoccurred at the beginning of the period presented. This unaudited pro formaconsolidated statement of operations data does not include adjustments toreflect any cost savings or other operational efficiencies that may be realizedas a result of the 

 

 

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merger of Edge and Miller, or any future merger-relatedrestructuring or integration expenses. The pro forma data presented is based onnumerous assumptions and is not necessarily indicative of future results ofoperations of the merged companies.

 
| ** **                                                                | ** ** | **Nine Months Ended  September 30, 2003**  | ** ** |
|---------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                | ** ** | **(In thousands, except  per share data)** | ** ** |
| **STATEMENT OF OPERATIONS DATA**                                          |       |                                       |       |
| Oil and natural gas revenue                                               |       | $                                          | 32,181     |   |
| Income before cumulative effect of accounting change                      |       | $                                          | 6,906      |   |
| Basic earnings per share before cumulative effect of accounting  change   |       | $                                          | 0.57       |   |
| Diluted earnings per share before cumulative effect of accounting  change |       | $                                          | 0.56       |   |

 

**9.     SUBSEQUENTEVENTS**

 

On October 7, 2004 the Companyexecuted an Asset Purchase Agreement to acquire oil and natural gas propertieslocated in South Texas from Contango Oil & Gas Company for a cash purchaseprice of approximately $50 million. These properties are located primarily inJim Hogg County, Texas. The Company expects approximately $5 million of the $50million purchase price to be allocated to the unproved property category. Theproperties to be acquired consist of 38 non-operated producing wells withcurrent net production of approximately 12 MMcfe per day as of October 2004, ofwhich 90% is natural gas. 

 

The purchase price is subject toadjustment for the results of operations after July 1, 2004 and title andenvironmental defects, if any. The acquisition is subject to certain closingconditions, including waivers or appropriate adjustments to the purchase pricein the event of exercise of preferential purchase rights, obtaining certainconsents from lessors and Contango’s shareholder approval. The transaction isexpected to close on or before December 31, 2004. The Company plans to financethe planned acquisition through borrowings under the unused portion of itscredit line, which is expected to increase as a result of this transaction, andthe issuance of equity securities under its outstanding shelf registrationstatement.

 

**10.  COMMITMENTSAND CONTINGENCIES**

 

From time to time the Company is aparty to various legal proceedings arising in the ordinary course ofbusiness.  While the outcome of lawsuitscannot be predicted with certainty, the Company is not currently a party to anyproceeding that it believes, if determined in a manner adverse to the Company,could have a potential material adverse effect on its financial condition,results of operations or cash flows.

 

During the second quarter of 2004,the Company received notice that its franchise tax returns for the State ofTexas would be audited for the tax years 1999 through 2002. After reviewingdocuments submitted, the agent representing the Office of the Comptroller ofthe State of Texas proposed adjustments to the calculation that would result inan increased franchise tax liability. The agent maintained that transfers by the parent company to itssubsidiaries that the Company classified as intercompany loans should insteadbe classified as equity investments in the subsidiary. The State of Texasoriginally proposed that the franchise tax liability of the subsidiaries wouldbe increased by approximately $3.0 million for the four-year period underaudit. 

 

During the third quarter the agentreduced the proposed franchise tax deficiency adjustment to the Company and itssubsidiaries to $467,000. The Company intends to vigorously contest thisproposed franchise tax assessment through appropriate administrative levels inthe Comptroller’s Office.   The next stepin the administrative process is a hearing at the Comptroller’s Officescheduled for November 2004.  Should theCompany’s administrative appeals prove unsuccessful, the Company plans to seekfurther appellate relief through available judicial means.  Due to its intention to continue tovigorously contest the proposed adjustments, the 

 

 

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Company has not recognized anyprovision for the additional franchise taxes that would result from theproposed deficiency.

 

 

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** **

**ITEM 2.   MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

Thefollowing is Management’s Discussion and Analysis (“MD&A”) of significantfactors that have affected certain aspects of our financial position andoperating results during the periods included in the accompanying unauditedcondensed consolidated financial statements. The following MD&A is intendedto help the reader understand Edge Petroleum Corporation (“Edge”). Thisdiscussion should be read in conjunction with the accompanying unauditedcondensed consolidated financial statements included elsewhere in this Form10-Q and 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, 2003and each of our quarterly reports on Form 10-Q for the corresponding prior 2004quarterly periods.

 

**FORWARD LOOKINGSTATEMENTS**

 

Thestatements contained in all parts of this document, including, but not limitedto, those relating to our outlook, the effects of our merger with MillerExploration Company (“Miller”), the consummation of the Contango Oil and GasCompany (“Contango”) acquisition, our financing plans related thereto,including any increase in our credit line, issuance of equity or debt,contribution of acquisition and any other benefit of such acquisition, ourability to access the capital markets to raise additional capital, ourdebt-to-total capital ratio, our drilling plans, our natural gas and oilproduction volumes, our 3-D project portfolio, our ability to hedge our risks,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 retirementobligations, the commodity pricing environment and the state of the economy andany other statements regarding future operations, financial results, businessplans, sources of liquidity and cash needs and other statements that are nothistorical 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” andsimilar expressions are intended to be among the statements that identifyforward looking statements.  Suchstatements involve risks and uncertainties, including, but not limited to, thoserelating to the results of and our dependence on our exploratory anddevelopment drilling activities, the volatility of oil and natural gas prices,the need to replace reserves depleted by production, operating risks of oil andnatural gas operations, our dependence on key personnel, our reliance ontechnological development and possible obsolescence of the technology currentlyused by us, the significant capital requirements of our exploration anddevelopment and technology development programs, the potential impact ofgovernment regulations and liability for environmental matters, results oflitigation and audits, expansion of our capital budgets, our ability to manageour growth and achieve our business strategy, competition from larger oil andgas companies, the uncertainty of reserve information and future net revenueestimates, property acquisition risks, our ability and Contango’s ability tofulfill each of the closing conditions to the Contango property acquisition,risks relating to acquisitions and other factors detailed in our Form 10-K andother filings with 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. 

 

**GENERALOVERVIEW**

 

EdgePetroleum Corporation is a Houston-based independent energy company thatfocuses its exploration, production and marketing activities in selectedonshore basins of the United States. In late 1998, we undertook a top-levelmanagement change and began a shift in strategy from pure exploration whichfocused more on prospect generation to our current strategy which focuses on abalanced program of exploration, exploitation and development and acquisitionof oil and gas properties. Our company generates revenues, income and cashflows by producing and marketing oil and natural gas produced from our oil andnatural gas properties. We make significant capital expenditures in ourexploration, development, and acquisition activities that allow us to continuegenerating 

 

 

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revenue, income andcash flows. In December 2003, we acquired 100 percent of the outstanding stockof Miller.  The transaction was treatedas a tax-free reorganization and accounted for as a purchase businesscombination. Miller continues to conduct exploration and development activitiesas a wholly-owned subsidiary of Edge.

 

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:

 

•      **Industry and Economic Factors** — a general description ofvalue drivers of our business as well as opportunities, challenges and risksrelated to the oil and gas industry.  

 

•      **Approach to the Business** — additional information regardingour approach and strategy.

 

•      **Mergers & Acquisitions** — information about significantchanges in our business structure.

 

•      **Outlook** — additional discussion relating to management’soutlook to the future of our business.

 

•      **Critical Accounting Policies and Estimates** — a discussion ofcertain accounting policies that require critical judgments and estimates.

 

•      **Results of Operations** — an analysis of our Company’sconsolidated results for the periods presented in our financial statements.

 

•      **Liquidity** — an analysis of cash flows and uses of cash.

 

•      **Capital Resources** — an analysis of our sources of cash andcontractual obligations.

 

•      **Risk Management Activities** —supplementary informationregarding our Company’s price-risk management activities involving commoditycontracts that are accounted for at fair value.

 

•      **Tax Matters**— supplementary discussion of income taxmatters.

 

•**      RecentlyIssued Accounting Pronouncements**—a discussion of certain accounting pronouncements recently issued that mayimpact our future results. 

 

**Industry andEconomic 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 difficult to predict. While our revenues are a function of both production and prices, wideswings in commodity prices have most often had the greatest impact on ourresults of operations. The economy as a whole has struggled thus far during2004, but the oil and gas industry has experienced a high commodity price environment,which has positively impacted the entire industry as well as 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 the discovery of no commercially productive reservoirs.Moreover, costs associated with operating within our industry are substantial. 

 

Theoil and gas industry is highly competitive. We compete with major and diversified energy companies, independent oiland gas businesses and individual operators. In addition, the industry as a whole competes with other businesses thatsupply energy to industrial and commercial end users. 

 

 

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Extensivefederal, state and local regulation of the industry significantly affects ouroperations.  In particular, ouractivities are subject to stringent operational and environmentalregulations.  These regulations haveincreased the costs of planning, designing, drilling, installing, operating andabandoning oil and gas wells and related facilities.  These regulations may become more demandingin the future.

 

**Approach to theBusiness**

 

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 maintain a blended portfolio of low, moderate andhigher risk exploration and development projects.  We also attempt to make selected acquisitionsof oil and gas properties to augment our growth and provide future drillingopportunities.  We believe that thisapproach should allow for consistent increases in our oil and gas reserves,while minimizing the chance of failure. To further mitigate risk, we have chosen to seek geologic and geographicdiversification by operating in multiple basins.  We periodically hedge our exposure tovolatile oil and gas prices on a portion of our production to reduce pricerisk. As of September 30, 2004, we have entered into hedge contracts coveringapproximately 55% and 60% of our remaining expected 2004 natural gas and crudeoil production, respectively.  During thesecond and third quarter, we entered into new hedge contracts resulting inapproximately 40-50% and 35% of our expected 2005 natural gas and crude oilproduction, respectively, before any acquisitions, being hedged.

 

Implementationof our business approach relies on our ability to fund ongoing exploration anddevelopment projects with cash flow provided by operating activities andexternal sources of capital.  In late2003, we announced plans for record capital expenditures of approximately $28million for 2004.   In May 2004, weannounced plans to expand the 2004 capital budget to approximately $39 millionand in October 2004 our Board approved an increased 2004 capital budget of $52million. We do not typically include acquisitions in our budgeted capitalexpenditures.  Based on currentexpectations for production volumes and commodity prices, we expect to fundthose capital expenditures from internally generated cash from operatingactivities plus some incremental borrowing on our line of credit. 

 

Debthas increased by $1.0 million in the first nine months of 2004 to $22.0 millionat September 30, 2004. As of that date, our debt to total capital ratio wasapproximately 19%, which we believe leaves us with the financial flexibility tocontinue to execute our business strategies. 

 

**Mergers andAcquisitions**

 

OnDecember 4, 2003 we completed our acquisition of Miller. Miller was anindependent oil and gas exploration and production company with explorationefforts concentrated primarily in the Mississippi Salt Basin of centralMississippi.  We acquired Miller for thedevelopment and exploitation projects in Miller’s core area, increasedfinancial flexibility, and expansion of our core areas. 

 

Underthe terms of the merger agreement, each share of issued and outstanding commonstock of Miller was converted into 1.22342 shares of Edge common stock.  We issued approximately 2.6 million shares ofEdge common stock to the shareholders of Miller in exchange for all of theoutstanding common stock of Miller. The merger was treated as a tax-freereorganization and accounted for as a purchase business combination undergenerally accepted accounting principles.

 

Thefair value of assets acquired from Miller totaled $15.7 million and included$6.4 million of cash.  We incurred $1.2million in costs associated with the merger resulting in net cash acquired inthe merger of $5.2 million for the year ended December 31, 2003. During thenine months ended September 30, 2004 we incurred approximately $233,000 ofexpenses associated with the transaction.

 

Theacquired Miller properties were estimated to contain at least 5.6 Bcfe ofproved reserves at December 31, 2003, of which approximately 60% was naturalgas and 100% was classified as proved developed. The acreage position wasapproximately 83,800 gross (17,200 net) acres with an option to acquire 80,000gross (68,000 net)

 

 

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acres at December 31,2003. We operate the majority of the acquired properties. Production fromMiller properties for the nine months ended September 30, 2004 wasapproximately 1.5 Bcfe. 

 

OnOctober 7, 2004, we executed an Asset Purchase Agreement to acquire oil andnatural gas properties located in South Texas from Contango for a cash purchaseprice of approximately $50 million. These properties, located primarily in JimHogg County, Texas and producing primarily from the Queen City formation, arein a geographic area that has been one of our most active and successful areasof focus in recent years. In addition to estimated proved reserves, ourtechnical team has also identified a substantial number of additional drillinglocations on undeveloped acreage with attractive exploitation and explorationpotential. We expect approximately $5 million of the $50 million purchase priceto be allocated to the unproved property category. The properties to beacquired consist of 38 non-operated producing wells with an average 68% workinginterest and 52% net revenue interest. As of October 2004, net production fromthe properties is approximately 12 MMcfe per day, and is 90% natural gas. 

 

Thepurchase price is subject to adjustment for the results of operations afterJuly 1, 2004 and title and environmental defects, if any. The acquisition issubject to certain closing conditions, including obtaining waivers orappropriate adjustments to the purchase price in the event of exercise of preferentialpurchase rights, obtaining certain consents from lessors and Contango’sshareholder approval. The transaction is expected to close on or beforeDecember 31, 2004. We plan to finance the planned acquisition throughborrowings under the unused portion of our credit line, which is expected toincrease as a result of this transaction, and the issuance of common stock.Following any such issuance of common stock, we intend to maintain ourfinancial goal of a debt-to-total capital ratio of less than 30%.

 

**Outlook**

 

Weexpect our drilling program to increase from 36 wells (17.922 net) in 2003 toapproximately 50 wells (28.0 net) in 2004. Our expected capital program,excluding acquisitions, will be approximately $52 million, approximately 85%greater than 2003. Our expected production volumes combined with a strongcommodity-pricing environment expected for the remainder of the year isanticipated to produce record cash flow. In order to manage the realized andanticipated growth over the year, we have increased our headcount from 35employees as of September 30, 2003 to 51 employees as of September 30, 2004resulting in increased G&A costs.  Tohelp protect against the possibility that commodity prices do not remain at thecurrent levels, we have entered into several hedges covering approximately 55%of our expected natural gas production and 60% of our expected crude oilproduction streams for the remainder of 2004 to offset the negative impact ofpotential downward price movements. During the second and third quarter, weentered into new hedge contracts resulting in approximately 40-50% of ourexpected 2005 natural gas and 35% of our expected 2005 crude oil productionbeing hedged.  We also expect to continueto spend considerable effort in 2004 on acquisitions, as we seek to further ourgrowth.  

 

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.” 

 

**CriticalAccounting Policies and Estimates**

 

Thepreparation of financial statements in conformity with generally acceptedaccounting principles in the United States requires management to make estimatesand assumptions that affect the reported amounts of assets, liabilities,revenues, expenses, contingent assets and liabilities and the relateddisclosures 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 requiresassumptions to be made that were uncertain at the time the estimate was made,and 

 

•      changes in the estimateor different estimates that could have been selected could have a materialimpact on our consolidated results of operations or financial condition. 

 

 

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

 

*Nature of Critical Estimate Item:*Oil & Natural Gas Reserves — Our estimate of proved reserves is based on the quantitiesof oil and gas which geological and engineering data demonstrate, withreasonable certainty, to be recoverable in the future years from knownreservoirs 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 infact vary considerably from actual results. In addition, as prices and cost levels change from year to year, theeconomics of producing the reserves may change and therefore the estimate ofproved reserves also may change.  Anysignificant variance in these assumptions could materially affect the estimatedquantity and value of our reserves. Despite the inherent imprecision in theseengineering estimates, our reserves are used throughout our financialstatements.

 

*Assumptions/Approach Used:*Units-of-production method to amortize our oil andnatural gas properties —The quantity of reserves could significantly impact our depletion expense. Anyreduction in proved reserves without a corresponding reduction in capitalizedcosts will increase the depletion rate.

 

“Ceiling”Test — The full-costmethod of accounting for oil and gas properties requires a quarterlycalculation of a limitation on capitalized costs, often referred to as afull-cost ceiling calculation. The ceiling is the discounted present value ofour estimated total proved reserves adjusted for taxes and the impact of hedgeson pricing, using a 10% discount rate. To the extent that our capitalized costs(net of accumulated depletion and deferred taxes) exceed the ceiling, theexcess must be written off to expense. Once incurred, this impairment of oiland gas properties is not reversible at a later date even if oil and gas pricesincrease. No such impairment was required in the nine months ended September30, 2004 and 2003. This calculation of our proved reserves could significantlyimpact our ceiling limitation used in determining whether an impairment of ourcapitalized costs is necessary. The ceiling calculation dictates that pricesand costs in effect as of the last day of the period are generally heldconstant indefinitely. Therefore, the future net revenues associated with theestimated proved reserves are not based on our assessment of future prices orcosts, but rather are based on prices and costs in effect as of the end of theperiod. Oil and natural gas prices used in the reserve valuation at September30, 2004 were $29.78 per barrel and $6.80 per MMBtu. 

 

*Effect if different assumptionsused:*Units-of-productionmethod to amortize our oil and natural gas properties — A 10% decrease in reserves would have increased ourdepletion expense for the quarter by 19%; however, a 10% increase in ourreserves would have decreased our depletion expense for the quarter by 27%.

 

“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, 2004, we had a cushion (i.e. the excess of theceiling over our capitalized costs) of $71.4 million. A 10% decrease in prices usedwould have decreased our cushion by 18%, but a 10% increase in prices wouldhave increased our cushion by 19%. Our hedging program would serve to mitigatesome of the impact of any price decline. Our hedges did not impact the ceilingtest this quarter, and would not have if the price was 10% lower as theseprices were within the collars, but had we increased the price by 10% the pricewould have exceeded our hedge caps and therefore resulted in a decrease in theceiling of $0.5 million. Another likely factor to contribute to a ceiling testimpairment is a revised estimate of reserves. A 10% decrease in reserve volumewould have decreased our cushion by 18% and a 10% increase in reserve volumeswould have increased our cushion by 20%. 

 

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*Nature of Critical Estimate Item:*Unproved Property Impairment — We have elected to use the full-cost method to account forour oil and gas activities. Investments in unproved properties are notamortized until proved 

 

 

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reservesassociated with the prospects can be determined or until impairmentoccurs.  Unproved properties areevaluated quarterly for impairment on a property-by-property basis.  If the results of an assessment indicate thatan unproved property is impaired, the amount of impairment is added to theproved oil and natural gas property costs to be amortized.

 

*Assumptions/Approach Used:* At September 30, 2004, we had $9.1 million allocated tounproved property. This allocation is based on the estimation by the technicalteam of whether the property has potential attributable reserves. Therefore,the assessment made by our technical team of the potential reserves willdetermine whether costs are moved from the unproved category to the full-costpool for depletion or whether an impairment is taken. 

 

*Effect if different assumptionsused:* A 10% increase ordecrease in the unproved property balance (i.e. transfer to full-cost pool)would have increased or decreased our depletion expense by 2% for the quarterended September 30, 2004.

 

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*Nature of Critical Estimate Item:*Asset Retirement Obligations — We have certain obligations to remove tangible equipmentand restore land at the end of oil and gas production operations.  Our removal and restoration obligations areprimarily associated with plugging and abandoning wells. Previously, the costsassociated with this activity were capitalized to the full-cost pool andcharged to income through depletion. We adopted SFAS No. 143, “*Accounting for Asset Retirement Obligations*” effectiveJanuary 1, 2003, as discussed in Note 1 to our Consolidated FinancialStatements.  SFAS No. 143 significantlychanged the method of accruing for costs an entity is legally obligated toincur related to the retirement of fixed assets (“asset retirement obligations”or “ARO”).  Primarily, the new statementrequires us to estimate asset retirement costs for all of our assets, inflationadjust those costs to the forecast abandonment date, discount that amount usinga credit-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:* Estimating the future asset removal costs is difficult andrequires management to make estimates and judgments because most of the removalobligations are many years in the future and contracts and regulations oftenhave 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 there are somany 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 an independent engineering firm to evaluate ourproperties annually. We use the remaining estimated useful life from theyear-end reserve reports by our independent reserve engineer in estimating whenabandonment 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 

 

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applicationof a discount factor and some significant calculations, could differ fromactual results, despite all our efforts to make an accurate estimate.

 

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*Nature of Critical Estimate Item:*Income Taxes — In accordance with the accounting for income taxes underSFAS No. 109, we have recorded a deferred tax asset to account for the expectedfuture tax consequences of events that have been recognized in our financialstatements and our tax returns. There are several items that result in deferredtax asset impact to the balance sheet, but the largest of which is income taxesand the impact of net operating loss (“NOL”) carryforwards. We routinely assessthe realizability 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/Approach Used:* Numerous judgments and assumptions are inherent in thedetermination of future taxable income, including factors such as futureoperating conditions (particularly as related to prevailing oil and gasprices). The Company is not currently required to pay any federal income taxesbecause of NOL carryforwards.

 

*Effect if different assumptionsused:*We have engaged anindependent public accounting firm to assist us in applying the numerous andcomplicated tax law requirements. However, despite our attempt to make anaccurate estimate, the ultimate utilization of our NOL carryforwards is highlydependent upon our actual production and the realization of taxable income infuture periods. If we estimate that some or all of our NOL carryforwards aremore likely than not going to expire or otherwise not be utilized to reducefuture tax, we would record a valuation allowance to remove the benefit ofthose NOL carryforwards from our financial statements.

 

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

 

HedgeContracts — We formallyassess, both at the hedge’s inception and on an ongoing basis, whether thederivatives that are used for hedging are expected to be highly effective inoffsetting 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 income statement. The effective portionof the changes in the fair value of hedge contracts is recorded initially inOCI. When the hedged production is sold, the realized gains and losses on thehedge contracts are removed from OCI and recorded in revenue. Ineffectiveportions of the changes in the fair value of the hedge contracts are recognizedin revenue as they occur. While the hedge contract is outstanding, theineffective gain or loss may increase or decrease until settlement of thecontract.

 

DerivativeContracts — Fortransactions not accounted for using cash flow hedge accounting, the change inthe fair value of the derivative contract is reflected in revenue immediately,i.e. not deferred through OCI, and there is no measurement of effectiveness.

 

*Assumptions/Approach Used:*Estimating the fair values of derivative instrumentsrequires complex calculations, including the use of a discounted cash flowtechnique, estimates of risk and volatility, and subjective judgment inselecting an appropriate discount rate. In addition, the calculations usefuture market commodity prices, which although posted for trading purposes, aremerely the market consensus of 

 

 

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forecastedprice trends. The results of the fair value calculations cannot be expected torepresent exactly the fair value of our commodity hedges. We currently obtainthe fair value of our positions from our counterparties. Our practice ofrelying on our counterparties who are more specialized and knowledgeable inpreparing these complex calculations reduces our management’s input.

 

*Effect if different assumptionsused:*At September 30,2004, 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 $217,400.

 

**Results ofOperations**

 

Thissection includes discussion of our results of operations for the three-monthand nine-month periods ended September 30, 2004 as compared to the same periodsof the prior year.  We are an independentenergy company engaged in the exploration, development, acquisition andproduction of oil and natural gas.  Ourresources and assets are managed and our results reported as one operatingsegment.  We conduct our operationsprimarily along the onshore United States Gulf Coast, with our primary emphasisin South Texas, Louisiana, Southeast New Mexico, and Southern Mississippi. 

 

**Third Quarter 2004 Compared to the Third Quarter 2003**

 

**Revenue and Production**

 

Totalrevenue increased 49% from the third quarter of 2003 to the comparable 2004period.  For the three months endedSeptember 30, 2004 and 2003, our product mix contributed the followingpercentages of production and revenues:

 
| ** **                 | ** ** | **REVENUES(1)** | ** ** | **PRODUCTION** |
|----------------------------|------------|-----------------|------------|----------------|
| ** **                 | ** ** | **2004**        | ** ** | **2003**       | ** ** | **2004** | ** ** | **2003** | ** ** |
| Natural Gas (Mcf)          |       | 89              | %          | 84             | % | 74 | % | 79 | % |
| Natural gas liquids (Bbls) |       | 8               | %          | 6              | % | 14 | % | 13 | % |
| Crude oil (Bbl)            |       | 3               | %          | 10             | % | 12 | % | 8 | % |
| Total (Mcfe)               |       | 100             | %          | 100            | % | 100 | % | 100 | % |

----

(1) Includes effectof hedging and derivative transactions.

 

Thefollowing table summarizes volume and price information with respect to our oiland gas production for the three-month periods ended September 30, 2004 and2003: 

 

24

----

 

 
| ** **                                  | ** ** | ** **             | ** ** | **2004 Period Compared  to 2003 Period** | ** ** |           |
|---------------------------------------------|------------|------------------------|------------|------------------------------------------|------------|----------------|
| ** **                                  | ** ** | **Three Months Ended** | ** ** | ** **                               | ** ** | **%**          | ** ** |
| ** **                                  | ** ** | **September 30,** | ** ** | **Increase**                             | ** ** | **Increase**   | ** ** |   |
| ** **                                  | ** ** | **2004**               | ** ** | **2003**                                 | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |   |
| **Production Volumes:**                     |       |                   |       |                                     |       |           |   |   |   |   |
| Natural gas (Mcf)                           |       | 2,077,791              |       | 1,717,559                                |       | 360,232        |   | 21 | % |   |
| Natural gas liquids (Bbls)                  |       | 63,857                 |       | 49,308                                   |       | 14,549         |   | 30 | % |   |
| Oil and condensate (Bbls)                   |       | 56,415                 |       | 29,918                                   |       | 26,497         |   | 89 | % |   |
| Natural gas equivalent (Mcfe)               |       | 2,799,423              |       | 2,192,915                                |       | 606,508        |   | 28 | % |   |
| **Average Sales Price:**                    |       |                   |       |                                     |       |           |   |   |   |   |
| Natural gas ($ per Mcf)(1)             |       | $                      | 5.74       |                                     | $          | 4.84           |   | $ | 0.89 |   | 18 | % |   |
| Natural gas liquids ($ per Bbl)        |       | $                      | 16.27      |                                     | $          | 10.05          |   | $ | 6.22 |   | 62 | % |   |
| Oil and condensate ($ per Bbl)(1)      |       | $                      | 39.17      |                                     | $          | 30.18          |   | $ | 8.99 |   | 30 | % |   |
| Natural gas equivalent ($ per Mcfe)(1) |       | $                      | 5.42       |                                     | $          | 4.43           |   | $ | 0.99 |   | 22 | % |   |
| Natural gas equivalent ($ per Mcfe)(2) |       | $                      | 4.73       |                                     | $          | 4.06           |   | $ | 0.67 |   | 17 | % |   |
| **Operating Revenue:**                      |       |                   |       |                                     |       |           |   |   |   |   |
| Natural gas (1)                             |       | $                      | 11,933,309 |                                     | $          | 8,320,546      |   | $ | 3,612,763 |   | 43 | % |   |
| Natural gas liquids                         |       | 1,038,811              |       | 495,448                                  |       | 543,363        |   | 110 | % |   |
| Oil and condensate (1)                      |       | 2,209,754              |       | 903,014                                  |       | 1,306,740      |   | 145 | % |   |
| Loss on hedging and derivatives             |       | (1,939,409             | )          | (824,470                                 | )          | (1,114,939     | ) | (135 | )% |   |
| Total                                       |       | $                      | 13,242,465 |                                     | $          | 8,894,538      |   | $ | 4,347,927 |   | 49 | % |   |
|                                             |            |                        |            |                                          |            |                |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

----

(1) Excludes theeffect of hedging and derivative transactions.

(2) Includes theeffect of hedging and derivative transactions. 

 

Ourrevenue is sensitive to changes in prices received for our products.  A substantial portion of our production issold at prevailing market prices, which fluctuate in response to many factorsthat are outside of our control.  Imbalancesin the supply and demand for oil and natural gas can have a dramatic effect onthe prices we receive for our production. Political instability and availability of alternative fuels could impactworldwide supply, while the economy, weather and other factors outside of ourcontrol could impact demand.

 

Naturalgas revenue, excluding hedging activity, increased 43% for the three monthsended September 30, 2004 over the same period in 2003 due to significantlyhigher production and higher realized prices. Average natural gas productionincreased 21% from 18.7 MMcf/D in the three months ended September 30, 2003 to22.6 MMcf/D in the comparable 2004 period due to production from new wellsdrilled and acquired, primarily in our O’Connor Ranch East, Gato Creek,Encinitas and Miller properties, partially offset by natural declines at ourAustin Field and O’Connor Ranch properties. This increase in production compared to the prior year period resultedin an increase in revenue of approximately $1.7 million (based on 2003comparable period pre-hedge prices). Excluding the effect of hedges, the average natural gas sales price forproduction in the third quarter of 2004 was $5.74 per Mcf compared to $4.85 perMcf for the same period in 2003.  Thisincrease in average price received resulted in increased revenue ofapproximately $1.9 million (based on current year production). 

 

Revenuefrom the sale of NGLs increased 110% for the three months ended September 30,2004 over the same period in 2003. Production volumes for NGLs increased 30%,from 536 Bbls/D for the three months ended September 30, 2003 to 694 Bbls/D forthe three months ended September 30, 2004 due primarily to increased productionfrom new wells drilled and acquired.  Theincrease in NGL production increased revenue by approximately $146,000 (basedon 2003 comparable period average prices). Higher average realized prices for the three months ended September 30,2004 resulted in an increase in revenue of approximately $397,000 (based oncurrent year production).  The averagerealized price for NGLs for the three months ended September 30, 2004 was$16.27 per barrel compared to $10.05 per barrel for the same period in 2003.

 

Revenuefrom the sale of oil and condensate, excluding derivative activity, increased145% for the three months ended September 30, 2004 as compared to the comparableprior year period in 2003 due to increased production and realized prices.Production volumes for oil and condensate increased 89% to 613 Bbls/D for thethree months ended September 30, 2004 compared to 325 Bbls/D for the same prioryear period due primarily to production from the properties acquired fromMiller, as well as new wells drilled. The increase in oil and condensate production resulted in an increase inrevenue of approximately $800,000 (based on 2003 comparable period averageprices). The average realized price for oil and condensate before thederivative losses for the three months ended September 30, 2004 was $39.17 perbarrel compared to $30.18 per barrel in the same period of 2003.  These higher average prices for the thirdquarter of 2004 resulted in an increase in revenue of approximately $507,000(based on current year production).

 

Losseson hedging and derivatives increased 135% for the three months ended September30, 2004 over the same period in 2003 due to the change in the fair marketvalue of the outstanding derivative contracts as a result of volatile commodityprices and cash settlements on expiring contracts. Oil and condensate revenueswere decreased by realized and unrealized losses on our oil derivatives. Forthe three months ended September 30, 2004 we recorded $307,437 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. We did not apply hedge accounting to thesetransactions.  See Note 7 to ourConsolidated Financial Statements.  Theselosses account for a $30.87 per barrel decrease in the realized oil price forthe three months ended September 30, 2004 from $39.17 per barrel to $8.30 perbarrel. There was no oil 

 

25

----

 

derivative activityduring the three months ended September 30, 2003. Should the crude oil pricesdecrease from the current levels, we would realize lower revenues, but our oilderivative losses would also decrease and could possibly result in a gainposition. For the three months ended September 30, 2004, we recognized $197,800of the premium paid for a natural gas hedge entered into in 2003.  This loss decreased the effective natural gassales price by $0.10 per Mcf.  Includedwithin natural gas revenue for the three months ended September 30, 2003 was$824,470 representing realized losses from hedging contract settlements.  These losses decreased the effective naturalgas sales price by $0.48 per Mcf for the three months ended September 30,2003.  Should natural gas prices decreasefrom the current high levels, this could materially affect our revenues thatare not hedged.

 

**Costs and Operating Expenses**

 

Thetable below presents a detail of our expenses for the three months endedSeptember 30, 2004 and 2003: 

 
| ** **                                           | ** ** | **Three Months Ended** | ** ** | **2004 Period Compared  to 2003 Period** | ** ** |
|------------------------------------------------------|------------|------------------------|------------|------------------------------------------|------------|
| ** **                                           | ** ** | **September 30,**      | ** ** | **Increase**                             | ** ** | **% Increase** | ** ** |
| ** **                                           | ** ** | **2004**               | ** ** | **2003**                                 | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
| Lease operating expenses                             |       | $                      | 1,176,732  |                                     | $          | 597,550 |   | $ | 579,182 |   | 97 | % |
| Severance and ad valorem taxes                       |       | 891,194                |       | 561,787                                  |       | 329,407 |   | 59 | % |
| Depreciation, depletion, amortization and accretion: |       |                   |       |                                     |       |   |   |   |   |
| Oil and gas property and equipment                   |       | 5,315,004              |       | 3,572,173                                |       | 1,742,831 |   | 49 | % |
| Other assets                                         |       | 103,815                |       | 140,062                                  |       | (36,247 | ) | (26 | )% |
| ARO accretion                                        |       | 27,627                 |       | 14,799                                   |       | 12,828 |   | 87 | % |
| General and administrative expenses:                 |       |                   |       |                                     |       |   |   |   |   |
| Deferred compensation — repriced options        |       | (153,808               | )          | —                                   |       | (153,808 | ) | * |   |
| Deferred compensation — restricted stock        |       | 143,500                |       | 93,604                                   |       | 49,896 |   | 53 | % |
| Other general and administrative expenses            |       | 1,844,062              |       | 1,157,259                                |       | 686,803 |   | 59 | % |
|                                                 |       | 9,348,126              |       | 6,137,234                                |       | 3,210,892 |   | 52 | %  |
| Other expense, net                                   |       | 50,065                 |       | 120,359                                  |       | (70,294 | ) | (58 | )% |
| Total                                                |       | $                      | 9,398,191  |                                     | $          | 6,257,593 |   | $ | 3,140,598 |   | 50 | % |
|                                                      |            |                        |            |                                          |            |  |  |  |  |  |  |  |  |

----

* Not meaningful

 

Leaseoperating expenses for the three months ended September 30, 2004 increased 97%over the same period of 2003. The 2003 acquisition of properties in South Texasand the Miller merger contributed 61% of the increase in costs. Wells drilledsince the third quarter of 2003 further increased the costs for the thirdquarter of 2004 compared to the prior year. We have experienced some cost increases on outside operated propertieson the O’Connor Ranch field and on operated properties at Gato Creek. Inaddition, the Miller and States properties acquired in 2003 have slightlyhigher costs than our other properties. These cost increases have led to anincrease in lease operating expenses to $0.42 per Mcfe for the three monthsended September 30, 2004 from $0.27 per Mcfe for the same prior year period.

 

Severanceand ad valorem taxes for the three months ended September 30, 2004 increased59% from the third quarter of 2003. Severance tax expense for the third quarter of 2004 was 72% higher thanthe comparable prior year period as a result of higher revenue. Our severancetax expense is levied on our oil and gas revenue dollars (excluding hedging andderivative impact), so if commodity prices remain high, we expect to continueto incur 

 

 

26

----

 

higher severance taxexpense.  For the three months endedSeptember 30, 2004, severance tax expense was approximately 5.2% of revenuesubject to severance taxes compared to 4.8% of revenue subject to severancetaxes for the comparable 2003 period. The increase in tax as a percent ofrevenue was due primarily to a shift in our revenue stream to properties withhigher severance tax rates. Ad valorem costs were comparable in the third quarterof 2003 and the third quarter of 2004. On an equivalent basis, severance and ad valorem taxes averaged $0.32per Mcfe and $0.26 per Mcfe for the three months ended September 30, 2004 and2003, respectively. 

 

Depletion,depreciation, and amortization (“DD&A”) and accretion expense for the threemonths ended September 30, 2004 totaled $5.4 million compared to $3.7 millionfor the three months ended September 30, 2003. Depletion on our oil and natural gas properties increased 49% for thethird quarter of 2004 compared to the same period of 2003 due to an increase inproduction levels and in the unit-of-production depletion rate from $1.63 in2003 as compared to $1.90 in 2004. The increase in depletion expense from thehigher production levels in the third quarter of 2004 as compared to the sameperiod of 2003 resulted in an increase in expense of approximately$988,000.  The increase in rate for thethird quarter of 2004 compared to 2003 added approximately $755,000 indepletion expense. Our rate has increased due to increased spending on ourdrilling program with disproportionate reserve additions. Depreciation offurniture and fixtures decreased 26% compared to the prior year third quarterdue to several larger depreciable assets that became fully depreciated byyear-end 2003 and are not currently contributing to expense. Accretion expenseassociated with our asset retirement obligations for the three months endedSeptember 30, 2004 increased 87% over 2003 for the new obligations incurredfrom the Miller merger, South Texas property acquisition and new wells drilled.

 

TotalG&A for the three months ended September 30, 2004 was $1.8 million, anincrease of 47% compared to the prior year third quarter total of $1.3million.  Pursuant to FIN 44 discussed inNote 1 to the consolidated financial statements, G&A costs include deferredcompensation related to repriced options, deferred compensation related torestricted stock grants and other G&A costs. A FIN 44 credit of $153,808was incurred for the three months ended September 30, 2004 compared to noactivity in the comparable prior year period. Amortization related torestricted stock awards granted over the past three years totaled $143,500 and$93,604, respectively, for the three months ended September 30, 2004 and 2003.The increase relates to new grants that have occurred since 2003. Other G&Afor the three months ended September 30, 2004, which does not include thedeferred compensation expenses discussed above, totaled $1.8 million, a 59%increase from the comparable 2003 period total of $1.2 million.  The increase in other G&A wasattributable to higher salaries and benefits, due in part to higher staffinglevels, as well as higher professional fees related to Sarbanes-Oxleyregulatory requirements and the costs of other work by our new independentaccountants.  For the three months endedSeptember 30, 2004 and 2003, overhead reimbursement fees reduced G&A costsby $49,716 and $30,798, respectively. Capitalized G&A costs further reduced other G&A by $552,070 and$571,667, respectively, for the three months ended September 30, 2004 and2003.  Other G&A on a unit ofproduction basis for the three months ended September 30, 2004 was $0.66 perMcfe compared to $0.53 per Mcfe for the comparable 2003 period. 

 

Includedin other income (expense) was interest expense of $22,204 for the three monthsended September 30, 2004 compared to $128,651 in the same 2003 period. Thedecrease is due to increased capitalization of interest and lower interestrates. Interest expense, including facility fees, was $188,843 for the thirdquarter of 2004 on weighted average debt of $19.0 million compared to interestexpense of $194,336 on weighted average debt of approximately $21.5 million forthe third quarter of 2003.  Capitalizedinterest for the three months ended September 30, 2004 totaled $166,639compared to $65,685 in the same prior year period due to our higher unprovedproperty balance at period end.  We alsorecorded amortization of deferred loan costs of $35,948 during the thirdquarter of 2004 related to our amended credit facility.

 

Anincome tax provision was recorded for the three months ended September 30, 2004and 2003 of $1.4 million and $0.9 million, respectively.  The increase resulted from higher pre-taxincome in 2004 as compared to 2003.

 

Forthe three months ended September 30, 2004, we had net income of $2.5 million,or $0.19 basic earnings per share and $0.18 diluted earnings per share, ascompared to net income of $1.7 million, or $0.18 basic and $0.17 dilutedearnings per share in the comparable 2003 period.  Basic weighted average shares outstandingincreased slightly for stock option exercises for the three months endedSeptember 30, 2004 and 2003.  Thesignificant increase in shares outstanding between September 30, 2004 and 2003was due primarily to the issuance

 

27

----

 

of 2.6 million sharesof stock in the merger with Miller in December 2003 as well as the exercise ofstock options and warrants and the vesting and issuance of restricted stockduring the fourth quarter 2003 and first nine months of 2004.

 

**Nine Months Ended September 30, 2004 Compared to the Nine Months EndedSeptember 30, 2003**

** **

**Revenue and Production**

** **

Totalrevenue increased 89% from the third quarter of 2003 to the comparable 2004period.  For the nine months endedSeptember 30, 2004, our product mix contributed the following percentages ofproduction and revenues:

 
| ** **                 | ** ** | **REVENUES (1)** | ** ** | **PRODUCTION** | ** ** |
|----------------------------|------------|------------------|------------|----------------|------------|
| ** **                 | ** ** | **2004**         | ** ** | **2003**       | ** ** | **2004** | ** ** | **2003** | ** ** |
| Natural Gas (Mcf)          |       | 84               | %          | 81             | %          | 76 | % | 76 | % |
| Natural gas liquids (Bbls) |       | 7                | %          | 7              | %          | 13 | % | 15 | % |
| Crude oil (Bbl)            |       | 9                | %          | 12             | %          | 11 | % | 9 | % |
| Total (Mcfe)               |       | 100              | %          | 100            | %          | 100 | % | 100 | % |

----

(1) Includes effectof hedging and derivative transactions. 

 

Thefollowing table summarizes volume and price information with respect to our oiland gas production for the nine-month periods ended September 30, 2004 and2003: 

 
| ** **                                  | ** ** | ** **            | ** ** | ** **   | ** ** | **2004 Period Compared  to 2003 Period** | ** ** |
|---------------------------------------------|------------|-----------------------|------------|--------------|------------|------------------------------------------|------------|
| ** **                                  | ** ** | **Nine Months Ended** | ** ** | ** **   | ** ** | **%**                                    | ** ** |
| ** **                                  | ** ** | **September 30,**     | ** ** | **Increase** | ** ** | **Increase**                             | ** ** |
| ** **                                  | ** ** | **2004**              | ** ** | **2003**     | ** ** | **(Decrease)**                           | ** ** | **(Decrease)** | ** ** |
| **Production Volumes:**                     |       |                  |       |         |       |                                     |       |   |   |
| Natural gas (Mcf)                           |       | 6,797,836             |       | 4,195,998    |       | 2,601,838                                |       | 62 | % |
| Natural gas liquids (Bbls)                  |       | 190,944               |       | 131,629      |       | 59,315                                   |       | 45 | % |
| Oil and condensate (Bbls)                   |       | 156,075               |       | 84,744       |       | 71,331                                   |       | 84 | % |
| Natural gas equivalent (Mcfe)               |       | 8,879,950             |       | 5,494,236    |       | 3,385,714                                |       | 62 | % |
| **Average Sales Price:**                    |       |                  |       |         |       |                                     |       |   |   |
| Natural gas ($ per Mcf)(1)             |       | $                     | 5.67       |         | $          | 5.59                                     |       | $ | 0.08 |   | 1 | % |
| Natural gas liquids ($ per Bbl)        |       | $                     | 15.40      |         | $          | 12.88                                    |       | $ | 2.52 |   | 20 | % |
| Oil and condensate ($ per Bbl)(1)      |       | $                     | 36.70      |         | $          | 32.47                                    |       | $ | 4.23 |   | 13 | % |
| Natural gas equivalent ($ per Mcfe)(1) |       | $                     | 5.32       |         | $          | 5.08                                     |       | $ | 0.24 |   | 5 | % |
| Natural gas equivalent ($ per Mcfe)(2) |       | $                     | 5.06       |         | $          | 4.32                                     |       | $ | 0.74 |   | 17 | % |
| **Operating Revenue:**                      |       |                  |       |         |       |                                     |       |   |   |
| Natural gas (1)                             |       | $                     | 38,535,571 |         | $          | 23,440,741                               |       | $ | 15,094,830 |   | 64 | % |
| Natural gas liquids                         |       | 2,939,992             |       | 1,695,787    |       | 1,244,205                                |       | 73 | % |
| Oil and condensate (1)                      |       | 5,728,237             |       | 2,751,525    |       | 2,976,712                                |       | 108 | % |
| Loss on hedging and derivatives             |       | (2,299,274            | )          | (4,160,350   | )          | 1,861,076                                |       | 45 | % |
| Total                                       |       | $                     | 44,904,526 |         | $          | 23,727,703                               |       | $ | 21,176,823 |   | 89 | % |

----

(1) Excludes theeffect of hedging and derivative transactions.

(2) Includes theeffect of hedging and derivative transactions. 

 

28

----

 

Naturalgas revenue, excluding hedging activity, increased 64% for the nine monthsended September 30, 2004 as compared to the same period in 2003 due tosignificantly higher production. Average natural gas production increased 62%from 15.4 MMcf/D in the nine months ended September 30, 2003 to 24.8 MMcf/D inthe comparable 2004 period due to production from new wells drilled andacquired, primarily our O’Connor Ranch East, Gato Creek, Encinitas and Millerproperties, partially offset by natural declines at our Austin Field andO’Connor Ranch properties.  This increasein production compared to the prior year period resulted in an increase inrevenue of approximately $14.5 million (based on 2003 comparable periodpre-hedge prices).  Excluding the effectof hedges, the average natural gas sales price for production in the first ninemonths of 2004 was $5.67 per Mcf compared to $5.59 per Mcf for the same periodin 2003.  This increase in average pricereceived resulted in increased revenue of approximately $560,000 (based oncurrent year production). 

 

Revenuefrom the sale of NGLs for the nine months ended September 30, 2004 increased73% from the same 2003 period due to both increased production and higherrealized prices. Production volumes for NGLs increased 45%, from 482 Bbls/D forthe nine months ended September 30, 2003 to 697 Bbls/D for the same period in2004 due primarily to increased production from new wells drilled andacquired.  The increase in NGL productionincreased revenue by approximately $764,000 (based on 2003 comparable periodaverage prices).  Higher average realizedprices for the nine months ended September 30, 2004 resulted in an increase inrevenue of approximately $480,000 (based on current year production).

 

Revenuefrom the sale of oil and condensate, excluding derivative activity, for thenine months ended September 30, 2004 increased 108% from the comparable prioryear period due primarily to production from our Miller properties acquired inlate 2003.  Production volumes for oiland condensate increased 84% to 570 Bbls/D for the nine months ended September30, 2004 compared to 310 Bbls/D for the same period in 2003.  The increase in oil and condensate productionresulted in an increase in revenue of approximately $2.3 million (based on 2003comparable period pre-derivative prices). Excluding the effect of the oilderivatives, the average realized price for oil and condensate for the ninemonths ended September 30, 2004 was $36.70 per barrel compared to $32.47 perbarrel in the same period of 2003.  Thishigher average price for the first nine months of 2004 resulted in an increasein revenue of approximately $661,000 (based on current year production). 

 

Losseson hedging and derivatives decreased 45% for the nine months ended September30, 2004 over the same period in 2003 due to the change in fair market value ofour outstanding derivative contracts as a result of volatile commodity pricesand cash settlements on expiring contracts. For the nine months ended September30, 2004, we realized natural gas hedge losses of $222,000.  In addition, we recognized $411,650 of thepremium paid for a hedge entered into in 2003. These losses decreased the effective natural gas sales price by $0.09per Mcf. Included within natural gas revenue for the nine months endedSeptember 30, 2003 was $4.2 million representing realized losses from hedgingactivity.  These losses decreased theeffective natural gas sales price by $0.99 per Mcf for the nine months endedSeptember 30, 2003. For the nine months ended September 30, 2004, we realizedcrude oil derivative losses of $410,713. In addition, we recordedmark-to-market unrealized losses on the change in fair value of the outstandingoil derivative contracts of $1.3 million for the nine months ended September30, 2004 as compared to none in 2003. We did not apply hedge accounting tothese transactions.  See Note 7 to ourConsolidated Financial Statements. The net loss related to the oil collarsdecreased the average price per barrel by $10.67.  Should the crude oil prices decrease from thecurrent highs, we would realize lower revenues, but our oil derivative losseswould also decrease and could possibly result in a gain position. 

 

**Costs and Operating Expenses**

 

Thetable below presents a detail of our expenses for the nine months endedSeptember 30, 2004 and 2003: 

** **

29

----

 

 
| ** **                                           | ** ** | ** **            | ** ** | **2004 Period Compared   to 2003 Period** | ** ** |           |
|------------------------------------------------------|------------|-----------------------|------------|-------------------------------------------|------------|----------------|
| ** **                                           | ** ** | **Nine Months Ended** | ** ** | ** **                                | ** ** | **%**          | ** ** |   |
| ** **                                           | ** ** | **September 30,**     | ** ** | **Increase**                              | ** ** | **Increase**   | ** ** |   |
| ** **                                           | ** ** | **2004**              | ** ** | **2003**                                  | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |   |
| Lease operating expenses                             |       | $                     | 3,601,898  |                                      | $          | 1,743,352      |   | $ | 1,858,546 |   | 107 | % |   |
| Severance and ad valorem taxes                       |       | 3,146,116             |       | 1,602,846                                 |       | 1,543,270      |   | 96 | % |   |
| Depreciation, depletion, amortization and accretion: |       |                  |       |                                      |       |           |   |   |   |   |
| Oil and gas property and equipment                   |       | 15,467,305            |       | 8,803,799                                 |       | 6,663,506      |   | 76 | % |   |
| Other assets                                         |       | 282,815               |       | 485,792                                   |       | (202,977       | ) | (42 | )% |   |
| ARO accretion                                        |       | 80,128                |       | 44,652                                    |       | 35,476         |   | 79 | % |   |
| General and administrative expenses:                 |       |                  |       |                                      |       |           |   |   |   |   |
| Deferred compensation — repriced options        |       | 1,294,677             |       | —                                    |       | 1,294,677      |   | * |   |   |
| Deferred compensation — restricted stock        |       | 354,600               |       | 270,043                                   |       | 84,557         |   | 31 | % |   |
| Other general and administrative expenses            |       | 5,476,342             |       | 3,844,277                                 |       | 1,632,065      |   | 42 | % |   |
|                                                 |       | 29,703,881            |       | 16,794,761                                |       | 12,909,120     |   | 77 | %  |   |
| Other expense, net                                   |       | 332,101               |       | 456,646                                   |       | (124,545       | ) | (27 | )% |   |
| Total                                                |       | $                     | 30,035,982 |                                      | $          | 17,251,407     |   | $ | 12,784,575 |   | 74 | % |
|                                                      |            |                       |            |                                           |            |                |  |  |  |  |  |  |  |  |  |  |

----

* Not meaningful

 

Leaseoperating expenses for the nine months ended September 30, 2004 increased 107%compared to the same period of 2003. Current year results were impacted by the drilling of 38 wells since thethird quarter of 2003 as well as increased production of 62% over 2003, theMiller merger, acquisitions of properties from third parties, increased costsat O’Connor Ranch, as well as salt water disposal costs at the Thibodeaux wellfor the first half of the year. These cost increases have lead to an increasein lease operating expenses to $0.41 per Mcfe for the nine months endedSeptember 30, 2004 from $0.32 per Mcfe in the comparable prior year period. 

 

Severanceand ad valorem taxes for the nine months ended September 30, 2004 increased 96%over 2003. Severance tax expense for the first nine months of 2004 of $2.8million was 111% higher than the comparable prior year period as a result ofhigher revenue. Our severance tax expense is levied on our oil and gas revenuedollars (excluding hedging and derivative impact), so if commodity pricesremain high, we expect to continue to incur higher severance tax expense.  For the nine months ended September 30, 2004,severance tax expense was approximately 6.0% of revenue subject to severancetaxes compared to 4.8% of revenue subject to severance taxes for the comparable2003 period. The increase in tax as a percent of revenue was due primarily to ashift in our revenue stream to properties with higher severance tax rates. Advalorem costs increased 26% from $274,405 in the first nine months of 2003 to$345,502 in the first nine months of 2004. On an equivalent basis, severance and ad valorem taxes averaged $0.35per Mcfe and $0.29 per Mcfe for the nine months ended September 30, 2004 and2003, respectively. 

 

Depletion,depreciation, and amortization (“DD&A”) and accretion expense for the ninemonths ended September 30, 2004 totaled $15.8 million compared to $9.3 millionfor the same period in 2003.  Depletionon our oil and natural gas properties increased 76% for the first nine monthsof 2004 compared to the same period of 2003. Depletion expense on a unit ofproduction basis for the nine months ended September 30, 2004 was $1.74 perMcfe, compared to a 2003 rate of $1.60 per Mcfe for the same period.  The increase in depletion expense was dueprimarily to the higher production levels in the first nine months of 2004 ascompared to the same period of 2003. Depreciation of furniture and fixtures for the nine months endedSeptember 30, 2004 decreased 42% compared to the prior year. In the firstquarter of 2003, we moved offices resulting in accelerated depreciation ofleasehold costs associated with our prior office building lease.  We recorded accretion expense associated withour asset retirement obligation for the nine months ended September 30, 2004with an increase of 79% over the comparable 2003 period due to the newobligations incurred for the acquisition, merger and new wells drilled sincethen.

 

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Total G&A for the nine monthsended September 30, 2004 was $7.1 million, an increase of 73% compared to thecomparable prior year total of $4.1 million. G&A costs include deferred compensation related to repriced options,deferred compensation related to restricted stock grants and other G&Acosts. A FIN 44 charge of $1.3 million was incurred for the nine months endedSeptember 30, 2004 compared to no charge in the comparable prior year period.Amortization related to restricted stock awards granted over the past threeyears totaled $354,600 and $270,043, respectively, for the nine months endedSeptember 30, 2004 and 2003. Other G&A for the nine months ended September30, 2004, which does not include the deferred compensation expenses discussedabove, totaled $5.5 million, a 42% increase from the comparable 2003 periodtotal of $3.8 million.  The increase inother G&A was attributable to higher salaries and benefits, due in part tohigher staffing levels, as well as higher legal and professional fees and higherinvestor relation costs.  In addition, weincurred costs associated with the Miller acquisition of approximately$233,000. For the nine months ended September 30, 2004 and 2003, overheadreimbursement fees reduced G&A costs by $179,762 and $87,033, respectively.  Capitalized G&A costs further reducedother G&A by $1.6 million and $1.2 million, respectively, for the ninemonths ended September 30, 2004 and 2003. Other G&A on a unit of production basis for the nine months endedSeptember 30, 2004 was $0.62 per Mcfe compared to $0.70 per Mcfe for thecomparable 2003 period.

 

Included in other income (expense)was interest expense of $241,887 for the nine months ended September 30, 2004compared to $470,086 in the same 2003 period. Interest expense, including facility fees, was $620,005 for the firstnine months of 2004 on weighted average debt of $19.8 million compared tointerest expense of $659,783 on weighted average debt of approximately $21.4million for the first nine months of 2003. Capitalized interest for the nine months ended September 30, 2004totaled $378,118 compared to $189,697 in the same prior year period.  At September 30, 2004, our unproved propertybalance was $9.1 million compared to $5.0 million at December 31, 2003 and $7.6million at September 30, 2003, resulting in the higher capitalized interest forthe 2004 period.  We also reporteddeferred loan costs of $106,332 during the first nine months of 2004.  We amended our credit facility after theMiller merger resulting in loan costs of $425,364 that will be amortized over athree-year period ending December 31, 2006. 

 

An income tax provision was recordedfor the nine months ended September 30, 2004 and 2003 of $5.2 million and $2.3million, respectively. The increase is primarily due to the increase in pre-taxincome. As of December 31, 2003, we had estimated cumulative NOL carryforwardsfor federal income tax purposes of approximately $50.1 million, including $17.4million of NOL carryforwards acquired in the Miller merger, that begin toexpire in 2012.  Currently, we do notanticipate making federal tax payments in 2004. 

 

Upon adoption of SFAS No. 143 onJanuary 1, 2003, we recorded a cumulative effect of a change in accountingprincipal of $357,825 (net of income taxes of $192,675) to recognize transitionamounts for asset retirement obligations, asset retirement costs andaccumulated depletion.

 

For the nine months ended September30, 2004, we had net income of $9.6 million, or $0.75 basic earnings per shareand $0.71 diluted earnings per share, as compared to net income of $3.8million, or $0.40 basic and $0.39 diluted earnings per share in the comparable2003 period.  Basic weighted averageshares outstanding increased from approximately 9.5 million for the nine monthsended September 30, 2003 to 12.9 million in the comparable 2004 period.  The increase in shares outstanding was dueprimarily to the issuance of stock for the acquisition of Miller in December2003 as well as the exercise of stock options, the exercise of warrants and thevesting and issuance of restricted stock during 2003 and the first ninemonths  2004. 

 

**Liquidity**

 

Our primary ongoing source ofcapital is the cash flow generated from our operating activities supplementedby borrowings under our credit facility. Net cash generated from operating activities is a function of productionvolumes, commodity prices, which are inherently volatile and unpredictable,operating efficiency and capital spending. Our business, as with other extractive industries, is a depleting one inwhich each gas equivalent unit produced must be replaced or we, and a criticalsource of our future liquidity, will shrink. Our overall production decline isapproximately 25% per year.  Lesspredictable than production declines from our proved reserves is the impact ofconstantly changing oil and natural gas prices on cash flows and, thereforecapital budgets.  

 

 

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We attempt to mitigate the price risk with our hedgingprogram. Reserves and production volumes are influenced, in part, by the amountof future capital expenditures. In turn, capital expenditures are influenced bymany factors including drilling results, oil and gas prices, industryconditions, prices, availability of goods and services and the extent to whichoil and gas properties are acquired. 

 

Some significant changes to workingcapital may also affect our liquidity in the short term. The increase inaccrued capital expenditures at September 30, 2004 accounts for most of the increasein accrued liabilities at September 30, 2004. These accruals representliabilities incurred from the increase in exploratory and developmentactivities in the third quarter of 2004 and will require payment as soon as wereceive invoices from our vendors. Therefore, we expect our short-term cashoutflows for the fourth quarter to increase as these liabilities come due. AtSeptember 30, 2004, we had 12 wells in various stages of drilling andcompletion.

 

Our liability related to commodityderivatives has increased to $2.3 million, as commodity prices increased,contributing to the working capital reduction. The derivative financialinstrument  liability represents theamount by which strip commodity prices exceed the price caps on our contracts.Should commodity prices decrease, the liability will decline, and theunrealized losses on the income statement and in other comprehensive incomewill reduce or could possibly result in gains. Since hedges and derivatives aresettled out of the receipts from the sale of production, we anticipate havingadequate cash inflows to settle any hedge payments when they come due whilemaintaining revenue near the derivative price. 

 

After considering the impact ofthese working capital changes and our forecasts of future results ofoperations, we believe that cash flows from operating activities, assupplemented by borrowings on our line of credit, combined with our ability tocontrol the timing of the majority of our future exploration and developmentrequirements will provide us with the flexibility and liquidity to meet ourplanned capital requirements for 2004. In addition, our revolving creditfacility has $23.0 million available for general corporate purposes, includingexploratory and developmental drilling and acquisitions of oil and gasproperties. 

 

*Net Cash Provided By OperatingActivities*

 

Cash flows provided by operatingactivities were $40.5 million for the nine months ended September 30, 2004compared to $16.3 million for the nine months ended September 30, 2003.  The significant increase in cash flowsprovided by operating activities for the nine months ended September 30, 2004compared to 2003 was primarily due to higher oil and gas production revenuepartially offset by higher operating expense. Although fluctuations in commodity prices have been the primary reasonfor our short-term changes in cash flow from operating activities, increasedproduction volumes significantly impacted us in the past few quarters.  In an effort to reduce the volatilityrealized on commodity prices, we enter into derivative instruments.  Due to the inflated commodity pricing forcrude oil, the impact related to the derivatives to the first nine months of2004 has been negative, as the prices have exceeded the highs we expected. Wehave realized the benefit of these high prices on our crude oil production, butalso realized the negative impact from $410,713 of cash settlements on ourcrude oil derivatives. We have also realized $222,000 of cash settlements onour natural gas hedges. Overall, oil and gas production revenue increased witha 62% increase in production and a 17% increase in the average price receivedfor our production.

 

*Net Cash Used In InvestingActivities*

 

We reinvest a substantial portion ofour cash flows in our drilling, acquisition, land and geophysicalactivities.  As a result, we used $42.1million in investing activities during the first nine months of 2004.  Capital expenditures of $37.0 million wereattributable to the drilling of 30 gross wells, 23 of which were successful,including 2, which were being tested at quarter end. Leasehold acquisitions,including seismic data and other geological and geophysical expenditurestotaled $2.6 million and acquisition costs totaled $0.1 million for the ninemonths ended September 30, 2004.  Theremaining capital expenditures were associated with computer hardware andoffice equipment.  Proceeds from the saleof oil and gas properties totaled $45,000 during the first nine months of2004.  During the nine months ended September30, 2003, we used $25.2 million in investing activities.  Capital expenditures of $25.5 million for thenine months ended September 30, 2003, were partially offset by $330,096 in

 

 

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proceeds from the sale of interests in certain oil and gasproperties, including the sale of our interest in the Essex I and Essex IIjoint ventures. 

 

We currently anticipate capitalexpenditures in 2004 to be approximately $52 million.  Approximately $43.3 million is allocated toour expected drilling and production activities; $4.3 million is allocated toland and seismic activities; and $4.6 million relates to capitalized interestand G&A and other.  We plan to fundthese expenditures from expected cash flow from operations plus someincremental borrowings.  We have notexplicitly budgeted for acquisitions; however, we have spent considerableeffort evaluating acquisition opportunities during 2004 and expect to continue.We have signed a Purchase and Sale Agreement with Contango to purchase onshoreSouth Texas properties for approximately $50 million (before purchase priceadjustments). We expect to fund this acquisition and any others that may occurin the near term through traditional oil and gas reserve-based bank debt, andthe issuance of common stock and, if required, through additional debt andequity financings.  We currently have$23.0 million of unused borrowing capacity under our credit facility. 

 

*Net Cash Provided By FinancingActivities*

 

Cash flows provided by financingactivities totaled $2.7 million for the nine months ended September 30, 2004.Net borrowings of $1.0 million under our current credit facility as well asdeferred loan costs of $0.4 million associated with amending that facilityafter the Miller merger were partially offset by $2.2 million in proceeds fromthe issuance of common stock related to stock options and warrants exercised inthe first nine months of 2004. Cash flows provided by financing activitiestotaled $9.6 million for the nine months ended September 30, 2003, and includedborrowings of $10.7 million and payments of $1.2 million under our creditfacility as well as $84,603 in proceeds from the issuance of common stock.

 

Due to our active exploration,development and acquisition activities, we have experienced and expect tocontinue to experience substantial working capital requirements.  We intend to fund our 2004 capitalexpenditures, commitments and working capital requirements through cash flowsfrom operations, and to the extent necessary, other financing activities.  The projected 2004 cash flows from operationsand borrowing supplements from our line of credit are estimated to besufficient to fund our budgeted exploration and development program.  We believe we will be able to generatecapital resources and liquidity sufficient to fund our capital expenditures andmeet such financial obligations as they come due.

 

*Contractual Cash Obligations*

 

In July 2004, we expanded ourcorporate office space and increased our lease obligation for a half floorwithin our current office building. This increases our total obligation from$4.1 million to $5.8 million over the same lease term. There were no othermaterial changes, outside the ordinary course of our business, in othercontractual obligations since December 31, 2003.

 

**Capital Resources**

 

Our primary needs for cash are forexploration, development and acquisition of oil and gas properties, and therepayment of principal and interest on outstanding debt.  We attempt to fund our exploration anddevelopment activities primarily from internally generated cash flows andany  shortfalls are supplemented byborrowings under our credit facility. We routinely adjust capital expendituresin response to changes in oil and natural gas prices, drilling and acquisitioncosts, and cash flow. We typically have funded acquisitions from borrowingsunder our credit facility and cash flow from operations.  We have historically utilized net cashprovided by operating activities, debt and equity as capital resources toobtain necessary funding for all of our cash needs.

 

During 2003 and 2004, the rise inour stock price contributed to significant exercise of warrants and stockoptions, from which we have realized increased cash flows from financingactivities. During November and December of 2003, we issued 375,000 shares ofcommon stock in connection with the exercise of warrants that resulted inproceeds to us of approximately $2.0 million. As of December 31, 2003, 45,000 of the warrants were 

 

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outstanding.  On March2, 2004, Mr. Elias, our Chairman and Chief Executive Officer, exercised theremaining warrants for 45,000 shares of common stock which resulted in  proceeds to us of approximately $241,000.Increased activity in stock option and warrant exercises has also resulted inproceeds to us of approximately $1.9 million for the nine months endedSeptember 30, 2004. We typically do not rely on proceeds from the exercise ofwarrants and stock options to sustain our business as they are unpredictableevents. 

 

We had cash and cash equivalents atSeptember 30, 2004 of $2.5 million consisting primarily of short-term moneymarket investments, as compared to $1.3 million at December 31, 2003.  Working capital was ($6.3) million as ofSeptember 30, 2004, as compared to $0.9 million at December 31, 2003.  Available borrowing capacity under ourfacility was $23.0 million at September 30, 2004 and we had $150 millionremaining under our shelf registration statement (see discussion below). 

 

In the event such capital resourcesare not available to us, our drilling and other activities may be curtailed,which may adversely affect our ability to replace our reserves and productionstreams.  

 

*Credit Facility *

 

In March 2004, but effectiveDecember 31, 2003, the Company entered into a new amended and restated creditfacility (the “Credit Facility”) which permits borrowings up to the lesser of(i) the borrowing base or (ii) $100 million. Borrowings under the Credit Facility bear interest at a rate equal toprime plus 0.50% or LIBOR plus 2.25%.  Asof September 30, 2004, $22.0 million in borrowings were outstanding under theCredit Facility and our interest rate was 4.06%.  The Credit Facility matures December 31, 2006and is secured by substantially all of the Company’s assets. 

 

Effective June 2004, the borrowingbase under the Credit Facility was increased to $45.0 million from $40.0million as a result  of the acquisitionof properties in the Miller merger and our drilling activities since the lastredetermination. Effective November 1, 2004, the Credit Facility’s borrowingbase was increased from $45.0 million to $48.0 million.

 

The Credit Facility provides forcertain restrictions, including but not limited to, limitations on additionalborrowings, sales of oil and natural gas properties or other collateral, andengaging in merger or consolidation transactions. The Credit Facility alsoprohibits dividends and certain distributions of cash or properties and certainliens.  The Credit Facility also containsthe following financial covenants, among others,: 

•      The EBITDAX toInterest Expense ratio requires that the ratio of(a) our consolidated EBITDAX(defined as EBITDA plus similar non-cash items and exploration and abandonmentexpenses for such period) for the four fiscal quarters then ended to (b) ourconsolidated interest expense for the four fiscal quarters then ended, to notbe less than 3.5 to 1.0. 

•      The Working Capitalratio requires that the amount of our consolidated current assets less ourconsolidated current liabilities, as defined in the agreement, be at least $1.0million. 

•      The MaximumLeverage ratio requires that the ratio, as of the last day of any fiscalquarter, of (a) Total Indebtedness (as defined in the Credit Facility) as ofsuch fiscal quarter to (b) an amount equal to consolidated EBITDAX for the twoquarters then ended times two, not be greater than 3.0 to 1.0.  

 

Consolidated EBITDAX is a componentof negotiated covenants with our lender and is presented here as part of theCompany’s disclosure of its covenant obligations. 

 

*Shelf Registration Statement*

 

We filed a $150 million shelfregistration statement with the SEC, which became effective in May 2004. Underthe shelf registration statement, we may issue, from time to time, anycombination of debt securities, preferred stock, common stock or warrants fordebt securities or equity securities in one or more offerings to those personswho agree to purchase our securities. At September 30, 2004, we had $150million remaining for issuance under the shelf registration. Our ability toutilize our shelf registration statement for the purpose of issuing, from 

 

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time to time, any combination of debt securities, preferredstock, common stock or warrants for debt securities or equity securities willdepend upon, among other things, market conditions and the existence ofinvestors who wish to purchase our securities at prices acceptable to us. 

 

*Off Balance Sheet Arrangements*

 

We currently do not have any offbalance sheet arrangements.

 

**Risk Management Activities — Derivatives &Hedging **

 

Due to the instability of oil andnatural gas 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 the use of these arrangements limit ourability to benefit from increases in the price of oil and natural gas, it alsoreduces our potential exposure to adverse price movements.  Our arrangements, to the extent we enter intoany, apply to only a portion of our production, provide only partial price protection against declines in oil andnatural gas prices and limits our potential gains from future increases inprices. None of these instruments are used for trading purposes. On a quarterlybasis, our management sets all of our 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 President andChairman of the Board.  Our Board ofDirectors reviews all price-risk management policies and trades.

 

All of these price-risk managementtransactions are considered derivative instruments and accounted for inaccordance with SFAS No. 133, “*Accounting for DerivativeInstruments and Hedging Activities*”. These derivative instrumentsare intended to hedge our price risk and may be considered hedges for economicpurposes, but certain of these transactions may not qualify for special cashflow hedge accounting. Therefore, depending on the type of transaction and thecircumstances, different accounting treatment may apply to the timing andlocation of the income statement impact, but all derivatives are recorded onthe balance sheet at fair value. The following table provides additionalinformation regarding the Company’s various derivative and hedging transactionsthat were recorded at fair value on the balance sheet as of September 30, 2004.

 
| Fair value of contracts outstanding at December 31, 2003                                |   | $          | 120,801    |   |
|-----------------------------------------------------------------------------------------|--------|------------|------------|--------|
| Contracts realized or otherwise settled during the period                               |   | (37,688    | )          |
| Fair value of new contracts when entered into during 2004                               |   | (1,930,329 | )          |
| Changes in fair values attributable to changes in valuation  techniques and assumptions |   | —     |       |
| Other changes in fair values                                                            |   | (429,747   | )          |
| Fair values of contracts outstanding at September 30, 2004                              |   | $          | (2,276,963 | )      |
|                                                                                         |        |            |            |        |  |

 

The following table details the fair value of ourcommodity-based derivative and hedging contracts by year of maturity andvaluation methodology as of September 30, 2004. 

 

** **
| ** **                                         | ** ** | **Fair Value of Contracts at September 30, 2004** | ** ** |
|----------------------------------------------------|------------|---------------------------------------------------|------------|
| **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          |       | (2,159,880                                        | )          | (117,083 | ) | — |   | — |   | (2,276,963 | ) |
| Prices based on models and other valuation methods |       | —                                            |       | — |   | — |   | — |   | — |   |
| Total                                              |       | $                                                 | (2,159,880 | ) | $ | (117,083 | ) | $ | — |   | $ | — |   | $ | (2,276,963 | ) |
|                                                    |            |                                                   |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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**Tax Matters**

 

At December 31, 2003, we hadestimated cumulative NOL carryforwards for federal income tax purposes ofapproximately $50.1 million, including $17.4 million of NOL’s acquired in theMiller merger, that will begin to expire in 2012.  We currently anticipate that all of theseNOL’s will be utilized in connection with federal income taxes payable in thefuture.  Our ability to fully utilize theNOL’s assumes that certain items, primarily intangible drilling costs, havebeen written off for tax purposes in the current year.  However, we have not made a finaldetermination if an election will be made to capitalize all or part of theseitems for tax purposes in the future. 

 

**Recently Issued Accounting Pronouncements**

 

In March 2004, the FASB issued anexposure draft entitled “*Share-Based Payment, anAmendment of FASB Statement No. 123 and 95*.”  This proposed statement addresses theaccounting for share-based payment transactions in which an enterprise receivesemployee services in exchange for (a) equity instruments of the enterprise or(b) liabilities that are based on the fair value of the enterprise’s equityinstruments or that may be settled by the issuance of such equityinstruments.  The proposed statementwould eliminate the ability to account for share-based compensationtransactions using APB Opinion No. 25, “*Accounting for StockIssued to Employees*”, and generally would require instead that suchtransactions be accounted for using a fair-value-based method. The FASBcontinued deliberations throughout the third quarter and expects to issue afinal statement in the fourth quarter of 2004. As proposed, this statementwould be effective for the Company on January 1, 2005.  We are currently evaluating the impact thatmay result from adoption of this proposed statement.

 

In September 2004, the SEC issuedSAB No. 106 regarding the application of SFAS No. 143 by oil and gas producingentities that follow the full cost accounting method. SAB No. 106, effective inthe fourth quarter of 2004, states that after adoption of SFAS No. 143, thefuture cash outflows associated with settling asset retirement obligations thathave been accrued on the balance sheet should be excluded from the presentvalue of estimated future net cash flows used for the full cost ceiling test calculation.It also confirms that the estimated dismantlement and abandonment costs, net ofestimated salvage values, should be included in amortizable base used incomputing unit-of-production depletion. This standard will also requirecompanies to disclose in the accounting impact of SFAS No. 143 on their oil andgas producing activities, including the calculation of the ceiling test anddepreciation, depletion and amortization. The Company currently does not expectthe adoption of SAB No. 106 in the fourth quarter of 2004 to have any materialimpact on its financial statements, nor does it expect adoption to have amaterial effect on the results of the ceiling test calculation. 

 

***ITEM 3.  QUALITATIVE AND QUANTITATIVE DISCLOSURESABOUT MARKET RISK***

 

We are exposed to market risk fromchanges in interest rates and commodity prices. We use a credit facility, which has a floating interest rate, to financea portion of our operations. We are not subject to fair value risk resultingfrom changes in our floating interest rates. The use of floating rate debt instruments provides a benefit due todownward interest rate movements but does not limit us to exposure from futureincreases in interest rates.  Based onthe September 30, 2004 outstanding borrowings and a floating interest rate of4.06%, a 10% change in interest rates would result in an increase or decreaseof interest expense of approximately $85,300 on an annual basis.

 

In the normal course of business weenter into hedging transactions, including commodity price collars, swaps andfloors to mitigate our exposure to commodity price movements, but not fortrading or speculative purposes.   During2003, due to the instability of prices and to achieve a more predictable cashflow, we put in place two natural gas collars for a portion of our 2004production. During the first nine months of 2004, we put in place fiveadditional natural gas collars and two crude oil collars covering 2004 and 2005production. 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 during the nine months ended September 30, 2004

 

 

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| **Transaction Date** | ** ** | **Transaction Type** | ** ** | **Beginning** | ** ** | **Ending**         | ** ** | **Price Per Unit** | ** ** | **Volumes Per Day** | ** ** |
|----------------------|------------|----------------------|------------|---------------|------------|--------------------|------------|--------------------|------------|---------------------|------------|
| ***Natural Gas:***   |       |                 |       |          |       |               |       |               |       |                |       |   |   |
| 12/03                |       | Natural  Gas Collar  |       | (1)           |       | 01/01/04           |       | 03/31/04           |       | $4.50-$7.05         |       | 5,000 |   |
| 08/03                |       | Natural  Gas Collar  |       | (1)(2)        |       | 04/01/04           |       | 09/30/04           |       | $4.50-$6.00         |       | 10,000 |   |
| 08/03                |       | Natural  Gas Collar  |       | (1)(2)        |       | 01/01/04  10/01/04 |       | 03/31/04  12/31/04 |       | $4.50-$7.00         |       | 10,000 |   |
| 02/04                |       | Natural  Gas Collar  |       | (1)           |       | 04/01/04           |       | 09/30/04           |       | $4.50-$6.20         |       | 5,000 |   |
| 03/04                |       | Natural  Gas Collar  |       | (1)           |       | 10/01/04           |       | 12/31/04           |       | $4.50-$7.25         |       | 5,000 |   |
| 05/04                |       | Natural  Gas Collar  |       | (1)           |       | 01/01/05           |       | 03/31/05           |       | $5.00-$10.39        |       | 10,000 |   |
| 07/04                |       | Natural  Gas Collar  |       | (1)           |       | 04/01/05           |       | 06/30/05           |       | $5.00-$7.53         |       | 10,000 |   |
| 07/04                |       | Natural  Gas Collar  |       | (1)           |       | 07/01/05           |       | 09/30/05           |       | $5.00-$7.67         |       | 10,000 |   |
| *** ***         |       |                 |       |          |       |               |       |               |       |                |       |   |   |
| ***Crude Oil:***     |       |                 |       |          |       |               |       |               |       |                |       |   |   |
| 03/04                |       | Crude  Oil Collar    |       | (3)           |       | 04/01/04           |       | 12/31/04           |       | $30.00-$35.50       |       | 400 |   |
| 05/04(08/04)         |       | Crude  Oil Collar    |       | (3)(4)        |       | 01/01/05           |       | 12/31/05           |       | $35.00-$40.00       |       | 200/290 |   |

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(1)   The Company’s current hedging activities fornatural gas were entered into on a per MMbtu delivered price basis, using theHouston Ship Channel Index, with settlement for each calendar month occurringfive business days following the expiration date.

(2)   This contract was entered into at a cost of$686,250.

(3)   Hedge accounting is not applied to theCompany’s collars on crude oil, which were entered into on a per barreldelivered price basis, using the West Texas Intermediate Index, with settlementfor each calendar month occurring five business days following the expirationdate. The change in fair value is reflected in net revenue for the nine monthsended September 30, 2004.

(4)   In August 2004, the Company replaced thehedge contract that was outstanding at June 30, 2004 with a new contract thatchanges the volume and pricing terms. The put option is on 200 Bbl/D and thecall option is on 290 Bbl/D. This transaction was completed at no additionalcost to the Company. 

 

At September 30, 2004, the fairvalue of the outstanding hedges was a liability of approximately $2.3 million.A 10% change in the commodity price per unit, as long as the price is eitherabove the ceiling or below the floor price would cause the fair value total ofthe hedge to increase or decrease by approximately $217,400. 

 

***ITEM 4. CONTROLS ANDPROCEDURES***

 

In accordance with Exchange ActRules 13a-15 and 15d-15, we carried out an evaluation, under the supervisionand with the participation of management, including our Chief Executive Officerand Chief Financial Officer, of the effectiveness of our disclosure controlsand procedures 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, 2004 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 ourinternal controls over financial reporting that occurred during the threemonths ended September 30, 2004 that has materially affected, or isreasonably likely to materially affect, our internal controls over financialreporting. 

 

 

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**PART II - OTHER INFORMATION**

 

**Item 1 - Legal Proceedings**

 

From time to time we are a party tovarious legal proceedings arising in the ordinary course of business.  While the outcome of lawsuits cannot bepredicted with certainty, we are not currently a party to any proceeding thatwe believe, if determined in a manner adverse to the Company, could have apotential material adverse effect on our financial condition, results ofoperations or cash flows.

 

During the second quarter of 2004,the Company received notice that its franchise tax returns for the State ofTexas would be audited for the tax years 1999 through 2002. After reviewingdocuments submitted, the agent representing the Office of the Comptroller ofthe State of Texas proposed adjustments to the calculation that would result inan increased franchise tax liability. The agent maintained that transfers by the parent company to itssubsidiaries that the Company classified as intercompany loans should insteadbe classified as  equity investments inthe subsidiary. The State of Texas originally proposed that the franchise taxliability of the subsidiaries would be increased by approximately $3.0 millionfor the four-year period under audit.

 

During the third quarter the agentreduced the proposed franchise tax deficiency adjustment to the Company and itssubsidiaries to an aggregate of $467,000. The Company intends to continue tovigorously contest this proposed franchise tax assessment through appropriateadministrative levels in the Comptroller’s Office.   The next step in the administrative processis a hearing at the Comptroller’s Office scheduled for November 2004.  Should the Company’s administrative appealsprove unsuccessful, the Company plans to seek further appellate relief throughavailable judicial means.  Due to itsintention to continue to vigorously contest the proposed adjustments, theCompany has not recognized any provision for the additional franchise taxesthat would result from the proposed 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 exhibits are 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 dated as of October 7, 2004 by  and among Contango Step, L.P., Contango Oil and Gas Company, Edge Petroleum  Exploration Company and Edge Petroleum Corporation (Incorporated by reference  from exhibit 2.1 to the Company’s Form 8-K filed on October 12, 2004). |

 

38

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| 3.1    | — | Restated Certificate of Incorporation of the Company  (Incorporated by reference from exhibit 3.1 to the Company’s Registration  Statement on Form S-1/A filed on February 5, 1997 (Registration No. 333-17267)).                                                                                                                                                                                                                                                                                                        |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 3.2    | — | Certificate of Amendment to the Restated Certificate of  Incorporation of the Company (Incorporated by reference from exhibit 3.1 to  the Company’s Registration Statement on Form S-1/A filed on February 5, 1997  (Registration No. 333-17267)).                                                                                                                                                                                                                                                                       |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 3.3    | — | 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).                                                                                                                                                                                                                                                                                                                                                   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 3.4    | — | First Amendment to Bylaws of the Company on September 28,  1999 (Incorporated by reference from exhibit 3.2 to the Company’s Quarterly  Report on Form 10-Q for the quarterly period ended September 30, 1999).                                                                                                                                                                                                                                                                                                          |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 3.5    | — | Second Amendment to Bylaws of the Company on May 7, 2003  (Incorporated by reference from exhibit 3.4 to the Company’s Quarterly Report  on Form 10-Q for the quarterly period ended March 31, 2003).                                                                                                                                                                                                                                                                                                                    |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 4.1    | — | Third Amended and Restated Credit Agreement dated December  31, 2003 by and between Edge Petroleum Corporation, Edge Petroleum  Exploration Company, Edge Petroleum Operating Company, Inc., Miller Oil  Corporation, and Miller Exploration Company, as borrowers, and Union Bank of  California, N.A., a national banking association, as Agent for itself and as  lender. (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    | — | Registration Rights Agreement by and among Edge, Guardian  Energy Management Corp., Kelly E. Miller and the Debra A. Miller Trust, dated  December 4, 2003 (Incorporated by reference from exhibit 4.2 of the Company’s  Registration Statement on Form S-3 filed on February 3, 2004 (Registration  No. 333-112462)).                                                                                                                                                                                                   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 4.3    | — | Securities Purchase Agreement between Miller and Guardian  Energy Management Corp., dated July 11, 2000 (Incorporated by reference from  exhibit 10.1 to Miller’s Current Report on Form 8-K, filed on July 25, 2000).                                                                                                                                                                                                                                                                                                   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 4.4    | — | Warrant between Miller and Guardian Energy Management  Corp., dated July 11, 2000, exercisable for 900,000 shares of Miller’s common  stock (as adjusted for the one for ten reverse stock split of Miller effected  October 11, 2002 and as adjusted pursuant to the Agreement and Plan of Merger  by and among the Company, Edge Delaware Sub Inc. and Miller) (incorporated by  reference from Exhibit 4.3 to Miller’s Current Report on Form 8-K filed on  July 25, 2000).                                      |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 4.5    | — | Miller Exploration Company Stock Option and Restricted  Stock Plan of 1997 (Incorporated by reference from exhibit 10.1(a) to  Miller’s Annual Report on Form 10-K for the year ended December 31, 1997  (File No. 000-23431)).                                                                                                                                                                                                                                                                                          |

 

39

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| 4.6    | — | 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’s Registration Statement on Form S-8 filed on April  11, 2001 (Registration No. 333-58678)).                                                                              |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                    |
| 4.7    | — | 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’s Registration Statement on Form S-8 filed on April 11,  2001 (Registration No. 333-58678)).                                                                              |
|   |   |                                                                                                                                                                                                                                                                                                                                    |
| 4.8    | — | Form of Miller Stock Option Agreement (Incorporated by  reference from exhibit 10.1(b) to Miller’s Annual Report on Form 10-K for the  year ended December 31, 1997 (File No. 000-23431)).                                                                                                                                         |
|   |   |                                                                                                                                                                                                                                                                                                                                    |
| 10.1   | — | Joint Venture Agreement between Edge Joint Venture II and  Essex Royalty Limited Partnership II, dated as of May 10, 1994 (Incorporated  by reference from exhibit 10.2 to the Company’s Registration Statement on  Form S-4 (Registration No. 333-17269)).                                                                        |
|   |   |                                                                                                                                                                                                                                                                                                                                    |
| 10.2   | — | Joint Venture Agreement between Edge Joint Venture II and  Essex Royalty Limited Partnership, dated as of April 11, 1992 (Incorporated  by reference from exhibit 10.3 to the Company’s Registration Statement on  Form S-4 (Registration No. 333-17269)).                                                                         |
|   |   |                                                                                                                                                                                                                                                                                                                                    |
| 10.3   | — | Amendment dated August 21, 2000 to the Joint Venture  Agreement between Edge Joint Venture II and Essex Royalty Limited Partnership  II, dated as of May 10, 1994. (Incorporated by reference from exhibit 10.3 to  the Company’s Annual Report on Form 10-K/A for the year ended December 31,  2002).                             |
|   |   |                                                                                                                                                                                                                                                                                                                                    |
| 10.4   | — | Amendment dated August 21, 2000 to the Joint Venture  Agreement between Edge Joint Venture II and Essex Royalty Limited  Partnership, dated as of April 11, 1992. (Incorporated by reference from  exhibit 10.2 to the Company’s Annual Report on Form 10-K/A for the year ended  December 31, 2002).                              |
|   |   |                                                                                                                                                                                                                                                                                                                                    |
| 10.5   | — | Letter Agreement between Edge Petroleum Corporation and  Essex Royalty Limited Partnership, dated as of July 30, 2002. (Incorporated  by reference from exhibit 10.4 to the Company’s Annual Report on Form 10-K/A  for the year ended December 31, 2002).                                                                         |
|   |   |                                                                                                                                                                                                                                                                                                                                    |
| 10.6   | — | 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)).                                                                                                                  |
|   |   |                                                                                                                                                                                                                                                                                                                                    |
| 10.7   | — | 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)).                                                                                                                            |
|   |   |                                                                                                                                                                                                                                                                                                                                    |
| 10.8   | — | 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).                                                                                                      |
|   |   |                                                                                                                                                                                                                                                                                                                                    |
| 10.9   | — | Incentive Plan of Edge Petroleum Corporation as Amended  and Restated Effective as of June 1, 2004.                                                                                                                                                                                                                                     |
|   |   |                                                                                                                                                                                                                                                                                                                                    |
| 10.10  | — | 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).  |
|   |   |                                                                                                                                                                                                                                                                                                                                    |
| 10.11  | — | 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). |

 

40

----

 
| 10.12  | — | Form of Director’s Restricted Stock Award Agreement under  the Incentive Plan of Edge Petroleum Corporation.                                                                                                                                                    |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                 |
| 10.13  | — | 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). |
|   |   |                                                                                                                                                                                                                                                                 |
| 10.14  | — | 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).      |
|   |   |                                                                                                                                                                                                                                                                 |
| 10.15  | — | 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)).                                |
|   |   |                                                                                                                                                                                                                                                                 |
| 10.16  | — | 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)).                      |
|   |   |                                                                                                                                                                                                                                                                 |
| *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 18 USC Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                                                                                                    |
|   |   |                                                                                                                                                                                                                                                                 |
| *32.2  | — | Certification by Michael G. Long, Chief Financial Officer,  pursuant to 18 USC Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                                                                                                  |

----

* Filed herewith.

 

 

41

----

 

**SIGNATURES**

 

Pursuant to the requirements of theSecurities Exchange Act of 1934, the registrant has duly caused this report tobe signed on its behalf by the undersigned thereunto duly authorized.

 

 
|   |              |   | EDGE PETROLEUM CORPORATION,  A DELAWARE CORPORATION (REGISTRANT) |
|--------|-------------------|--------|------------------------------------------------------------------|
|   |              |   |                                                             |
|   |              |   |                                                             |
| Date   | November 12, 2004 |   | /s/ John W. Elias                                                |
|   |              |   | John W. Elias                                                    |
|   |              |   | Chief Executive Officer and Chairman of the Board                |
|   |              |   |                                                             |
|   |              |   |                                                             |
| Date   | November 12, 2004 |   | /s/ Michael G. Long                                              |
|   |              |   | Michael G. Long                                                  |
|   |              |   | Senior Vice President and Chief Financial Officer                |

 

42

----

 

**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 dated as of October 7, 2004 by  and among Contango Step, L.P., Contango Oil and Gas Company, Edge Petroleum  Exploration Company and Edge Petroleum Corporation (Incorporated by reference  from exhibit 2.1 to the Company’s Form 8-K filed on October 12, 2004). |
|            |   |   |
| 3.1             | — | Restated Certificate of Incorporation of the Company  (Incorporated by reference from exhibit 3.1 to the Company’s Registration  Statement on Form S-1/A filed on February 5, 1997 (Registration No.  333-17267)). |
|            |   |   |
| 3.2             | — | Certificate of Amendment to the Restated Certificate of  Incorporation of the Company (Incorporated by reference from exhibit 3.1 to  the Company’s Registration Statement on Form S-1/A filed on February 5, 1997  (Registration No. 333-17267)). |
|            |   |   |
| 3.3             | — | 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). |
|            |   |   |
| 3.4             | — | First Amendment to Bylaws of the Company on September 28,  1999 (Incorporated by reference from exhibit 3.2 to the Company’s Quarterly  Report on Form 10-Q for the quarterly period ended September 30, 1999). |
|            |   |   |
| 3.5             | — | Second Amendment to Bylaws of the Company on May 7, 2003  (Incorporated by reference from exhibit 3.4 to the Company’s Quarterly Report  on Form 10-Q for the quarterly period ended March 31, 2003). |
|            |   |   |
| 4.1             | — | Third Amended and Restated Credit Agreement dated December  31, 2003 by and between Edge Petroleum Corporation, Edge Petroleum  Exploration Company, Edge Petroleum Operating Company, Inc., Miller Oil  Corporation, and Miller Exploration Company, as borrowers, and Union Bank of  California, N.A., a national banking association, as Agent for itself and as  lender. (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). |

 

43

----

 
| 4.2    | — | Registration Rights Agreement by and among Edge, Guardian  Energy Management Corp., Kelly E. Miller and the Debra A. Miller Trust, dated  December 4, 2003 (Incorporated by reference from exhibit 4.2 of the Company’s  Registration Statement on Form S-3 filed on February 3, 2004 (Registration  No. 333-112462)).                                                                                                                                                              |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 4.3    | — | Securities Purchase Agreement between Miller and Guardian  Energy Management Corp., dated July 11, 2000 (Incorporated by reference from  exhibit 10.1 to Miller’s Current Report on Form 8-K, filed on July 25, 2000).                                                                                                                                                                                                                                                              |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 4.4    | — | Warrant between Miller and Guardian Energy Management  Corp., dated July 11, 2000, exercisable for 900,000 shares of Miller’s common  stock (as adjusted for the one for ten reverse stock split of Miller effected  October 11, 2002 and as adjusted pursuant to the Agreement and Plan of Merger  by and among the Company, Edge Delaware Sub Inc. and Miller) (incorporated by  reference from Exhibit 4.3 to Miller’s Current Report on Form 8-K filed on  July 25, 2000). |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 4.5    | — | Miller Exploration Company Stock Option and Restricted  Stock Plan of 1997 (Incorporated by reference from exhibit 10.1(a) to  Miller’s Annual Report on Form 10-K for the year ended December 31, 1997 (File  No. 000-23431)).                                                                                                                                                                                                                                                     |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 4.6    | — | 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’s Registration Statement on Form S-8 filed on April  11, 2001 (Registration No. 333-58678)).                                                                                                                                                                                                                               |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 4.7    | — | 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’s Registration Statement on Form S-8 filed on April 11,  2001 (Registration No. 333-58678)).                                                                                                                                                                                                                               |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 4.8    | — | Form of Miller Stock Option Agreement (Incorporated by  reference from exhibit 10.1(b) to Miller’s Annual Report on Form 10-K for the  year ended December 31, 1997 (File No. 000-23431)).                                                                                                                                                                                                                                                                                          |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 10.1   | — | Joint Venture Agreement between Edge Joint Venture II and  Essex Royalty Limited Partnership II, dated as of May 10, 1994 (Incorporated  by reference from exhibit 10.2 to the Company’s Registration Statement on  Form S-4 (Registration No. 333-17269)).                                                                                                                                                                                                                         |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 10.2   | — | Joint Venture Agreement between Edge Joint Venture II and  Essex Royalty Limited Partnership, dated as of April 11, 1992 (Incorporated  by reference from exhibit 10.3 to the Company’s Registration Statement on  Form S-4 (Registration No. 333-17269)).                                                                                                                                                                                                                          |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 10.3   | — | Amendment dated August 21, 2000 to the Joint Venture  Agreement between Edge Joint Venture II and Essex Royalty Limited Partnership  II, dated as of May 10, 1994. (Incorporated by reference from exhibit 10.3 to  the Company’s Annual Report on Form 10-K/A for the year ended December 31,  2002).                                                                                                                                                                              |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 10.4   | — | Amendment dated August 21, 2000 to the Joint Venture  Agreement between Edge Joint Venture II and Essex Royalty Limited  Partnership, dated as of April 11, 1992. (Incorporated by reference from  exhibit 10.2 to the Company’s Annual Report on Form 10-K/A for the year ended  December 31, 2002).                                                                                                                                                                               |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 10.5   | — | Letter Agreement between Edge Petroleum Corporation and  Essex Royalty Limited Partnership, dated as of July 30, 2002. (Incorporated  by reference from exhibit 10.4 to the Company’s Annual Report on Form 10-K/A  for the year ended December 31, 2002).                                                                                                                                                                                                                          |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 10.6   | — | 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)).                                                                                                                                                                                                                                                                   |

 

44

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| 10.7   | — | 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)).                                                                                                                            |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                    |
| 10.8   | — | 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).                                                                                                      |
|   |   |                                                                                                                                                                                                                                                                                                                                    |
| 10.9   | — | Incentive Plan of Edge Petroleum Corporation as Amended  and Restated Effective as of June 1, 2004.                                                                                                                                                                                                                                     |
|   |   |                                                                                                                                                                                                                                                                                                                                    |
| 10.10  | — | 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).  |
|   |   |                                                                                                                                                                                                                                                                                                                                    |
| 10.11  | — | 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). |
|   |   |                                                                                                                                                                                                                                                                                                                                    |
| 10.12  | — | Form of Director’s Restricted Stock Award Agreement under  the Incentive Plan of Edge Petroleum Corporation.                                                                                                                                                                                                                       |
|   |   |                                                                                                                                                                                                                                                                                                                                    |
| 10.13  | — | 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).                                                                    |
|   |   |                                                                                                                                                                                                                                                                                                                                    |
| 10.14  | — | 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).                                                                         |
|   |   |                                                                                                                                                                                                                                                                                                                                    |
| 10.15  | — | 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)).                                                                                                   |
|   |   |                                                                                                                                                                                                                                                                                                                                    |
| 10.16  | — | 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)).                                                                                         |
|   |   |                                                                                                                                                                                                                                                                                                                                    |
| *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 18 USC Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                                                                                                                                                                       |
|   |   |                                                                                                                                                                                                                                                                                                                                    |
| *32.2  | — | Certification by Michael G. Long, Chief Financial Officer,  pursuant to 18 USC Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                                                                                                                                                                     |

----

* Filed herewith.

 

45

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