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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
 Washington, D.C. 20549
 FORM 10-KSB
 þ
    
    Annual Report Under Section 13 or 15(d) of the
Securities Exchange Act of 1934
 For the fiscal year ended December 31, 2006
 o
    
    Transition Report Under Section 13 or 15(d) of the
Securities Exchange Act of 1934
 For
the transition period from
 to
 Commission file Number: 0-15905
 BLUE DOLPHIN ENERGY COMPANY
  Delaware
(State or other jurisdiction of 
incorporation or organization)
    
    73-1268729
(I.R.S. Employer Identification No.)801 Travis Street, Suite 2100, Houston, Texas
(Address of principal executive office)
    
    77002
(Zip Code)
 (713) 227-7660
 common stock, par value $.01 per share
 none
 o
 þ o
 o
 o þ
    Documents Incorporated By Reference
  o þ




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##### 



BLUE DOLPHIN ENERGY COMPANY
FORM 10-KSB REPORT INDEX
 PART IItem 1.
    
    Description of Business
    
    
    3Item 2.
    
    Description of Property
    
    
    21Item 3.
    
    Legal Proceedings
    
    
    21PART IIItem 5.
    
    Market for Common Equity and Related Stockholder Matters
    
    
    22Item 6.
    
    Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    24Item 7.
    
    Financial Statements
    
    
    34Item 8.
    
    Changes in and Disagreements with Accountants on Accounting and Financial Disclosures
    
    
    62Item 8A.
    
    Controls and Procedures
    
    
    62PART IIIItem 9.
    
    Directors, Executive Officers, Promoters, Control Persons and Corporate
Governance; Compliance with Section 16(a) of the Exchange Act
    
    
    64Item 10.
    
    Executive Compensation
    
    
    64Item 11.
    
    Security Ownership of Certain Beneficial Owners and Management
    
    
    64Item 12.
    
    Certain Relationships and Related Transactions, and Director Independence
    
    
    64Item 13.
    
    Exhibits
    
    
    64Item 14.
    
    Principal Accountant Fees and Services
    
    
    66SIGNATURES
    
    
    
    
    67SubsidiariesConsent of UHY LLPIvar Siem Certification Pursuant to Section 302Gregory W. Starks Certification Pursuant to Section 302Ivar Siem Certification Pursuant to Section 906Gregory W. Starks Certification Pursuant to Section 906
  2




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PART I
 Forward Looking Statements . Certain of the statements included in this annual report
on Form 10-KSB, including those regarding future financial performance or results or that are not
historical facts, are forward-looking statements as that term is defined in Section 21E of the
Securities Exchange Act of 1934, as amended, and Section 27A of the Securities Act of 1933, as
amended. The words expect, plan, believe, anticipate, project, estimate, and similar
expressions are intended to identify forward-looking statements. Blue Dolphin Energy Company
(referred to herein, with its predecessors and subsidiaries, as Blue Dolphin, we, us and
our) cautions readers that these statements are not guarantees of future performance or events
and such statements involve risks and uncertainties that may cause actual results and outcomes to
differ materially from those indicated in forward-looking statements. Some of the important
factors, risks and uncertainties that could cause actual results to vary from forward-looking
statements include:
 
    
    the level of utilization of our pipelines;
    
    availability and cost of capital;
    
    actions or inactions of third party operators for properties where we have an interest;
    
    the risks associated with exploration;
    
    the level of production from oil and gas properties that we have interests in;
    
    gas and oil price volatility;
    
    uncertainties in the estimation of proved reserves, in the projection of future rates of
production, the timing of development expenditures and the amount and timing of property
abandonment;
    
    regulatory developments; and
    
    general economic conditions.
 Additional factors that could cause actual results to differ materially from those indicated in the
forward-looking statements are discussed under the caption Risk Factors. Readers are
cautioned not to place undue reliance on these forward-looking statements which speak only as of
the date hereof. We undertake no duty to update these forward-looking statements. Readers are
urged to carefully review and consider the various disclosures made by us which attempt to advise
interested parties of the additional factors which may affect our business, including the
disclosures made under the caption Managements Discussion and Analysis of Financial Condition and
Results of Operations in this report.
 
 Item 1. Description of Business
 THE COMPANY
  
    
    Blue Dolphin Pipe Line Company, a Delaware corporation;
    
    Blue Dolphin Petroleum Company, a Delaware corporation;
    
    Blue Dolphin Exploration Company, a Delaware corporation; and
    
    Blue Dolphin Services Co., a Texas corporation.
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Recent Developments
     4




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Pipeline Operations and Activities
   Blue Dolphin Pipeline System
  5




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Galveston Area Block 350 Pipeline
 Other
 Oil and Gas Exploration and Production Activities
    High Island Block 37.
 6




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High Island Block A-7.
 Unproved Leasehold Interests
  Proved Oil and Gas Reserves
    7




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(1)(2)
 Present Valueof Future NetCash InflowsNet Oil
    
    
    Net Gas
    
    
    (Outflows)Reserves
    
    
    Reserves
    
    
    After Income(Mbbls)
    
    
    (MMcf)
    
    
    Taxes(1)Total Proved ReservesHigh Island Block A-7
    
    
    0.1
    
    
    
    39
    
    
    $
    (63
    )High Island Block 37
    
    
    0.1
    
    
    
    69
    
    
    
    1220.2
    
    
    
    108
    
    
    $
    59Total Proved DevelopedHigh Island Block A-7
    
    
    0.1
    
    
    
    39
    
    
    $
    (63
    )High Island Block 37
    
    
    0.1
    
    
    
    69
    
    
    
    1220.2
    
    
    
    108
    
    
    $
    59
 
 (1)
    
    The estimated present value of future net cash outflows after income taxes from
our proved reserves has been determined by using prices of $58.99 per barrel of oil
and $5.52 per Mcf of gas, representing the December 31, 2006 prices for oil and gas
and discounted at a 10% annual rate in accordance with requirements for reporting
oil and gas reserves pursuant to regulations promulgated by the United States
Securities and Exchange Commission (the SEC Method).(2)
    
    As of December 31, 2006, we reported no proved undeveloped reserves. Capital Expenditures for Proved Reserves
 
 Years Ending December 31,2007
    
    2008
    
    2009
    
    2010
    
    2011High Island Block A-7
    
    
    
    
    
    
    340
    
    
    
    
    
    
    
    
    
    
    
    High Island Block 37
    
    
    
    
    
    
    
    
    
    
    92
    
    
    
    
    
    
    
    
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Production, Price and Cost Data
  Years Ended December 31,2006
    
    2005
    
    2004Gas:Production (Mcf)
    
    
    312,146
    
    
    
    378,791
    
    
    
    66,491Revenue
    
    $
    2,131,415
    
    
    $
    3,071,811
    
    
    $
    338,808Average production (Mcf) per day(*)
    
    
    772.3
    
    
    
    1,037.8
    
    
    
    182.2Average sales price per Mcf
    
    $
    6.83
    
    
    $
    8.11
    
    
    $
    5.10Condensate:Production (Bbls)
    
    
    1,823
    
    
    
    781
    
    
    
    810Revenue
    
    $
    114,114
    
    
    $
    40,481
    
    
    $
    28,089Average production (Bbls) per day(*)
    
    
    5.0
    
    
    
    2.1
    
    
    
    2.2Average sales price per Bbl
    
    $
    62.60
    
    
    $
    51.83
    
    
    $
    34.68NGLs:Production (gallons)
    
    
    137,139
    
    
    
    27,935
    
    
    
    45,675Revenue
    
    $
    113,285
    
    
    $
    23,718
    
    
    $
    28,803Average production (gallons) per day(*)
    
    
    375.7
    
    
    
    76.5
    
    
    
    125.1Average sales price per gallon
    
    $
    0.83
    
    
    $
    0.85
    
    
    $
    0.63Production costs (**):Per Mcfe:
    
    $
    1.34
    
    
    $
    0.40
    
    
    $
    1.88
 
 (*)
    
    Average production is based on a 365 day year. However, 2005 average
production per day contains 549 days of production for High Island Block 37.(**)
    
    Production costs, exclusive of workover costs, are costs incurred to operate
and maintain wells and equipment and to pay production taxes. Drilling Activity
 Employees
  9




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Customers
  Oil and Gas
    
    PipelineSales
    
    Operations
    
    TotalYear Ended December 31, 2006:Hydro Gulf, LLC (formerly Spinnaker
Exploration Company)
    
    $
    1,469,132
    
    
    $
    
    
    
    $
    1,469,132Fidelity Exploration and Production Company
    
    $
    889,682
    
    
    $
    
    
    
    $
    889,682Year Ended December 31, 2005:Hydro Gulf, LLC (formerly Spinnaker
Exploration Company)
    
    $
    722,499
    
    
    $
    
    
    
    $
    722,499Fidelity Exploration and Production Company
    
    $
    2,413,511
    
    
    $
    
    
    
    $
    2,413,511
 Competition
  Markets
  
    
    the level of domestic production;
    
    actions taken by foreign oil and gas producing nations;
    
    the availability of pipelines with adequate capacity;
    
    the availability of vessels for direct shipment;
    
    lightering, transshipment and other means of transportation;
    
    the availability and marketing of other competitive fuels;
    
    fluctuating and seasonal demand for oil, natural gas and refined products; and
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
    
    the extent of governmental regulation and taxation (under both present and future
legislation) of the production, importation, refining, transportation, pricing, use and
allocation of oil, gas, refined products and alternative fuels.
  Governmental Regulation
  Federal Regulation of Natural Gas Transportation.
   Federal Regulation of Oil Pipelines
 11




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Safety and Operational Regulations
 Federal Oil and Gas Leases
  Environmental Regulation
 12




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13




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Legislation and Rulemaking
   14




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RISK FACTORS
 We are primarily dependent on revenues from our pipeline systems and our working interests in
two oil and gas producing properties.
   The geographic concentration of our assets may have a greater effect on us as compared to other
companies.
  If we are not able to generate sufficient funds from our operations and other financing sources, we
may not be able to finance our operations.
   15




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We face strong competition from larger companies that may negatively affect our ability to carry on
operations.
  
    
    most of our competitors have greater financial resources than we do, which gives them
better access to capital to acquire assets; and
    
    we often establish a higher standard for the minimum projected rate of return on
invested capital than some of our competitors since we cannot afford to absorb certain
risks. We believe this puts us at a competitive disadvantage in acquiring pipelines and
oil and gas properties.
 Oil and gas prices are volatile and a substantial and extended decline in the price of oil and gas
would have a material adverse effect on us.
  
    
    weather conditions in the United States;
    
    the condition of the United States economy;
    
    the actions of the Organization of Petroleum Exporting Countries;
    
    governmental regulation;
    
    political stability in the Middle East, South America and elsewhere;
    
    the foreign supply of oil and natural gas;
    
    the price of foreign imports; and
    
    the availability of alternate fuel sources.
  
    
    reducing the exploration for and development of oil and gas reserves held by third party
companies around our pipeline systems;
    
    increasing our dependence on external sources of capital to meet our cash needs; and
    
    generally impairing our ability to obtain needed capital.
 Reserve estimates depend on many assumptions that may prove to be inaccurate. Any material
inaccuracies in our reserve estimates or underlying assumptions could cause the quantities and net
present value of our reserves to be overstated.
  
    
    the quality and quantity of available data;
    
    the interpretation of that data;
 16




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
    
    the accuracy of various mandated economic assumptions; and
    
    the judgment of the persons preparing the estimate.
    We cannot control the activities on properties we do not operate.
   We have pursued, and intend to continue to pursue, acquisitions. Our business may be adversely
affected if we cannot effectively integrate acquired operations.
  
    
    inadvertently becoming subject to liabilities of the acquired company that were unknown
to us at the time of the acquisition, such as later asserted litigation matters or tax
liabilities;
    
    the difficulty of assimilating operations, systems and personnel of the acquired businesses; and
    
    maintaining uniform standards, controls, procedures and policies.
 17




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Operating hazards, including those peculiar to the marine environment, may adversely affect our
ability to conduct business.
  
    
    pipeline ruptures;
    
    sudden violent expulsions of oil, gas and mud while drilling a well, commonly referred to as a blowout;
    
    a cave in and collapse of the earths structure surrounding a well, commonly referred to as cratering;
    
    explosions;
    
    fires;
    
    pollution; and
    
    other environmental risks.
  Losses and liabilities from uninsured or underinsured drilling and operating activities could have
a material adverse effect on our financial condition and results of operations.
   18




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Compliance with environmental and other government regulations could be costly and could negatively
impact our operations.
  
    
    require the acquisition of a permit before operations can be commenced;
    
    restrict the types, quantities and concentration of various substances that can be
released into the environment from drilling and production activities;
    
    limit or prohibit drilling and pipeline activities on certain lands lying within
wilderness, wetlands and other protected areas;
    
    require remedial measures to mitigate pollution from former operations, such as plugging
abandoned wells and abandoning pipelines; and
    
    impose substantial liabilities for pollution resulting from our operations.
    GLOSSARY OF CERTAIN OIL AND GAS TERMS
  Back-in After Payout Interest.
 Bbl.
 Bcf.
 Btu or British Thermal Unit.
 Condensate.
 19




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Development Well.
 Exploratory Well.
 Field.
 Leasehold Interest.
 Mbbls.
 Mcf.
 Mcfe.
 MMbtu.
 MMcf.
 MMcfe.
 Net Revenue Interest.
 Nonoperating Working Interest.
 Overriding Royalty.
 Prospect.
 Proved Developed Reserves.
 Proved Developed Producing.
 Proved Developed Non-producing.
 Proved Reserves.
 20




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Proved Undeveloped Reserves.
 Reversionary Interest.
 Royalty Interest.
 Undivided Interest.
 Working interest.
 
 Item 2. Description of Property
   
 Item 3. Legal Proceedings
   21




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PART II
 
 Item 5. Market for Common Equity and Related Stockholder Matters
 Market Price for Common Stock
  Quarter Ended
    
    High
    
    LowMarch 31, 2005
    
    $
    4.15
    
    
    $
    0.76June 30, 2005
    
    $
    4.26
    
    
    $
    1.35September 30, 2005
    
    $
    3.52
    
    
    $
    2.04December 31, 2005
    
    $
    3.06
    
    
    $
    1.95March 31, 2006
    
    $
    3.32
    
    
    $
    1.91June 30, 2006
    
    $
    8.00
    
    
    $
    3.45September 30, 2006
    
    $
    6.14
    
    
    $
    3.65December 31, 2006
    
    $
    4.34
    
    
    $
    2.91
  Dividend Policy
  Recent Sales of Unregistered Securities
  22




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Purchases of Equity Securities
  Total Number ofShares
    
    
    Maximum NumberPurchased as
    
    
    of Shares that MayTotal Number
    
    
    Average
    
    
    Part of Publicly
    
    
    Yet be Purchasedof Shares
    
    
    Price Paid
    
    
    Announced Plans
    
    
    Under the Plans orPeriod
    
    Purchased (1)
    
    
    per Share
    
    
    or Programs
    
    
    ProgramsOctober 1-31, 2006
    
    
    
    
    
    $
    
    
    
    
    
    
    
    
    November 1-30, 2006
    
    
    2,618
    
    
    
    3.16
    
    
    
    
    
    
    
    December 1-31, 2006
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Total
    
    
    2,618
    
    
    $
    3.16
    
    
    
    
    
    
    
    
 
 (1)
    
    Shares surrendered upon exercise of warrants outstanding. Equity Compensation Plan Information
  Number ofSecuritiesNumber of
    
    
    
    
    
    RemainingSecurities to be
    
    
    
    
    
    Available for FutureIssued upon
    
    Weighted-Average
    
    Issuance underExercise of
    
    Exercise Price of
    
    EquityOutstanding Options
    
    Outstanding Options
    
    Compensation PlansEquity compensation plans approved
security holders
    
    
    143,997
    
    
    $
    1.56
    
    
    
    99,540
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Item 6. Managements Discussion and Analysis of Financial Condition and Results of
Operations
  Executive Summary
   
    
    In March and April 2006, we completed private placements of 1,571,432 shares of our
common stock. Net proceeds from these offerings after payment of commissions and expenses
were approximately $3.8 million.
    
    In May 2006, we entered into gas and condensate transportation and handling agreements
with a new shipper to deliver production into the Blue Dolphin System. In June 2006, this
new shipper began deliveries of production into the Blue Dolphin System.
    
    Also in May 2006, a shipper that we contracted with in 2005 began deliveries of
production into the Blue Dolphin System.
    
    In July 2006, a shipper on the Blue Dolphin System recompleted an existing well, which
resulted in an increase in the rate of production.
    
    In November 2006, another shipper we contracted with in 2005 began deliveries of
production into the Blue Dolphin System.
    
    Also, in November 2006, we entered into gas and condensate transportation and handling
agreements with a new shipper to deliver production into the GA350 Pipeline. In December
2006, this new shipper began deliveries into the GA 350 Pipeline.
  24




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Liquidity and Capital Resources
   Years Ended December 31,2006
    
    
    2005Amount
    
    
    %
    
    
    Amount
    
    
    %Working capital
    
    $
    6,652
    
    
    
    57
    
    
    $
    2,053
    
    
    
    29Property and equipment, net
    
    
    4,912
    
    
    
    43
    
    
    
    4,980
    
    
    
    71Other noncurrent assets
    
    
    22
    
    
    
    
    
    
    
    11
    
    
    
    Total
    
    $
    11,586
    
    
    
    100
    
    
    $
    7,044
    
    
    
    100Long-term liabilities
    
    $
    2,014
    
    
    
    17
    
    
    $
    2,256
    
    
    
    32Stockholders equity
    
    
    9,572
    
    
    
    83
    
    
    
    4,788
    
    
    
    68Total
    
    $
    11,586
    
    
    
    100
    
    
    $
    7,044
    
    
    
    100
  25




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Payments Due by Period1 Year
    
    
    
    
    
    
    
    
    
    
    5 YearsTotal
    
    
    or Less
    
    
    1-3 Years
    
    
    3-5 Years
    
    
    or MoreOperating leases
    
    $
    430
    
    
    $
    71
    
    
    $
    211
    
    
    $
    148
    
    
    $
    Asset retirement obligations
    
    
    2,014
    
    
    
    
    
    
    
    403
    
    
    
    
    
    
    
    1,611Total contractual obligations
and other commercial commitments
    
    $
    2,444
    
    
    $
    71
    
    
    $
    614
    
    
    $
    148
    
    
    $
    1,611
   27




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Results of Operations
  2006 Compared to 2005
 Revenue from Pipeline Operations .
  Revenue from Oil and Gas Sales .
 Pipeline Operating Expenses .
 28




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Lease Operating Expenses
 Depletion, Depreciation and Amortization .
 General and Administrative .
 Interest and Other Expense .
 Interest and Other Income .
 Gain on Sale of Assets
 Gain on Extinguishment of Debt
 Critical Accounting Policies
  29




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Accounting for the Impairment or Disposal of Long-Lived Assets
  Recently Issued Accounting Pronouncements and Accounting Developments
 The Fair Value Option for Financial
Assets and Financial Liabilities  Including an Amendment of FASB Statement No. 115 Accounting for Certain Investments in Debt and Equity Securities
  30




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Fair Value Measurements
     Accounting for Uncertainty in Income Taxes-An
Interpretation of FASB Statement No. 109 Accounting for Income Taxes
  31




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Financial Statements Considering the Effects of Prior Year Misstatements when
Quantifying Misstatements in Current Year Financial Statements Financial Statements Materiality
 Accounting Changes and Error
Corrections
  32




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Item 7. Financial Statements
 Index to Financial Statements:Report of Independent Registered Public Accounting Firm
    
    
    35Consolidated Balance Sheet at December 31, 2006
    
    
    36Consolidated Statements of Income 
Years Ended December 31, 2006 and 2005
    
    
    37Consolidated Statements of Stockholders Equity
Years Ended December 31, 2006 and 2005
    
    
    38Consolidated Statements of Cash Flows
Years Ended December 31, 2006 and 2005
    
    
    39Notes to Consolidated Financial Statements
    
    
    40
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Report of Independent Registered Public Accounting Firm
 
    
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BLUE DOLPHIN ENERGY COMPANY AND SUBSIDIARIES
 
 Consolidated Balance Sheet
 December 31,2006ASSETSCurrent assets:Cash and cash equivalents
    
    $
    5,499,147Accounts receivable
    
    
    1,174,319Prepaid expenses and other assets
    
    
    337,167Total current assets
    
    
    7,010,633Property and equipment, at cost:Oil and gas properties (full-cost method)
    
    
    715,970Pipelines
    
    
    4,575,295Onshore separation and handling facilities
    
    
    1,919,402Land
    
    
    860,275Other property and equipment
    
    
    269,1928,340,134Less:Accumulated depletion, depreciation,
amortization and impairment
    
    
    3,428,2684,911,866Other assets
    
    
    21,999TOTAL ASSETS
    
    $
    11,944,498LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    264,684Accrued expenses and other liabilities
    
    
    93,661Total current liabilities
    
    
    358,345Long-term liabilities:Asset retirement obligations
    
    
    2,014,408Total long-term liabilities
    
    
    2,014,408Stockholders equity:Common stock, ($.01 par value, 25,000,000 shares authorized,
11,555,452 shares issued and outstanding
    
    
    115,555Additional paid-in capital
    
    
    31,835,137Accumulated deficit
    
    
    (22,378,947
    )9,571,745TOTAL LIABILITIES AND STOCKHOLDERS EQUITY
    
    $
    11,944,498
  36




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BLUE DOLPHIN ENERGY COMPANY AND SUBSIDIARIES
 
 Consolidated Statements of Income
 Years Ended December 31,2006
    
    
    2005Revenue from operations:Pipeline operations
    
    $
    1,939,894
    
    
    $
    1,375,173Oil and gas sales
    
    
    2,358,814
    
    
    
    3,136,010Total revenue from operations
    
    
    4,298,708
    
    
    
    4,511,183Cost of operations:Pipeline operating expenses
    
    
    1,126,539
    
    
    
    1,081,563Lease operating expenses
    
    
    457,312
    
    
    
    155,174Depletion, depreciation and amortizaton
    
    
    502,058
    
    
    
    403,217General and administrative expenses
    
    
    1,773,102
    
    
    
    2,608,511Accretion expense
    
    
    107,589
    
    
    
    100,308Total cost of operations
    
    
    3,966,600
    
    
    
    4,348,773Income from operations
    
    
    332,108
    
    
    
    162,410Other income (expense):Interest and other expense
    
    
    (42,224
    )
    
    
    (124,294
    )Interest and other income
    
    
    137,659
    
    
    
    375,966Gain on extinguishment of debt
    
    
    500,000
    
    
    
    Gain on sale of assets
    
    
    
    
    
    
    140,409Income before income taxes
    
    
    927,543
    
    
    
    554,491Income tax expense
    
    
    (14,679
    )
    
    
    (13,105
    )Net income
    
    $
    912,864
    
    
    $
    541,386Income per common share:Basic
    
    $
    0.08
    
    
    $
    0.06Diluted
    
    $
    0.08
    
    
    $
    0.06Weighted average number of common shares outstanding:Basic
    
    
    11,202,951
    
    
    
    8,763,475Diluted
    
    
    11,306,662
    
    
    
    8,874,117
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BLUE DOLPHIN ENERGY COMPANY AND SUBSIDIARIES
 
 Consolidated Statements of Stockholders Equity
 Common
    
    
    
    
    
    
    Additional
    
    
    
    
    
    
    TotalStock
    
    
    Common
    
    
    Paid-In
    
    
    Accumulated
    
    
    StockholdersShares
    
    
    Stock
    
    
    Capital
    
    
    Deficit
    
    
    EquityBalance at December 31, 2004
    
    
    6,863,689
    
    
    $
    68,637
    
    
    $
    27,129,162
    
    
    $
    (23,833,197
    )
    
    $
    3,364,602Exercise of stock options
    
    
    201,899
    
    
    
    2,019
    
    
    
    772,350
    
    
    
    
    
    
    
    774,369Common stock issued for services
    
    
    53,345
    
    
    
    533
    
    
    
    107,167
    
    
    
    
    
    
    
    107,700Exercise of warrants
    
    
    2,820,369
    
    
    
    28,204
    
    
    
    (28,204
    )
    
    
    
    
    
    
    Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    541,386
    
    
    
    541,386Balance at December 31, 2005
    
    
    9,939,302
    
    
    
    99,393
    
    
    
    27,980,475
    
    
    
    (23,291,811
    )
    
    
    4,788,057Sale of common stock
    
    
    1,571,432
    
    
    
    15,714
    
    
    
    3,825,110
    
    
    
    
    
    
    
    3,840,824Common stock issued for services
    
    
    39,960
    
    
    
    400
    
    
    
    29,600
    
    
    
    
    
    
    
    30,000Exercise of warrants
    
    
    4,758
    
    
    
    48
    
    
    
    (48
    )
    
    
    
    
    
    
    Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    912,864
    
    
    
    912,864Balance at December 31, 2006
    
    
    11,555,452
    
    
    $
    115,555
    
    
    $
    31,835,137
    
    
    $
    (22,378,947
    )
    
    $
    9,571,745
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BLUE DOLPHIN ENERGY COMPANY AND SUBSIDIARIES
 
 Consolidated Statements of Cash Flows
 Years Ended December 31,2006
    
    
    2005OPERATING ACTIVITIESNet income
    
    $
    912,864
    
    
    $
    541,386Adjustments to reconcile net income to net cash provided by
operating activities:Depletion, depreciation and amortization
    
    
    502,058
    
    
    
    403,217Amortization of debt issue costs
    
    
    
    
    
    
    54,630Gain on sale of assets
    
    
    
    
    
    
    (140,409
    )Accretion of asset retirement obligations
    
    
    107,589
    
    
    
    100,308Gain on modification of note payable
    
    
    
    
    
    
    (132,368
    )Gain on extinguishment of debt
    
    
    (500,000
    )
    
    
    Compensation from exercise of stock options
    
    
    
    
    
    
    774,369Common stock issued for services
    
    
    30,000
    
    
    
    94,800Changes in operating assets and liabilities:Accounts receivable
    
    
    427,977
    
    
    
    (1,285,932
    )Prepaid expenses and other assets
    
    
    (164,053
    )
    
    
    (68,095
    )Accounts payable, accrued expenses and other liabilities
    
    
    (100,876
    )
    
    
    (292,274
    )Net cash provided by operating activities
    
    
    1,215,559
    
    
    
    49,632INVESTING ACTIVITIESExploration and development costs
    
    
    (15,700
    )
    
    
    (72,501
    )Property, equipment and other assets
    
    
    (267,447
    )
    
    
    (35,849
    )Proceeds from sale of assets
    
    
    
    
    
    
    214,632Investment in unconsolidated affiliates
    
    
    (1,177
    )
    
    
    Net cash provided by (used in) investing activities
    
    
    (284,324
    )
    
    
    106,282FINANCING ACTIVITIESProceeds from the sale of common stock, net of offering costs
    
    
    3,840,824
    
    
    
    Payments on borrowings
    
    
    (570,000
    )
    
    
    (430,000
    )Financing costs incurred
    
    
    
    
    
    
    (2,275
    )Proceeds from exercise of stock options
    
    
    
    
    
    
    12,900Net cash provided by (used in) financing activities
    
    
    3,270,824
    
    
    
    (419,375
    )Increase (decrease) in cash and cash equivalents
    
    
    4,202,059
    
    
    
    (263,461
    )CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR
    
    
    1,297,088
    
    
    
    1,560,549CASH AND CASH EQUIVALENTS AT END OF YEAR
    
    $
    5,499,147
    
    
    $
    1,297,088Supplementary cash flow information:Interest paid
    
    $
    88,334
    
    
    $
    46,422
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BLUE DOLPHIN ENERGY COMPANY AND SUBSIDIARIES
 
 Notes to Consolidated Financial Statements
 (1)
    
    Organization and Significant Accounting PoliciesOrganizationBlue Dolphin Energy Company was incorporated in Delaware in January 1986 to engage in oil
and gas exploration, production and acquisition activities and oil and gas transportation
and marketing. We were formed pursuant to a reorganization effective June 9, 1986.Principles of ConsolidationOur consolidated financial statements include the accounts of our wholly-owned subsidiaries.
All significant intercompany balances and transactions have been eliminated in
consolidation.Accounting EstimatesWe have made a number of estimates and assumptions relating to the reporting of assets and
liabilities and to the disclosure of contingent assets and liabilities, including reserve
information, which affects the depletion calculation as well as the computation of the full
cost ceiling limitation to prepare these consolidated financial statements in conformity
with accounting principles generally accepted in the United States of America. While we
believe current estimates are reasonable and appropriate, actual results could differ from
those estimated.Cash EquivalentsCash equivalents include liquid investments with an original maturity of three months or
less. Cash balances are maintained in depository and overnight investment accounts with
financial institutions which at times, exceed insured limits. We monitor the financial
condition of the financial institutions and have experienced no losses associated with these
accounts.Oil and Gas PropertiesOil and gas properties are accounted for using the full-cost method of accounting, whereby
all costs associated with acquisition, exploration, and development of oil and gas
properties, including directly related internal costs, are capitalized on a
country-by-country cost center basis. We utilize one cost center for all of our properties.
Amortization of such costs and estimated future development costs is determined using the
unit-of-production method. Costs directly associated with the acquisition and evaluation of
unproved properties are excluded from the amortization computation until it is determined
whether or not proved reserves can be assigned to the properties or impairment has occurred.Estimated proved oil and gas reserves are based upon reports prepared internally by us. The
net carrying value of oil and gas properties, less related deferred income taxes, is limited
to the lower of unamortized cost or the cost center ceiling, defined as the sum of the
present value (10% discount rate applied) of estimated future net revenues from proved
reserves, after giving effect to income taxes, and the lower of cost or estimated fair value
of unproved properties. Disposition of oil and gas properties are recorded as adjustments
to capitalized costs, with no gain or loss recognized unless such adjustments would
significantly alter the relationship between capitalized costs and proved reserves.
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BLUE DOLPHIN ENERGY COMPANY AND SUBSIDIARIES
 Notes to Consolidated Financial Statements (Continued)
 We capitalize interest on expenditures made in connection with significant exploration and
development projects that are not subject to current amortization. Interest is capitalized
only for the period that activities are in progress to bring these projects to their
intended use. No interest has been capitalized for the years reflected herein.Pipelines and FacilitiesPipelines and facilities are recorded at cost. Depreciation is computed using the
straight-line method over estimated useful lives ranging from 10 to 22 years.Other Property and EquipmentDepreciation of furniture, fixtures and other equipment, including assets held under capital
leases, is computed using the straight-line method over estimated useful lives ranging from
3 to 10 years.In accordance with Statements of Financial Accounting Standards (SFAS) No. 144, Accounting
for the Impairment or Disposal of Long-lived Assets, assets are grouped and evaluated for
impairment based on the ability to identify separate cash flows generated therefrom.Asset Retirement ObligationsIn August 2001, the Financial Accounting Standards Board (FASB) issued SFAS No. 143,
Accounting for Asset Retirement Obligations, as amended, which addresses financial
accounting and reporting for obligations associated with the retirement of tangible
long-lived assets and the associated asset retirement costs. The standard applies to
legal obligations associated with the retirement of long-lived assets that result from the
acquisition, construction, development and/or normal use of the asset.SFAS No. 143 requires that the fair value of a liability for an asset retirement obligation
be recognized in the period in which it is incurred if a reasonable estimate of fair value
can be made. The fair value of the liability is added to the carrying amount of the
associated asset and this additional carrying amount is depreciated over the life of
the asset. If the obligation is settled for other than the carrying amount of the
liability, a gain or loss on settlement is recognized.We have asset retirement obligations associated with the future abandonment of pipelines and
related facilities and offshore oil and gas properties. The following table summarizes our
asset retirement obligation transactions during the years ended December 31, 2006 and 2005
(in thousands).
 Years Ended December 31,2006
    
    
    2005Beginning asset retirement obligations
    
    $
    1,756
    
    
    $
    1,622Liabilities incurred
    
    
    
    
    
    
    40Liabilities settled
    
    
    
    
    
    
    Gain from adjustment to estimated obligations
    
    
    
    
    
    
    (6
    )Accretion expense
    
    
    108
    
    
    
    100Revisions in estimated cash flows
    
    
    150
    
    
    
    Ending asset retirement obligations
    
    $
    2,014
    
    
    $
    1,756
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BLUE DOLPHIN ENERGY COMPANY AND SUBSIDIARIES
 Notes to Consolidated Financial Statements (Continued)
 Stock-Based CompensationEffective January 1, 2006, we adopted Statement of Financial Accounting Standards No. 123
(Revised), Share-Based Payments(SFAS 123(R)) utilizing the modified prospective approach.
Prior to the adoption of SFAS 123(R) we accounted for stock option grants in accordance with
APB Opinion No. 25, Accounting for Stock Issued to Employees(the intrinsic value method),
and accordingly, recognized no compensation expense when stock options were granted with an
exercise price equal to the grant date fair market value of a share of our common stock.Under the modified prospective approach, SFAS 123(R) applies to new awards and to awards
that were outstanding on January 1, 2006 that are subsequently modified, repurchased, or
cancelled. Under the modified prospective approach, had there been any awards granted during
2006, compensation expense recognized in the periods would have included compensation cost
for all share-based payments granted prior to, but not yet vested, based on the grant date
fair value estimated in accordance with the original provisions of Statement of Financial
Accounting Standards No. 123, Accounting for Stock-Based Compensation, and compensation cost
for all share-based payments granted subsequent to January 1, 2006, based on the grant date
fair value estimated in accordance with the provisions of SFAS 123(R). Prior periods were
not restated to reflect the impact of adopting the new standard.Recognition of Oil and Gas RevenueSales from producing wells are recognized on the entitlement method of accounting which
defers recognition of sales when, and to the extent that, deliveries to customers exceed our
net revenue interest in production. Similarly, when deliveries are below our net revenue
interest in production, sales are recorded to reflect the full net revenue interest. Our
imbalance liability at December 31, 2006 was not material.Recognition of Pipeline Transportation RevenueRevenues from our pipelines are derived from fee-based contracts and are typically based on
transportation fees per unit of volume transported multiplied by the volume delivered.
Revenue is recognized when volumes have been physically delivered for the customer through
the pipeline.Income TaxesWe provide for income taxes using the asset and liability method pursuant to SFAS No. 109,
Accounting for Income Taxes. Under the asset and liability method of SFAS No. 109, deferred
tax assets and liabilities are recognized for the future tax consequences attributable to
differences between the financial statement carrying amounts of existing assets and
liabilities and their respective tax bases and operating loss and tax credit carryforwards.
Deferred tax assets and liabilities are measured using enacted tax rates expected to apply
to taxable income in the years in which those temporary differences are expected to be
recovered or settled. The effect on deferred tax assets and liabilities of a change in tax
rates is recognized in income in the period that includes the enactment date.
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BLUE DOLPHIN ENERGY COMPANY AND SUBSIDIARIES
 Notes to Consolidated Financial Statements (Continued)
 Earnings Per ShareWe apply the provisions of Statement of Financial Accounting Standards No. 128, Earnings per
Share(SFAS 128). SFAS 128 requires the presentation of basic earnings per share (EPS)
which excludes dilution and is computed by dividing net income (loss) available to common
stockholders by the weighted-average number of shares of common stock outstanding for the
period. SFAS 128 requires dual presentation of basic EPS and diluted EPS on the face of the
income statement and requires a reconciliation of the numerators and denominators of basic
EPS and diluted EPS. Diluted EPS is computed by dividing net income (loss) available to
common shareholders by the diluted weighted average number of common shares outstanding,
which includes the potential dilution that could occur if securities or other contracts to
issue common stock were converted to common stock that then shared in the earnings of the
entity.The following table provides reconciliation between basic and diluted earnings per share:
 Weighted-Average Numberof Common SharesOutstandingand Potential
    
    
    PerDilutive
    
    
    ShareNet Income
    
    
    Common Shares
    
    
    AmountYear ended December 31, 2006:Basic income per share
    
    $
    912,864
    
    
    
    11,202,951
    
    
    $
    0.08Effect of dilutive stock options
    
    
    
    
    
    
    103,711
    
    
    
    Diluted income per share
    
    $
    912,864
    
    
    
    11,306,662
    
    
    $
    0.08Year ended December 31, 2005:Basic income per share
    
    $
    541,386
    
    
    
    8,763,475
    
    
    $
    0.06Effect of dilutive stock options
    
    
    
    
    
    
    110,642
    
    
    
    Diluted income per share
    
    $
    541,386
    
    
    
    8,874,117
    
    
    $
    0.06
 EnvironmentalWe are subject to extensive federal, state and local environmental laws and regulations.
These laws, which are constantly changing, regulate the discharge of materials into the
environment and may require us to remove or mitigate the environmental effects of the
disposal or release of petroleum or chemical substances at various sites. Environmental
expenditures are expensed or capitalized depending on their future economic benefit.
Expenditures that relate to an existing condition caused by past operations and that have no
future economic benefits are expensed. Liabilities for expenditures of a noncapital nature
are recorded when environmental assessment and/or remediation is probable, and the costs can
be reasonably estimated. Such liabilities are generally recorded at their undiscounted
amounts unless the amounts and timing of payments is fixed or reliably determinable.
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BLUE DOLPHIN ENERGY COMPANY AND SUBSIDIARIES
 Notes to Consolidated Financial Statements (Continued)
 Recently Issued Accounting PronouncementsIn February 2007, FASB issued FASB Statement No. 159, The Fair Value Option for Financial
Assets and Financial Liabilities  Including an Amendment of FASB Statement No. 115(SFAS
159). This standard permits an entity to choose to measure many financial instruments and
certain other items at fair value. This option is available to all entities, including
not-for-profit organizations. Most of the provisions in SFAS 159 are elective; however, the
amendment to FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity
Securities, applies to all entities with available-for-sale and trading securities. Some
requirements apply differently to entities that do not report net income. The FASBs stated
objective in issuing this standard is as follows: to improve financial reporting by
providing entities with the opportunity to mitigate volatility in reported earnings caused
by measuring related assets and liabilities differently without having to apply complex
hedge accounting provisions.The fair value option established by SFAS 159 permits all entities to choose to measure
eligible items at fair value at specified election dates. A business entity will report
unrealized gains and losses on items for which the fair value option has been elected in
earnings (or another performance indicator if the business entity does not report earnings)
at each subsequent reporting date. A not-for-profit organization will report unrealized
gains and losses in its statement of activities or similar statement. The fair value
option: (i) may be applied instrument by instrument, with a few exceptions, such as
investments otherwise accounted for by the equity method; (ii) is irrevocable (unless a new
election date occurs); and (iii) is applied only to instruments and not to portions of
instruments.SFAS 159 is effective as of the beginning of an entitys first fiscal year that begins after
November 15, 2007. Early adoption is permitted as of the beginning of the previous fiscal
year provided that the entity makes that choice in the first 120 days of that fiscal year
and also elects to apply the provisions of FASB Statement No. 157, Fair Value Measurements
(SFAS 157). We are currently assessing the impact of SFAS 159 on our consolidated
financial statements.In September 2006, SFAS 157 was issued by the FASB. This new standard provides guidance for
using fair value to measure assets and liabilities. The FASB believes the standard also
responds to investors requests for expanded information about the extent to which companies
measure assets and liabilities at fair value, the information used to measure fair value and
the effect of fair value measurements on earnings. SFAS 157 applies whenever other
standards require (or permit) assets or liabilities to be measured at fair value but does
not expand the use of fair value in any new circumstances.Currently, over 40 accounting standards within GAAP require (or permit) entities to measure
assets and liabilities at fair value. Prior to SFAS 157, the methods for measuring fair
value were diverse and inconsistent, especially for items that are not actively traded. The
standard clarifies that for items that are not actively traded, such as certain kinds of
derivatives, fair value should reflect the price in a transaction with a market participant,
including an adjustment for risk, not just the companys mark-to-model value. SFAS 157 also
requires expanded disclosure of the effect on earnings for items measured using unobservable
data.Under SFAS 157, fair value refers to the price that would be received to sell an asset or
paid to transfer a liability in an orderly transaction between market participants in the
market in which the reporting entity transacts. In this standard, FASB clarifies the
principle that fair value should be based on the assumptions market participants would use
when pricing the asset or liability. In support of this principle, SFAS 157 establishes a
fair value hierarchy that prioritizes the
information used to develop those assumptions. The fair value hierarchy gives the highest
priority
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BLUE DOLPHIN ENERGY COMPANY AND SUBSIDIARIES
 Notes to Consolidated Financial Statements (Continued)
 to quoted prices in active markets and the lowest priority to unobservable data,
for example, the reporting entitys own data. Under the standard, fair value measurements
would be separately disclosed by level within the fair value hierarchy.The provisions of SFAS 157 are effective for financial statements issued for fiscal years
beginning after November 15, 2007, and interim periods within those fiscal years. Earlier
application is encouraged, provided that the reporting entity has not yet issued financial
statements for that fiscal year, including any financial statements for an interim period
within that fiscal year. We are currently assessing the impact of SFAS 157 on our financial
statements.In July 2006, FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes-An
Interpretation of FASB Statement No. 109(FIN 48), was issued. FIN 48 clarifies the
accounting for uncertainty in income taxes recognized in an enterprises financial
statements in accordance with FASB Statement No. 109, Accounting for Income Taxes. FIN 48
also prescribes a recognition threshold and measurement attribute for the financial
statement recognition and measurement of a tax position taken or expected to be taken in a
tax return. The new FASB standard also provides guidance on derecognition, classification,
interest and penalties, accounting in interim periods, disclosure, and transition.The evaluation of a tax position in accordance with FIN 48 is a two-step process. The first
step is a recognition process whereby the enterprise determines whether it is more likely
than not that a tax position will be sustained upon examination, including resolution of any
related appeals or litigation processes, based on the technical merits of the position. In
evaluating whether a tax position has met the more-likely-than-not recognition threshold,
the enterprise should presume that the position will be examined by the appropriate taxing
authority that has full knowledge of all relevant information. The second step is a
measurement process whereby a tax position that meets the more-likely-than-not recognition
threshold is calculated to determine the amount of benefit to recognize in the financial
statements. The tax position is measured at the largest amount of benefit that is greater
than 50% likely of being realized upon ultimate settlement.The provisions of FIN 48 are effective for fiscal years beginning after December 15, 2006.
Earlier application is permitted as long as the enterprise has not yet issued financial
statements, including interim financial statements, in the period of adoption. The
provisions of FIN 48 are to be applied to all tax positions upon initial adoption of this
standard. Only tax positions that meet the more-likely-than-not recognition threshold at
the effective date may be recognized or continue to be recognized upon adoption of FIN 48.
The cumulative effect of applying the provisions of FIN 48 should be reported as an
adjustment to the opening balance of retained earnings (or other appropriate components of
equity or net assets in the statement of financial position) for that fiscal year. We are
currently assessing the impact on our consolidated financial statements of FIN 48.On September 13, 2006, the SEC staff issued Staff Accounting Bulletin No. 108, which adds
Section N to Topic 1, Financial Statements  Considering the Effects of Prior Year
Misstatements when Quantifying Misstatements in Current Year Financial Statements(SAB
108). The SEC staff provides guidance on how prior year misstatements should be taken into
consideration when quantifying misstatements in current year financial statements for the
purposes of determining whether the current years financial statements are materially
misstated. In providing this guidance, the SEC staff references both the iron curtain and
rollover approaches to quantifying a current year misstatement for purposes of determining
its materiality. The iron curtain approach focuses on how the current years balance sheet
would be affected in correcting a
misstatement without considering the year(s) in which the misstatement originated. The
rollover approach focuses on the amount of the misstatement that originated in the current
years income statement. The SEC staff indicates in SAB 108 that registrants must quantify
the impact of
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BLUE DOLPHIN ENERGY COMPANY AND SUBSIDIARIES
 Notes to Consolidated Financial Statements (Continued)
 correcting all misstatements, including both the carryover and reversing
effects of prior year misstatements, on the current year financial statements. In other
words, both the iron curtain approach and rollover approach should be used in assessing the
materiality of a current year misstatement. SAB 108 provides that once a current year
misstatement has been quantified, the guidance in Staff Accounting Bulletin No. 99, Section
M, Topic 1, Financial Statements  Materiality(SAB 99), should be applied to
determine whether the misstatement is material and should result in an adjustment to the
financial statements.If correcting a misstatement in the current year would materially misstate the current
years income statement, the SEC staff indicates that the prior year financial statements
should be adjusted. In addition, adjusting for one misstatement in the current year may
alter the amount of the misstatement attributable to prior years that exists in the current
years financial statements. If adjusting for the resultant misstatement is material to the
current years financial statements, the SEC staff again indicates that the prior year
financial statements should be adjusted. These adjustments to prior year financial
statements are necessary even though such adjustments were appropriately viewed as
immaterial in the prior year. In making these adjustments, previously filed reports do not
need to be amended. Instead, the adjustments should be reflected the next time the
registrant would otherwise be filing those prior year financial statements. It should be
noted that if, in the current year, a registrant identifies a misstatement in the prior year
financial statements and determines that the misstatement is material to those prior year
financial statements, the registrant would be required to restate for the material
misstatement in accordance with FASB Statement No. 154, Accounting Changes and Error
Corrections(SFAS 154).If a registrant has historically been using either the iron curtain approach or the rollover
approach and, upon application of the guidance of SAB 108, determines that there is a
material misstatement in its financial statements, the SEC staff will not require the
registrant to restate its prior year financial statements provided that: (a) management
properly applied the approach it previously used as its accounting policy and (b) management
considered all relevant qualitative factors in its materiality assessment. If the
registrant does not elect to restate its financial statements for the material misstatements
that arise in connection with application of the guidance in SAB 108, then for fiscal years
ending after November 15, 2006, it must recognize the cumulative effect of applying SAB 108
in the current year beginning balances of the affected assets and liabilities with a
corresponding adjustment to the current year opening balance in retained earnings. Certain
disclosures are required in this situation. SAB 108 provides additional transition guidance
if it is adopted early in an interim period. The adoption of SAB 108 did not have a
material effect on our consolidated financial statements.(2)
    
    LiquidityWe ended 2006 with working capital of approximately $6.7 million and notes payable have
been reduced to zero. At the end of 2005, our working capital was approximately $2.1
million and our short-term and long-term notes payable totaled $950,000. The increase in
working capital from year-end 2005 was primarily the result of proceeds received from two
private placements that were completed in the first half of 2006, significant revenues from
oil and gas sales and increased revenues from our pipeline operations.Throughput on the Blue Dolphin System and the GA 350 Pipeline increased significantly during
2006. The Blue Dolphin System is currently transporting approximately 26 MMcf per day and
the GA 350 Pipeline is currently transporting approximately 20 MMcf per day. All five of
the new shippers we have contracted with since 2005 have commenced deliveries. Four of the
new shippers are delivering production into the Blue Dolphin System and one of the new
shippers is delivering production into the GA 350 Pipeline. One of the five new shippers
began deliveries into the Blue Dolphin System in August 2005. In 2006, one new shipper
began deliveries
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BLUE DOLPHIN ENERGY COMPANY AND SUBSIDIARIES
 Notes to Consolidated Financial Statements (Continued)
 into the Blue Dolphin System in each of May, June and November. A new
shipper began deliveries into the GA 350 Pipeline in December 2006. Also, in July 2006, a
shipper that has delivered production into the Blue Dolphin System for a number of years,
successfully recompleted an existing well, resulting in an increase of daily production.Revenues from our working interests in High Island Block 37 and High Island Block A-7 are
declining as the rate of production declines. Production from High Island Block 37 is
currently 8 MMcf per day and High Island Block A-7 is currently 2 MMcf per day. Recent
production data has provided evidence that the well in High Island Block A-7 is reaching the
end of its production life. We currently believe that the High Island Block A-7 well could
cease production before mid 2007. We believe that production from one of the High Island
Block 37 wells could continue into early 2008 at a declining rate. However, the wells could
deplete faster than anticipated or could develop production problems resulting in the
cessation of production. Without the revenues and resulting cash inflows we receive from
oil and gas sales, we may not be able to generate sufficient cash from operations to cover
our operating and general and administrative expenses.In March 2006, we entered into a stock purchase agreement with certain accredited investors
for the private placement of 1,171,432 shares of our common stock at a price of $1.75 per
share. The net proceeds from this offering after commissions and expenses were
approximately $2,025,000. The net proceeds from this offering are being used for general
corporate and working capital purposes. We may also use these proceeds for possible
acquisitions and planned expansions of our existing facilities.In April 2006, we entered into a second stock purchase agreement with an accredited
institutional investor for the private placement of 400,000 shares of our common stock at a
purchase price of $4.90 per share. Net proceeds from the offering were approximately $1.8
million. We incurred commissions and expenses of approximately $160,000 associated with the
offering, and issued warrants to purchase an aggregate of 24,000 shares of common stock. The
net proceeds from the offering are also being used for general corporate and working capital
purposes, but may be used for possible acquisitions and planned expansions of our
facilities. We believe we have sufficient liquidity to satisfy our working capital
requirements through December 31, 2007.The net cash provided by or used in operating, investing and financing activities is
summarized below (in thousands):
 Years Ended December 31,2006
    
    
    2005Net cash provided by (used in):Operating activities
    
    $
    1,215
    
    
    $
    50Investing activities
    
    
    (284
    )
    
    
    106Financing activites
    
    
    3,271
    
    
    
    (419
    )Net decrease in cash
    
    $
    4,202
    
    
    $
    (263
    )
 47




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BLUE DOLPHIN ENERGY COMPANY AND SUBSIDIARIES
 Notes to Consolidated Financial Statements (Continued)
 (3)
    
    Fair Value of Financial InstrumentsThe carrying values of cash and cash equivalents, accounts receivable and accounts
payable approximate fair value due to the short-term maturities of these instruments.(4)
    
    Income TaxesIncome tax expense consisted of current federal expense of $14,679 and $13,105 for 2006
and 2005, respectively.The income tax effects of temporary differences that give rise to significant portions of
deferred tax assets and deferred tax liabilities at December 31, 2006 are presented below:
 Deferred tax assets:Net operating loss and capital loss carryforwards
    
    $
    5,157,648AMT credit carryforward
    
    
    16,687Basis differences in property and equipment
    
    
    48,022Total deferred tax assets
    
    
    5,222,357Less: valuation allowance
    
    
    (5,222,357
    )Deferred tax assets, net
    
    $
    
 In assessing the reliability of deferred tax assets, we apply SFAS No. 109 to determine
whether it is more likely than not that some portion or all of the deferred tax assets will
not be realized. As a result, a full valuation allowance against our deferred tax asset was
recognized at December 31, 2006 due to our uncertainty as to the utilization of the deferred
tax assets in the foreseeable future.Our effective tax rate applicable to continuing operations in 2006 and 2005 is as
follows:
 Years Ended December 31,2006
    
    2005Expected tax rate
    
    
    34
    %
    
    
    34
    %Change in valuation allowance recognized
in earnings
    
    
    (32.42
    %)
    
    
    (31.65
    %)1.58
    %
    
    
    2.35
    %
 For federal tax purposes, we have net operating loss carryforwards (NOLs) of approximately
$15.2 million at December 31, 2006. These NOLs must be utilized prior to their expiration,
which is between 2007 and 2024.(5)
    
    Long-term Debt and Notes PayableOn February 28, 2005 (effective as of January 1, 2005), we entered into the Amendment
to our Purchase Agreement with MCNIC. Under the terms of the original Purchase Agreement,
we acquired MCNICs one-third interests in both the Blue Dolphin System and the inactive
Omega Pipeline. Pursuant to the terms of the Amendment, the Original Promissory Note was
exchanged
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BLUE DOLPHIN ENERGY COMPANY AND SUBSIDIARIES
 Notes to Consolidated Financial Statements (Continued)
 for the New Promissory Note, and all accrued interest on the Original Promissory
Note, $132,368 at December 31, 2004, was forgiven and included in other income for the year
ended December 31, 2005. In addition to the New Promissory Note, MCNIC could receive
additional payments of up to $500,000 from 50% of the net profits, if any, realized from the
one-third interest in the Blue Dolphin System through December 31, 2006. We made a
principal payment on the New Promissory Note of $30,000 upon the execution of the Amendment.
Under the terms of the New Promissory Note we made monthly principal payments of $10,000
through its maturity date of December 31, 2006. The principal amount of the New Promissory
Note also could have been increased by up to $500,000 if 50% or more of our 83% interest in
the Blue Dolphin System was sold before December 31, 2006. We were not required to make any
contingent payments on the New Promissory Note and extinguished the $500,000 contingent
portion of the New Promissory Note effective December 31, 2006.In April 2005, the holders of $450,000 of the $750,000 aggregate principal amount of
promissory notes sold in September 2004, agreed to extend the maturity date of their
promissory notes to June 30, 2006, and to defer the payment of all unpaid and future
interest on their promissory notes until maturity. The promissory notes were originally
sold on September 8, 2004 pursuant to the Note and Warrant Purchase Agreement we entered
into with certain accredited investors and certain of our directors. The $300,000 aggregate
principal amount of promissory notes was retired at maturity on September 8, 2005. The
remaining $450,000 aggregate principal amount of promissory notes was retired on June 30,
2006.Total interest expense was approximately $32,000 and $82,000 for 2006 and 2005,
respectively.(6)
    
    Exercise of WarrantsOn December 21, 2006, 4,286 outstanding warrants were exercised by warrant holders.
The exercises were accomplished via a net exercise, whereby holders surrender their right to
receive a portion of the shares of common stock. The rights to receive 2,618 shares of
common stock were surrendered and we issued 1,668 shares of common stock upon exercise. The
Company did not receive any proceeds from the net exercise of these warrants.On August 8, 2006, 11,417 outstanding warrants were exercised by warrant holders. The
exercises were also accomplished via a net exercise, whereby holders surrender their right
to receive a portion of the shares of common stock. The rights to receive 8,622 shares of
common stock were surrendered and we issued 2,795 shares of common stock upon exercise. The
Company did not receive any proceeds from the net exercise of these warrants.On April 17, 2006, 429 outstanding warrants were exercised by warrant holders. The
exercises were accomplished via a net exercise, whereby holders surrendered their right to
receive a portion of the shares of common stock. The rights to receive 134 shares of common
stock were surrendered and the Company issued 295 shares of common stock upon exercise.These securities were issued in reliance upon the exemption from registration pursuant to
Section 4(2) under the Securities Act of 1933, as amended.At January 1, 2005, there were 3,100,000 warrants outstanding that were issued pursuant to
our Note and Warrant Purchase Agreement dated September 8, 2004. During the twelve months
ended December 31, 2005, all 3,100,000 warrants were exercised.The exercise of the warrants was accomplished via net exercises, whereby holders surrendered
their right to purchase a portion of the shares of common stock, resulting in 279,631 shares
of
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##### Table of Contents



BLUE DOLPHIN ENERGY COMPANY AND SUBSIDIARIES
 Notes to Consolidated Financial Statements (Continued)
 common stock being surrendered to us for payment of the warrant exercise price and 2,820,369
shares issued to warrant holders.A summary of warrant activity for 2006 and 2005 is as follows:
 Weighted-
    
    
    
    
    
    Weighted-Average
    
    
    
    
    
    AverageNumber of
    
    Exercise
    
    Warrants
    
    ExerciseWarrants
    
    Price
    
    Exercisable
    
    PriceOutstanding, December 31, 2004
    
    
    3,100,000
    
    
    $
    0.25
    
    
    
    3,100,000
    
    
    $
    0.25Granted
    
    
    
    
    
    
    Exercised
    
    
    (3,100,000
    )
    
    $
    0.25Outstanding, December 31, 2005
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Granted
    
    
    32,572
    
    
    $
    4.48Exercised
    
    
    (16,132
    )
    
    $
    3.55Outstanding, December 31, 2006
    
    
    16,440
    
    
    $
    5.39
    
    
    
    16,440
    
    
    $
    5.39
 At December 31, 2006, the range of warrant prices for shares under warrants and the
weighted-average remaining contractual life was as follows:
 Warrants Outstanding,
Fully Vested and Exercisableat December 31, 2006WeightedAverageRemaining
    
    WeightedNumber
    
    Contractual Life
    
    AverageExercise Prices
    
    Outstanding
    
    in Years
    
    Exercise Price$5.00 to $5.50
    
    
    16,440
    
    
    
    2.2
    
    
    $
    5.39
 (7)
    
    Stockholders EquityIn March 2006, we entered into a stock purchase agreement with certain accredited
investors for the private placement of 1,171,432 shares of our common stock. Net proceeds
from the offering after payment of commissions and expenses were approximately $2.0 million.
In April 2006, we entered into a second stock purchase agreement with an accredited
institutional investor for the private placement of 400,000 shares of our common stock. Net
proceeds from the offering after
payment of commissions and expenses were approximately $1.8 million. Warrants to purchase
32,572 shares of common stock were issued associated with these offerings and 16,132 of the
warrants were exercised in 2006 via a net exercise resulting in the issuance of 4,758 shares
of common stock.
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BLUE DOLPHIN ENERGY COMPANY AND SUBSIDIARIES
 Notes to Consolidated Financial Statements (Continued)
 In January 2006, we issued 30,000 shares of common stock into our Blue Dolphin Services Co.
401K Plan as a 2005 contribution. We recorded compensation expense of $64,800 associated
with this contribution in 2005.In 2005, 319,321 stock options were exercised in a cashless manner, resulting in the
issuance of 201,899 shares of common stock and recognition of approximately $774,000 of
non-cash compensation expense. Also in 2005, 3,100,000 warrants outstanding were exercised
in a cashless manner, whereby holders surrendered a portion of the shares obtained to pay
for the exercise price of the warrants, resulting in 279,631 shares of common stock being
surrendered and 2,820,369 shares of common stock issued to the warrant holders.(8)
    
    Stock OptionsEffective April 14, 2000, we adopted, after approval by our stockholders, the 2000
Stock Incentive Plan (the 2000 Plan). Under the 2000 Plan, we are able to make incentive
stock awards. We amended the 2000 Plan effective March 19, 2003, after approval by our
stockholders on May 21, 2003, increasing the number of shares of common stock available for
incentive stock options (ISOs) and other stock incentive awards from 500,000 to 650,000
shares. The 2000 Plan is administered by the Compensation Committee of our Board of
Directors. Options granted must be exercised within 10 years from their date of grant. The
exercise price of ISOs cannot be less than 100% of the grant date fair market value of a
share of our common stock. All ISO awards granted in previous years vested immediately.
Although the 2000 Plan provides for the granting of other incentive awards, only ISOs and
non-statutory stock options have been issued under the 2000 Plan.Effective January 1, 2006, we adopted Statement of Financial Accounting Standards No. 123
(Revised), Share-Based Payments(SFAS 123(R)) utilizing the modified prospective approach.
Prior to the adoption of SFAS 123(R) we accounted for stock option grants in accordance with
APB Opinion No. 25, Accounting for Stock Issued to Employees(the intrinsic value method),
and accordingly, recognized no compensation expense when stock options were granted with an
exercise price equal to the grant date fair market value of a share of our common stock.Under the modified prospective approach, SFAS 123(R) applies to new awards and to awards
that were outstanding on January 1, 2006 that are subsequently modified, repurchased, or
cancelled. Under the modified prospective approach, had there been any awards granted during
2006, and had there been awards granted prior to January 1, 2006 which were not yet fully
vested, compensation expense recognized in 2006 would have included compensation cost for
all share-based payments granted prior to, but not yet vested, based on the grant date fair
value estimated in accordance with the original provisions of Statement of Financial
Accounting Standards No. 123, Accounting for Stock-Based Compensation, and compensation cost
for all share-based payments granted subsequent to January 1, 2006, based on the grant date
fair value estimated in accordance with the provisions of SFAS 123(R). Prior periods were
not restated to reflect the impact of adopting the new standard.As a result of adopting SFAS 123(R) on January 1, 2006, our income before taxes, net income
and basic and diluted earnings per share for the twelve months ended December 31, 2006 was
unchanged compared to if we had continued to account for stock-based compensation under APB
Opinion No. 25 for our stock option grants.Stock-based compensation expense of $774,369 was recognized in the twelve months ended
December 31, 2005. Prior to adoption of SFAS 123(R), recognition of non-cash compensation
expense was required by Financial Accounting Standards Board Interpretation No. 44,
Accounting
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BLUE DOLPHIN ENERGY COMPANY AND SUBSIDIARIES
 Notes to Consolidated Financial Statements (Continued)
 for Certain Transactions involving Stock Compensation  An Interpretation of APB
Opinion No. 25(FIN 44). Pursuant to FIN 44, stock options exercised in a cashless
manner by surrendering a portion of the option shares issued to pay the option exercise
price, trigger variable accounting treatment, requiring the measurement of compensation
expense at a period beyond the date of grant.SFAS 123(R) states that a tax deduction is permitted for stock options exercised during the
period, generally for the excess of the price at which the options are sold over the
exercise price of the options. Tax benefits are to be shown on the Statement of Cash Flows
as financing cash inflows. Any tax deductions we receive from the exercise of stock options
for the foreseeable future will be applied to the valuation allowance in determining our net
operating loss carryforward.Additionally, we utilized the alternate transition method (simplified method) for
calculating the beginning balance in the pool of excess tax benefits in accordance with FASB
Staff Position FAS123(R)-3, Transition Election Related to Accounting for the Tax Effects of
Share-Based Payment Awards.The fair market value of each option granted, pursuant to SFAS No. 123(R), is estimated on
the date of grant using the Black-Scholes-Merton option-pricing model, which uses
assumptions noted in the following table:
 Years EndedDecember 31,2006
    
    2005Stock options granted
    
    
    
    
    
    
    90,376Risk-free interest rate (on date of grant)
    
    
    N/A
    
    
    
    3.72
    %Expected term, in years
    
    
    N/A
    
    
    
    10.00Expected volatility
    
    
    N/A
    
    
    
    104.6
    %Dividend yield
    
    
    0.00
    %
    
    
    0.00
    %
 Expected volatility is based on implied volatility of our common stock. Historical data is
used to estimate option exercises and employee terminations used in the model. The data
shows that of the 117,142 shares exercised in 2004 and 289,321 exercised in 2005, the
average length of time between grant date and exercise date was approximately 2.05 years.
Also, of the option grants that have been outstanding for two or more years, approximately
14% of the total number of shares granted are forfeited within the first two years after the
grant date. The expected term of options granted used in the model represents the period of
time that options granted are expected to be outstanding. This is the simplified method as
allowed under the provisions of the Securities and Exchange Commissions Staff Accounting
Bulletin No. 107. This number is calculated by taking the average of the vesting period
(zero) and the original contract term (10 years). The risk-free
interest rate for periods within the contractual life of the option is based on the U.S.
Treasury yield curve in effect at the date of the grant. As we have not declared dividends
on our common stock since we became a public entity, no dividend yield was used. Actual
value realized, if any, is dependent on the future performance of our common stock and
overall stock market conditions. There is no assurance that the value realized by an
optionee will be at or near the value estimated by the Black-Scholes-Merton option-pricing
model.Had compensation cost for our stock options been determined based on the fair market value
at the grant dates for awards made in 2005, our net income and earnings per share would have
been
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BLUE DOLPHIN ENERGY COMPANY AND SUBSIDIARIES
 Notes to Consolidated Financial Statements (Continued)
 adjusted to the pro forma amounts indicated below. For purposes of this pro forma
disclosure, the value of the options is estimated using the Black-Scholes-Merton
option-pricing model.
 Year EndedDecember 31,2005Net income as reported
    
    $
    541,386Add: total stock-based employee compensation expense included
in net income, net of related tax effects
    
    
    774,369Deduct: total stock-based employee compensation expense
determined under fair value based method for all awards, net
of tax related effects
    
    
    (66,420
    )Pro forma net income
    
    $
    1,249,335Basic income per share:As reported
    
    $
    0.06Pro forma
    
    $
    0.14Diluted income per share:As reported
    
    $
    0.06Pro forma
    
    $
    0.14
  53




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BLUE DOLPHIN ENERGY COMPANY AND SUBSIDIARIES
 Notes to Consolidated Financial Statements (Continued)
 At December 31, 2006 we reserved a total of 143,997 shares of common stock for issuance
under the above mentioned stock option plans. A summary of the status of our stock options
granted to key employees, officers and directors, for the purchase of shares of common
stock, was as follows:
 Years Ended December 31,2006
    
    2005Weighted
    
    
    
    
    
    WeightedAverage
    
    
    
    
    
    AverageShares
    
    Exercise Price
    
    Shares
    
    Exercise PriceOptions outstanding at the beginning
of the year
    
    
    143,997
    
    
    $
    1.56
    
    
    
    346,942
    
    
    $
    1.09Options granted
    
    
    
    
    
    $
    0.00
    
    
    
    90,376
    
    
    $
    0.80Options exercised
    
    
    
    
    
    $
    0.00
    
    
    
    (289,321
    )
    
    $
    0.71Options expired or cancelled
    
    
    
    
    
    $
    0.00
    
    
    
    (4,000
    )
    
    $
    4.89Options outstanding at the end of
the year
    
    
    143,997
    
    
    
    
    
    
    
    143,997Weighted average exercise price of
options outstanding
    
    $
    1.56
    
    
    
    
    
    
    $
    1.56Weighted average fair value of options
granted during the period
    
    $
    0.00
    
    
    
    
    
    
    $
    0.73Weighted average remaining contractual
life of options outstanding
    
    6.0 years
    
    
    
    
    
    7.1 years
 At December 31, 2006, options for 143,997 shares of common stock were vested and immediately
exercisable. There were no options granted during 2006, and 90,376 options granted during
2005, all of which occurred in the first quarter of 2005. Pursuant to the requirements of
SFAS No. 123(R), the weighted average fair market value of options granted during 2005 was
$0.73 per share. The weighted average exercise price for outstanding options at December 31,
2006 and 2005 was $1.56 and $1.56 per share, respectively. Outstanding options at December
31, 2006 expire between May 17, 2010 and February 3, 2015.
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BLUE DOLPHIN ENERGY COMPANY AND SUBSIDIARIES
 Notes to Consolidated Financial Statements (Continued)
 
 Options Outstanding, Fully Vested and Exercisableat December 31, 2006WeightedAverageRemaining
    
    WeightedNumber
    
    Contractual Life
    
    AverageExercise Prices
    
    Outstanding
    
    In Years
    
    Exercise Price$0.35 to $0.80
    
    
    98,768
    
    
    
    6.8
    
    
    $
    0.54$1.55 to $1.90
    
    
    23,429
    
    
    
    5.1
    
    
    $
    1.71$6.00
    
    
    21,800
    
    
    
    3.4
    
    
    $
    6.00143,997
 (9)
    
    Related Party TransactionsRelated party transactions which are not disclosed elsewhere in these consolidated
financial statements are discussed in the following paragraphs:We own 0.07% of the common stock of Drillmar, Inc. (Drillmar). Our Chairman, Ivar Siem,
and one of our Directors, Harris A. Kaffie, beneficially own 26.6%, and 22.1%, respectively,
of Drillmar Inc.s common stock and 34.5% and 10.1%, respectively, of Drillmar Energy,
Inc.s common stock. Messrs. Siem and Kaffie are both Directors of Drillmar, and Mr. Siem
is Chairman and President of Drillmar.On March 31, 2006, we purchased 334 shares of common stock in Drillmar Energy, Inc. for $334
in a private placement offering by Drillmar, Inc. to its shareholders on a proportionate
basis to their current ownership percentage in Drillmar, Inc. This investment represented
0.07% of the total offering, which is approximately equal to our current ownership in
Drillmar, Inc.On May 25, 2006, we purchased 2 shares of common stock in Drillmar, Inc. (an affiliate of
Drillmar Energy, Inc.) for $563 in a private placement offering by Drillmar, Inc. to its
shareholders on a proportionate basis to their current ownership percentage in Drillmar,
Inc. This investment represented 0.07% of the total offering.On September 25, 2006, we participated in an issuance of callable notes by Drillmar, Inc. in
proportion to our 0.07% interest in Drillmar, Inc. We were issued a note in the amount of
$280. The note is callable by Drillmar, Inc. at any time on or after three months from the
date of issuance and accrues interest at 3% per annum, which is due and payable at maturity.
The note matures on January 1, 2009.In 2002, we recorded a full impairment of our investment in Drillmar and a full reserve for
the accounts receivable amount owed to us by Drillmar of approximately $200,000 due to
Drillmars working capital deficiency and delays in securing capital funding. During 2004,
we collected $165,000 of the accounts receivable from Drillmar and we collected the
remaining balance of approximately $45,000 in 2005.In January 2003, Drillmar stockholders approved a restructuring plan whereby Drillmar was
able to issue up to $3.0 million of convertible notes that will convert into common stock
representing over 99% of Drillmars outstanding shares. As a result, our ownership
in Drillmar has been reduced to less than 1%. In November 2003, we converted a contingent
obligation due from Drillmar for providing office space, accounting and administrative
services from May 2002
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BLUE DOLPHIN ENERGY COMPANY AND SUBSIDIARIES
 Notes to Consolidated Financial Statements (Continued)
 through January 2003 totaling $162,000 (9 months at $18,000 per
month) into a convertible note. In December 2005, we collected $178,555 from Drillmar for
this convertible note, including interest at 6% per annum.We entered into an agreement with Drillmar effective as of February 1, 2003, whereby we
provided and charged for office space. This agreement terminated December 31, 2006. We also
provided professional, accounting and administrative services to Drillmar at hourly rates
based upon our cost. Since our implementation of staff reductions in mid 2004, no such
services have been provided.(10)
    
    LeasesWe have various operating leases that extend through April 2017. Certain of these
operating leases are non-cancelable through May 2010. In March 2003, we entered into a
sublease agreement expiring December 31, 2006 for certain of our office space with TexCal
Energy (GP) LLC, formerly Tri-Union Development Corporation. Our annual receipts from this
sublease were approximately $78,000.The following is a schedule of future minimum lease payments required under noncancelable
operating leases at December 31, 2006:
 FutureMinimumYears Ending
    
    LeaseDecember 31,
    
    Payments2007
    
    
    $  70,8212008
    
    
    103,2662009
    
    
    107,5922010
    
    
    148,7132011
    
    
    Thereafter
    
    
    $430,392
 Rental expense on operating leases, net of sublease income and other rental
reimbursements, for the years indicated are as follows:
 Years EndedDecember 31,
    
    Rent Expense2006
    
    $
    78,8152005
    
    $
    46,287
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BLUE DOLPHIN ENERGY COMPANY AND SUBSIDIARIES
 Notes to Consolidated Financial Statements (Continued)
 (11)
    
    Commitments and ContingenciesWe are involved in various claims and legal actions arising in the ordinary course of
business. In our opinion, the ultimate disposition of these matters will not have a
material effect on our consolidated financial position, results of operations or cash flows.(12)
    
    Business Segment InformationOur income producing operations are conducted in two principal business segments: (i)
pipeline transportation services and (ii) oil and gas exploration and production.
Intercompany revenue and expenses are eliminated in consolidation. Information concerning
these segments for the years ended December 31, 2006 and 2005 is as follows:
 Depletion,Operating
    
    
    
    
    
    
    Depreciation,Income
    
    
    Identifiable
    
    
    Amortization andRevenues
    
    
    (Loss)(1)
    
    
    Assets(2)
    
    
    Impairment (3)Year Ended December 31, 2006:Pipeline transportation
    
    $
    1,939,894
    
    
    
    (228,460
    )
    
    
    6,360,814
    
    
    
    353,472Oil and gas exploration
and production
    
    
    2,358,814
    
    
    
    1,032,681
    
    
    
    851,668
    
    
    
    139,643Other
    
    
    
    
    
    
    (472,113
    )
    
    
    4,732,016
    
    
    
    8,943Consolidated
    
    
    4,298,708
    
    
    
    332,108
    
    
    
    11,944,498
    
    
    
    502,058Other income
    
    
    
    
    
    
    595,435Income before income taxes
    
    
    
    
    
    
    927,543Year Ended December 31, 2005:Pipeline transportation
    
    $
    1,375,173
    
    
    
    (467,484
    )
    
    
    5,645,179
    
    
    
    319,686Oil and gas exploration
and production
    
    
    3,136,010
    
    
    
    2,025,255
    
    
    
    1,358,484
    
    
    
    73,940Other
    
    
    
    
    
    
    (1,395,361
    )
    
    
    1,069,884
    
    
    
    9,591Consolidated
    
    
    4,511,183
    
    
    
    162,410
    
    
    
    8,073,547
    
    
    
    403,217Other income
    
    
    
    
    
    
    392,081Loss before income taxes
    
    
    
    
    
    
    554,491
 
 (1)
    
    Consolidated income (loss) from operations includes $463,170 and $1,385,768 in
unallocated general and administrative expenses, and unallocated depletion,
depreciation, amortization and impairment of $8,943 and $9,591 for the years ended
December 31, 2006 and 2005, respectively. All unallocated amounts are included in
Other.(2)
    
    See the supplemental disclosures for oil and gas producing activities for
discussion of capitalized costs incurred for oil and gas production operations.
Capital expenditures of $262,684 and $25,179 were recorded for pipeline operations
for the years ended December 31, 2006 and 2005, respectively.(3)
    
    Pipeline depletion, depreciation and amortization includes a provision
for pipeline abandonment of $48,595 for the years ended December 31, 2006 and 2005.
Oil and gas depletion, depreciation, amortization and impairment includes a
provision for abandonment costs of platforms and wells of $34,694 and $20,169 for
the years ended December 31, 2006 and 2005, respectively. 57




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BLUE DOLPHIN ENERGY COMPANY AND SUBSIDIARIES
 Notes to Consolidated Financial Statements (Continued)
 Our primary market area is the Texas and Louisiana Gulf Coast region of the United
States. We have a concentration of credit risk with customers in the energy industry. Our
customers may be similarly affected by changes in economic, regulatory or other factors.
Trade receivables are generally not collateralized; however, our customers historical and
future credit positions are thoroughly analyzed prior to extending credit. Revenues from
major customers exceeding 10% of revenues were as follows for the period indicated:
 Oil and Gas
    
    PipelineSales
    
    Operations
    
    TotalYear Ended December 31, 2006:Hydro Gulf, LLC (formerly Spinnaker
Exploration Company)
    
    $
    1,469,132
    
    
    $
    
    
    
    $
    1,469,132Fidelity Exploration and Production Company
    
    $
    889,682
    
    
    $
    
    
    
    $
    889,682Year Ended December 31, 2005:Hydro Gulf, LLC (formerly Spinnaker
Exploration Company)
    
    $
    722,499
    
    
    $
    
    
    
    $
    722,499Fidelity Exploration and Production Company
    
    $
    2,413,511
    
    
    $
    
    
    
    $
    2,413,511
 (13)
    
    Supplemental Oil and Gas Information  UnauditedThe following supplemental information regarding our oil and gas activities are
presented pursuant to the disclosure requirements promulgated by the Securities and Exchange
Commission and SFAS No. 69, Disclosures about Oil and Gas Producing Activities.Associated with our non-operating interest in High Island Block A-7, we recognized gross gas
and oil sales revenues of approximately $1.5 million and $722,000 in 2006 and 2005,
respectively, and lease operating expenses of approximately $430,000 and $139,000 in 2006
and 2005. Our working interest is approximately 8.9%. In September 2005, the two wells in
High Island Block A-7 were successfully recompleted and resumed production at significantly
higher rates compared to the single well that produced through the first and second quarters
of 2005. One of the wells produced throughout 2006. The second well ceased production in
February 2006. We non-consented to a recompletion of the second well.Associated with our non-operating interest in High Island Block 37, we recognized gross gas
and oil sales revenues of approximately $0.9 million and $2.4 million in 2006 and 2005,
respectively, and lease operating expenses of approximately $27,000 and $16,000 in 2006 and
2005, respectively. We have a working interest of approximately 2.8% in two producing wells
in the block. The wells are currently producing an aggregate of approximately 8 MMcf per
day.
 58




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##### Table of Contents



BLUE DOLPHIN ENERGY COMPANY AND SUBSIDIARIES
 Notes to Consolidated Financial Statements (Continued)
 Estimated Quantities of Proved Oil and Gas ReservesSet forth below is a summary of the changes in the estimated quantities of our crude oil and
condensate, and gas reserves for the periods indicated, as estimated by us at December 31,
2006 and 2005. All of our reserves are located within the United States of America. Proved
reserves cannot be measured exactly because the estimation of reserves involves numerous
judgmental determinations. Accordingly, reserve estimates must be continually revised as a
result of new information obtained from drilling and production history, new geological and
geophysical data and changes in economic conditions.Proved reserves are estimated quantities of gas, crude oil, and condensate which geological
and engineering data demonstrate, with reasonable certainty, to be recoverable in future
years from known reservoirs under existing economic and operating conditions. Proved
developed reserves are proved reserves that can be expected to be recovered through existing
wells with existing equipment and operating methods.
 Oil
    
    GasQuantity of Oil and Gas Reserves
    
    (Bbls)
    
    (Mcf)Total proved reserves at December 31, 2004:
    
    
    365
    
    
    
    35,264Revisions to previous estimates
    
    
    
    
    
    
    Extensions, discoveries, improved recovery
and other additions
    
    
    1,303
    
    
    
    685,080Purchase of reserves in place
    
    
    
    
    
    
    Sales of reserves in place
    
    
    
    
    
    
    Production
    
    
    (781
    )
    
    
    (378,791
    )Total proved reserves at December 31, 2005
    
    
    887
    
    
    
    341,553Total proved reserves at December 31, 2005:
    
    
    887
    
    
    
    341,553Revisions to previous estimates
    
    
    1,089
    
    
    
    78,640Extensions, discoveries, improved recovery
and other additions
    
    
    
    
    
    
    Purchase of reserves in place
    
    
    
    
    
    
    Sales of reserves in place
    
    
    
    
    
    
    Production
    
    
    (1,823
    )
    
    
    (312,146
    )Total proved reserves at December 31, 2006
    
    
    153
    
    
    
    108,047Proved developed reserves:December 31, 2006
    
    
    153
    
    
    
    108,047December 31, 2005
    
    
    887
    
    
    
    341,553Total proved reserves:December 31, 2006
    
    
    153
    
    
    
    108,047December 31, 2005
    
    
    887
    
    
    
    341,553
 59




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##### Table of Contents



BLUE DOLPHIN ENERGY COMPANY AND SUBSIDIARIES
 Notes to Consolidated Financial Statements (Continued)
 Capitalized Costs of Oil and Gas Producing ActivitiesThe following table sets forth the aggregate amounts of capitalized costs relating to our
oil and gas producing activities and the aggregate amount of related accumulated depletion,
depreciation, amortization and impairment as of:
 December 31,2006
    
    
    2005Unproved properties and prospect generation
costs not being amortized
    
    $
    
    
    
    $
    5,343Proved properties being amortized
    
    
    715,970
    
    
    
    544,377Total capitalized costs
    
    
    715,970
    
    
    
    549,720Accumulated depreciation, depletion and amortization
    
    
    (541,915
    )
    
    
    (403,982
    )Net capitalized costs
    
    $
    174,055
    
    
    $
    145,738
 Costs Incurred in Oil and Gas Producing ActivitiesThe following table reflects the costs incurred in oil and gas property acquisition,
disposition, exploration and development activities during the periods indicated:
 Years Ended December 31,2006
    
    
    2005Costs incurred:Acquisition of proved properties
    
    $
    
    
    
    $
    Acquisition of unproved properties
    
    
    
    
    
    
    Exploration costs
    
    
    
    
    
    
    Development costs
    
    
    15,700
    
    
    
    72,501Total costs incurred
    
    $
    15,700
    
    
    $
    72,501
 We did not acquire any oil and gas properties in 2006 or 2005.
  60




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BLUE DOLPHIN ENERGY COMPANY AND SUBSIDIARIES
 Notes to Consolidated Financial Statements (Continued)
 Results of Operations for Oil and Gas Producing ActivitiesThe results of operations from oil and gas producing activities below exclude non-oil and
gas revenues, general and administrative expenses, interest expense and interest income.
 Years Ended December 31,2006
    
    
    2005Revenues from oil and gas producing activities
    
    $
    2,358,814
    
    
    $
    3,136,010Production costs
    
    
    (457,312
    )
    
    
    (155,174
    )Depreciation, depletion, and amortization
    
    
    (139,643
    )
    
    
    (73,940
    )Pretax income from producing activities
    
    
    1,761,859
    
    
    
    2,906,896Income tax expense/estimated loss carryforward benefit
    
    
    (27,883
    )
    
    
    (123,698
    )Results of oil and gas producing activities (excluding
corporate overhead and interest costs)
    
    $
    1,733,976
    
    
    $
    2,783,198
 Standardized Measure of Discounted Future Net Cash FlowsThe following table reflects the Standardized Measure of Discounted Future Net Cash Flows
relating to our interest in proved oil and gas reserves for:
 Years Ended December 31,2006
    
    
    2005Future cash inflows
    
    $
    605,000
    
    
    $
    3,807,000Future development and dismantlement costs
    
    
    (432,000
    )
    
    
    (268,000
    )Future production costs
    
    
    (126,000
    )
    
    
    (162,000
    )Future income taxes
    
    
    (15,980
    )
    
    
    (1,148,180
    )10% discount factor
    
    
    27,720
    
    
    
    (123,420
    )Standardized measure of discounted
future net cash inflows (outflows)
    
    $
    58,740
    
    
    $
    2,105,400
 
 Future net cash flows at each year end, as reported in the above schedule, were
determined by summing the estimated annual net cash flows computed by: (1)
multiplying estimated quantities of proved reserves to be produced during each year
by year-end prices and (2) deducting estimated expenditures to be incurred during
each year to develop and produce the proved reserves (based on year-end costs). Income taxes were computed by applying year-end statutory rates to pretax net cash
flows, reduced by the tax basis of the properties and available net operating loss
carryforwards. The
annual future net cash flows were discounted, using a prescribed 10% rate, and summed to
determine the standardized measure of discounted future net cash flow.
 61




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##### Table of Contents



BLUE DOLPHIN ENERGY COMPANY AND SUBSIDIARIES
 Notes to Consolidated Financial Statements (Continued)
 We caution readers that the standardized measure information which places a value on proved
reserves is not indicative of either fair market value or present value of future cash
flows. Other logical assumptions could have been used for this computation which would
likely have resulted in significantly different amounts. Such information is disclosed
solely in accordance with Statement 69 and the requirements promulgated by the Securities
Exchange Commission to provide readers with a common base for use in preparing their own
estimates of future cash flows and for comparing reserves among companies. We do not rely on
these computations when making investment and operating decisions. Principal changes in the
Standardized Measure of Discounted Future Net Cash Flowsattributable to our proved oil and
gas reserves for the periods indicated are as follows:
 Years Ended December 31,2006
    
    
    2005Sales and transfers, net of production costs
    
    $
    (1,901,502
    )
    
    $
    (2,980,836
    )Net change in sales and transfer prices, net of
production costs
    
    
    (959,002
    )
    
    
    (54,000
    )Extension, discoveries and improved recovery, net
of future production and development costs
    
    
    
    
    
    
    6,170,836Changes in estimated future development cost
    
    
    (310,553
    )
    
    
    204,039Revisions of quantity estimates
    
    
    (235,475
    )
    
    
    Accretion of discount
    
    
    319,000
    
    
    
    (1,800
    )Net change in income taxes
    
    
    1,054,340
    
    
    
    (1,090,720
    )Change in production rates (timing) and other
    
    
    (13,468
    )
    
    
    (130,239
    )Net change
    
    $
    (2,046,660
    )
    
    $
    2,117,280
 
 Item 8. Changes in and Disagreements with Accountants on Accounting and Financial Disclosures
  
 Item 8A. Controls and Procedures
 Evaluation of Disclosure Controls and Procedures
  62




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##### Table of Contents



BLUE DOLPHIN ENERGY COMPANY AND SUBSIDIARIES
 Notes to Consolidated Financial Statements (Continued)
 Changes in Internal Controls over Financial Reporting
   63




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##### Table of Contents



PART III
 
 Item 9.
    
    Directors, Executive Officers, Promoters, Control Persons and Corporate Governance;
Compliance with Section 16(a) of the Exchange Act
  
 Item 10. Executive Compensation
  
 Item 11. Security Ownership of Certain Beneficial Owners and Management
  
 Item 12. Certain Relationships and Related Transactions, and Director Independence
  
 Item 13. Exhibits
 (a) 1.
    
    Exhibits
 No.
    
    Description3.1 (1)
    
    Amended and Restated Certificate of Incorporation of the Company.3.2 (8)
    
    Amended and Restated Bylaws of the Company.4.1 (2)
    
    Specimen Certificate of our Company common stock.4.2 (6)
    
    Form of Promissory Note issued pursuant to the Note and Warrant Purchase
Agreement dated September 8, 2004.* 10.1 (3)
    
    Blue Dolphin Energy Company 2000 Stock Incentive Plan.* 10.2 (4)
    
    Amendment to the Blue Dolphin Energy Company 2000 Stock Incentive Plan.10.3 (5)
    
    Purchase and Sale Agreement by and between Blue Dolphin Pipeline Company and
MCNIC, dated February 1, 2002.
 64




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##### Table of Contents



No.
    
    Description10.4 (6)
    
    Sale of American Resources Offshore , Inc. Common Stock Agreement between Blue
Dolphin Exploration Co. and Ivar Siem, dated September 8, 2004.10.7 (7)
    
    Purchase and Sale Agreement by and between Blue Dolphin Energy Company, WBI
Pipeline & Storage Group, Inc. and SemGas LP, dated October 29, 2004.10.8 (9)
    
    Amendment to the Asset Purchase Agreement by and among MCNIC Offshore Pipeline and
Processing Company and Blue Dolphin Pipe Line Company dated February 28, 2005.10.9 (11)
    
    Placement Agency Agreement by and between Blue Dolphin Energy Company and Starlight
Investments, LLC dated May 27, 2005.10.10 (12)
    
    Form of Stock Purchase Agreement between Blue Dolphin Energy Company and Osler
Holdings Limited, Gilbo Invest AS, Spencer Energy AS, Spencer Finance Corp., Hudson Bay Fund,
LP, Don Fogel and SIBEX Capital Fund, Inc. dated March 8, 2006.14.1 (10)
    
    Code of Ethics applicable to the Chairman, Chief Executive Officer and Senior
Financial Officer.** 21.1
    
    List of Subsidiaries of the Company.** 23.1
    
    Consent of UHY, LLP.** 31.1
    
    Ivar Siem Certification Pursuant to 18 U.S.C. Section 1350, as adopted
pursuant to section 302 of the Sarbanes-Oxley Act of 2002.** 31.2
    
    Gregory W. Starks Certification Pursuant to 18 U.S.C. Section 1350, as adopted
pursuant to section 302 of the Sarbanes-Oxley Act of 2002.** 32.1
    
    Ivar Siem Certification Pursuant to 18 U.S.C. Section 1350, as adopted
pursuant to section 906 of the Sarbanes-Oxley Act of 2002.** 32.2
    
    Gregory W. Starks Certification Pursuant to 18 U.S.C. Section 1350, as adopted
pursuant to section 906 of the Sarbanes-Oxley Act of 2002.
 
 *
    
    Management Compensation Plan.**
    
    Filed herewith.(1)
    
    Incorporated herein by reference to Exhibits filed in connection with the definitive Proxy
Statement of Blue Dolphin Energy Company under the Securities and Exchange Act of 1934, dated
October 13, 2004 (Commission File No. 000-15905).(2)
    
    Incorporated herein by reference to Exhibits filed in connection with Form 10-K of Blue
Dolphin Energy Company for the year ended December 31, 1989 under the Securities and Exchange
Act of 1934, dated March 30, 1990 (Commission File No. 000-15905).(3)
    
    Incorporated herein by reference to Exhibits filed in connection with the Proxy Statement of
Blue Dolphin Energy Company under the Securities and Exchange Act of 1934, dated May 18, 2000
(Commission File No. 000-15905). 65




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##### Table of Contents



(4)
    
    Incorporated herein by reference to Exhibits filed in connection with the definitive Proxy
Statement of Blue Dolphin Energy Company under the Securities and Exchange Act of 1934, dated
April 16, 2003 (Commission File No. 000-15905).(5)
    
    Incorporated herein by reference to Exhibits filed in connection with Form 10-KSB of Blue
Dolphin Energy Company under the Securities and Exchange Act of 1934, dated July 23, 2002
(Commission File No. 000-15905).(6)
    
    Incorporated herein by reference to Exhibits filed in connection with Form 8-K of Blue
Dolphin Energy Company under the Securities and Exchange Act of 1934, dated September 14, 2004
(Commission File No. 000-15905).(7)
    
    Incorporated herein by reference to Exhibits filed in connection with Form 8-K of Blue
Dolphin Energy Company under the Securities and Exchange Act of 1934, dated December 6, 2004
(Commission File No. 000-15905).(8)
    
    Incorporated herein by reference to Exhibits filed in connection with Form 10-QSB of Blue
Dolphin Energy Company for the quarter ended June 30, 2004 under the Securities and Exchange
Act of 1934, dated August 20, 2004 (Commission File No. 000-15905).(9)
    
    Incorporated herein by reference to Exhibits filed in connection with Form 8-K of Blue
Dolphin Energy Company under the Securities and Exchange Act of 1934, dated March 2, 2005
(Commission File No. 000-15905).(10)
    
    Incorporated herein by reference to Exhibit 14.1 filed in connection with Form 10-KSB of Blue
Dolphin Energy Company for the year ended December 31, 2004 under the Securities Exchange Act
of 1934, dated March 25, 2005 (Commission File No. 000-15905).(11)
    
    Incorporated herein by reference to Exhibit 10.9 filed in connection with Form 10-KSB of Blue
Dolphin Energy Company for the year ended December 31, 2005 under the Securities Exchange Act
of 1934, dated March 30, 2006 (Commission File No. 000-15905).(12)
    
    Incorporated herein by reference to Exhibit 10.10 filed in connection with Form 10-KSB of
Blue Dolphin Energy Company for the year ended December 31, 2005 under the Securities Exchange
Act of 1934, dated March 30, 2006 (Commission File No. 000-15905). 
 Item 14. Principal Accountant Fees and Services
  66




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##### Table of Contents



SIGNATURES
  BLUE DOLPHIN ENERGY COMPANY
(Registrant)By:
    /s/ Ivar SiemIvar Siem  (Chairman and CEO)Date:  March 30, 2007  Signature
    
    Title
    
    Date/s/ Ivar Siem
    
    Chairman and CEO
    
    March 30, 2007Ivar Siem
    
    (Principal
Executive Officer)/s/ Gregory W. Starks
    
    Treasurer
    
    March 30, 2007Gregory W. Starks
    
    (Principal
Accounting and Financial Officer)/s/ Laurence N. Benz
    
    Director
    
    March 30, 2007Laurence N. Benz/s/ Michael S. Chadwick
    
    Director
    
    March 30, 2007Michael S. Chadwick/s/ John N. Goodpasture
    
    Director
    
    March 30, 2007John N. Goodpasture/s/ Harris A. Kaffie
    
    Director
    
    March 30, 2007Harris A. Kaffie/s/ Erik Ostbye
    
    Director
    
    March 30, 2007Erik Ostbye
 67




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##### Table of Contents



Exhibit Index
 No.
    
    Description3.1 (1)
    
    Amended and Restated Certificate of Incorporation of the Company.3.2 (8)
    
    Amended and Restated Bylaws of the Company.4.1 (2)
    
    Specimen Certificate of our Company common stock.4.2 (6)
    
    Form of Promissory Note issued pursuant to the Note and Warrant Purchase
Agreement dated September 8, 2004.* 10.1 (3)
    
    Blue Dolphin Energy Company 2000 Stock Incentive Plan.* 10.2 (4)
    
    Amendment to the Blue Dolphin Energy Company 2000 Stock Incentive Plan.10.3 (5)
    
    Purchase and Sale Agreement by and between Blue Dolphin Pipeline Company and
MCNIC, dated February 1, 2002.




---



##### Table of Contents



No.
    
    Description10.4 (6)
    
    Sale of American Resources Offshore , Inc. Common Stock Agreement between Blue
Dolphin Exploration Co. and Ivar Siem, dated September 8, 2004.10.7 (7)
    
    Purchase and Sale Agreement by and between Blue Dolphin Energy Company, WBI
Pipeline & Storage Group, Inc. and SemGas LP, dated October 29, 2004.10.8 (9)
    
    Amendment to the Asset Purchase Agreement by and among MCNIC Offshore Pipeline and
Processing Company and Blue Dolphin Pipe Line Company dated February 28, 2005.10.9 (11)
    
    Placement Agency Agreement by and between Blue Dolphin Energy Company and Starlight
Investments, LLC dated May 27, 2005.10.10 (12)
    
    Form of Stock Purchase Agreement between Blue Dolphin Energy Company and Osler
Holdings Limited, Gilbo Invest AS, Spencer Energy AS, Spencer Finance Corp., Hudson Bay Fund,
LP, Don Fogel and SIBEX Capital Fund, Inc. dated March 8, 2006.14.1 (10)
    
    Code of Ethics applicable to the Chairman, Chief Executive Officer and Senior
Financial Officer.** 21.1
    
    List of Subsidiaries of the Company.** 23.1
    
    Consent of UHY, LLP.** 31.1
    
    Ivar Siem Certification Pursuant to 18 U.S.C. Section 1350, as adopted
pursuant to section 302 of the Sarbanes-Oxley Act of 2002.** 31.2
    
    Gregory W. Starks Certification Pursuant to 18 U.S.C. Section 1350, as adopted
pursuant to section 302 of the Sarbanes-Oxley Act of 2002.** 32.1
    
    Ivar Siem Certification Pursuant to 18 U.S.C. Section 1350, as adopted
pursuant to section 906 of the Sarbanes-Oxley Act of 2002.** 32.2
    
    Gregory W. Starks Certification Pursuant to 18 U.S.C. Section 1350, as adopted
pursuant to section 906 of the Sarbanes-Oxley Act of 2002.
 
 *
    
    Management Compensation Plan.**
    
    Filed herewith.(1)
    
    Incorporated herein by reference to Exhibits filed in connection with the definitive Proxy
Statement of Blue Dolphin Energy Company under the Securities and Exchange Act of 1934, dated
October 13, 2004 (Commission File No. 000-15905).(2)
    
    Incorporated herein by reference to Exhibits filed in connection with Form 10-K of Blue
Dolphin Energy Company for the year ended December 31, 1989 under the Securities and Exchange
Act of 1934, dated March 30, 1990 (Commission File No. 000-15905).(3)
    
    Incorporated herein by reference to Exhibits filed in connection with the Proxy Statement of
Blue Dolphin Energy Company under the Securities and Exchange Act of 1934, dated May 18, 2000
(Commission File No. 000-15905).




---



##### Table of Contents



(4)
    
    Incorporated herein by reference to Exhibits filed in connection with the definitive Proxy
Statement of Blue Dolphin Energy Company under the Securities and Exchange Act of 1934, dated
April 16, 2003 (Commission File No. 000-15905).(5)
    
    Incorporated herein by reference to Exhibits filed in connection with Form 10-KSB of Blue
Dolphin Energy Company under the Securities and Exchange Act of 1934, dated July 23, 2002
(Commission File No. 000-15905).(6)
    
    Incorporated herein by reference to Exhibits filed in connection with Form 8-K of Blue
Dolphin Energy Company under the Securities and Exchange Act of 1934, dated September 14, 2004
(Commission File No. 000-15905).(7)
    
    Incorporated herein by reference to Exhibits filed in connection with Form 8-K of Blue
Dolphin Energy Company under the Securities and Exchange Act of 1934, dated December 6, 2004
(Commission File No. 000-15905).(8)
    
    Incorporated herein by reference to Exhibits filed in connection with Form 10-QSB of Blue
Dolphin Energy Company for the quarter ended June 30, 2004 under the Securities and Exchange
Act of 1934, dated August 20, 2004 (Commission File No. 000-15905).(9)
    
    Incorporated herein by reference to Exhibits filed in connection with Form 8-K of Blue
Dolphin Energy Company under the Securities and Exchange Act of 1934, dated March 2, 2005
(Commission File No. 000-15905).(10)
    
    Incorporated herein by reference to Exhibit 14.1 filed in connection with Form 10-KSB of Blue
Dolphin Energy Company for the year ended December 31, 2004 under the Securities Exchange Act
of 1934, dated March 25, 2005 (Commission File No. 000-15905).(11)
    
    Incorporated herein by reference to Exhibit 10.9 filed in connection with Form 10-KSB of Blue
Dolphin Energy Company for the year ended December 31, 2005 under the Securities Exchange Act
of 1934, dated March 30, 2006 (Commission File No. 000-15905).(12)
    
    Incorporated herein by reference to Exhibit 10.10 filed in connection with Form 10-KSB of
Blue Dolphin Energy Company for the year ended December 31, 2005 under the Securities Exchange
Act of 1934, dated March 30, 2006 (Commission File No. 000-15905).