**UNITED STATES****SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-Q**

 

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

 

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

 

**OR**

 

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

 

**For the transition period from          to          **

 

**Commission file number 0-22149**

 

**EDGE PETROLEUM CORPORATION**

(Exact name of registrant as specified in its charter)

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

 

Indicate by checkmark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15 (d) ofthe Securities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days.       Yes  ý   No  o

 

Indicateby check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2of the ExchangeAct). Yes  ý   No  o

 

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

 

| **Class**    | ** ** | **Outstanding at August 5, 2005** |
|--------------|------------|----------------------------------------|
|         |       |                                   |
| Common Stock |       | 17,138,357                             |

 

 

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**EDGE PETROLEUM CORPORATION**

 

**Table of Contents**

 
| Part I.  Financial Information                                                                                                                 |   |
|-----------------------------------------------------------------------------------------------------------------------------------------------------|--------|
| Item 1. Financial Statements:                                                                                                                       |   |
| Consolidated Balance Sheets as of  June 30, 2005 and December 31, 2004                                                                    |   |
| Consolidated Statements of  Operations for the Three and Six Months in the Periods Ended June 30,  2005 and June 30, 2004                 |   |
| Consolidated Statements of  Other Comprehensive Income for the Three and Six Months in the Periods Ended  June 30, 2005 and June 30, 2004 |   |
| Consolidated Statements of  Cash Flows for the Six Months in the Periods Ended June 30, 2005 and  June 30, 2004                           |   |
| Consolidated Statements of  Stockholders’ Equity as of June 30, 2005 and December 31, 2004                                           |   |
| Notes to the Consolidated  Financial Statements                                                                                                     |   |
| Item 2. Management’s Discussion and Analysis of  Financial Condition and Results of Operations                                                 |   |
| Item 3. Qualitative and Quantitative  Disclosures About Market Risk                                                                                 |   |
| Item 4.  Controls and Procedures                                                                                                                    |   |
| Part II.  Other Information                                                                                                                    |   |
| Item  1. Legal Proceedings                                                                                                                          |   |
| Item 2. Unregistered Sale of Equity Securities and Use  of Proceeds                                                                                 |   |
| Item 3. Defaults Upon Senior Securities                                                                                                             |   |
| Item 4. Submission of Matters to a Vote of Security  Holders                                                                                        |   |
| Item  5. Other Information                                                                                                                          |   |
| Item 6.  Exhibits                                                                                                                                   |   |
| Signatures                                                                                                                                          |   |

 

2

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**PART I. FINANCIAL INFORMATION**

 

**Item 1.****Financial Statements**

 

**EDGE PETROLEUM CORPORATION**

 

**CONSOLIDATED BALANCE SHEETS**

 
| ** **                                                                                                                                                                                                                           | ** ** | **June 30,  2005** | ** **  | **December 31,  2004** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|-------------|-----------------------------|------------|
| ** **                                                                                                                                                                                                                           | ** ** | **(Unaudited)**         | ** **  | ** **                  | ** ** |
| **ASSETS**                                                                                                                                                                                                                           |       |                    |        |                        |       |
| ** **                                                                                                                                                                                                                           |       |                    |        |                        |       |
| CURRENT ASSETS:                                                                                                                                                                                                                      |       |                    |        |                        |       |
| Cash and cash  equivalents                                                                                                                                                                                                           |       | $                       | 2,179,589   |                        | $          | 2,267,423 |   |
| Accounts  receivable, trade, net of allowance of $525,248 at June 30, 2005 and  December 31, 2004                                                                                                                          |       | 14,945,716              |        | 12,756,097                  |       |
| Accounts  receivable, joint interest owners, net of allowance of $93,000 and $82,000 at  June 30, 2005 and December 31, 2004, respectively                                                                                 |       | 2,559,601               |        | 5,911,073                   |       |
| Deferred income  taxes                                                                                                                                                                                                               |       | 1,305,333               |        | 660,223                     |       |
| Derivative  financial instruments                                                                                                                                                                                                    |       | —                  |        | 1,824,790                   |       |
| Other current  assets                                                                                                                                                                                                                |       | 3,200,943               |        | 1,445,923                   |       |
|                                                                                                                                                                                                                                 |       |                    |        |                        |       |
| Total current  assets                                                                                                                                                                                                                |       | 24,191,182              |        | 24,865,529                  |       |
|                                                                                                                                                                                                                                 |       |                    |        |                        |       |
| PROPERTY AND  EQUIPMENT, Net – full cost method of accounting for oil and natural gas  properties (including unproved costs of $15.9 million and $15.5 million at  June 30, 2005 and December 31, 2004, respectively) |       | 182,409,838             |        | 165,840,345                 |       |
|                                                                                                                                                                                                                                 |       |                    |        |                        |       |
| OTHER ASSETS                                                                                                                                                                                                                         |       | 213,210                 |        | 284,280                     |       |
|                                                                                                                                                                                                                                 |       |                    |        |                        |       |
| TOTAL ASSETS                                                                                                                                                                                                                         |       | $                       | 206,814,230 |                        | $          | 190,990,154 |   |
|                                                                                                                                                                                                                                 |       |                    |        |                        |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                       |       |                    |        |                        |       |
| ** **                                                                                                                                                                                                                           |       |                    |        |                        |       |
| CURRENT  LIABILITIES:                                                                                                                                                                                                                |       |                    |        |                        |       |
| Accounts  payable, trade                                                                                                                                                                                                             |       | $                       | 1,022,216   |                        | $          | 3,141,235 |   |
| Accrued  liabilities                                                                                                                                                                                                                 |       | 11,271,704              |        | 12,105,694                  |       |
| Asset retirement  obligation – current portion                                                                                                                                                                                  |       | 197,109                 |        | 193,647                     |       |
| Derivative  financial instruments                                                                                                                                                                                                    |       | 1,220,041               |        | 468,308                     |       |
| Total current  liabilities                                                                                                                                                                                                           |       | 13,711,070              |        | 15,908,884                  |       |
|                                                                                                                                                                                                                                 |       |                    |        |                        |       |
| ASSET RETIREMENT  OBLIGATION – non-current portion                                                                                                                                                                              |       | 2,100,472               |        | 1,995,441                   |       |
|                                                                                                                                                                                                                                 |       |                    |        |                        |       |
| DEFERRED TAX  LIABILITY                                                                                                                                                                                                              |       | 8,911,769               |        | 2,618,934                   |       |
|                                                                                                                                                                                                                                 |       |                    |        |                        |       |
| LONG-TERM DEBT                                                                                                                                                                                                                       |       | 13,000,000              |        | 20,000,000                  |       |
|                                                                                                                                                                                                                                 |       |                    |        |                        |       |
| Total  liabilities                                                                                                                                                                                                                   |       | 37,723,311              |        | 40,523,259                  |       |
|                                                                                                                                                                                                                                 |       |                    |        |                        |       |
| COMMITMENTS AND  CONTINGENCIES (NOTE 9)                                                                                                                                                                                              |       |                    |        |                        |       |
|                                                                                                                                                                                                                                 |       |                    |        |                        |       |
| STOCKHOLDERS’  EQUITY                                                                                                                                                                                                           |       |                    |        |                        |       |
| Preferred stock,  $0.01 par value; 5,000,000 shares authorized; none issued and outstanding                                                                                                                                          |       | —                  |        | —                      |       |
| Common stock,  $0.01 par value; 60,000,000 shares authorized; 17,127,837 and 16,535,901  shares issued and outstanding at June 30, 2005 and December 31,  2004, respectively                                               |       | 171,278                 |        | 165,359                     |       |
| Additional  paid-in capital                                                                                                                                                                                                          |       | 134,956,715             |        | 126,957,059                 |       |
| Retained  earnings                                                                                                                                                                                                                   |       | 34,028,849              |        | 22,095,807                  |       |
| Accumulated  other comprehensive income (loss)                                                                                                                                                                                       |       | (65,923                 | )           | 1,248,670                   |       |
|                                                                                                                                                                                                                                 |       |                    |        |                        |       |
| Total  stockholders’ equity                                                                                                                                                                                                     |       | 169,090,919             |        | 150,466,895                 |       |
|                                                                                                                                                                                                                                 |       |                    |        |                        |       |
| TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                                                                     |       | $                       | 206,814,230 |                        | $          | 190,990,154 |   |

 

See accompanying notes toconsolidated financial statements.

 

3

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**EDGE PETROLEUM CORPORATION**

 

**CONSOLIDATED STATEMENTS OFOPERATIONS (Unaudited)**

 
| ** **                                                    | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|---------------------------------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                                                    | ** ** | **2005**                             | ** ** | **2004**                           | ** ** | **2005** | ** ** | **2004** | ** ** |
| OIL AND NATURAL  GAS REVENUE                                  |       |                                 |       |                               |       |   |   |   |   |
| Oil and natural  gas sales                                    |       | $                                    | 26,228,287 |                               | $          | 16,225,435 |   | $ | 50,156,976 |   | $ | 32,021,926 |   |
| Loss on hedging  and derivatives                              |       | (17,834                              | )          | (378,031                           | )          | (1,002,678 | ) | (359,865 | ) |
| Total revenue                                                 |       | 26,210,453                           |       | 15,847,404                         |       | 49,154,298 |   | 31,662,061 |   |
|                                                          |       |                                 |       |                               |       |   |   |   |   |
| OPERATING  EXPENSES:                                          |       |                                 |       |                               |       |   |   |   |   |
| Oil and natural  gas operating expenses                       |       | 1,802,049                            |       | 1,220,092                          |       | 4,044,514 |   | 2,425,166 |   |
| Severance and ad  valorem taxes                               |       | 1,784,837                            |       | 1,210,208                          |       | 3,651,325 |   | 2,254,922 |   |
| Depletion,  depreciation, amortization and accretion          |       | 8,938,998                            |       | 5,141,387                          |       | 17,574,627 |   | 10,383,802 |   |
| General and  administrative expenses:                         |       |                                 |       |                               |       |   |   |   |   |
| Deferred  compensation – repriced options                |       | (90,259                              | )          | 337,386                            |       | 171,645 |   | 1,448,485 |   |
| Deferred  compensation – restricted stock                |       | 262,745                              |       | 114,600                            |       | 406,344 |   | 211,100 |   |
| Bad debt expense                                              |       | —                               |       | —                             |       | 11,000 |   | — |   |
| Other general  and administrative expenses                    |       | 2,357,413                            |       | 1,731,453                          |       | 4,836,138 |   | 3,632,280 |   |
|                                                          |       |                                 |       |                               |       |   |   |   |   |
| Total operating  expenses                                     |       | 15,055,783                           |       | 9,755,126                          |       | 30,695,593 |   | 20,355,755 |   |
|                                                          |       |                                 |       |                               |       |   |   |   |   |
| OPERATING INCOME                                              |       | 11,154,670                           |       | 6,092,278                          |       | 18,458,705 |   | 11,306,306 |   |
|                                                          |       |                                 |       |                               |       |   |   |   |   |
| OTHER INCOME AND  EXPENSE:                                    |       |                                 |       |                               |       |   |   |   |   |
| Interest income                                               |       | 24,129                               |       | 4,023                              |       | 56,475 |   | 8,031 |   |
| Interest  expense, net of amounts capitalized                 |       | —                               |       | (105,405                           | )          | — |   | (219,683 | ) |
| Amortization of  deferred loan costs                          |       | (35,535                              | )          | (40,748                            | )          | (71,070 | ) | (70,384 | ) |
|                                                          |       |                                 |       |                               |       |   |   |   |   |
| INCOME BEFORE  INCOME TAXES                                   |       | 11,143,264                           |       | 5,950,148                          |       | 18,444,110 |   | 11,024,270 |   |
|                                                          |       |                                 |       |                               |       |   |   |   |   |
| INCOME TAX  EXPENSE                                           |       | (3,933,752                           | )          | (2,094,067                         | )          | (6,511,068 | ) | (3,884,953 | ) |
|                                                          |       |                                 |       |                               |       |   |   |   |   |
| NET INCOME                                                    |       | $                                    | 7,209,512  |                               | $          | 3,856,081 |   | $ | 11,933,042 |   | $ | 7,139,317 |   |
|                                                          |       |                                 |       |                               |       |   |   |   |   |
| BASIC EARNINGS  PER SHARE:                                    |       | $                                    | 0.42       |                               | $          | 0.30 |   | $ | 0.70 |   | $ | 0.56 |   |
|                                                          |       |                                 |       |                               |       |   |   |   |   |
| DILUTED EARNINGS  PER SHARE:                                  |       | $                                    | 0.40       |                               | $          | 0.28 |   | $ | 0.67 |   | $ | 0.53 |   |
|                                                          |       |                                 |       |                               |       |   |   |   |   |
| BASIC WEIGHTED  AVERAGE NUMBER OF COMMON SHARES OUTSTANDING   |       | 17,120,163                           |       | 12,940,504                         |       | 17,081,493 |   | 12,833,226 |   |
|                                                          |       |                                 |       |                               |       |   |   |   |   |
| DILUTED WEIGHTED  AVERAGE NUMBER OF COMMON SHARES OUTSTANDING |       | 17,796,443                           |       | 13,588,578                         |       | 17,744,965 |   | 13,412,589 |   |

 

See accompanyingnotes to consolidated financial statements.

 

4

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**EDGE PETROLEUM CORPORATION**

** **

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

 
| ** **                                                                  | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|-----------------------------------------------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                                                                  | ** ** | **2005**                             | ** ** | **2004**                           | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                        |       |                                 |       |                               |       |   |   |   |   |
| NET INCOME                                                                  |       | $                                    | 7,209,512  |                               | $          | 3,856,081 |   | $ | 11,933,042 |   | $ | 7,139,317 |   |
|                                                                        |       |                                 |       |                               |       |   |   |   |   |
| OTHER  COMPREHENSIVE INCOME (LOSS), net of tax:                             |       |                                 |       |                               |       |   |   |   |   |
| Change in fair  value of outstanding hedging and derivative instruments (1) |       | 540,721                              |       | 112,991                            |       | (647,997 | ) | (368,047 | ) |
| Reclassification  of hedging and derivative losses (gains) (2)              |       | 142,622                              |       | 241,773                            |       | (666,596 | ) | 155,199 |   |
|                                                                        |       |                                 |       |                               |       |   |   |   |   |
| Other comprehensive  income (loss)                                          |       | 683,343                              |       | 354,764                            |       | (1,314,593 | ) | (212,848 | ) |
|                                                                        |       |                                 |       |                               |       |   |   |   |   |
| COMPREHENSIVE  INCOME                                                       |       | $                                    | 7,892,855  |                               | $          | 4,210,845 |   | $ | 10,618,449 |   | $ | 6,926,469 |   |

 
|                                        |   |
|----------------------------------------|--------|
| (1) Income  tax (expense) benefit |   | $ | 291,157 |   | $ | 60,842 |   | $ | (348,921 | ) | $ | (198,179 | ) |
|                                   |   |   |   |   |   |   |   |   |   |
| (2) Income  tax (expense) benefit |   | $ | 76,797 |   | $ | 130,186 |   | $ | (358,936 | ) | $ | 89,828 |   |

 

See accompanyingnotes to consolidated financial statements.

 

5

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**EDGEPETROLEUM CORPORATION**

** **

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS (Unaudited)**

 
| ** **                                                                         | ** ** | **Six Months Ended June 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                                         | ** ** | **2005**                           | ** ** | **2004** | ** ** |
| **CASH  FLOWS FROM OPERATING ACTIVITIES:**                                         | ** ** | ** **                         | ** ** | ** ** | ** ** |
| Net income                                                                         |       | $                                  | 11,933,042 |   | $ | 7,139,317 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                               |       |   |   |
| Loss (gain) on  the unrealized change in fair value of derivatives                 |       | 554,074                            |       | (179,261 | ) |
| Loss on property                                                                   |       | 1,778                              |       | — |   |
| Deferred income  taxes                                                             |       | 6,511,068                          |       | 3,884,953 |   |
| Depletion,  depreciation, amortization and accretion                               |       | 17,574,627                         |       | 10,383,802 |   |
| Amortization of deferred  loan costs                                               |       | 71,070                             |       | 70,384 |   |
| Deferred  compensation                                                             |       | 577,989                            |       | 1,659,585 |   |
| Bad debt expense                                                                   |       | 11,000                             |       | — |   |
| Changes in  assets and liabilities:                                                |       |                               |       |   |   |
| Increase in  accounts receivable, trade                                            |       | (1,229,826                         | )          | (630,158 | ) |
| (Increase)  decrease in accounts receivable, joint interest owners                 |       | 3,340,472                          |       | (264,742 | ) |
| Increase in  other assets                                                          |       | (1,755,020                         | )          | (946,179 | ) |
| Increase  (decrease) in accounts payable, trade                                    |       | (2,119,019                         | )          | 977,797 |   |
| Increase  (decrease) in accrued liabilities                                        |       | (1,731,857                         | )          | 1,131,301 |   |
| Increase in  accrued interest payable                                              |       | —                             |       | 20,573 |   |
|                                                                               |       |                               |       |   |   |
| Net cash  provided by operating activities                                         |       | 33,739,398                         |       | 23,247,372 |   |
|                                                                               |       |                               |       |   |   |
| **CASH  FLOWS FROM INVESTING ACTIVITIES:**                                         |       |                               |       |   |   |
| Oil and natural  gas property and equipment additions                              |       | (34,037,405                        | )          | (19,397,552 | ) |
| Proceeds from  the sale of oil and natural gas properties                          |       | —                             |       | 40,000 |   |
|                                                                               |       |                               |       |   |   |
| Net cash used in  investing activities                                             |       | (34,037,405                        | )          | (19,357,552 | ) |
|                                                                               |       |                               |       |   |   |
| **CASH  FLOWS FROM FINANCING ACTIVITIES:**                                         |       |                               |       |   |   |
| Borrowings from  long-term debt                                                    |       | 3,000,000                          |       | — |   |
| Payments of  long-term debt                                                        |       | (10,000,000                        | )          | (3,000,000 | ) |
| Net proceeds  from issuance of common stock                                        |       | 7,210,173                          |       | 1,938,853 |   |
| Deferred loan  costs                                                               |       | —                             |       | (422,304 | ) |
|                                                                               |       |                               |       |   |   |
| Net cash  provided by (used in) financing activities                               |       | 210,173                            |       | (1,483,451 | ) |
|                                                                               |       |                               |       |   |   |
| **NET  INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS**                          |       | (87,834                            | )          | 2,406,369 |   |
| ** **                                                                         |       |                               |       |   |   |
| **CASH  AND CASH EQUIVALENTS, BEGINNING OF PERIOD**                                |       | 2,267,423                          |       | 1,327,081 |   |
| ** **                                                                         |       |                               |       |   |   |
| **CASH  AND CASH EQUIVALENTS, END OF PERIOD**                                      |       | $                                  | 2,179,589  |   | $ | 3,733,450 |   |

 

See accompanying notes toconsolidated financial statements.

 

6

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**EDGE PETROLEUM CORPORATION**

 

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

 
| ** **                                                           | ** ** | **Common  Stock** | ** ** | **Additional  Paid-in Capital** | ** ** | **Retained  Earnings** | ** ** | **Accumulated  Other  Comprehensive  Income (Loss)** | ** ** | **Total  Stockholders’  Equity** | ** ** |
|----------------------------------------------------------------------|------------|-------------------|------------|---------------------------------|------------|------------------------|------------|------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                           | ** ** | ** **        | ** ** | ** **                      | ** ** |
| ** **                                                           | ** ** | **Shares**        | ** ** | **Amount**                      | ** ** | ** **             | ** ** | ** **                                           | ** ** |
| BALANCE,  DECEMBER 31, 2004                                     |       | 16,535,901        |       | $                               | 165,359    |                   | $          | 126,957,059                                          |       | $                                     | 22,095,807 |   | $ | 1,248,670 |   | $ | 150,466,895 |   |
|                                                                 |       |              |       |                            |       |                   |       |                                                 |       |                                  |       |   |   |
| Issuance of  common stock                                            |       | 591,936           |       | 5,919                           |       | 7,266,180              |       | —                                               |       | —                                |       | 7,272,099 |   |
|                                                                 |       |              |       |                            |       |                   |       |                                                 |       |                                  |       |   |   |
| Deferred  compensation – restricted stock                       |       | —            |       | —                          |       | 406,344                |       | —                                               |       | —                                |       | 406,344 |   |
|                                                                 |       |              |       |                            |       |                   |       |                                                 |       |                                  |       |   |   |
| Deferred  compensation - repriced options                            |       | —            |       | —                          |       | 171,645                |       | —                                               |       | —                                |       | 171,645 |   |
|                                                                 |       |              |       |                            |       |                   |       |                                                 |       |                                  |       |   |   |
| Change in  valuation of hedging instruments                          |       | —            |       | —                          |       | —                 |       | —                                               |       | (1,314,593                            | )          | (1,314,593 | ) |
|                                                                 |       |              |       |                            |       |                   |       |                                                 |       |                                  |       |   |   |
| Tax benefit  associated with exercise of non-qualified stock options |       | —            |       | —                          |       | 155,487                |       | —                                               |       | —                                |       | 155,487 |   |
|                                                                 |       |              |       |                            |       |                   |       |                                                 |       |                                  |       |   |   |
| Net income                                                           |       | —            |       | —                          |       | —                 |       | 11,933,042                                           |       | —                                |       | 11,933,042 |   |
|                                                                 |       |              |       |                            |       |                   |       |                                                 |       |                                  |       |   |   |
| BALANCE,  JUNE 30, 2005                                         |       | 17,127,837        |       | $                               | 171,278    |                   | $          | 134,956,715                                          |       | $                                     | 34,028,849 |   | $ | (65,923 | ) | $ | 169,090,919 |   |

 

See accompanying notes to consolidated financialstatements.

 

7

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**EDGEPETROLEUM CORPORATION**

 

**NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS**

 

**1.**          SUMMARY OF SIGNIFICANT ACCOUNTINGPOLICIES

** **

The financial statementsincluded herein have been prepared by Edge Petroleum Corporation, a Delawarecorporation (“we”, “our”, “us” or the “Company”), without audit (with theexception of the balance sheet as of December 31, 2004 which has beenderived from our Annual Report on Form 10-K for the year ended December 31,2004) pursuant to the rules and regulations of the Securities and ExchangeCommission (“SEC”), and reflect all adjustments which are, in the opinion ofmanagement, necessary to present a fair statement of the results for theinterim periods on a basis consistent with the annual audited consolidatedfinancial statements.  All suchadjustments are of a normal recurring nature. The results of operations for the interim periods are not necessarilyindicative of the results to be expected for an entire year.  Certain information, accounting policies andfootnote disclosures normally included in financial statements prepared inaccordance with accounting principles generally accepted in the United Statesof America have been omitted pursuant to such rules and regulations,although we believe that the disclosures are adequate to make the informationpresented not misleading. These financial statements should be read inconjunction with our audited consolidated financial statements included in ourAnnual Report on Form 10-K for the year ended December 31,2004.

 

***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 thatare unique to the oil and gas industry. There are two allowable methods of accounting for oil and gas businessactivities:  the successful-effortsmethod and the full-cost method.  Thereare several significant differences between these methods. Among thesedifferences is that, under the successful-efforts method, costs such asgeological and geophysical (“G&G”), exploratory dry holes and delay rentalsare expensed as incurred whereas under the full-cost method these types ofcharges are capitalized to their respective full-cost pool.  In the measurement of impairment of oil andgas properties, the successful-efforts method of accounting follows theguidance provided in Statement of Financial Accounting Standards (“SFAS”) No. 144,“*Accounting for the Impairment or Disposalof Long-Lived Assets*,” where the first measurement for impairment isto compare the net book value of the related asset to its undiscounted futurecash flows using commodity prices consistent with management expectations.  The full-cost method follows guidanceprovided in SEC Regulation S-X Rule 4-10, where impairment isdetermined by comparing the net book value (full-cost pool) to the future netcash flows discounted at 10 percent using commodity prices in effect at the endof the reporting period.

 

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

 

Oil and natural gas properties are amortized based ona unit-of-production method using estimates of proved reserve quantities. Oiland natural gas liquids (“NGLs”) are converted to gas equivalent basis (“Mcfe”)at the rate of one barrel equals six Mcf. Investments in unproved propertiesare not amortized until proved reserves associated with the prospects can bedetermined or until impairment occurs. Oil and natural gas properties include costs of $15.9 million and $15.5million at June 30, 2005 and December 31, 2004, respectively, relatedto unproved property, which were excluded from capitalized costs beingamortized. Unproved properties are evaluated quarterly, and as needed, forimpairment on a property-by-property basis. If the results of an assessment indicate that an unproved property isimpaired, the amount of impairment is added to the proved oil and natural gasproperty costs to be amortized.  Inaccordance with SEC Staff Accounting Bulletin (“SAB”) No. 106, *“Interaction of Statement 143 and the Full CostRules,”*the amortizable base includes estimated future developmentand dismantlement costs, and restoration and abandonment costs, net ofestimated salvage values.

 

8

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In addition, the capitalized costs of oil and naturalgas properties are subject to a “ceiling test,” whereby to the extent that suchcapitalized costs subject to amortization in the full-cost pool (net ofaccumulated depletion, depreciation and amortization, asset retirement obligationsand related deferred taxes) exceed the present value (using a 10% discountrate) of estimated future net after-tax cash flows from proved oil and naturalgas reserves, such excess costs are charged to expense.  Once incurred, an impairment of oil andnatural gas properties is not reversible at a later date.  In accordance with SAB No.103, “*Update of Codification of Staff Accounting Bulletins*,”derivative instruments qualifying as cash flow hedges are included in thecomputation of limitation on capitalized costs. The period-end price was between the cap and floor established by theCompany’s hedge contracts at June 30, 2005 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 six-month periods ended June 30, 2005 or 2004.

 

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

 

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

 

***Asset RetirementObligations –***TheCompany records a liability for legal obligations associated with theretirement of tangible long-lived assets in the period in which they areincurred in accordance with SFAS No. 143, “*Accounting for Asset Retirement Obligations.*” The Companyadopted this policy effective January 1, 2003, using a cumulative effectapproach to recognize transition amounts for asset retirement obligations,asset retirement costs and accumulated accretion and depletion. Under thismethod, when liabilities for dismantlement and abandonment costs, excludingsalvage values, are initially recorded, the carrying amount of the related oil andgas properties is increased. Accretion of the liability is recognized eachperiod using the interest method of allocation, and the capitalized cost isdepleted over the useful life of the related asset.

 

At January 1, 2003, the Company recorded thepresent value of its future Asset Retirement Obligations (“ARO”) for oil andnatural gas properties and related equipment. The changes to the ARO during theperiods ended June 30, 2005 and 2004 are as follows:

 

| ** **                                  | ** ** | **Six Months Ended June 30,** | ** ** |
|---------------------------------------------|------------|------------------------------------|------------|
| ** **                                  | ** ** | **2005**                           | ** ** | **2004** | ** ** |
| ARO, Beginning  of Period                   |       | $                                  | 2,189,088  |   | $ | 1,811,995 |   |
| Liabilities  incurred in the current period |       | 138,883                            |       | 139,737 |   |
| Liabilities  settled in the current period  |       | (97,919                            | )          | (113,136 | ) |
| Accretion  expense                          |       | 67,529                             |       | 52,501 |   |
| Revisions                                   |       | —                             |       | — |   |
| ARO, End of  Period                         |       | $                                  | 2,297,581  |   | $ | 1,891,097 |   |
|                                        |       |                               |       |   |   |
| Current Portion                             |       | $                                  | 197,109    |   | $ | 386,889 |   |
| Long Term  Portion                          |       | $                                  | 2,100,472  |   | $ | 1,504,208 |   |

 

During the six monthsended June 30, 2005, ARO liabilities incurred include 15 new wellobligations and liabilities settled include six wells that were plugged.

 

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

 

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

 

Had compensation expensefor stock-based compensation been determined based on the fair value at thedate of grant, the Company’s net income and earnings per share would have beenas follows:

 
| ** **                                                                                                                           | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                                                                                                                           | ** ** | **2005**                             | ** ** | **2004**                           | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net income as  reported                                                                                                              |       | $                                    | 7,209,512  |                               | $          | 3,856,081 |   | $ | 11,933,042 |   | $ | 7,139,317 |   |
| Add:                                                                                                                                 |       |                                 |       |                               |       |   |   |   |   |
| Stock-based  employee compensation expense included in reported net income, net of related  income tax                               |       | 112,116                              |       | 293,791                            |       | 375,693 |   | 1,078,730 |   |
| Deduct:                                                                                                                              |       |                                 |       |                               |       |   |   |   |   |
| Total stock-based  employee compensation expense determined under fair value based method for  all awards, net of related income tax |       | (200,765                             | )          | (90,111                            | )          | (325,510 | ) | (208,288 | ) |
| Pro forma net  income                                                                                                                |       | $                                    | 7,120,863  |                               | $          | 4,059,761 |   | $ | 11,983,225 |   | $ | 8,009,759 |   |
|                                                                                                                                 |       |                                 |       |                               |       |   |   |   |   |
| Earnings Per  Share:                                                                                                                 |       |                                 |       |                               |       |   |   |   |   |
| Basic – as  reported                                                                                                            |       | $                                    | 0.42       |                               | $          | 0.30 |   | $ | 0.70 |   | $ | 0.56 |   |
| Basic – pro  forma                                                                                                              |       | $                                    | 0.42       |                               | $          | 0.31 |   | $ | 0.70 |   | $ | 0.62 |   |
|                                                                                                                                 |       |                                 |       |                               |       |   |   |   |   |
| Diluted – as  reported                                                                                                          |       | $                                    | 0.40       |                               | $          | 0.28 |   | $ | 0.67 |   | $ | 0.53 |   |
| Diluted – pro  forma                                                                                                            |       | $                                    | 0.40       |                               | $          | 0.30 |   | $ | 0.68 |   | $ | 0.60 |   |

 

As a result of there-pricing in May 1999 of certain non-qualified stock options granted toour employees and directors in prior years, as well as issuing new options inconjunction with such re-pricing, we became subject to the reportingrequirements of FASB Interpretation No. (“FIN”) 44, “*Accounting for Certain Transactions Involving Stock Compensation*”.FIN 44 requires a company, among other things, to record anon-cash, pre-tax charge to deferred compensation expense if the marketprice of such company’s common stock at the end of a reporting period isgreater than the exercise price of any re-priced stock options.  After the first such adjustment is made, eachsubsequent period is adjusted upward or downward, and a charge or credit, asapplicable, for the period is recorded. Volatility in a company’s stock price can have a direct impact on theamount of these charges and credits from period to period, which may affect thecomparability of results between periods. As of June 30, 2005, we had159,750 of such options outstanding that were subject to these FIN 44reporting requirements. The market price used to calculate the related chargeor credit, as applicable, was $15.68 per share at June 30, 2005, ascompared to $16.25 per share at March 31, 2005 and $14.66 per share at December 31,2004. For the second quarter of 2005, we recorded a non-cash,pre-tax credit of $90,259, as compared to a non-cash, pre-tax charge of$337,386 for the second quarter of 2004. For the first half of 2005, we recorded a non-cash,pre-tax charge of $171,645 as compared to a non-cash, pre-tax charge ofapproximately $1.4 million for the same period in 2004.

 

***AccountingPronouncements***–In December 2004, the FASB issued SFAS No. 123(R), “*Share-Based Payment.*” This statementrequires companies to measure the cost of employee services in exchange for anaward of equity instruments based on a grant-date fair value of the award (withlimited exceptions), and that cost must generally be recognized over the vestingperiod. SFAS No. 123(R) amends the original SFAS No. 123 and 95 that hadallowed companies to choose between expensing stock options orshowing pro forma disclosure only. This statement eliminates the ability toaccount for share-based compensation transactions using APB Opinion No. 25.We currently account for our stock-based compensation plans under theprinciples prescribed by APB Opinion No. 25. Accordingly, no stock optioncompensation cost is reflected in net income, as all options granted under theplan had an exercise price equal to the market value of the underlying commonstock on the date of grant. The adoption of SFAS No. 123(R) will impactour results of operations, but will have no impact on our overall financialposition. In March 2005, the SEC issuedSAB No. 107. Among other things, SAB No. 107 provides interpretiveguidance related to the interaction between SFAS No. 123(R) and certainSEC rules and regulations, as well as provides the SEC staff’s viewsregarding the valuation of share-based payment arrangements for publiccompanies.

 

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SFAS No. 123(R)was to become effective as of the beginning of the first interim or annualreporting period that begins after June 15, 2005, but on April 14,2005, the SEC issued press release 2005-57, which amends the compliancedate of SFAS No. 123(R) for fiscal years beginning after June 15,2005. We anticipate adopting the provisions of SFAS No. 123(R) in thefirst quarter of 2006 using the modified prospective method for transition.Under this method we will recognize compensation expense for all stock-basedawards granted or modified on or after July 1, 2005, as well as anypreviously granted awards that are not fully vested as of July 1, 2005.Compensation expense will be measured based on the fair value of the awardspreviously calculated in developing the pro forma disclosures in accordancewith the provisions of SFAS No. 123 (see Stock-Based Compensationabove). The Company expects the impact to be immaterial due to the fact thatthe Company has not issued options since April 2004 and there will be aminimal amount of unvested options as of our adoption date. SFAS No. 123(R)also requires the benefits of tax deductions in excess of recognized compensationcost be reflected as a financing cash flow, rather than as an operating cashflow as currently required.

 

In March 2005, the FASB issued FASBInterpretation No. 47, *Accounting forConditional Asset Retirement Obligations, an interpretation of FASB Statement No. 143*(“FIN 47”).  FIN 47 clarifies that the term, “conditional asset retirementobligation” as used in SFAS No. 143, *Accountingfor Asset Retirement Obligations*, refers to a legal obligation toperform an asset retirement activity in which the timing and/or method ofsettlement are conditional upon a future event that may or may not be withinthe control of the entity.  Even though uncertainty about the timingand/or method of settlement exists and may be conditional upon a future event,the obligation to perform the asset retirement activity is unconditional. Accordingly, an entity is required to recognize a liability for the fair valueof a conditional asset retirement obligation if the fair value of the liabilitycan be reasonably estimated.  Uncertainty about the timing and/or methodof settlement of a conditional asset retirement obligation should be factoredinto the measurement of the liability when sufficient information exists. The fair value of a liability for the conditional asset retirement obligationshould be recognized when incurred generally upon acquisition, construction, ordevelopment or through the normal operation of the asset.  SFAS No. 143acknowledges that in some cases, sufficient information may not be available toreasonably estimate the fair value of an asset retirement obligation.  FIN47 also clarifies when an entity would have sufficient information toreasonably estimate the fair value of an asset retirement obligation.  FIN47 is effective no later than the end of reporting periods ending after December 15,2005.  Retrospective application for interim financial information ispermitted but is not required.  Early adoption of FIN 47 isencouraged.  The Company is currently evaluating what impact FIN 47 willhave on its financial statements, but at this time, it does not believe thatthe adoption of FIN 47 will have a material effect on the Company’sconsolidated financial position, results of operations or cash flows.

 

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

 

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

 

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

 

Effective December 31,2003, the Company entered into a new amended and restated credit facility (the “CreditFacility”) which permits borrowings up to the lesser of (i) the borrowingbase or (ii) $100 million. Borrowings under the Credit Facility bear interest at a rate equal toprime plus 0.50% or LIBOR plus 2.25%.  AtJune 30, 2005, the interest rate applied to our outstanding balance was6.00%. Commitment fees of 0.50% to 3.75% accrue on the unused portion of theborrowing base, depending on the utilization percentage, and are included as acomponent of interest expense. As of June 30, 2005, $13.0 million inborrowings were outstanding under the Credit Facility.

 

Effective December 29,2004, the Credit Facility’s borrowing base was increased from $48.0 million to$65.0 million. The borrowing base under the Credit Facility was increased as aresult of the asset acquisition that

 

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closedDecember 29, 2004 and drilling activities since the last redetermination.On May 31, 2005, the borrowing base was increased from $65.0 million to$70.0 million as a result of drilling activities since the lastredetermination. In addition, the maturity date was extended from December 31,2006 to December 31, 2007 and the interest rate margins were reduced fromprevious levels.  The Company’s availableborrowing capacity under this facility was $57.0 million at June 30, 2005.

 

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

 

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

•                  TheWorking Capital ratio requires that the amount of the Company’s consolidatedcurrent assets less its consolidated current liabilities, as defined in theagreement, be at least $1.0 million. For the purposes of calculating theWorking Capital ratio, current assets are adjusted for unused capacity undercredit agreement and derivative financial instruments, and current liabilitiesare adjusted for derivative financial instruments and asset retirementobligations.

•                  TheMaximum Leverage ratio requires that the ratio, as of the last day of anyfiscal quarter, of (a) Total Indebtedness (as defined in the CreditFacility) as of such fiscal quarter to (b) an amount equal to consolidatedEBITDAX for the two quarters then ended times two, not be greater than 3.0 to1.0.

 

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

 

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

 

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

 

The Company completed an offering on December 21,2004 of 3.5 million shares of its common stock under the Company’s initialshelf registration statement, which generated net proceeds of $47.8 million,before direct costs of the offering of $0.6 million. These funds were used tofinance the asset acquisition that closed December 29, 2004 and fund othergeneral corporate purposes. On January 5, 2005, the underwriters exercisedtheir over-allotment option for an additional 525,000 shares of common stock,which generated additional net proceeds of $7.2 million. These funds were usedto reduce outstanding debt. Each of these sales was made under the Company’sinitial shelf registration statement. At June 30, 2005, the Company had $390 million availablefor issuance under its current shelf registration statement.

 

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

 

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

 

The following is areconciliation of the numerators and denominators of basic and diluted earningsper common share computations, in accordance with SFAS No. 128, for thethree-month and six-month periods ended June 30, 2005 and 2004:

 
| ** **                               | ** ** | **Three Months Ended June 30, 2005** | ** ** | **Three Months Ended June 30, 2004** | ** ** |
|------------------------------------------|------------|-------------------------------------------|------------|-------------------------------------------|------------|
| ** **                               | ** ** | **Income  (Numerator)**                   | ** ** | **Shares  (Denominator)**                 | ** ** | **Per Share  Amount** | ** ** | **Income  (Numerator)** | ** ** | **Shares  (Denominator)** | ** ** | **Per  Share  Amount** | ** ** |
| **Basic  EPS**                           |       |                                      |       |                                      |       |   |   |   |   |   |   |   |   |
| Income available  to common stockholders |       | $                                         | 7,209,512  |                                      | 17,120,163 |   | $ | 0.42 |   | $ | 3,856,081 |   | 12,940,504 |   | $ | 0.30 |   |
| Effect of  dilutive securities:          |       |                                      |       |                                      |       |   |   |   |   |   |   |   |   |
| Restricted stock                         |       | —                                    |       | 197,061                                   |       | (0.01 | ) | — |   | 138,138 |   | (0.01 | ) |
| Common stock options                     |       | —                                    |       | 479,219                                   |       | (0.01 | ) | — |   | 509,936 |   | (0.01 | ) |
| **Diluted  EPS**                         |       |                                      |       |                                      |       |   |   |   |   |   |   |   |   |
| Income available  to common stockholders |       | $                                         | 7,209,512  |                                      | 17,796,443 |   | $ | 0.40 |   | $ | 3,856,081 |   | 13,588,578 |   | $ | 0.28 |   |

 
| ** **                               | ** ** | **Six Months Ended June 30, 2005** | ** ** | **Six Months Ended June 30, 2004** | ** ** |
|------------------------------------------|------------|------------------------------------|------------|------------------------------------|------------|
| ** **                               | ** ** | **Income  (Numerator)**            | ** ** | **Shares  (Denominator)**          | ** ** | **Per Share  Amount** | ** ** | **Income  (Numerator)** | ** ** | **Shares  (Denominator)** | ** ** | **Per  Share  Amount** | ** ** |
| **Basic  EPS**                           |       |                               |       |                               |       |   |   |   |   |   |   |   |   |
| Income available  to common stockholders |       | $                                  | 11,933,042 |                               | 17,081,493 |   | $ | 0.70 |   | $ | 7,139,317 |   | 12,833,226 |   | $ | 0.56 |   |
| Effect of  dilutive securities:          |       |                               |       |                               |       |   |   |   |   |   |   |   |   |
| Restricted stock                         |       | —                             |       | 173,593                            |       | (0.01 | ) | — |   | 105,368 |   | (0.01 | ) |
| Common stock  options                    |       | —                             |       | 489,879                            |       | (0.02 | ) | — |   | 473,995 |   | (0.02 | ) |
| **Diluted  EPS**                         |       |                               |       |                               |       |   |   |   |   |   |   |   |   |
| Income available  to common stockholders |       | $                                  | 11,933,042 |                               | 17,744,965 |   | $ | 0.67 |   | $ | 7,139,317 |   | 13,412,589 |   | $ | 0.53 |   |

 

**5.****          INCOMETAXES**

 

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

 

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The Company currently estimates that its effective taxrate for the year ending December 31, 2005 will be approximately35.3%.  A provision for income taxes of$6.5 million and $3.9 million was reported for the six months ended June 30,2005 and 2004, respectively. The Company was not required to pay income taxesin 2004 or 2003 because of the generation of net operating losses from drillingactivity.

 

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

 

The Company considers allhighly liquid debt instruments purchased with an original maturity of threemonths or less to be cash equivalents. A summary of non-cash investing andfinancing activities for the six months ended June 30, 2005 and 2004 ispresented below:

 
| **Description**                                                                                       | ** ** | **Number of  Shares  Issued** | ** ** | **Fair Market  Value** | ** ** |
|-------------------------------------------------------------------------------------------------------|------------|-------------------------------|------------|------------------------|------------|
| **Six  months ended June 30, 2005:**                                                             |       |                          |       |                   |       |
| Shares issued to  satisfy restricted stock grants                                                     |       | 48,261                        |       | $                      | 481,842    |   |
| Shares issued to  fund the Company’s matching contribution under the Company’s 401-k plan   |       | 4,275                         |       | $                      | 61,926     |   |
| **Six  months ended June 30, 2004:**                                                             |       |                          |       |                   |       |
| Shares issued to  satisfy restricted stock grants                                                     |       | 56,136                        |       | $                      | 354,183    |   |
| Shares issued to  fund the Company’s matching contribution under the Company’s 401 (k) plan |       | 3,360                         |       | $                      | 43,582     |   |

 

For the six months ended June 30,2005 and 2004, the non-cash portion of Asset Retirement Costs was $40,964 and$26,601, respectively.  A supplementaldisclosure of cash flow information related to interest for the six monthsended June 30, 2005 and 2004 is presented below:

 
| ** **                                                                                                                         | ** ** | **For the Six Months Ended  June 30,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                                         | ** ** | **2005**                                    | ** ** | **2004** | ** ** |
| Cash paid during  the period for:                                                                                                  |       |                                        |       |   |   |
| Interest, net of  amounts capitalized of $480,089 and $211,479 for the six months ended  June 30, 2005 and 2004, respectively |       | $                                           | —     |   | $ | 199,109 |   |
| Income taxes*                                                                                                                      |       | —                                      |       | — |   |
|                                                                                                                                    |            |                                             |            |  |  |  |  |

 

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*The Company was notrequired to pay income taxes in 2004 or 2003.

 

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

 

Due to the volatility ofoil and natural gas prices, the Company periodically enters into price-riskmanagement transactions (e.g., swaps, collars and floors) for a portion of itsoil and natural gas production to achieve a more predictable cash flow, as wellas to reduce exposure from price fluctuations. While the use of 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 or speculative purposes. On a quarterly basis, the Company’s managementsets all of the Company’s price-risk management policies, including volumes,types of instruments and counterparties. These policies are implemented bymanagement through the execution of trades by the Chief Financial Officer afterconsultation and concurrence by the President and Chairman of the Board.  The Board of Directors continuously monitorsthe Company’s policies and trades.

 

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All of these price-riskmanagement transactions are considered derivative instruments and accounted forin accordance with SFAS No. 133, *“Accountingfor Derivative Instruments and Hedging Activities.”* These derivativeinstruments are intended to hedge our price risk and may be considered hedgesfor economic purposes, but certain of these transactions may not qualify forcash flow hedge accounting. All derivative instrument contracts are recorded onthe balance sheet at fair value. For those derivative instrument contracts thatqualify for cash flow hedge accounting, the effective portion of the changes inthe fair value of the contracts is recorded in other comprehensive income andthe ineffective portion of the changes in the fair value of the contracts isrecorded in revenue as they occur. While the contract is outstanding, theineffective gain or loss may increase or decrease until settlement of thecontract depending on the fair value at the measurement dates. When the hedgedproduction is sold, the realized gains and losses on the contracts are removedfrom other comprehensive income and recorded in revenue. The Company iscurrently accounting for its natural gas contracts as cash flow hedges offuture cash flows from the sale of natural gas. For those derivative instrumentcontracts that either do not qualify for cash flowhedge accounting or the Company does not designate as hedges of future cashflows, the changes in fair value are not deferred through other comprehensiveincome, but rather recorded in revenue immediately as unrealized gains orlosses. The Company did not apply cash flow hedge accounting to its crude oilcollars entered into in May/August of 2004, because although they wereeconomic hedges, they did not qualify for hedge accounting.

 

For the six months ended June 30,2005 and 2004, the Company included in revenue realized and unrealized lossesof $1.0 million and $0.4 million, respectively, related to its natural gashedges and oil derivatives. There was no ineffectiveness recognized during thesix months ended June 30, 2005 or 2004.

 
| ** **                                               | ** ** | **Six Months Ended June 30,** | ** ** |
|----------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                               | ** ** | **2005**                           | ** ** | **2004** | ** ** |
| Natural gas  hedging contract settlements                |       | $                                  | 156,500    |   | $ | (222,000 | ) |
| Oil derivative  contract settlements                     |       | (605,104                           | )          | (103,276 | ) |
| Hedge premium  reclassification                          |       | —                             |       | (213,850 | ) |
| Oil derivative  contract unrealized change in fair value |       | (554,074                           | )          | 179,261 |   |
| Gain (loss) on  hedging and derivatives                  |       | $                                  | (1,002,678 | ) | $ | (359,865 | ) |

 

The outstanding hedges at June 30, 2005 and December 31,2004 impacting the balance sheet were as follows:

 
| ** **              | ** ** | ** **            | ** ** | ** **    | ** ** | ** ** | ** ** | ** **          | ** ** | ** **           | ** ** | **Fair  Value of Outstanding Hedging and  Derivative Contracts as of** | ** ** |
|-------------------------|------------|-----------------------|------------|---------------|------------|------------|------------|---------------------|------------|----------------------|------------|------------------------------------------------------------------------|------------|
| **Transaction Date**    | ** ** | **Transaction  Type** | ** ** | **Beginning** | ** ** | **Ending** | ** ** | **Price  Per Unit** | ** ** | **Volumes  Per Day** | ** ** | **June 30,  2005**                                                | ** ** | **December 31,  2004 (4)** | ** ** |
| ***Natural  Gas (1):*** |       |                  |       |          |       |       |       |                |       |                 |       |                                                                   |       |   |   |
| 05/04                   |       | Collar                |       | 01/01/2005    |       | 03/31/2005 |       | $5.00-$10.39        |       | 10,000MMbtu          |       | $                                                                      | —     |   | $ | 92,703 |   |
| 07/04                   |       | Collar                |       | 04/01/2005    |       | 06/30/2005 |       | $5.00-$7.53         |       | 10,000MMbtu          |       | —                                                                 |       | 9,162 |   |
| 07/04                   |       | Collar                |       | 07/01/2005    |       | 09/30/2005 |       | $5.00-$7.67         |       | 10,000MMbtu          |       | (76,232                                                                | )          | (41,210 | ) |
| 10/04                   |       | Collar                |       | 01/01/2005    |       | 12/31/2005 |       | $6.00-$9.52         |       | 10,000MMbtu          |       | (25,187                                                                | )          | 1,860,375 |   |
| ***Crude  Oil (2):***   |       |                  |       |          |       |       |       |                |       |                 |       |                                                                   |       |   |   |
| 03/04                   |       | Collar                |       | 04/01/2004    |       | 12/31/2004 |       | $30.00-$35.50       |       | 400Bbl               |       | —                                                                 |       | (96,240 | ) |
| 05/04 (08/04) (3)       |       | Collar                |       | 01/01/2005    |       | 12/31/2005 |       | $35.00-$40.00       |       | 200/290Bbl           |       | (1,118,622                                                             | )          | (468,308 | ) |
|                    |       |                  |       |          |       |       |       |                |       |                 |       | $                                                                      | (1,220,041 | ) | $ | 1,356,482 |   |

 

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

2.               Hedgeaccounting is not applied to the Company’s collars on crude oil, which wereentered into on a per barrel delivered price basis, using the West TexasIntermediate Index, with settlement for each calendar month occurring fivebusiness days following the expiration date. The change in fair value is reflectedin net revenue for the applicable period.

 

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3.               InAugust 2004, the Company replaced the contract that was entered into May 2004with a new contract that changes the volume and pricing terms. The put optionis on 200 Bbl/D and the call option is on 290 Bbl/D. This transaction wascompleted at no additional cost to the Company.

4.               Thefair value of the Company’s outstanding transactions is presented on thebalance sheet by counterparty. Our counterparties net our positions with them,but we cannot present the net of the two counterparty positions because we donot have legal right of offset. Therefore one counterpartyis presented in the Derivative Asset and one is presented in the DerivativeLiability. At December 31, 2004 crude oil collar with a balance of($468,308) is presented as a liability and the remaining contracts arepresented as an asset. All contracts are considered current.

 

Hedges entered into afterJune 30, 2005 were as follows:

 
| **Transaction  Date** | ** ** | **Transaction  Type** | ** ** | **Effective Dates** | ** ** | **Price Per  Unit** | ** ** | **Volumes  Per Day** | ** ** |
|-----------------------|------------|-----------------------|------------|---------------------|------------|---------------------|------------|----------------------|------------|
| ** **            | ** ** | **Beginning**         | ** ** | **Ending**          | ** ** | ** **          | ** ** |
| 08/05                 |       | Natural Gas Collar    | (1)        | 01/01/2006          |       | 12/31/2006          |       | $7.00-$10.50         |       | 10,000 MMBTU |   |

 

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(1)                TheCompany’s current hedging activities for natural gas were entered into on a perMMbtu delivered price basis, Houston Ship Channel Index, with settlement foreach calendar month occurring five business days following the expiration date

 

**8.****          ASSETACQUISITION**

 

On December 29, 2004, the Company consummated theacquisition of interests in certain oil and natural gas properties located inSouth Texas from Contango Oil & Gas Company (“Contango”). The finalcash purchase price for the acquisition was $40.1 million, which was adjustedfrom the original price of $50.0 million for the results of operations betweenthe July 1, 2004 effective date and the December 29, 2004 closingdate pursuant to the closing adjustment provisions. The Company also realizedother acquisition costs of approximately $135,200 related to professional feesfor assistance with the transaction. The purchase price was funded from the netproceeds of a public offering of common stock completed December 21, 2004(see Note 3).

 

The following unaudited proforma results for the three- and six-months ended June 30, 2004 show theeffect on the Company’s consolidated results of operations as if the assetacquisition had occurred on January 1, 2003 and are derived from the proforma results as reported on Form 8-K/Afiled April 5, 2005. They are the result of combining the statement ofincome of Edge with the statements of revenues and direct operating expensesfor the acquired properties adjusted for (1) the completion of the publicoffering of common stock to finance the cash purchase price, (2) assumptionof ARO liabilities and accretion expense for the properties acquired, (3) depletion,depreciation and amortization expense applied to the adjusted basis of theproperties acquired using the purchase method of accounting, and (4) therelated income tax effects of these adjustments based on the applicablestatutory rates. The statements of revenues and direct operatingexpenses for the acquired assets exclude all other historical Contangoexpenses.  As a result, certain estimatesand judgments were made in preparing the pro forma adjustments, including as tothe incremental expenses associated with the acquired assets.  Thepro forma information includes numerous assumptions, and is not necessarilyindicative of future results of operations:

 

| ** **                    | ** ** | **For the Three  Months Ended**                             | ** ** | **For the Six  Months Ended** | ** ** |
|-------------------------------|------------|-------------------------------------------------------------|------------|-------------------------------|------------|
| ** **                    | ** ** | **June 30, 2004**                                      | ** ** |
| ** **                    | ** ** | **(unaudited)****(In thousands, except per share amounts)** | ** ** |
| Revenue                       |       | $                                                           | 22,646     |                          | $          | 45,009 |   |
| Net income                    |       | $                                                           | 7,429      |                          | $          | 13,879 |   |
| Net income per  common share: |       |                                                        |       |                          |       |
| Basic                         |       | $                                                           | 0.43       |                          | $          | 0.82 |   |
| Diluted                       |       | $                                                           | 0.43       |                          | $          | 0.80 |   |

 

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**9.****          COMMITMENTSAND CONTINGENCIES**

 

From time to time theCompany is a party to various legal proceedings arising in the ordinary courseof business.  While the outcome oflawsuits cannot be predicted with certainty, the Company is not currently aparty to any proceeding that it believes, if determined in a manner adverse tothe Company, could have a potential material adverse effect on its financialcondition, results of operations or cash flows.

 

During the second quarter of 2004, the Companyreceived notice that its franchise tax returns for the State of Texas would beaudited 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 of 2004 the agent reduced theproposed franchise tax deficiency adjustment to the Company and itssubsidiaries to an aggregate of $467,000. In the fourth quarter of 2004, therewas an informal hearing at the local Comptroller’s Office during which theagent indicated he would formally assess the proposed deficiency.  On March 24, 2005, the Company receivedsuch deficiency assessment in the amount of $471,482, including penalty andinterest. The Company responded on April 21, 2005 with a request for aformal redetermination hearing. In July 2005, the Company submittedadditional documents and evidence supporting its position for the hearing. TheCompany intends to continue to vigorously contest the assessment throughappropriate administrative levels in the Comptroller’s Office and any otheravailable means.  Due to its intention tocontinue to vigorously contest the proposed adjustments, the Company has notrecognized any provision for the additional franchise taxes that would result fromthe proposed deficiency.

 

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

 

The following is Management’s Discussion and Analysis (“MD&A”) ofsignificant factors that have affected certain aspects of our financialposition and operating results during the periods included in the accompanyingunaudited condensed consolidated financial statements. The followingMD&A is intended to help the reader understand Edge Petroleum Corporation (“Edge”).This discussion should be read inconjunction with the accompanying unaudited condensed consolidated financialstatements included elsewhere in this Form 10-Q and with Management’sDiscussion and Analysis of Financial Condition and Results of Operations andour audited consolidated financial statements included in our annual report on Form 10-Kfor the year ended December 31, 2004.

 

### **FORWARD LOOKING STATEMENTS**

###  

The statements contained in all parts of thisdocument, including, but not limited to, those relating to our outlook, theeffects of our acquisitions, our financing plans related thereto, including anyincrease in our credit line, issuance of equity or debt, contribution and anyother benefit of an acquisition, our ability to access the capital markets toraise additional capital, our debt-to-total capital ratio, our drilling plansand the ability to secure drilling rigs to effectuate these plans, our naturalgas and oil production volumes, our 3-D project portfolio, our ability tohedge our risks, our ability to reduce our interest rates, capital expendituresand capital program, future capabilities, the sufficiency of capital resourcesand liquidity to support working capital and capital expenditure requirements, sufficiency,growth and reinvestment of cash flows, our ability to control the timing of ourfuture exploration and development requirements, use of NOLs, tax rates, theoutcome of litigation and audits, the impact of changes in interest rates onour estimates of asset retirement obligations, production declines, thecommodity pricing environment and the state of the economy and any otherstatements regarding future operations, financial results, business plans,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” and similar expressionsare intended to be among the statements that identify forward lookingstatements.  Such statements involverisks and uncertainties, including, but not limited to, those relating to theresults of and our dependence on our exploratory and development drillingactivities, the volatility of oil and natural gas prices, the need to replacereserves depleted by production, operating risks of oil and natural gasoperations, our dependence on key personnel, our reliance on technological developmentand possible obsolescence of the technology currently used by us, thesignificant capital requirements of our exploration and development andtechnology development programs, the potential impact of government regulationsand liability for environmental matters, results of litigation and audits,expansion of our capital budgets, our ability to manage our growth and achieveour business strategy, competition from larger oil and gas companies, theuncertainty of reserve information and future net revenue estimates, hedgingopportunities in the future, property acquisition risks, risks relating toacquisitions and other factors detailed in our Form 10-K and otherfilings 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.

 

## **GENERAL OVERVIEW**

## ** **

Edge Petroleum Corporation is a Houston-basedindependent energy company that focuses its exploration, production andmarketing activities in selected onshore basins of the United States. In late1998, we undertook a top-level management change and began a shift in strategyfrom pure exploration, which focused more on prospect generation, to ourcurrent strategy which focuses on a balanced program of exploration,exploitation and development and acquisition of oil and gas properties. Ourcompany generates revenues, income and cash flows by producing and marketingoil and natural gas produced from our oil and natural gas properties. We makesignificant capital expenditures in our exploration, development, andacquisition activities that allow us to continue generating revenue, income andcash flows. In December 2003, we acquired 100 percent of the outstandingstock of Miller

 

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Exploration Company (“Miller”).  The transaction was treated as a tax-freereorganization and accounted for as a purchase business combination. Millercontinues to conduct exploration and development activities as a wholly-ownedsubsidiary of Edge. In December 2004, we acquired substantially all of theoperating assets of Contango Oil & Gas Company (“Contango”) for a cashpurchase price financed by proceeds from a public offering of our common stock.This acquisition is herein referred to as the Contango Asset Acquisition.

 

This overview providesour perspective on the individual sections of MD&A, as well as helpfulhints for reading these pages. Our MD&A includes the following sections:

 

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

 

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

 

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

 

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

 

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

 

•                  **Results of Operations** – an analysis of ourCompany’s consolidated results for the periods presented in our financialstatements.

 

•                  **Liquidity and Capital Resources -**ananalysis of cash flows, sources and uses of cash, and contractual obligations.

 

•                  **Risk Management Activities – Derivatives &Hedging -**supplementary information regarding our Company’sprice-risk management activities involving commodity contracts that areaccounted for at fair value.

 

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

 

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

 

# **Industry and EconomicFactors**

# ** **

In managing our business,we must deal with many factors inherent in our industry.  First and foremost is the fluctuation of oiland gas prices.  Historically, oil andgas markets have been cyclical and volatile with future price movements whichare difficult to predict.  While ourrevenues are a function of both production and prices, wide swings in commodityprices have most often had the greatest impact on our results of operations. Wehave no way to predict those prices or to control them without losing someadvantage of the upside potential. The oil and gas industry has experienced ahigh commodity price environment in 2005, which has positively impacted theentire industry as well as our Company.

 

Our operations entailsignificant complexities.  Advancedtechnologies requiring highly trained personnel are utilized in bothexploration and production.  Even whenthe 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,often times resulting in no commercially productive reserves being discovered.Moreover, costs associated with operating within our industry are substantial.The recent high commodity price environment has also led to increased costs inour industry, which together with increased demand for rigs, equipment and supplies, have made it difficult at times for us to furtherour growth.

 

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Our business, as with other extractive industries, isa depleting one in which each gas equivalent produced must be replaced or ourbusiness, and a critical source of our future liquidity, will shrink.

 

The oil and gas industry is highly competitive.  We compete with major and diversified energycompanies, independent oil and gas businesses and individual operators inexploration, production, marketing and acquisition activities.  In addition, the industry as a whole competeswith other businesses that supply energy to industrial and commercial endusers.

 

Extensive federal, stateand local regulation of the industry significantly affects our operations.  In particular, our activities are subject tostringent operational and environmental regulations.  These regulations have increased the costs ofplanning, designing, drilling, installing, operating and abandoning oil and gaswells and related facilities.  Theseregulations may become more demanding in the future.

 

# **Approach to the Business**

# ** **

Profitable growth of ourbusiness will largely depend upon our ability to successfully find and developnew proved reserves of oil and natural gas in a cost-effective manner.  In order to achieve an overall acceptablerate of growth, we seek to maintain a prudent blend of low, moderate and higherrisk exploration and development projects. We also attempt to make selected acquisitions of oil and gas propertiesto augment our growth and provide future drilling opportunities.  To further mitigate risk, we have chosen toseek geologic and geographic diversification 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 June 30, 2005, we had hedge contracts in place coveringapproximately 40% and 31% of our remaining expected 2005 natural gas and crudeoil production, respectively, or approximately 33% of total production on an Mcfe basis, before any acquisitions that may occur.

 

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 December 2004, our Board approved a 2005capital budget of $63 million. At our July 27, 2005 Board of Director’smeeting, a budget supplement of $13 million was approved, effectively raisingour planned capital budget to $76 million. The capital budget could be furtherincreased to accommodate an increase in wells, if and when additional drillingrigs become available. Based on current expectations for production volumes andcommodity prices, we expect to fund those capital expenditures from internallygenerated cash from operating activities. We do not typically include acquisitions in our budgeted capitalexpenditures, but expect to fund those with either borrowings under our creditfacility or offerings of common stock or other securities under our shelfregistration statement or other sources.

 

We reduced debt by a net$7.0 million in the first six months of 2005 to $13.0 million at June 30,2005. As of that date, our debt to total capital ratio was approximately 7.1%.Also in the second quarter of 2005, we took steps to increase our shelfregistration statement capacity to $390 million from approximately $90 million(see Note 3 to our consolidated financial statements), which became effective onJuly 1, 2005. We believe we have the financial flexibility to continue toexecute our business strategies.

 

**Acquisitions and Divestitures**

 

*Acquisitions–*Acquisitions add meaningful incremental increases inreserves and production and may range in size from acquiring a working interestin non-operated producing property to an entire field or company. Unlikedrilling capital, which is planned and budgeted, acquisition capital is neitherbudgeted nor allocated.  Specific timingof acquisitions cannot be predicted. Although we consider a wide variety ofacquisitions, a significant part of our growth strategy is expected to befocused toward producing property acquisitions, which we believe haveexploitable potential.  Because of ourfinancial flexibility, we are positioned to take advantage of producingproperty acquisition opportunities as they may arise. In today’s high priceenvironment, where production is providing greater cash flow and earnings tomost companies, identifying quality opportunities is difficult. We believethrough hard work, technical ability and creative thinking of our people, wewill continue to grow through

 

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both acquisitions and drilling.Any such acquisition could involve the payment by us of a substantial amount ofcash or the issuance of a substantial number of additional shares or othersecurities.

 

On December 29, 2004 we successfully completedthe acquisition of oil and natural gas properties located in South Texas for afinal adjusted cash purchase price of $40.1 million, before other acquisitioncosts of approximately $135,200. The original purchase price of $50 million wassubject to adjustment for the results of operations between the July 1,2004 effective date and the December 29, 2004 closing date, pursuant tothe post-closing adjustments provision. We financed the acquisition withproceeds from a public offering of our common stock under our then currentshelf registration (see Note 3 to our consolidated financial statements). Theproperties acquired consist of 39 non-operated producing wells with workinginterests ranging from approximately 41% to 75% and net revenue interestsranging from 29% to 56%. The addition of these properties increased ourproduction and activity levels during 2005. These properties, located primarilyin Jim Hogg County, Texas and producing primarily from the Queen Cityformation, are in a geographic area that has been one of our most active andsuccessful areas of focus in recent years. In addition to estimated provedreserves, our technical team identified a substantial number of additionaldrilling locations on undeveloped acreage with attractive exploitation andexploration potential, therefore, we allocated $6million of the purchase price to the unproved property category. We began workon these undeveloped locations during the first half of 2005.

 

*Divestitures-*We regularlyreview our asset base for the purpose of identifying non-core assets, thedisposition of which would increase capital resources available for otheractivities and create organizational and operational efficiencies. While wegenerally do not dispose of assets solely for the purpose of reducing debt,such dispositions can have the result of furthering our objective of financialflexibility through reduced debt levels. During the six months ended June 30,2005, there were no divestitures as compared to the first six months of 2004,during which we divested oil and natural gas properties in Louisiana generatingnet proceeds of $40,000.

 

**Outlook**

 

We expect to continue ouracquisition program as we seek to further our growth. We expect our drillingprogram to increase from 49 wells (26.9 net) in 2004 to approximately 50 to 55wells (26 to 29 net) in 2005. Our ability to materially increase the number ofwells to be drilled beyond our original budget number is heavily dependent uponthe timely access to oilfield services, particularly drilling rigs. The rigsituation has delayed the drilling of several larger interest,higher impact wells causing delays in our forecasted growth in production. Ourexpected production volumes combined with a strong commodity-pricing environment, that if sustained, as expected for theremainder of the year, is anticipated to produce record cash flow. We initiatedactivities in the Fayettville and Floyd Shales that we expect to become newcore areas for us.

 

To help protect againstthe possibility that commodity prices do not remain at the current levels, wehave entered into several hedges covering approximately 40% of our expectednatural gas production and 31% of our expected crude oil production streams forthe remainder of 2005 to offset the negative impact of potential downward pricemovements. This equates to approximately 33% of total production on an Mcfe basis. We currently have no contracts coveringperiods beyond 2005, but may consider hedging opportunities in the future.

 

In order to manage ourrealized and anticipated growth, we increased our headcount from 51 employeesas of December 31, 2004 to 57 employees as of June 30, 2005 and we arecurrently expanding our office space, resulting in increased G&A costs for2005. We expect to continue to add to our staff levels for the remainder of2005 in response to past and anticipated growth.

 

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

 

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**Critical Accounting Policies and Estimates**

 

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

 

•                  it requires assumptions to be made thatwere uncertain at the time the estimate was made, and

 

•                  changes in the estimate or different estimatesthat could have been selected could have a material impact on our consolidatedresults of operations or financial condition.

 

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

 

*Natureof Critical Estimate Item:*Oil & Natural Gas Reserves - Our estimate of proved reserves isbased on the quantities of oil and gas which geological and engineering datademonstrate, with reasonable certainty, to be recoverable in future years fromknown reservoirs under existing economic and operating conditions.  The accuracy of any reserve estimate is afunction of the quality of available data, engineering and geologicalinterpretation, and judgment.  Forexample, we must estimate the amount and timing of future operating costs, severancetaxes, development costs and workover costs, all of which may in fact varyconsiderably from actual results.  Inaddition, as prices and cost levels change from year to year, the economics ofproducing the reserves may change and therefore the estimate of proved reservesalso may change.  Any significantvariance in these assumptions could materially affect the estimated quantityand value of our reserves. Despite the inherent imprecision in theseengineering estimates, our reserves are used throughout our financialstatements.

 

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

 

* *“Ceiling” Test  - The full-cost method ofaccounting for oil and gas properties requires a quarterly calculation of alimitation on capitalized costs, often referred to as a full-cost ceilingcalculation. The ceiling is the discounted present value of our estimated totalproved reserves adjusted for taxes and the impact of hedges on pricing, using a10% discount rate. To the extent that our capitalized costs (net of accumulateddepletion and deferred taxes) exceed the ceiling, the excess must be writtenoff to expense. Once incurred, this impairment of oil and gas properties is notreversible at a later date even if oil and gas prices increase. No suchimpairment was required in the six months ended June 30, 2005 and 2004.This calculation of our proved reserves could significantly impact our ceilinglimitation used in determining whether an impairment of our capitalized costsis necessary. The ceiling calculation dictates that prices and costs in effectas of the last day of the period are generally held constant indefinitely.Therefore, the future net revenues associated with the estimated provedreserves are not based on our assessment of future prices or costs, but ratherare based on prices and costs in effect as of the end of the period. Oil andnatural gas prices used in the reserve valuation at June 30, 2005 were$56.50 per barrel and $6.98 per MMbtu.

 

*Effectif different assumptions used:*Units-of-production method to amortize our oil andnatural gas properties - A 10% increase or decrease in reserves would have decreased orincreased, respectively, our depletion expense for the quarter by approximately10%.

 

“Ceiling” limitation test  - The most likely factor to contribute to a ceilingtest impairment is the price used to calculate the reserve limitationthreshold. A significant reduction in the prices at a future measurement datecould trigger a full-cost ceiling impairment. At June 30, 2005, we had acushion (i.e. the excess of the

 

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ceiling over our capitalized costs) of $84.0million. A 10% increase or decrease in prices used would have increased ordecreased our cushion by approximately 45%. Our hedging program would serve tomitigate some of the impact of any price decline. Our hedges did not impact theceiling test this quarter, and would not have if the price was 10% higher asthese prices would be within the collars, but had we decreased the price by 10%the price would have breached our several hedge floors and therefore resultedin a minimal decrease in the ceiling of approximately $8,400. Another likelyfactor to contribute to a ceiling test impairment is arevised estimate of reserves. A 10% increase or decrease in reserve volumewould have increased or decreased our cushion by approximately 34%.

 

*Natureof Critical Estimate Item:*Unproved Property Impairment****- We have elected to use the full-costmethod to account for our oil and gas activities. Investments in unprovedproperties are not amortized until proved reserves associated with theprospects can be determined or until impairment occurs.  Unproved properties are evaluated quarterlyfor impairment on a property-by-property basis. If the results of an assessment indicate that an unproved property isimpaired, the amount of impairment is added to the proved oil and natural gasproperty costs to be amortized.

 

*Assumptions/ApproachUsed:*At June 30,2005, we had $15.9 million allocated to unproved property. This allocation isbased on the estimation by the technical team of whether the property haspotential attributable reserves. Therefore, the assessment made by ourtechnical team of the potential reserves will determine whether costs are movedfrom the unproved category to the full-cost pool for depletion or whether an impairment is taken.

 

*Effectif different assumptions used:* A 10% increase or decrease in the unproved propertybalance (i.e. transfer to full-cost pool) would have increased or decreased ourdepletion expense by approximately 1% for the quarter ended June 30, 2005.

 

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

 

*Assumptions/Approach Used:*Estimating thefuture asset removal costs is difficult and requires management to makeestimates and judgments because most of the removal obligations are many yearsin the future and contracts and regulations often have vague descriptions ofwhat constitutes removal.  Asset removaltechnologies and costs are constantly changing, as are regulatory, political,environmental, safety and public relations considerations. Inherent in theestimate of the present value calculation of our AROs are numerous assumptionsand judgments including the ultimate settlement amounts, inflation factors,credit-adjusted-risk-free-rates, timing of settlement, and changes in thelegal, regulatory, environmental and political environments.

 

23

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*Effectif different assumptions used:* Since there are so many variables in estimating AROs,we attempt to limit the impact of management’s judgment on certain of thesevariables by using input of qualified third parties. We engage independentengineering firms to evaluate our properties annually. We use the remainingestimated useful life from the year-end reserve reports by our independentreserve engineers in estimating when abandonment could be expected for eachproperty. We utilize a three-year average rate for inflation to diminish anysignificant volatility that may be present in the short term. We expect to seeour calculations impacted significantly if interest rates move from theircurrent lows, as the credit-adjusted-risk-free rate is one of the variablesused on a quarterly basis. Our technical team developed a standard costestimate based on historical costs, industry quotes and depth of wells. Unlesswe expect a well’s plugging to be significantly different than a normalabandonment, we use this estimate. The resulting estimate, after application ofa discount factor and some significant calculations, could differ from actualresults, despite all our efforts to make an accurate estimate.

 

*Natureof Critical Estimate Item:*Income Taxes**-**In accordance with the accounting for income taxesunder SFAS No. 109, *Accounting forIncome Taxes,* we have recorded a deferred tax asset and liability toaccount for the expected future tax benefits and consequences of events thathave been recognized in our financial statements and our tax returns. There areseveral items that result in deferred tax asset and liability impact to thebalance sheet, but the largest of which is income taxes and the impact of netoperating loss (“NOL”) carryforwards. We routinely assess the realizability ofour NOL carryforwards that resulted from substantial income tax deductions,prior year losses and acquisitions. We consider future taxable income in makingsuch assessments.  If we conclude that itis more likely than not that some portion or all of the deferred tax assetswill not be realized under accounting standards, it is reduced by a valuationallowance.

 

*Assumptions/ApproachUsed:*Numerousjudgments and assumptions are inherent in the determination of future taxableincome, including factors such as future operating conditions (particularly asrelated to prevailing oil and gas prices). The Company is not currentlyrequired to pay any federal income taxes because of the prior generation of NOL’s.

 

*Effectif different assumptions used:* Our independent public accounting firm assists us inapplying the numerous and complicated tax law requirements. However, despiteour attempt to make an accurate estimate, the ultimate utilization of our NOLcarryforwards is highly dependent upon our actual production and therealization of taxable income in future periods. If we estimate that some orall of our NOL carryforwards are more likely than not going to expire orotherwise not be utilized to reduce future tax, we would record a valuationallowance to remove the benefit of those NOL carryforwards from our financialstatements.

 

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

 

Hedge Contracts - We formally assess, both at thehedge’s inception and on an ongoing basis, whether the derivatives that areused for hedging are expected to be highly effective in offsetting changes incash flows of the hedged transactions. In the event it is determined that the use of a particular derivativemay not be or has ceased to be effective in pursuing a hedging strategy, hedgeaccounting is discontinued prospectively. The ongoing measurement ofeffectiveness determines whether the change in fair value is deferred throughother comprehensive income (“OCI”) on the balance sheet or recorded immediatelyin revenue on the income statement. The effective portion of the changes in thefair value of hedge contracts is recorded initially in OCI. When the hedgedproduction is sold, the realized gains and losses on the hedge contracts areremoved from OCI and recorded in revenue. Ineffective portions of the changesin the fair value of the hedge contracts are recognized in revenue as theyoccur. While the hedge contract is outstanding, the ineffective gain or lossmay increase or decrease until settlement of the contract.

 

24

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

 

*Assumptions/ApproachUsed:*Estimatingthe fair values of derivative instruments requires complex calculations,including the use of a discounted cash flow technique, estimates of risk andvolatility, and subjective judgment in selecting an appropriate discount rate.In addition, the calculations use future market commodity prices, whichalthough posted for trading purposes, are merely the market consensus offorecasted price trends. The results of the fair value calculations cannot beexpected to represent exactly the fair value of our commodity hedges. Wecurrently obtain the fair value of our positions from our counterparties. Ourpractice of relying on our counterparties who are more specialized and knowledgeablein preparing these complex calculations reduces our management’s input.

 

*Effectif different assumptions used:* At June 30, 2005, a 10% change in the commodityprice per unit, as long as the price is either above the ceiling or below thefloor price, would cause the fair value total of our derivative financialinstrument to increase or decrease by approximately $116,500.

 

# **Results of Operations**

# ** **

This section includesdiscussion of our results of operations for the three-month period ended June 30,2005 as compared to the same period of the prior year.  We are an independent energy company engagedin the exploration, development, acquisition and production of oil and naturalgas.  Our resources and assets aremanaged and our results reported as one operating segment.  We conduct our operations primarily along theonshore United States Gulf Coast, with our primary emphasis in South Texas,Mississippi, Louisiana, and southeast New Mexico.

 

**SecondQuarter 2005 Compared to the Second Quarter 2004**

 

**Revenueand Production**

 

Total revenue increased 65% from the second quarter of2004 to the comparable 2005 period.  Forthe second quarter of 2005 and 2004, our product mix contributed the followingpercentages of revenues and production:

 
| ** **                  | ** ** | **REVENUES (1)** | ** ** | **PRODUCTION** | ** ** |
|-----------------------------|------------|------------------|------------|----------------|------------|
| ** **                  | ** ** | **2005**         | ** ** | **2004**       | ** ** | **2005** | ** ** | **2004** | ** ** |
| Natural Gas  (Mcf)          |       | 80%              |       | 83%            |       | 76% |   | 79% |   |
| Natural gas  liquids (Bbls) |       | 5%               |       | 6%             |       | 12% |   | 12% |   |
| Crude oil (Bbl)             |       | 15%              |       | 11%            |       | 12% |   | 9% |   |
|                        |       |             |       |           |       |   |   |   |   |
| Total (Mcfe)                |       | 100%             |       | 100%           |       | 100% |   | 100% |   |

 

----

(1) Includes effect of hedging and derivativetransactions.

 

The following table summarizes volume and priceinformation with respect to our oil and gas production for the second quarterof 2005 and 2004:

 

25

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| ** **                                   | ** ** | **Three Months Ended  June 30,** | ** **                  | **2005 Period Compared  to 2004 Period** | ** **                  |
|----------------------------------------------|------------|---------------------------------------|-----------------------------|------------------------------------------|-----------------------------|
| ** **                                   | ** ** | ** **                            | **$  Increase  (Decrease)** | ** **                               | **%  Increase  (Decrease)** | ** ** |
| ** **                                   | ** ** | **2005**                              | ** **                  | **2004**                                 | ** **                  | ** ** | ** ** |
| **Production  Volumes:**                     |       |                                  |                        |                                     |                        |   |   |   |   |
| Natural gas  (Mcf)                           |       | 3,082,932                             |                        | 2,298,064                                |                        | 784,868 |   | 34 | % |
| Natural gas  liquids (Bbls)                  |       | 83,156                                |                        | 57,602                                   |                        | 25,554 |   | 44 | % |
| Oil and  condensate (Bbls)                   |       | 79,583                                |                        | 45,832                                   |                        | 33,751 |   | 74 | % |
| Natural gas  equivalent (Mcfe)               |       | 4,059,334                             |                        | 2,918,668                                |                        | 1,140,666 |   | 39 | % |
| **Average  Sales Price:**                    |       |                                  |                        |                                     |                        |   |   |   |   |
| Natural gas ($ per  Mcf)(1)             |       | $                                     | 6.76                        |                                     | $                           | 5.92 |   | $ | 0.84 |   | 14 | % |
| Natural gas  liquids ($ per Bbl)        |       | $                                     | 17.15                       |                                     | $                           | 14.87 |   | $ | 2.28 |   | 15 | % |
| Oil and  condensate ($ per Bbl)(1)      |       | $                                     | 49.78                       |                                     | $                           | 38.30 |   | $ | 11.48 |   | 30 | % |
| Natural gas  equivalent ($ per Mcfe)(1) |       | $                                     | 6.46                        |                                     | $                           | 5.56 |   | $ | 0.90 |   | 16 | % |
| Natural gas  equivalent ($per Mcfe)(2)       |       | $                                     | 6.46                        |                                     | $                           | 5.43 |   | $ | 1.03 |   | 19 | % |
| **Operating  Revenue:**                      |       |                                  |                        |                                     |                        |   |   |   |   |
| Natural gas (1)                              |       | $                                     | 20,840,741                  |                                     | $                           | 13,613,310 |   | $ | 7,227,431 |   | 53 | % |
| Natural gas  liquids                         |       | 1,425,794                             |                        | 856,777                                  |                        | 569,017 |   | 66 | % |
| Oil and  condensate (1)                      |       | 3,961,752                             |                        | 1,755,348                                |                        | 2,206,404 |   | 126 | % |
| Loss on hedging  and derivatives             |       | (17,834                               | )                           | (378,031                                 | )                           | 360,197 |   | 95 | % |
| Total                                        |       | $                                     | 26,210,453                  |                                     | $                           | 15,847,404 |   | $ | 10,363,049 |   | 65 | % |

 

----

(1) Excludes the effect of hedging and derivativetransactions.

(2) Includes the effect of hedging and derivativetransactions.

 

Our revenue is sensitive tochanges in prices received for our products. A substantial portion of our production is sold at prevailing marketprices, which fluctuate in response to many factors that are outside of ourcontrol.  Imbalances in the supply anddemand for oil and natural gas can have a dramatic effect on the prices wereceive for our production.  Politicalinstability and availability of alternative fuels could impact worldwidesupply, while the economy, weather and other factors outside of our controlcould impact demand.

 

Natural gas revenue, excluding hedging activity,increased 53% for the three months ended June 30, 2005 over the sameperiod in 2004 due to significantly higher production and higher realizedprices. Average natural gas production increased 34% from 2.3 Bcfe in the threemonths ended June 30, 2004 to 3.1 Bcfe in the comparable 2005 period dueto production from new wells acquired on December 29, 2004 in South Texas,new wells drilled, primarily on our Encinitas, Gato Creek, southeast New Mexicoand other acquired properties, partially offset by natural declines on otherproperties. The overall increase in production compared to the prior yearperiod resulted in an increase in revenue of approximately $4.6 million (basedon 2004 comparable period pre-hedge prices). Excluding the effect of hedges,the average natural gas sales price for production in the three months ended June 30,2005 was $6.76 per Mcf compared to $5.92 per Mcf for the same period in2004.  This increase in average pricereceived resulted in increased revenue of approximately $2.6 million (based oncurrent year production).

 

Revenue from the sale of NGLs increased 66% for thethree months ended June 30, 2005 over the same period in 2004. Productionvolumes for NGLs increased 44%, from 57.6 MBbls for the three months ended June 30,2004 to 83.2 MBbls for the three months ended June 30, 2005 due primarilyto increased production from new wells at Encinitas and Gato Creek, partiallyoffset by natural declines on other properties. The increase in NGL productionincreased revenue by approximately $380,000 (based on 2004 comparable periodaverage prices).  Higher average realizedprices for the three months ended June 30, 2005 resulted in an increase inrevenue of approximately $189,000 (based on current year production).  The average realized price for NGLs for thethree months ended June 30, 2005 was $17.15 per barrel compared to $14.87per barrel for the same period in 2004.

 

Revenue from the sale of oil and condensate, excludingderivative activity, increased 126% for the three months ended June 30,2005 as compared to the comparable prior year period in 2004 due to higherprice environment and increased production. The average realized price for oiland condensate before the derivative losses for the three months ended June 30,2005 was $49.78 per barrel compared to $38.30 per barrel in the same period of

 

26

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2004.  These higher averageprices for the three months ended June 30, 2005 resulted in an increase inrevenue of approximately $1.3 million (based on current year production).  Production volumes for oil and condensateincreased 74% to 79.6 MBbls for the three months ended June 30, 2005compared to 45.8 MBbls for the same prior year period due primarily toproduction from the properties acquired on December 29, 2004 fromContango, as well as new wells drilled on our New Mexico and other acquiredproperties. The increase in oil and condensate production resulted in anincrease in revenue of approximately $0.9 million (based on 2004 comparableperiod average prices).

 

Losses on hedging and derivatives decreased for thethree months ended June 30, 2005 over the same period in 2004 due to thechange in the fair market value of the outstanding derivative contracts andcash settlements on expiring contracts. Oil and condensate revenues werereduced slightly by realized losses partially offset by unrealized gains on ouroil derivatives. For the three months ended June 30, 2005, we recorded$346,590 of realized losses on oil derivatives settlements and $328,756 ofunrealized gains representing the change in the mark-to-market fair value ofour outstanding oil derivative contracts. We did not apply hedge accounting tothese transactions. See Note 7 to our consolidated financial statements.  These net losses account for a $0.22 perbarrel decrease in the realized oil price for the three months ended June 30,2005 from $49.78 per barrel to $49.56 per barrel. Should the crude oil pricesdecrease from the current levels, we would realize lower revenues from the saleof our crude oil, but our oil derivative gains would also increase. The oilderivatives could also result in larger losses if the prices begin to riseagain. There was no hedge impact on natural gas revenue for the three monthsended June 30, 2005.  Should naturalgas prices move outside the bounds of our collars, it could materially affectour revenues. At June 30, 2004 we had an unrealized gain of $133,795,representing an increase in our realized oil price of $2.92 per barrel, whichwas partially offset by realized losses on expiring contracts of $103,276,representing a decrease in our realized oil price of $2.25 per barrel. For thethree months ended June 30, 2004, we also recognized $186,550 of thepremium paid for a natural gas hedge entered into in 2003 and realized $222,000of losses on settlements of expiring contracts. These losses decreased theeffective natural gas sales price by $0.18 per Mcf.

 

**Costs and Operating Expenses**

 

The table below presentsa detail of our expenses for the three months ended June 30, 2005 and2004:

 
| ** **                                            | ** ** | **Three Months Ended  June 30,** | ** **                  | **2005 Period Compared  to 2004 Period** | ** **                  |
|-------------------------------------------------------|------------|---------------------------------------|-----------------------------|------------------------------------------|-----------------------------|
| ** **                                            | ** ** | ** **                            | **$  Increase  (Decrease)** | ** **                               | **%  Increase  (Decrease)** | ** ** |
| ** **                                            | ** ** | **2005**                              | ** **                  | **2004**                                 | ** **                  | ** ** | ** ** |
| ** **                                            |       |                                  |                        |                                     |                        |   |   |   |   |
| Oil and natural  gas operating expenses               |       | $                                     | 1,802,049                   |                                     | $                           | 1,220,092 |   | $ | 581,957 |   | 48 | % |
| Severance and ad  valorem taxes                       |       | 1,784,837                             |                        | 1,210,208                                |                        | 574,629 |   | 47 | % |
| Depreciation,  depletion, amortization and accretion: |       |                                  |                        |                                     |                        |   |   |   |   |
| Oil and gas  property and equipment                   |       | 8,839,703                             |                        | 5,023,148                                |                        | 3,816,555 |   | 76 | % |
| Other assets                                          |       | 65,152                                |                        | 92,023                                   |                        | (26,871 | ) | (29 | )% |
| ARO accretion                                         |       | 34,143                                |                        | 26,216                                   |                        | 7,927 |   | 30 | % |
| General and  administrative:                          |       |                                  |                        |                                     |                        |   |   |   |   |
| Deferred  compensation – repriced options        |       | (90,259                               | )                           | 337,386                                  |                        | (427,645 | ) | (127 | )% |
| Deferred  compensation – restricted stock        |       | 262,745                               |                        | 114,600                                  |                        | 148,145 |   | 129 | % |
| Other general  and administrative                     |       | 2,357,413                             |                        | 1,731,453                                |                        | 625,960 |   | 36 | % |
|                                                  |       | 15,055,783                            |                        | 9,755,126                                |                        | 5,300,657 |   | 54 | % |
| Other expense,  net                                   |       | 11,406                                |                        | 142,130                                  |                        | (130,724 | ) | (92 | )% |
| Total                                                 |       | $                                     | 15,067,189                  |                                     | $                           | 9,897,256 |   | $ | 5,169,933 |   | 52 | % |

 

27

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Oil and natural gas operating expenses are theday-to-day costs incurred to bring hydrocarbons out of the ground and to themarket together with the daily costs incurred to maintain our producingproperties. For the three months ended June 30, 2005 these costs increased48% over the same period of 2004. A substantial portion of this cost increase canbe attributed to our increased production. On a Mcfe basis, costs haveincreased 5% from $0.42 per Mcfe for the three months ended June 30, 2004to $0.44 per Mcfe for the three months ended June 30, 2005. The December 29,2004 acquisition of producing properties in South Texas contributedapproximately 50% of the increase in costs and new wells drilled since June 30,2004 further increased the costs for the three months ended June 30, 2005compared to the prior year. We are experiencing increased costs due toincreased demand for oil field products and services. The oil and natural gasindustry tends to be cyclical in nature and the demand for goods and servicesof oil field companies, suppliers and others associated with the industry canput extreme pressure on the economic stability and pricing structure within theindustry. Typically, as prices for oil and natural gas increase, so doassociated costs. When commodity prices decline, associated costs do notnecessarily decline at the same rate.

 

Severance and ad valoremtaxes for the three months ended June 30, 2005 increased 47% from the sameperiod of 2004.  Severance tax expensefor the three months ended June 30, 2005 was 46% higher than thecomparable prior year period as a result of higher revenue. Our severance taxexpense is levied on our oil and gas revenue dollars (excluding hedging andderivative impact), so if commodity prices remain high, we expect to continueto incur higher severance tax expense. For the three months ended June 30,2005, severance tax expense was approximately 6.0% of revenue subject toseverance taxes compared to 6.7% of revenue subject to severance taxes for thecomparable 2004 period. The decrease in tax as a percent of revenue was dueprimarily to a shift in our revenue stream to properties with lower severancetax rates. Ad valorem tax expense for the three months ended June 30, 2005was impacted by increased accruals for the estimated costs related to theaddition of the South Texas properties acquired on December 29, 2004. Onan equivalent basis, severance and ad valorem taxes averaged $0.44 per Mcfe and$0.41 per Mcfe for the three months ended June 30, 2005 and 2004,respectively.

 

Depletion, depreciation,and amortization (“DD&A”) represents the systematic expensing of capitalcosts incurred to acquire, explore and develop natural gas and crude oil, aswell as maintain administrative offices to manage these activities. As a fullcost company, we capitalize all costs associated with our acquisition,exploration and development efforts, and apportion these costs to each unit ofproduction through DD&A expense. Accretion expense is the systematicaccretion of future abandonment costs of our properties. For the three monthsended June 30, 2005, DD&A and accretion expense totaled $8.9 millioncompared to $5.1 million for the same period of 2004.  Depletion on our oil and natural gasproperties increased 76% for the three months ended June 30, 2005 comparedto the same period of 2004 due to an increase in production levels and in theunit-of-production depletion rate from $1.72 per Mcfe for the three monthsended June 30, 2004 as compared to $2.18 per Mcfe in the same period in2005. The increase in depletion expense from the higher production levels inthe three months ended June 30, 2005 as compared to the same period of2004 resulted in an increase in expense of approximately $2.0 million. Theincrease in depletion rate for the three months ended June 30, 2005compared to the same period of 2004 added approximately $1.9 million indepletion expense. Our depletion rate has increased due to increased spendingon our drilling program with disproportionate reserve additions. Depreciationof furniture and fixtures for the three months ended June 30, 2005decreased 29% compared to the same prior year period due to several largerdepreciable assets that became fully depreciated by year-end 2004 and are notcurrently contributing to expense. Accretion expense associated with our assetretirement obligations for the three months ended June 30, 2005 increased30% over the same prior year period for the new obligations incurred from thewells drilled and acquired since June 30, 2004.

 

G&A expense includesoverhead, payroll and benefits of our corporate staff, costs of maintaining ourheadquarters, managing our production and development operations and legalcompliance. We capitalize G&A expense directly related to our acquisition,exploration and development activities. Total G&A for the three monthsended June 30, 2005 was $2.5 million, an increase of 16% compared to thesame prior year period total of $2.2 million. 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 $90,259 was incurred for the three months ended June 30,2005 compared to a charge of  $337,386 inthe same period of 2004. Amortization related to restricted stock awardsgranted over the past three years totaled $262,745 and $114,600, respectively,for the three months ended June 30, 2005 and 2004. The increase relates tonew grants that have occurred since the June 30, 2004. Other G&A forthe three months ended June 30, 2005, which does not include the deferredcompensation expenses discussed above, totaled $2.4 million, a 36% increasefrom the comparable 2004 period total of $1.7 million. The increase in otherG&A was attributable to

 

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higher salaries andbenefits, due in part to higher staffing levels, as well as higher rent expensefor additional office space, higher board of director compensation, higherfranchise taxes and higher professional fees for auditors and lawyers,partially offset by reductions in fees paid to consultants for Sarbanes-Oxleyimplementation. For the three months ended June 30, 2005 and 2004,overhead reimbursement fees reduced G&A costs by $108,482 and $83,569,respectively. Capitalized G&A costs further reduced other G&A by$666,200 and $532,066 for the three months ended June 30, 2005 and 2004,respectively.  Other G&A on a unit ofproduction basis for the three months ended June 30, 2005 was $0.58 perMcfe compared to $0.59 per Mcfe for the comparable 2004 period.

 

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

 

| ** **                  | ** ** | **For the Three Months Ended June 30,** | ** ** |
|-----------------------------|------------|----------------------------------------------|------------|
| ** **                  | ** ** | **2005**                                     | ** ** | **2004** | ** ** |
|                        |       |                                         |       |   |   |
| Gross interest              |       | $                                            | 256,171    |   | $ | 228,329 |   |
| Less: Capitalized  interest |       | (256,171                                     | )          | (122,924 | ) |
| Interest  expense, net      |       | $                                            | —     |   | $ | 105,405 |   |
|                        |       |                                         |       |   |   |
| Weighted Average  Debt      |       | $                                            | 11,186,813 |   | $ | 19,494,505 |   |

 

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

 

We are subject to state and federal income taxes andalthough we are currently generating taxable income for financial reportingpurposes, we are not in a federal income tax paying position as a result ofdeducting intangible drilling costs (“IDC”) that reduce our taxable income forincome tax purposes and NOL carryforwards that offset any remaining taxableincome. A deferred income tax provision was recorded for the three months endedJune 30, 2005 and 2004 of $3.9 million and $2.1 million, respectively. Theincrease resulted from higher pre-tax income in 2005 as compared to 2004.

 

For the three monthsended June 30, 2005, we had net income of $7.2 million, or $0.42 basicearnings per share and $0.40 diluted earnings per share, as compared to netincome of $3.9 million, or $0.30 basic earnings per share and $0.28 dilutedearnings per share in the comparable 2004 period. Basic weighted average sharesoutstanding increased for the three months ended June 30, 2005 over thesame period 2004 primarily due to the stock offering completed in December 2004and the related over-allotment exercise in January 2005. We issued a totalof 4,025,000 shares in these transactions.

 

**SixMonths Ended June 30, 2005 Compared to the Six Months Ended June 30,2004**

 

**Revenueand Production**

 

Total revenue increased 55% from the first half of2004 to the comparable 2005 period.  Forthe six months ended June 30, 2005 and 2004, our product mix contributedthe following percentages of revenues and production:

 

| ** **                  | ** ** | **REVENUES (1)** | ** ** | **PRODUCTION** | ** ** |
|-----------------------------|------------|------------------|------------|----------------|------------|
| ** **                  | ** ** | **2005**         | ** ** | **2004**       | ** ** | **2005** | ** ** | **2004** | ** ** |
| Natural Gas  (Mcf)          |       | 80%              |       | 83%            |       | 76% |   | 78% |   |
| Natural gas  liquids (Bbls) |       | 6%               |       | 6%             |       | 12% |   | 12% |   |
| Crude oil (Bbl)             |       | 14%              |       | 11%            |       | 12% |   | 10% |   |
|                        |       |             |       |           |       |   |   |   |   |
| Total (Mcfe)                |       | 100%             |       | 100%           |       | 100% |   | 100% |   |

 

----

(1) Includes effect of hedging and derivativetransactions.

 

29

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The following table summarizes volume and priceinformation with respect to our oil and gas production for the six-monthperiods ended June 30, 2005 and 2004:

 
| ** **                             | ** ** | **Six Months Ended  June 30,** | ** **                  | **2005 Period Compared  to 2004 Period** | ** **                  |
|----------------------------------------|------------|--------------------------------|-----------------------------|------------------------------------------|-----------------------------|
| ** **                             | ** ** | ** **                     | **$  Increase  (Decrease)** | ** **                               | **%  Increase  (Decrease)** | ** ** |
| ** **                             | ** ** | **2005**                       | ** **                  | **2004**                                 | ** **                  | ** ** | ** ** |
| **Production  Volumes:**               |       |                           |                        |                                     |                        |   |   |   |   |
| Natural gas  (Mcf)                     |       | 6,285,166                      |                        | 4,720,044                                |                        | 1,565,122 |   | 33 | % |
| Natural gas  liquids (Bbls)            |       | 167,239                        |                        | 127,086                                  |                        | 40,153 |   | 32 | % |
| Oil and  condensate (Bbls)             |       | 162,594                        |                        | 99,660                                   |                        | 62,934 |   | 63 | % |
| Natural gas  equivalent (Mcfe)         |       | 8,264,164                      |                        | 6,080,520                                |                        | 2,183,644 |   | 36 | % |
| **Average  Sales Price:**              |       |                           |                        |                                     |                        |   |   |   |   |
| Natural gas  ($per Mcf)(1)             |       | $                              | 6.26                        |                                     | $                           | 5.64 |   | $ | 0.62 |   | 11 | % |
| Natural gas  liquids ($per Bbl)        |       | $                              | 17.31                       |                                     | $                           | 14.96 |   | $ | 2.35 |   | 16 | % |
| Oil and  condensate ($per Bbl)(1)      |       | $                              | 48.75                       |                                     | $                           | 35.30 |   | $ | 13.45 |   | 38 | % |
| Natural gas  equivalent ($per Mcfe)(1) |       | $                              | 6.07                        |                                     | $                           | 5.27 |   | $ | 0.80 |   | 15 | % |
| Natural gas  equivalent ($per Mcfe)(2) |       | $                              | 5.95                        |                                     | $                           | 5.21 |   | $ | 0.74 |   | 14 | % |
| **Operating  Revenue:**                |       |                           |                        |                                     |                        |   |   |   |   |
| Natural gas (1)                        |       | $                              | 39,335,572                  |                                     | $                           | 26,602,261 |   | $ | 12,733,311 |   | 48 | % |
| Natural gas  liquids                   |       | 2,895,369                      |                        | 1,901,181                                |                        | 994,188 |   | 52 | % |
| Oil and  condensate (1)                |       | 7,926,035                      |                        | 3,518,484                                |                        | 4,407,551 |   | 125 | % |
| Loss on hedging  and derivatives       |       | (1,002,678                     | )                           | (359,865                                 | )                           | (642,813 | ) | 179 | % |
| Total                                  |       | $                              | 49,154,298                  |                                     | $                           | 31,662,061 |   | $ | 17,492,237 |   | 55 | % |

 

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(1) Excludes the effect of hedging and derivative transactions.

(2) Includes the effect of hedging and derivative transactions.

 

Our revenue is sensitive tochanges in prices received for our products. A substantial portion of our production is sold at prevailing marketprices, which fluctuate in response to many factors that are outside of ourcontrol.  Imbalances in the supply anddemand for oil and natural gas can have a dramatic effect on the prices wereceive for our production.  Politicalinstability and availability of alternative fuels could impact worldwidesupply, while the economy, weather and other factors outside of our controlcould impact demand.

 

Natural gas revenue, excluding hedging activity,increased 48% for the six months ended June 30, 2005 over the same periodin 2004 due to significantly higher production and higher realized prices.Average natural gas production increased 33% from 4.7 Bcfe in the six monthsended June 30, 2004 to 6.3 Bcfe in the comparable 2005 period due toproduction from new wells acquired on December 29, 2004 in South Texas,new wells drilled, primarily on our Encinitas, Gato Creek, southeast New Mexicoand other acquired properties, partially offset by natural declines on otherproperties. The overall increase in production compared to the prior yearperiod resulted in an increase in revenue of approximately $8.8 million (basedon 2004 comparable period pre-hedge prices). Excluding the effect of hedges, the average natural gas sales price forproduction in the six months ended June 30, 2005 was $6.26 per Mcfcompared to $5.64 per Mcf for the same period in 2004.  This increase in average price receivedresulted in increased revenue of approximately $3.9 million (based on currentyear production).

 

Revenue from the sale of NGLs increased 52% for thesix months ended June 30, 2005 over the same period in 2004. Productionvolumes for NGLs increased 32%, from 127.1 MBbls for the six months ended June 30,2004 to 167.2 MBbls for the six months ended June 30, 2005 due primarilyto increased production from new wells at Encinitas and Gato Creek, partiallyoffset by natural declines on our other properties. The increase in NGLproduction increased revenue by approximately $600,700 (based on 2004comparable period average prices). Higher average realized prices for the six months ended June 30,2005 resulted in an increase in revenue of approximately $393,500 (based oncurrent year production).  The averagerealized price for NGLs for the six months ended June 30, 2005 was $17.31per barrel compared to $14.96 per barrel for the same period in 2004.

 

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Revenue from the sale of oil and condensate, excludingderivative activity, increased 125% for the six months ended June 30, 2005as compared to the comparable prior year period in 2004 due to higher priceenvironment and increased production. The average realized price for oil andcondensate before the derivative losses for the six months ended June 30,2005 was $48.75 per barrel compared to $35.30 per barrel in the same period of2004.  These higher average prices forthe six months ended June 30, 2005 resulted in an increase in revenue ofapproximately $2.2 million (based on current year production).  Production volumes for oil and condensateincreased 63% to 162.6 MBbls for the six months ended June 30, 2005compared to 99.7 MBbls for the same prior year period due primarily toproduction from the properties acquired on December 29, 2004 fromContango, as well as new wells drilled on our Miller, Encinitas and Gato Creekproperties. The increase in oil and condensate production resulted in anincrease in revenue of approximately $2.2 million (based on 2004 comparableperiod average prices).

 

Losses on hedging and derivatives increasedsignificantly for the six months ended June 30, 2005 over the same periodin 2004 due to the change in the fair market value of the outstandingderivative contracts as a result of volatile commodity prices and cashsettlements on expiring contracts. Oil and condensate revenues were decreasedby realized and unrealized losses on our oil derivatives. For the six monthsended June 30, 2005, we recorded $605,104 of realized losses on oilderivatives settlements and $554,074 of unrealized losses representing thechange in the mark-to-market fair value of our outstanding oil derivativecontracts. We did not apply hedge accounting to these transactions.  See Note 7 to our consolidated financialstatements.  These losses account for a$7.13 per barrel decrease in the realized oil price for the six months ended June 30,2005 from $48.75 per barrel to $41.62 per barrel. At June 30, 2004 we had$103,276 of realized losses on oil derivatives settlements and an unrealizedgain of $179,261. This net gain represented an increase in our realized oilprice of $0.77 per barrel. Should the crude oil prices decrease from thecurrent levels, we would realize lower revenues, but our oil derivative losseswould also decrease and could possibly result in a gain position. Includedwithin natural gas revenue for the six months ended June 30, 2005 was$156,500 representing realized gains from hedging contract settlements. Thesegains increased the effective natural gas sales price by $0.02 per Mcf for thesix months ended June 30, 2005. Should natural gas prices continue to decrease from the current highlevels, this could materially affect our revenues that are not hedged. For thesix months ended June 30, 2004, we realized $222,000 of losses on gashedge settlements and recognized $213,850 of the premium paid for a natural gashedge entered into in 2003.  These lossesdecreased the effective natural gas sales price by $0.09 per Mcf.

 

**Costs and Operating Expenses**

 

The table below presentsa detail of our expenses for the six months ended June 30, 2005 and 2004:

 

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| ** **                                            | ** ** | **Six Months Ended  June 30,** | ** **                  | **2005 Period Compared  to 2004 Period** | ** **                  |
|-------------------------------------------------------|------------|--------------------------------|-----------------------------|------------------------------------------|-----------------------------|
| ** **                                            | ** ** | ** **                     | **$  Increase  (Decrease)** | ** **                               | **%  Increase  (Decrease)** | ** ** |
| ** **                                            | ** ** | **2005**                       | ** **                  | **2004**                                 | ** **                  | ** ** | ** ** |
| ** **                                            |       |                           |                        |                                     |                        |   |   |   |   |
| Oil and natural  gas operating expenses               |       | $                              | 4,044,514                   |                                     | $                           | 2,425,166 |   | $ | 1,619,348 |   | 67 | % |
| Severance and ad  valorem taxes                       |       | 3,651,325                      |                        | 2,254,922                                |                        | 1,396,403 |   | 62 | % |
| Depreciation,  depletion, amortization and accretion: |       |                           |                        |                                     |                        |   |   |   |   |
| Oil and gas  property and equipment                   |       | 17,379,837                     |                        | 10,152,301                               |                        | 7,227,536 |   | 71 | % |
| Other assets                                          |       | 127,261                        |                        | 179,000                                  |                        | (51,739 | ) | (29 | )% |
| ARO accretion                                         |       | 67,529                         |                        | 52,501                                   |                        | 15,028 |   | 29 | % |
| General and  administrative:                          |       |                           |                        |                                     |                        |   |   |   |   |
| Deferred  compensation – repriced options        |       | 171,645                        |                        | 1,448,485                                |                        | (1,276,840 | ) | (88 | )% |
| Deferred  compensation – restricted stock        |       | 406,344                        |                        | 211,100                                  |                        | 195,244 |   | 92 | % |
| Bad debt expense                                      |       | 11,000                         |                        | —                                   |                        | 11,000 |   |   | * |
| Other general  and administrative                     |       | 4,836,138                      |                        | 3,632,280                                |                        | 1,203,858 |   | 33 | % |
|                                                  |       | 30,695,593                     |                        | 20,355,755                               |                        | 10,339,838 |   | 51 | % |
| Other expense,  net                                   |       | 14,595                         |                        | 282,036                                  |                        | (267,441 | ) | (95 | )% |
| Total                                                 |       | $                              | 30,710,188                  |                                     | $                           | 20,637,791 |   | $ | 10,072,397 |   | 49 | % |

 

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*Not meaningful

 

Oil and natural gas operating expenses for the sixmonths ended June 30, 2005 increased 67% over the same period of 2004. Asignificant portion of this cost increase can be attributed to our increasedproduction. On a Mcfe basis, costs have increased 23% from $0.40 per Mcfe forthe six months ended June 30, 2004 to $0.49 per Mcfe for the six monthsended June 30, 2005. The December 29, 2004 acquisition of producingproperties in South Texas contributed approximately 44% of the increase incosts and new wells drilled since June 30, 2004 further increased thecosts for the six months ended June 30, 2005 compared to the prioryear.  During the first half of 2005, wealso recognized higher expenses attributable to the fourth quarter 2004 thanoriginally estimated in our year-end accruals for our States, Encinitas, GatoCreek and other properties, which equated to approximately 26% of the increasein costs. We are experiencing increased costs due to increased demand for oilfield products and services. The oil and natural gas industry tends to becyclical in nature and the demand for goods and services of oil fieldcompanies, suppliers and others associated with the industry can put extremepressure on the economic stability and pricing structure within the industry.Typically, as prices for oil and natural gas increase, so do all associatedcosts. When commodity prices decline, associated costs do not necessarilydecline at the same rate.

 

Severance and ad valoremtaxes for the six months ended June 30, 2005 increased 62% from the sameperiod in 2004.  Severance tax expensefor the six months ended June 30, 2005 was 53% higher than the comparableprior year period as a result of higher revenue. Our severance tax expense islevied on our oil and gas revenue dollars (excluding hedging and derivativeimpact), so if commodity prices remain high, we expect to continue to incurhigher severance tax expense. For the six months ended June 30, 2005,severance tax expense was approximately 6.1% of revenue subject to severancetaxes compared to 6.4% of revenue subject to severance taxes for the comparable2004 period. Ad valorem tax expense for the six months ended June 30, 2005was impacted by increased accruals for the estimated costs related to theaddition of the South Texas properties acquired on December 29, 2004.  On an equivalent basis, severance and advalorem taxes averaged $0.44 per Mcfe and $0.37 per Mcfe for the six monthsended June 30, 2005 and 2004, respectively.

 

DD&A and accretionexpense for the six months ended June 30, 2005 totaled $17.6 millioncompared to $10.4 million for the six months ended June 30, 2004.  Depletion on our oil and natural gasproperties increased 71% for the six months ended June 30, 2005 comparedto the same period of 2004 due to an increase in production levels and in theunit-of-production depletion rate from $1.67 per Mcfe in the six months ended June 30,2004as compared to $2.10 per Mcfe in the comparable 2005 period. The increase indepletion expense from the higher

 

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production levels in thesix months ended June 30, 2005 as compared to the same period of 2004resulted in an increase in expense of approximately $3.6 million. The increasein depletion rate for the six month ended June 30,2005 compared to thesame prior year period added approximately $3.6 million in depletion expense.Our depletion rate has increased due to increased spending on our drillingprogram with disproportionate reserve additions. Depreciation of furniture andfixtures decreased 29% compared to the six months ended June 30, 2004 dueto several larger depreciable assets that became fully depreciated by year-end2004 and are not currently contributing to expense. Accretion expenseassociated with our asset retirement obligations for the six months ended June 30,2005 increased 29% over the same prior year period for the new obligationsincurred from the wells drilled in 2004 and 2005, as well as those South Texasproperties acquired on December 29, 2004.

 

Total G&A for the sixmonths ended June 30, 2005 was $5.4 million, an increase of 3% compared tothe prior year six months total of $5.3 million. A FIN 44 charge of $171,645 was incurred for the six months ended June 30,2005 compared to $1.4 million in the same period of 2004. Amortizationrelated to restricted stock awards granted over the past three years totaled$406,344 and $211,100, respectively, for the six months ended June 30,2005 and 2004. The increase relates to new grants that have occurred since June 30,2004. We recorded $11,000 of bad debt expense and increased our allowancerelated to JIB Accounts Receivable. Other G&A for the six months ended June 30,2005, which does not include the deferred compensation expenses discussedabove, totaled $4.8 million, a 33% increase from the comparable 2004 periodtotal of $3.6 million. The increase in other G&A was attributable to highersalaries and benefits, due in part to higher staffing levels, as well as higherrent expense for additional office space, higher board of directorcompensation, increased audit and Sarbanes-Oxley 404 audit fees, franchise taxexpense and costs relating to strategic planning. For the six months ended June 30,2005 and 2004, overhead reimbursement fees reduced G&A costs by $158,884and $130,047, respectively. Capitalized G&A costs further reduced otherG&A by $1,379,900 and $1,039,130 for the six months ended June 30,2005 and 2004, respectively.  OtherG&A on a unit of production basis for the six months ended June 30,2005 was $0.59 per Mcfe compared to $0.60 per Mcfe for the comparable 2004period.

 

Other income (expense) for the six months ended June 30,2005 excludes interest expense because 100% of our interest expense for the sixmonths ended June 30, 2005 was capitalized as compared to only a portionof interest expense in the same 2004 period. We incurred higher interest costsfor the six months ended June 30, 2005 than for the same period of 2004,but we capitalized all of our expense as a result of our unproved propertybalance exceeding our debt balance.

 

| ** **                  | ** ** | **For the Six Months Ended June 30,** | ** ** |
|-----------------------------|------------|--------------------------------------------|------------|
| ** **                  | ** ** | **2005**                                   | ** ** | **2004** | ** ** |
|                        |       |                                       |       |   |   |
| Gross interest              |       | $                                          | 480,089    |   | $ | 431,162 |   |
| Less:  Capitalized interest |       | (480,089                                   | )          | (211,479 | ) |
| Interest  expense, net      |       | $                                          | —     |   | $ | 219,683 |   |
|                        |       |                                       |       |   |   |
| Weighted Average  Debt      |       | $                                          | 11,602,210 |   | $ | 20,214,286 |   |

 

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

 

An income tax provision was recorded for the sixmonths ended June 30, 2005 and 2004 of $6.5 million and $3.9 million,respectively. The increase resulted from higher pre-tax income in 2005 ascompared to 2004.

 

For the six months ended June 30, 2005, we hadnet income of $11.9 million, or $0.70 basic earnings per share and $0.67diluted earnings per share, as compared to net income of $7.1 million, or $0.56basic earnings per share and $0.53 diluted earnings per share in the comparable2004 period. Basic weighted average shares outstanding increased for the sixmonths ended June 30, 2005 over the same period 2004 primarily due to thestock offering completed in December 2004 and the related over-allotmentexercise in January 2005. We issued a total of 4,025,000 shares in thesetransactions.

 

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## **Liquidity and Capital Resources**

## ** **

Our primary ongoingsource of capital is the cash flow generated from our operating activitiessupplemented by borrowings under our credit facility.  Net cash generated from operating activitiesis a function of production volumes, commodity prices (which are inherentlyvolatile and unpredictable), operating efficiency and capital spending. Ourbusiness, as with other extractive industries, is a depleting one in which eachgas equivalent unit produced must be replaced or our business, and a criticalsource of our future liquidity, will shrink. Our overall existing productionhas a decline rate of approximately 16% per year.  Less predictable than production declinesfrom our proved reserves is the impact of constantly changing oil and naturalgas prices on cash flows and, therefore capital budgets.  We attempt to mitigate the price risk withour hedging program. Reserves and production volumes are influenced, in part,by the amount of future capital expenditures. In turn, capital expenditures areinfluenced by many factors including drilling results, oil and gas prices,industry conditions, availability and prices of goods and services and theextent to which oil and gas properties are acquired.

 

Our primary needs forcash are for exploration, development and acquisition of oil and gasproperties, and the repayment of principal and interest on outstanding debt. Weattempt to fund our exploration and development activities primarily throughinternally generated cash flows and budget capital expenditures based onprojected cash flows.  We routinelyadjust capital expenditures in response to changes in oil and natural gasprices, drilling and acquisition costs, and cash flow. We typically have fundedacquisitions from borrowings under our credit facility, cash flow fromoperations and sales of common stock. We have historically used our creditfacility to supplement any deficiencies between operating cash flow and capitalexpenditures.

 

Significant changes toworking capital may also affect our liquidity in the short term. The increasein the derivative instrument liability is indicative of potential future cashsettlements on our hedge positions as the months settle. The fair value of ouroutstanding hedge and derivative contracts is reflected on the balance sheet,and we show a liability for the positions with each of our two counterparties.The hedge and derivative financial instrument liability represents the amountby which future strip commodity prices exceed the price caps on our contractsat the balance sheet date. Should commodity prices decrease or increase, thepositions would change accordingly and the unrealized losses that are reflectedin revenue and other comprehensive income could possibly increase or reverseresulting in gains, respectively. When hedges and derivatives require cashsettlement, the Company is receiving higher cash inflows on the sale ofunhedged production at higher prices, therefore the use of those funds wouldadequately cover any derivative and hedge payments when they come due.

 

After considering the impact of these working capitalchanges and our forecasts of future results of operations, we believe that cashflows from operating activities, as supplemented by borrowings on our creditfacility, combined with our ability to control the timing of the majority ofour future exploration and development requirements will provide us with theflexibility and liquidity to meet our planned capital requirements for 2005. Inaddition, our credit facility had $57.0 million available at June 30, 2005for general corporate purposes, exploratory and developmental drilling andacquisitions of oil and gas properties.

 

During 2004 and early2005, we realized increased cash flows as a result of our public stockofferings and activity in stock option and warrant exercises. Mostsignificantly was the net proceeds of $47,810,000 that we received, beforedirect costs of $0.6 million, from our December 2004 offering of ourcommon stock and the related exercise of the underwriter’s over-allotmentoption for 525,000 additional shares of our common stock, resulting in anadditional $7.2 million of net proceeds to us in January 2005. Wetypically do not rely on proceeds from offerings and the exercise of warrantsand stock options to sustain our business as they are unpredictable events.

 

We had cash and cash equivalentsat June 30, 2005 of $2.2 million consisting primarily of short-term moneymarket investments, as compared to $2.3 million at December 31, 2004.  Working capital was $10.5 million as of June 30,2005, as compared to $9.0 million at December 31, 2004. We had $13.0million outstanding under the credit facility at June 30, 2005, which wasreduced from $20.0 million at December 31, 2004 by applying the netproceeds we received from the exercise of the underwriter’s over-allotmentoption (see discussion above). The maturity date for the credit facility is December 31,2007.

 

34

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*NetCash Provided By Operating Activities*

 

Cash flows provided byoperating activities were $33.7 million for the six months ended June 30,2005 compared to $23.2 million for the six months ended June 30, 2004. Theincrease in cash flows provided by operating activities for the six monthsended June 30, 2005 compared to 2004 was primarily due to higher oil andgas production revenue partially offset by higher operating expense.  Although fluctuations in commodity priceshave been the primary reason for our short-term changes in cash flow fromoperating activities, increased production volumes significantly impacted us inthe past few quarters. In an effort to reduce the volatility realized oncommodity prices, we enter into derivative instruments.  Due to the inflated market crude oil pricing,the impact related to the derivatives for the first six months of 2005 has beennegative, as the prices have exceeded the highs we originally expected. We haverealized the benefit of these high prices on our crude oil production, but alsorealized the negative impact from $605,104 of cash settlements on our crude oilderivatives. We have realized $156,500 of cash gains on our natural gas hedgesettlements due to the market natural gas prices falling below our hedgefloors. Overall, oil and gas production revenue increased for the six monthsended June 30, 2005 as compared to the same period in 2004 with a 36%increase in production and a 14% increase in the average net price received forour production.

 

*NetCash Used In Investing Activities*

 

We reinvest a substantial portion of our cashflows from operating activities in our drilling, acquisition, land andgeophysical activities.  As a result, weused $34.0 million in investing activities during the first six months of 2005.Capital expenditures of $27.7 million were attributable to our drillingprogram. In addition to drilling that was in progress at year-end 2004, wedrilled 22 gross wells during the six months ended June 30, 2005, all butone of which were successful. Leasehold acquisitions, including seismic dataand other geological and geophysical expenditures totaled $4.6 million andacquisition costs totaled $1.4 million for the six months ended June 30,2005. The remaining capital expenditures were associated with computer hardwareand office equipment. During the six months ended June 30, 2004, we used$19.4 million in investing activities and we incurred capital expenditures of$16.3 million attributable to the drilling of 20 gross wells, 18 of which weresuccessful.  Leasehold acquisitions,including seismic data and other geological and geophysical expenditurestotaled $2.7 million and acquisition costs totaled $0.1 million for the sixmonths ended June 30, 2004. The remaining capital expenditures wereassociated with computer hardware and office equipment.  Proceeds from the sale of oil and gasproperties totaled $40,000 during the six months ended June 30, 2004.

 

We currently anticipatecapital expenditures in 2005 to be approximately $76 million.  Approximately $52.4 million is allocated toour expected drilling and production activities; $16.7 million is allocated toland and seismic activities; $1.0 million to acquisitions and $3.4 millionrelates to capitalized interest and G&A and other.  We plan to fund these expenditures fromexpected cash flow from operations.  Wedo not explicitly budget for acquisitions; however, we do expect to spendconsiderable effort evaluating acquisition opportunities. We expect to fundacquisitions through traditional oil and gas reserve-based bank debt and theissuance of common stock and, if required, through additional debt and equityfinancings and production payment financings. We currently have $57.0 millionof unused borrowing capacity under our credit facility and $390 million ofunused capacity under our current shelf registration statement.

 

*NetCash Provided By (Used In) Financing Activities*

 

Cash flows provided byfinancing activities totaled $0.2 million for the six months ended June 30,2005. We received $7.2 million in proceeds from the issuance of common stockrelated to the exercise of the over-allotment option on our December 21,2004 public offering and stock options exercised in the first six months of2005. These were partially offset by net repayments of $7.0 million under ourcurrent credit facility. Cash flows used in financing activities totaled $1.5million for the six months ended June 30, 2004, and included repayments of$3.0 million under our credit facility, $1.9 million of net proceeds from theissuance of common stock and deferred loan costs of $0.4 million associatedwith amending that facility after the Miller merger.

 

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Due to our activeexploration, development and acquisition activities, we have experienced andexpect to continue to experience substantial working capital requirements. Weintend to fund our projected 2005 capital expenditures, commitments and workingcapital requirements through cash flows from operations. We believe we will beable to generate capital resources and liquidity sufficient to fund our capitalexpenditures and meet such financial obligations as they come due.

 

*Credit Facility*

 

In March 2004, buteffective December 31, 2003, the Company entered into a new amended andrestated credit facility (the “Credit Facility”) which permits borrowings up tothe lesser of (i) the borrowing base or (ii) $100 million.  Borrowings under the Credit Facility bearinterest at a rate equal to prime plus 0.50% or LIBOR plus 2.25%. Commitmentfees of 0.50% to 3.75% accrue on the unused portion of the borrowing base,depending on the utilization percentage, and are included as a component ofinterest expense. As of June 30, 2005, $13.0 million in borrowings wereoutstanding under the Credit Facility and our interest rate was 6.00%. On June 30,2005, we entered into a short term fixed rate LIBOR agreement, which shouldreduce our interest rates. The Credit Facility matures December 31, 2007and is secured by substantially all of the Company’s assets.

 

Effective December 2004,the borrowing base under the Credit Facility was increased from $48.0 millionto $65.0 million as a result of the asset acquisition that closed December 29,2004 and our drilling activities since the last redetermination. On May 31,2005, the borrowing base was increased from $65.0 million to $70.0 million andthe maturity date was extended from December 31, 2006 to December 31,2007 and the interest rate margins were reduced from previous levels. Based onthe increase in our borrowing base, our available borrowing capacity at June 30,2005 was $57.0 million.

 

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

 

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

•                  TheWorking Capital ratio requires that the amount of our consolidated currentassets less our consolidated current liabilities, as defined in the agreement,be at least $1.0 million. For the purposes of calculating the Working Capitalratio, current assets are adjusted for unused capacity under credit agreementand derivative financial instruments, and current liabilities are adjusted forderivative financial instruments and asset retirement obligations.

•                  TheMaximum Leverage ratio requires that the ratio, as of the last day of anyfiscal quarter, of (a) Total Indebtedness (as defined in the CreditFacility) as of such fiscal quarter to (b) an amount equal to consolidatedEBITDAX for the two quarters then ended times two, not be greater than 3.0 to1.0.

 

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

 

*Shelf Registration Statement*

 

We filed a $150 million shelf registration statement with the SEC, which became effective in May 2004. During the second quarter 2005, we filed a new registration statement that replaced the prior registration statement and increased the amount of securities registered to $390 million. Under this shelf registration statement, we may issue, from time to time, any combination of debt securities, preferred stock, common stock or warrants for debt securities or equity securities in one or more offerings to those persons who agree to purchase our securities. Net proceeds, terms and pricing of the offering of securities issued under the shelf registration statement will be

 

36

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determined at the time of the offerings. The shelf registration statement does not provide assurance that we will or could sell any such securities. Our ability to utilize our shelf registration statement for the purpose of issuing, from time to time, any combination of debt securities, preferred stock, common stock or warrants for debt securities or equity securities will depend upon, among other things, market conditions and the existence of investors who wish to purchase our securities at prices acceptable to us.

 

We completed an offeringon December 21, 2004 of 3.5 million shares of our common stock under ourinitial shelf registration statement, which generated net proceeds to us,before direct costs of the offering, of $47.8 million. These funds were used tofinance the asset acquisition that closed on December 29, 2004 with afinal adjusted purchase price of $40.1 million, before other acquisition costs,and fund the costs of the offering and other general corporate purposes. On January 5,2005, the underwriters exercised their over-allotment option for an additional525,000 shares of common stock, which generated net proceeds to us of $7.2million. These funds were used to reduce our outstanding debt. Each of thesesales was made under our shelf registration statement. At June 30, 2005,we had approximately $390 million remaining for issuance under our new shelfregistration statement.

 

*Off Balance Sheet Arrangements*

 

We do not have any off balance sheet arrangements.

 

*Contractual Cash Obligations*

 

There were no materialchanges outside the ordinary course of our business in lease obligations orother contractual obligations since December 31, 2004.

 

**Risk Management Activities –Derivatives & Hedging**

 

Due to the instability ofoil and natural gas prices, we may enter into, from time to time, price-riskmanagement transactions (e.g., swaps, collars and floors) for a portion of ouroil and natural gas production to achieve a more predictable cash flow, as wellas to reduce 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 priceprotection against declines in oil and natural gas prices and limits ourpotential gains from future increases in prices. We also use price-riskmanagement transactions to protect forward pricing as a bidding strategy withrespect to acquisition offers and execution. None of these instruments are usedfor trading purposes. On a quarterly basis, our management sets all of ourprice-risk management policies, including volumes, types of instruments andcounterparties. These policies are implemented by management through theexecution of trades by the Chief Financial Officer after consultation andconcurrence by the President and Chairman of the Board.  Our Board of Directors monitors the Company’sprice-risk management policies and trades.

 

All of these price-riskmanagement transactions are considered derivative instruments and accounted forin accordance with SFAS No. 133, *“Accountingfor Derivative Instruments and Hedging Activities.”* These derivativeinstruments are intended to hedge our price risk and may be considered hedgesfor economic purposes, but certain of these transactions may not qualify forspecial cash flow hedge accounting. Therefore, depending on the type oftransaction and the circumstances, different accounting treatment may apply tothe timing and location of the income statement impact, but all derivatives arerecorded on the balance sheet at fair value. The following table providesadditional information regarding the Company’s various derivative and hedgingtransactions that were recorded at fair value on the balance sheet as of June 30,2005.

 

37

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| Fair value of  contracts outstanding at December 31, 2004                          |   | $          | 1,356,482  |   |
|-----------------------------------------------------------------------------------------|--------|------------|------------|--------|
| Contracts  realized or otherwise settled during the period                              |   | (833,565   | )          |
| Fair value of  new contracts when entered into during 2005:                             |   |       |       |
| Asset                                                                                   |   | —     |       |
| Liability                                                                               |   | —     |       |
| Changes in fair  values attributable to changes in valuation techniques and assumptions |   | (1,742,958 | )          |
| Other changes in  fair values                                                           |   | —     |       |
| Fair values of  contracts outstanding at June 30, 2005                             |   | $          | (1,220,041 | )      |

 

The following table details the fair value of ourcommodity-based derivative and hedging contracts by year of maturity andvaluation methodology as of June 30, 2005.

 
| ** **                                           | ** ** | **Fair Value of Contracts at June 30, 2005** | ** ** |
|------------------------------------------------------|------------|---------------------------------------------------|------------|
| **Source of Fair Value**                             | ** ** | **Maturity less  than 1 year**                    | ** ** | **Maturity 1-3  years** | ** ** | **Maturity 4-  5 years** | ** ** | **Maturity in  excess of 5  years** | ** ** | **Total fair  value** | ** ** |
| Prices actively  quoted:                             |       | $                                                 | —     |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   |
| Prices provided  by other external sources:          |       |                                              |       |   |   |   |   |   |   |   |   |
| Asset                                                |       | —                                            |       | — |   | — |   | — |   | — |   |
| Liability                                            |       | (1,220,041                                        | )          | — |   | — |   | — |   | (1,220,041 | ) |
| Prices based on  models and other valuation methods: |       | —                                            |       | — |   | — |   | — |   | — |   |
| Total                                                |       | $                                                 | (1,220,041 | ) | $ | — |   | $ | — |   | $ | — |   | $ | (1,220,041 | ) |

 

Hedges entered into afterJune 30, 2005 were as follows:

 
| **Transaction  Date** | ** ** | **Transaction  Type** | ** ** | **Effective Dates** | ** ** | **Price Per  Unit** | ** ** | **Volumes  Per Day** | ** ** |
|-----------------------|------------|-----------------------|------------|---------------------|------------|---------------------|------------|----------------------|------------|
| ** **            | ** ** | **Beginning**         | ** ** | **Ending**          | ** ** | ** **          | ** ** |
| 08/05                 |       | Natural Gas Collar    | (1)        | 01/01/2006          |       | 12/31/2006          |       | $7.00-$10.50         |       | 10,000 MMBTU |   |

 

----

(1)          TheCompany’s current hedging activities for natural gas were entered into on a perMMbtu delivered price basis, Houston Ship Channel Index, with settlement foreach calendar month occurring five business days following the expiration date

 

**Tax Matters**

 

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

 

**Recently Issued Accounting Pronouncements**

 

In December 2004,the FASB issued SFAS No. 123(R), “*Share-BasedPayment.*” This statement requires companies to measure the cost ofemployee services in exchange for an award of equity instruments based on agrant-date fair value of the award (with limited exceptions), and that costmust generally be recognized over the vesting period. SFAS No. 123(R)amends the original SFAS No. 123 and 95 that had allowed companies tochoose between expensing stock options or showing pro forma disclosure only.This statement eliminates the ability to account for share-based compensationtransactions using APB Opinion No. 25. We currently account for ourstock-based compensation plans under the principles prescribed by APB Opinion No. 25.Accordingly, no stock option compensation cost is reflected in net income, asall options granted under the plan had an exercise price equal to the marketvalue of the underlying common stock on the date of grant. The adoption of SFASNo. 123(R) will impact our results of operations, but will have no impacton our overall financial position. In March 2005, the SEC issued SAB No. 107.Among other things, SAB No. 107 provides interpretive guidance related tothe interaction between SFAS No. 123(R) and certain SEC rules andregulations, as well as provides the SEC staff’s views regarding the

 

38

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valuation of share-basedpayment arrangements for public companies. SFAS No. 123(R) was to becomeeffective as of the beginning of the first interim or annual reporting periodthat begins after June 15, 2005, but on April 14, 2005, the SEC issuedpress release 2005-57, which amends the compliance date of SFAS No. 123(R)until fiscal years beginning after June 15, 2005. We anticipate adoptingthe provisions of SFAS No. 123(R) in the first quarter of 2006 usingthe modified prospective method for transition. Under this method we willrecognize compensation expense for all stock-based awards granted or modifiedon or after July 1, 2005, as well as any previously granted awards thatare not fully vested as of July 1, 2005. Compensation expense will bemeasured based on the fair value of the awards previously calculated indeveloping the pro forma disclosures in accordance with the provisions ofSFAS No. 123. We expect the impact to be immaterial due to the factthat the Company has not issued options since April 2004 and there willonly be a minimal amount of unvested options as of our adoption date. SFAS No. 123(R)also requires the benefits of tax deductions in excess of recognizedcompensation cost be reflected as a financing cash flow, rather than as anoperating cash flow as currently required.

 

In March 2005, the FASB issued FASBInterpretation No. 47, *Accounting forConditional Asset Retirement Obligations, an interpretation of FASB Statement No. 143*(“FIN 47”).  FIN 47 clarifies that the term, “conditional asset retirementobligation” as used in SFAS No. 143, *Accountingfor Asset Retirement Obligations*, refers to a legal obligation toperform an asset retirement activity in which the timing and/or method ofsettlement are conditional upon a future event that may or may not be withinthe control of the entity.  Even though uncertainty about the timingand/or method of settlement exists and may be conditional upon a future event,the obligation to perform the asset retirement activity is unconditional. Accordingly, an entity is required to recognize a liability for the fair valueof a conditional asset retirement obligation if the fair value of the liabilitycan be reasonably estimated.  Uncertainty about the timing and/or methodof settlement of a conditional asset retirement obligation should be factoredinto the measurement of the liability when sufficient information exists. The fair value of a liability for the conditional asset retirement obligationshould be recognized when incurred generally upon acquisition, construction, ordevelopment or through the normal operation of the asset.  SFAS No. 143acknowledges that in some cases, sufficient information may not be available toreasonably estimate the fair value of an asset retirement obligation.  FIN47 also clarifies when an entity would have sufficient information toreasonably estimate the fair value of an asset retirement obligation.  FIN47 is effective no later than the end of reporting periods ending after December 15,2005.  Retrospective application for interim financial information ispermitted but is not required.  Early adoption of FIN 47 isencouraged.  We are currently evaluating what impact FIN 47 will have onour financial statements, but at this time, we do not believe that the adoptionof FIN 47 will have a material effect on our consolidated financial position,results of operations or cash flows.

 

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

 

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

## ** **

We are exposed to market risk from changes in interestrates and commodity prices.  We use acredit facility, which has a floating interest rate, to finance a portion ofour operations. We are not subject to fair value risk resulting from changes inour floating interest rates.  The use offloating rate debt instruments provides a benefit due to downward interest ratemovements but does not limit us to exposure from future increases in interestrates.  Based on the June 30, 2005outstanding borrowings and a floating interest rate of 5.24%, a 10% change ininterest rates would result in an increase or decrease of interest expense ofapproximately $65,000 on an annual basis.

 

In the normal course ofbusiness we enter into hedging transactions, including commodity price collars,swaps and floors to mitigate our exposure to commodity price movements, but notfor trading or speculative purposes.  During 2004, due to the instability of pricesand to achieve a more predictable cash flow, we put in place natural gas andcrude oil collars for a portion of our 2005 production. Please refer to Note 7to our consolidated financial statements. While the use of these arrangementsmay limit the benefit to us of increases in the price of oil and natural gas,it also limits the downside risk of adverse price movements.  The following is a list of contractsoutstanding as of June 30, 2005:

 

39

----

 
| **Transaction  Date** | ** ** | **Transaction  Type** | ** ** | **Beginning** | ** ** | **Ending** | ** ** | **Price  Per Unit** | ** ** | **Volumes  Per  Day** | ** ** | **Fair  Value  Outstanding as of  June 30, 2005** | ** ** |
|-----------------------|------------|-----------------------|------------|---------------|------------|------------|------------|---------------------|------------|-----------------------|------------|--------------------------------------------------------|------------|
|                  |       |                  |       |          |       |       |       |                |       |                  |       |                                                   |       |
| ***Natural  Gas:***   |       |                  |       |          |       |       |       |                |       |                  |       |                                                   |       |
| 07/04                 |       | Collar                | (1)        | 07/01/05      |       | 09/30/05   |       | $5.00-$7.67         |       | 10,000 MMbtu          |       | $                                                      | (76,232    | ) |
| 10/04                 |       | Collar                | (1)        | 01/01/05      |       | 12/31/05   |       | $6.00-$9.52         |       | 10,000 MMbtu          |       | (25,187                                                | )          |
|                  |       |                  |       |          |       |       |       |                |       |                  |       |                                                   |       |
| ***Crude  Oil:***     |       |                  |       |          |       |       |       |                |       |                  |       |                                                   |       |
| 05/04(08/04)          |       | Collar                | (2)(3)     | 01/01/05      |       | 12/31/05   |       | $35.00-$40.00       |       | 200/290 Bbl           |       | (1,118,622                                             | )          |
|                  |       |                  |       |          |       |       |       |                |       |                  |       |                                                   |       |
|                  |       |                  |       |          |       |       |       |                |       |                  |       | $                                                      | (1,220,041 | ) |

 

----

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

(2)                Hedgeaccounting is not applied to the Company’s collars on crude oil, which wereentered into on a per barrel delivered price basis, using the West TexasIntermediate Index, with settlement for each calendar month occurring fivebusiness days following the expiration date. The change in fair value isreflected in net revenue for the applicable periods.

(3)                InAugust 2004, the Company replaced the hedge contract that was outstandingat June 30, 2004 with a new contract that changes the volume and pricingterms. The put option is on 200 Bbl/D and the call option is on 290 Bbl/D. Thistransaction was completed at no additional cost to the Company.

 

At June 30, 2005, the fair value of theoutstanding hedges was a liability of approximately $1.2 million. A 10% changein the commodity price per unit, as long as the price is either above theceiling or below the floor price would cause the fair value total of the hedgeto increase or decrease by approximately $116,500.

 

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

#####  

In accordance with Exchange Act Rules 13a-15and 15d-15, we carried out an evaluation, under the supervision and withthe participation of management, including our Chief Executive Officer andChief Financial Officer, of the effectiveness of our disclosure controls andprocedures as of the end of the period covered by this report.  Based on that evaluation, our Chief ExecutiveOfficer and Chief Financial Officer concluded that our disclosure controls andprocedures were effective as of June 30, 2005 to provide reasonableassurance that information required to be disclosed in our reports filed orsubmitted under the Exchange Act is recorded, processed, summarized andreported within the time periods specified in the SEC’s rules and forms.

 

Except as described in this item, there has been nochange in our internal controls over financial reporting that occurred duringthe six months ended June 30, 2005 that has materially affected, or isreasonably likely to materially affect, our internal controls over financialreporting.  In March 2005,management discovered an error in a spreadsheet application, which was designedto eliminate intercompany balances.  As aresult of the error, amounts accumulated in the property account for onesubsidiary were also included as an accrued capital expenditure by anothersubsidiary and inadvertently not eliminated in consolidation.  This caused property balances to beoverstated.  This error in the propertybalance also impacted the computation of depletion expense and therefore operatingexpenses, operating income, income tax expense, net income and earnings pershare.  Management concluded, based onthe circumstances involving the error, that, as of December 31, 2004, amaterial weakness in internal control over financial reporting existed and theCompany’s internal control over financial reporting was not effective.  Changes were made to the Company’s internalcontrol over financial reporting in order to remediate the materialweakness.  The change in accountingprocess in the second quarter of 2004 which led to the error was made in orderto meet our shortened reporting deadlines with our then-existing staffinglevel.  In the first quarter of 2005,management effectively corrected the problem by re-instituting the accountingprocess we had used prior to the second quarter of 2004.  We were able to re-institute the old methodas a result of increasing our staffing levels to assist with the closing of ourfinancial statements.  Managementbelieves that these actions remediate the material weakness.  These changes have been tested by the Companyand are operating effectively.

 

40

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**PART II - OTHER INFORMATION**

 

**Item 1. -Legal Proceedings**

 

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

 

During the second quarter of 2004, the Companyreceived notice that its franchise tax returns for the State of Texas would beaudited for the tax years 1999 through 2002. After reviewing documentssubmitted, the agent representing the Office of the Comptroller of the State ofTexas proposed adjustments to the calculation that would result in an increasedfranchise tax liability.  The agentmaintained that transfers by the parent company to its subsidiaries that theCompany classified as intercompany loans should instead be classified as equityinvestments in the subsidiary. The State of Texas originally proposed that thefranchise tax liability of the subsidiaries would be increased by approximately$3.0 million for the four-year period under audit.

 

During the third quarter of 2004, the agent reducedthe proposed franchise tax deficiency adjustment to the Company and itssubsidiaries to an aggregate of $467,000. In the fourth quarter of 2004, therewas an informal hearing at the local Comptroller’s Office during which theagent indicated he would formally assess the proposed deficiency.  On March 24, 2005, the Company receivedsuch deficiency assessment in the amount of $471,482 including penalty andinterest.  The Company responded on April 21,2005 with a request for a formal redetermination hearing. In July 2005,the Company submitted additional documents and evidence supporting its positionfor the hearing. The Company intends to continue to vigorously contest theassessment through appropriate administrative levels in the Comptroller’sOffice and any other available means. Due to its intention to continue to vigorously contest the proposedadjustments, the Company has not recognized any provision for the additionalfranchise taxes that 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**        |   |   |

 

Our stockholders voted onthe following matters at the Annual Meeting of Shareholders on April 27,2005:

 
| ** **                                                                                                         | ** ** | **For**    | ** ** | **Against** | ** ** | **Withheld** | ** ** | **Abstain** | ** ** | **Broker  Non Votes** | ** ** |
|--------------------------------------------------------------------------------------------------------------------|------------|------------|------------|-------------|------------|--------------|------------|-------------|------------|-----------------------|------------|
| (A) Election  of Directors:                                                                                   |       |       |       |        |       |         |       |        |       |                  |       |
| Vincent S.  Andrews                                                                                                |       | 13,491,846 |       | —      |       | 1,047,477    |       | —      |       | —                |       |
| (B) Charter  amendment to increase number of authorized shares of Common Stock from 25  million to 60 million |       | 11,506,540 |       | 2,819,495   |       | —       |       | 213,288     |       | —                |       |
| (C) Approval  of the Appointment of BDO Seidman LLP as Independent Auditors                                   |       | 14,262,904 |       | 257,822     |       | —       |       | 18,597      |       | —                |       |

 

In addition to theelection of the directors indicated above, the following directors continued asdirectors following the meeting: Thurmon Andress, John W. Elias, Stanley S.Raphael, Robert W. Shower, David F. Work and John Sfondrini.

 

41

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**Item 5. -Other Information**

 

On May 31, 2005, weexecuted Agreement andAmendment No. 1 to Third Amended and Restated Credit Agreement (“AmendmentNo. 1”) to amend our current Credit Facility Agreement. Amendment No. 1increases the borrowing base from $65.0 million to $70.0 million, extends thematurity date from December 31, 2006 to December 31, 2007 and reducesthe interest rate margins.

 

Amendment No. 1 tothe Credit Facility Agreement is attached hereto as Exhibit 4.2 to this Form 10-Qfor the period ended June 30, 2005.

 

**Item 6. -Exhibits**

 

The following exhibits are filed as partof this report:

 

# **INDEX TO EXHIBITS**

# ** **

| **Exhibit No.** |   |   |
|----------------------|--------|--------|
|                 |
| 2.1                  | — |   | Amended and Restated  Combination Agreement by and among (i) Edge Group II Limited  Partnership, (ii) Gulfedge Limited Partnership, (iii) Edge Group  Partnership, (iv) Edge Petroleum Corporation, (v) Edge  Mergeco, Inc. and (vi) the Company, dated as of January 13, 1997  (Incorporated by reference from exhibit 2.1 to the Company’s Registration  Statement on Form S-4 (Registration No. 333-17269)). |
|                 |   |   |   |
| 2.2                  | — |   | Agreement and Plan of  Merger dated as of May 28, 2003 among Edge Petroleum Corporation, Edge  Delaware Sub Inc. and Miller Exploration Company (Miller”) (Incorporated by  reference from Annex A to the Joint Proxy Statement/Prospectus contained in  the Company’s Registration Statement on Form S-4/A filed on  October 31, 2003 (Registration No. 333-106484)). |
|                 |   |   |   |
| 2.3                  | — |   | Asset Purchase  Agreement by and among Contango STEP, L.P., Contango Oil & Gas  Company, Edge Petroleum Exploration Company and Edge Petroleum Corporation  dated October 7, 2004 (Incorporated by reference from exhibit 2.1 to the  Company’s Current Report on Form 8-K filed October 12, 2004). |
|                 |   |   |   |
| 3.1                  | — |   | Restated Certificate of  Incorporation of the Company effective January 27, 1997 (Incorporated by  reference from exhibit 3.1 to the Company’s Current Report on Form 8-K  filed April 29, 2005). |
|                 |   |   |   |
| 3.2                  | — |   | Certificate of  Amendment to the Restated Certificate of Incorporation of the Company  effective January 31, 1997 (Incorporated by reference from exhibit 3.2  to the Company’s Current Report on Form 8-K filed April 29,  2005). |
|                 |   |   |   |
| 3.3                  | — |   | Certificate of  Amendment to the Restated Certificate of Incorporation of the Company  effective April 27, 2005 (Incorporated by reference from exhibit 3.3 to  the Company’s Current Report on Form 8-K filed April 29,  2005). |
|                 |   |   |   |
| 3.4                  | — |   | Bylaws of the Company  (Incorporated by Reference from exhibit 3.3 to the Company’s Quarterly Report  on

Form 10-Q for the  quarterly period ended September 30, 1999). |
|                 |   |   |   |
| 3.5                  | — |   | First Amendment to  Bylaws of the Company on September 28, 1999 (Incorporated by Reference  from exhibit 3.4 to the Company’s Quarterly Report on Form 10-Q  for the quarterly period ended March 31, 2003). |
|                 |   |   |   |
| 3.6                  | — |   | Second Amendment to  Bylaws of the Company on May 7, 2003 (Incorporated by reference from  exhibit 3.2 to the Company’s Quarterly Report on Form 10-Q for the  quarterly period ended September 30, 1999). |

 

42

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| 4.1        | — |   | Third Amended and  Restated Credit Agreement dated December 31, 2003 among Edge Petroleum  Corporation, Edge Petroleum Exploration Company, Edge Petroleum Operating Company, Inc.,  Miller Oil Corporation and Miller Exploration Company, as borrowers, the  lenders thereto and Union Bank of California, N.A., a national banking  association, as agent for the lenders (Incorporated by reference from  Exhibit 4.1 to the Company’s Quarterly Report on Form 10-Q  for the quarterly period ended March 31, 2004). |
|------------|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| *4.2       | — |   | Agreement and Amendment No. 1 to Third Amended  and Restated Credit Agreement dated May 31, 2005 among Edge Petroleum  Corporation, Edge Petroleum Exploration Company, Edge Petroleum Operating  Company, Inc., Miller Exploration Company and Miller Oil Corporation, as  borrowers, the lenders thereto and Union Bank of California, N.A., a national  banking association, as agent for the lenders.                                                                                                                                |
|       |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 4.3        | — |   | Common Stock Subscription  Agreement dated as of April 30, 1999 between the Company and the  purchasers named therein (Incorporated by reference from exhibit 4.5 to the  Company’s Quarterly Report on Form 10-Q/A for the quarter ended  March 31, 1999).                                                                                                                                                                                                                                                                         |
|       |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 4.4        | — |   | Registration Rights Agreement by and among Edge  Petroleum Corporation, Guardian Energy Management Corp., Kelly E. Miller and  the Debra A. Miller Trust, dated December 4, 2003 (Incorporated by  reference from exhibit 4.2 to the Company’s Registration Statement on  Form S-3 filed on February 3, 2004 (Registration No. 333-112462)).                                                                                                                                                                                   |
|       |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 4.5        | — |   | Miller Exploration  Company Stock Option and Restricted Stock Plan of 1997 (Incorporated by  reference from exhibit 10.1(a) to Miller Exploration Company’s Annual  Report on Form 10-K for the year ended December 31, 1997  (File No. 000-23431)).                                                                                                                                                                                                                                                                           |
|       |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 4.6        | — |   | 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 Exploration  Company’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 Exploration Company’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 Exploration Company’s Annual Report on Form 10-K  for the year ended December 31, 1997 (File No. 000-23431)).                                                                                                                                                                                                                                                                                                           |
|       |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| †10.1 | — |   | Form of  Indemnification Agreement between the Company and each of its directors  (Incorporated by reference from exhibit 10.7 to the Company’s Registration  Statement on Form S-4 (Registration No. 333-17269)).                                                                                                                                                                                                                                                                                                                  |
|       |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| †10.2 | — |   | Stock Option Plan of  Edge Petroleum Corporation, a Texas corporation (Incorporated by reference  from exhibit 10.13 to the Company’s Registration Statement on Form S-4  (Registration No. 333-17269)).                                                                                                                                                                                                                                                                                                                                 |
|       |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| †10.3 | — |   | Employment Agreement  dated as of November 16, 1998, by and between the Company and John W.  Elias (Incorporated by reference from 10.12 to the Company’s Annual Report on  Form 10-K for the year ended December 31, 1998).                                                                                                                                                                                                                                                                                                        |
|       |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| †10.4 | — |   | Incentive Plan of Edge Petroleum  Corporation as Amended and Restated Effective as of June 1, 2004  (Incorporated by reference from exhibit 10.9 to the Company’s Quarterly  Report on Form 10-Q for the quarterly period ended June 30,  2004).                                                                                                                                                                                                                                                                                    |

 

43

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| †10.5  | — |   | Edge Petroleum  Corporation Incentive Plan “Standard Non-Qualified Stock Option Agreement” by  and between Edge Petroleum Corporation and the Officers named therein  (Incorporated by reference from exhibit 10.2 to the Company’s Quarterly Report  on Form 10-Q for the quarterly period ended September 30,  1999). |
|-------------|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|        |   |   |                                                                                                                                                                                                                                                                                                                                             |
| †10.6  | — |   | Edge Petroleum  Corporation Incentive Plan “Director Non-Qualified Stock Option Agreement” by  and between Edge Petroleum Corporation and the Directors named therein (Incorporated  by reference from exhibit 10.3 to the Company’s Quarterly Report on  Form 10-Q for the quarterly period ended September 30, 1999). |
|        |   |   |                                                                                                                                                                                                                                                                                                                                             |
| †10.7  | — |   | Severance Agreements by  and between Edge Petroleum Corporation and the Officers of the Company named  herein (Incorporated by reference from exhibit 10.4 to the Company’s  Quarterly Report on Form 10-Q for the quarterly period ended  September 30, 1999).                                                                   |
|        |   |   |                                                                                                                                                                                                                                                                                                                                             |
| †10.8  | — |   | Form of Director’s Restricted Stock Award  Agreement under the Incentive Plan of Edge Petroleum Corporation  (Incorporated by reference from exhibit 10.12 to the Company’s Quarterly  Report on Form 10-Q for the quarterly period ended June 30,  2004).                                                              |
|        |   |   |                                                                                                                                                                                                                                                                                                                                             |
| †10.9  | — |   | Form of Employee  Restricted Stock Award Agreement under the Incentive Plan of Edge Petroleum  Corporation (Incorporated by reference from exhibit 10.15 to the Company’s  Quarterly Report on Form 10-Q/A for the quarterly period ended  March 31, 1999).                                                                  |
|        |   |   |                                                                                                                                                                                                                                                                                                                                             |
| †10.10 | — |   | Edge Petroleum  Corporation Amended and Restated Elias Stock Incentive Plan. (Incorporated by  reference from exhibit 4.5 to the Company’s Registration Statement on  Form S-8 filed May 30, 2001 (Registration No. 333-61890)).                                                                                             |
|        |   |   |                                                                                                                                                                                                                                                                                                                                             |
| †10.11 | — |   | Form of Edge  Petroleum Corporation John W. Elias Non-Qualified Stock Option Agreement  (Incorporated by reference from exhibit 4.6 to the Company’s Registration  Statement on Form S-8 filed May 30, 2001 (Registration  No. 333-61890)).                                                                             |
|        |   |   |                                                                                                                                                                                                                                                                                                                                             |
| †10.12 | — |   | Summary of Compensation of Non-Employee Directors  (Incorporated by reference from Exhibit 10.12 to the

Company’s Annual Report on Form 10-K for  the year ended December 31, 2004, as updated in part by the

Company’s Current Report on Form 8-K  filed May 4, 2005).                                     |
|        |   |   |                                                                                                                                                                                                                                                                                                                                             |
| †10.13 | — |   | 2005 Bonus Plan for Executive Officers (Incorporated  by reference from the Company’s Current Report on Form 8-K filed  May 4, 2005).                                                                                                                                                                                             |
|        |   |   |                                                                                                                                                                                                                                                                                                                                             |
| †10.14 | — |   | 2004 Bonus Program (Incorporated by reference from  Exhibit 10.1 to the Company’s Current Report on Form 8-K  filed on April 6, 2005).                                                                                                                                                                                       |
|        |   |   |                                                                                                                                                                                                                                                                                                                                             |
| †10.15 | — |   | Salaries and Other Compensation of Executive  Officers (Incorporated by reference from Exhibit 10.13 to the Company’s  Annual Report on Form 10-K for the year ended December 31,  2004, as updated in part by Exhibit 10.2 to the Company’s Current Report  on Form 8-K filed on April 6, 2005).        |
|        |   |   |                                                                                                                                                                                                                                                                                                                                             |
| *31.1       | — |   | Certification by John  W. Elias, Chief Executive Officer, pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                       |
|        |   |   |                                                                                                                                                                                                                                                                                                                                             |
| *31.2       | — |   | Certification by  Michael G. Long, Chief Financial Officer, pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                     |
|        |   |   |                                                                                                                                                                                                                                                                                                                                             |
| *32.1       | — |   | Certification by John  W. Elias, Chief Executive Officer, pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002 (Subsections (a) and (b) of  Section 1350, Chapter 63 of Title 18, United States Code).                                                                                                                 |

 

44

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| *32.2 | — |   | Certification by  Michael G. Long, Chief Financial and Accounting Officer, pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002 (Subsections (a) and  (b) of Section 1350, Chapter 63 of Title 18, United States Code). |
|-------|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

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* Filed herewith.

†Denotes management or compensatory contract, arrangement or agreement.

 

45

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## **SIGNATURES**

## ** **

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

 

 
|   | EDGE PETROLEUM  CORPORATION,  |
|--------|-------------------------------|
|   | A DELAWARE CORPORATION        |
|   | (REGISTRANT)                  |
|   |                          |
|   |                          |
| Date   | August 8, 2005           |   | /s/ John W.  Elias |   |
|   | John W. Elias                 |   |
|   | Chief Executive  Officer and  |   |
|   | Chairman of the  Board        |   |
|   |                          |   |
|   |                          |   |
| Date   | August 8, 2005           |   | /s/ Michael G.  Long |   |
|   | Michael G. Long               |   |
|   | Executive Vice  President and |   |
|   | Chief Financial  Officer      |   |

 

46

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# **INDEX TO EXHIBITS**

# ** **

| **Exhibit No.** |   |
|----------------------|--------|
|                 |
| 2.1                  | — |   | Amended and Restated Combination  Agreement by and among (i) Edge Group II Limited Partnership,  (ii) Gulfedge Limited Partnership, (iii) Edge Group Partnership,  (iv) Edge Petroleum Corporation, (v) Edge Mergeco, Inc. and  (vi) the Company, dated as of January 13, 1997 (Incorporated by  reference from exhibit 2.1 to the Company’s Registration Statement on  Form S-4 (Registration No. 333-17269)). |
|                 |   |   |   |
| 2.2                  | — |   | Agreement and Plan of  Merger dated as of May 28, 2003 among Edge Petroleum Corporation, Edge  Delaware Sub Inc. and Miller Exploration Company (Miller”) (Incorporated by  reference from Annex A to the Joint Proxy Statement/Prospectus contained in  the Company’s Registration Statement on Form S-4/A filed on  October 31, 2003 (Registration No. 333-106484)). |
|                 |   |   |   |
| 2.3                  | — |   | Asset Purchase Agreement  by and among Contango STEP, L.P., Contango Oil & Gas Company, Edge  Petroleum Exploration Company and Edge Petroleum Corporation dated  October 7, 2004 (Incorporated by reference from exhibit 2.1 to the  Company’s Current Report on Form 8-K filed October 12, 2004). |
|                 |   |   |   |
| 3.1                  | — |   | Restated Certificate of  Incorporation of the Company effective January 27, 1997 (Incorporated by  reference from exhibit 3.1 to the Company’s Current Report on Form 8-K  filed April 29, 2005). |
|                 |   |   |   |
| 3.2                  | — |   | Certificate of Amendment  to the Restated Certificate of Incorporation of the Company effective  January 31, 1997 (Incorporated by reference from exhibit 3.2 to the  Company’s Current Report on Form 8-K filed April 29, 2005). |
|                 |   |   |   |
| 3.3                  | — |   | Certificate of  Amendment to the Restated Certificate of Incorporation of the Company  effective April 27, 2005 (Incorporated by reference from exhibit 3.3 to  the Company’s Current Report on Form 8-K filed April 29,  2005). |
|                 |   |   |   |
| 3.4                  | — |   | Bylaws of the Company  (Incorporated by Reference from exhibit 3.3 to the Company’s Quarterly Report  on Form 10-Q for the quarterly period ended September 30,  1999). |
|                 |   |   |   |
| 3.5                  | — |   | First Amendment to  Bylaws of the Company on September 28, 1999 (Incorporated by Reference  from exhibit 3.4 to the Company’s Quarterly Report on Form 10-Q  for the quarterly period ended March 31, 2003). |
|                 |   |   |   |
| 3.6                  | — |   | Second Amendment to  Bylaws of the Company on May 7, 2003 (Incorporated by reference from  exhibit 3.2 to the Company’s Quarterly Report on Form 10-Q for the  quarterly period ended September 30, 1999). |
|                 |   |   |   |
| 4.1                  | — |   | Third Amended and  Restated Credit Agreement dated December 31, 2003 among Edge Petroleum  Corporation, Edge Petroleum Exploration Company, Edge Petroleum Operating  Company, Inc., Miller Oil Corporation and Miller Exploration Company, as  borrowers, the lenders thereto and Union Bank of California, N.A., a national  banking association, as agent for the lenders (Incorporated by reference from  Exhibit 4.1 to the Company’s Quarterly Report on Form 10-Q  for the quarterly period ended March 31, 2004). |
|                 |   |   |   |
| *4.2                 | — |   | Agreement and Amendment No. 1 to Third Amended  and Restated Credit Agreement dated May 31, 2005 among Edge Petroleum  Corporation, Edge Petroleum Exploration Company, Edge Petroleum Operating  Company, Inc., Miller Exploration Company and Miller Oil Corporation, as  borrowers, the lenders thereto and Union Bank of California, N.A., a national  banking association, as agent for the lenders. |
|                      |        |  |  |  |

 

47

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| 4.3        | — |   | Common Stock  Subscription Agreement dated as of April 30, 1999 between the Company  and the purchasers named therein (Incorporated by reference from exhibit 4.5  to the Company’s Quarterly Report on Form 10-Q/A for the quarter  ended March 31, 1999).                                                                                       |
|------------|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       |   |   |                                                                                                                                                                                                                                                                                                                                                                  |
| 4.4        | — |   | Registration Rights Agreement by and among Edge  Petroleum Corporation, Guardian Energy Management Corp., Kelly E. Miller and  the Debra A. Miller Trust, dated December 4, 2003 (Incorporated by  reference from exhibit 4.2 to the Company’s Registration Statement on  Form S-3 filed on February 3, 2004 (Registration No. 333-112462)). |
|       |   |   |                                                                                                                                                                                                                                                                                                                                                                  |
| 4.5        | — |   | Miller Exploration  Company Stock Option and Restricted Stock Plan of 1997 (Incorporated by  reference from exhibit 10.1(a) to Miller Exploration Company’s Annual  Report on Form 10-K for the year ended December 31, 1997  (File No. 000-23431)).                                                                                         |
|       |   |   |                                                                                                                                                                                                                                                                                                                                                                  |
| 4.6        | — |   | 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 Exploration  Company’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 Exploration  Company’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 Exploration Company’s Annual Report on Form 10-K  for the year ended December 31, 1997 (File No. 000-23431)).                                                                                                                         |
|       |   |   |                                                                                                                                                                                                                                                                                                                                                                  |
| †10.1 | — |   | Form of  Indemnification Agreement between the Company and each of its directors  (Incorporated by reference from exhibit 10.7 to the Company’s Registration  Statement on Form S-4 (Registration No. 333-17269)).                                                                                                                                |
|       |   |   |                                                                                                                                                                                                                                                                                                                                                                  |
| †10.2 | — |   | Stock Option Plan of  Edge Petroleum Corporation, a Texas corporation (Incorporated by reference  from exhibit 10.13 to the Company’s Registration Statement on Form S-4  (Registration No. 333-17269)).                                                                                                                                               |
|       |   |   |                                                                                                                                                                                                                                                                                                                                                                  |
| †10.3 | — |   | Employment Agreement  dated as of November 16, 1998, by and between the Company and John W.  Elias (Incorporated by reference from 10.12 to the Company’s Annual Report on  Form 10-K for the year ended December 31, 1998).                                                                                                                      |
|       |   |   |                                                                                                                                                                                                                                                                                                                                                                  |
| †10.4 | — |   | Incentive Plan of Edge  Petroleum Corporation as Amended and Restated Effective as of June 1,  2004 (Incorporated by reference from exhibit 10.9 to the Company’s Quarterly  Report on Form 10-Q for the quarterly period ended June 30,  2004).                                                                                                  |
|       |   |   |                                                                                                                                                                                                                                                                                                                                                                  |
| †10.5 | — |   | Edge Petroleum  Corporation Incentive Plan “Standard Non-Qualified Stock Option Agreement” by  and between Edge Petroleum Corporation and the Officers named therein  (Incorporated by reference from exhibit 10.2 to the Company’s Quarterly  Report on Form 10-Q for the quarterly period ended  September 30, 1999).                      |
|       |   |   |                                                                                                                                                                                                                                                                                                                                                                  |
| †10.6 | — |   | Edge Petroleum  Corporation Incentive Plan “Director Non-Qualified Stock Option Agreement” by  and between Edge Petroleum Corporation and the Directors named therein  (Incorporated by reference from exhibit 10.3 to the Company’s Quarterly  Report on Form 10-Q for the quarterly period ended  September 30, 1999).                     |
|       |   |   |                                                                                                                                                                                                                                                                                                                                                                  |
| †10.7 | — |   | Severance Agreements by  and between Edge Petroleum Corporation and the Officers of the Company named  herein (Incorporated by reference from exhibit 10.4 to the Company’s  Quarterly Report on Form 10-Q for the quarterly period ended  September 30, 1999).                                                                                        |

 

48

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| †10.8  | — |   | Form of Director’s Restricted Stock Award  Agreement under the Incentive Plan of Edge Petroleum Corporation  (Incorporated by reference from exhibit 10.12 to the Company’s Quarterly  Report on Form 10-Q for the quarterly period ended June 30,  2004).                                                        |
|-------------|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|        |   |   |                                                                                                                                                                                                                                                                                                                                       |
| †10.9  | — |   | Form of Employee  Restricted Stock Award Agreement under the Incentive Plan of Edge Petroleum  Corporation (Incorporated by reference from exhibit 10.15 to the Company’s  Quarterly Report on Form 10-Q/A for the quarterly period ended  March 31, 1999).                                                            |
|        |   |   |                                                                                                                                                                                                                                                                                                                                       |
| †10.10 | — |   | Edge Petroleum  Corporation Amended and Restated Elias Stock Incentive Plan. (Incorporated by  reference from exhibit 4.5 to the Company’s Registration Statement on  Form S-8 filed May 30, 2001 (Registration No. 333-61890)).                                                                                       |
|        |   |   |                                                                                                                                                                                                                                                                                                                                       |
| †10.11 | — |   | Form of Edge  Petroleum Corporation John W. Elias Non-Qualified Stock Option Agreement  (Incorporated by reference from exhibit 4.6 to the Company’s Registration  Statement on Form S-8 filed May 30, 2001 (Registration  No. 333-61890)).                                                                       |
|        |   |   |                                                                                                                                                                                                                                                                                                                                       |
| †10.12 | — |   | Summary of Compensation of Non-Employee Directors  (Incorporated by reference from Exhibit 10.12 to the Company’s Annual  Report on Form 10-K for the year ended December 31, 2004, as  updated in part by the Company’s Current Report on Form 8-K filed  May 4, 2005).                                |
|        |   |   |                                                                                                                                                                                                                                                                                                                                       |
| †10.13 | — |   | 2005 Bonus Plan for Executive Officers (Incorporated  by reference from the Company’s Current Report on Form 8-K filed  May 4, 2005).                                                                                                                                                                                       |
|        |   |   |                                                                                                                                                                                                                                                                                                                                       |
| †10.14 | — |   | 2004 Bonus Program (Incorporated by reference from  Exhibit 10.1 to the Company’s Current Report on Form 8-K  filed on April 6, 2005).                                                                                                                                                                                 |
|        |   |   |                                                                                                                                                                                                                                                                                                                                       |
| †10.15 | — |   | Salaries and Other  Compensation of Executive Officers (Incorporated by reference from  Exhibit 10.13 to the Company’s Annual Report on Form 10-K for  the year ended December 31, 2004, as updated in part by  Exhibit 10.2 to the Company’s Current Report on Form 8-K  filed on April 6, 2005). |
|        |   |   |                                                                                                                                                                                                                                                                                                                                       |
| *31.1       | — |   | Certification by John  W. Elias, Chief Executive Officer, pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                 |
|        |   |   |                                                                                                                                                                                                                                                                                                                                       |
| *31.2       | — |   | Certification by  Michael G. Long, Chief Financial Officer, pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                               |
|        |   |   |                                                                                                                                                                                                                                                                                                                                       |
| *32.1       | — |   | Certification by John  W. Elias, Chief Executive Officer, pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002 (Subsections (a) and (b) of  Section 1350, Chapter 63 of Title 18, United States Code).                                                                                                           |
|        |   |   |                                                                                                                                                                                                                                                                                                                                       |
| *32.2       | — |   | Certification by  Michael G. Long, Chief Financial and Accounting Officer, pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002 (Subsections (a) and  (b) of Section 1350, Chapter 63 of Title 18, United States Code).                                                                                          |

 

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* Filed herewith.

†Denotes management or compensatory contract, arrangement or agreement.

 

49

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