<PAGE>
 
                       SECURITIES AND EXCHANGE COMMISSION
                            Washington, D.C.  20549
                                        
                                   FORM 10-K
                                        
     [X]  ANNUAL REPORT PURSUANT TO SECTION 13 or 15(d) OF THE
                        SECURITIES EXCHANGE ACT OF 1934
                  for the fiscal year ended December  31, 1998

                                       OR
                                        
     [ ]  TRANSITION REPORT PURSUANT TO SECTION 13 or 15(d) OF THE
                        SECURITIES EXCHANGE ACT OF 1934
            for the transition period from __________ to __________

                        Commission file number:  0-22076
                                        
                              Zydeco Energy, Inc.
                                        
             (Exact name of registrant as specified in its charter)
                                        
                                    Delaware
         (State or other jurisdiction of incorporation or organization)
                                        
                                   76-0404904
                      (I.R.S. Employer Identification No.)
                                        
                    1710 Two Allen Center, 1200 Smith Street
                                 Houston, Texas
                    (Address of principal executive offices)
                                        
                                     77002
                                   (Zip Code)

                                 (713) 659-2222
              (Registrant's telephone number, including area code)
                                        
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:  None

SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:

                         Common Stock, $.001 par value
                 Warrants to Purchase One Share of Common Stock
         Units Consisting of One Share of Common Stock and Two Warrants
                                (Title of Class)

     Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.  Yes   X     No 
                                               ------    ------

     Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K ((S) 229.405 under the Securities Exchange Act of 1934) is
not contained herein, and will not be contained, to the best of registrant's
knowledge, in definitive proxy or information statements incorporated by
reference in Part III of this Form 10-K or any amendment to this Form 10-K. ____

     As of March 22, 1999, there were 10,357,096 shares of Zydeco Energy, Inc.
Common Stock, $.001 par value, issued and outstanding, of which 6,775,643
shares, having an aggregate market value of approximately $2,329,466 were held
by non-affiliates of the registrant (affiliates being, for these purposes only,
directors, executive officers, and holders of more than 5% of the registrant's
Common Stock).

                      DOCUMENTS INCORPORATED BY REFERENCE

     Part III, Items 10 through 13 are incorporated from the registrant's
definitive Proxy Statement to be filed in connection with its Annual Meeting of
Stockholders.


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                               TABLE OF CONTENTS

Item 1.  Business........................................................  1
           The Company...................................................  1
           Seismic Technology............................................  2
           Geologic and Geophysical Expertise............................  3
           Louisiana Transition Zone.....................................  3
           West Cameron Seismic Project..................................  3
           Proprietary Rights and Licenses...............................  5
           Competition and Markets.......................................  5
           Governmental Regulation.......................................  6
           Risk Factors..................................................  9
           Facilities.................................................... 11
           Employees..................................................... 12
Item 2.  Properties...................................................... 12
           Prospects and Leases.......................................... 12
           Oil and Gas Reserves.......................................... 13
           Statistical Information - Oil and Gas Properties.............. 13
Item 3.  Legal Proceedings............................................... 15
Item 4.  Submission of Matters to a Vote of Security Holders............. 16

                                    Part II

Item 5.  Market for Registrant's Common Equity and Related
           Stockholder Matters........................................... 17
           Dividend Policy............................................... 18
           Sales of Unregistered Securities.............................. 18
Item 6.  Selected Financial Data......................................... 18
Item 7.  Management's Discussion and Analysis of Financial Condition
           and Results of Operations..................................... 20
           Overview...................................................... 20
           Results of Operations......................................... 22
           Year Ended December 31, 1998
           Compared to Year Ended December 31, 1997...................... 22
           Year Ended December 31, 1997
           Compared to Year Ended December 31, 1996...................... 23
           Liquidity and Capital Resources............................... 23
           Year 2000 Compliance.......................................... 25
Item 7A. Quantitative & Qualitative Disclosures About Market Risk........ 26
Item 8.  Financial Statements and Supplementary Data..................... 26
Item 9.  Changes in and Disagreements with Accountants on
           Accounting and Financial Disclosure........................... 26

                                    Part III

Item 10. Directors and Executive Officers of the Registrant.............. 26
Item 11. Executive Compensation.......................................... 26
Item 12. Security Ownership of Certain Beneficial Owners and
           Management.................................................... 26
Item 13. Certain Relationships and Related Transactions.................. 26

                                    Part IV

Item 14. Exhibits, Financial Statement Schedules and Reports on
         Form 8-K........................................................ 26
         Signatures...................................................... 28
         Exhibit Index................................................... E-1
         Index to Consolidated Financial Statements...................... F-1

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                                     PART I
                                        
     When used in this document, the words "anticipate," "believe," "expect,"
"estimate," "project," and similar expressions are intended to identify forward-
looking statements.  Such statements are subject to certain risks,
uncertainties, and assumptions.  Should one or more of these risks or
uncertainties materialize, or should underlying assumptions prove incorrect,
actual results may vary materially from those anticipated, believed, expected,
estimated, or projected.  For additional discussion of such risks,
uncertainties, and assumptions, see "Item 1. Business--Risk Factors" included
elsewhere in this report.


ITEM 1. BUSINESS


THE COMPANY

     Zydeco Energy, Inc. (the "Company"), a Delaware corporation incorporated in
1993, is an independent energy company engaged in the exploration for oil and
gas utilizing advanced three-dimensional seismic ("3D")  and computer-aided
exploration ("CAEX") techniques.  The Company has developed comprehensive in-
house technology and software and expertise enabling it to use recent advances
in such 3D seismic and CAEX technology.  Such technology includes the Company's
"Wavefield Imaging Technology", a patented data processing technique designed to
substantially reduce the cost of 3D seismic data acquisition for certain surveys
without significantly sacrificing the quality of the 3D subsurface image.

     The Company's primary business objective is to discover and develop oil and
gas reserves and thereby increase revenues, net income and cash flows.  As
described below, changed market conditions have recently caused the Company to
alter its business plan.  However, implementing its strategy in the past, the
Company had sought to  (i) focus its efforts in geologic areas that it believed
to be underexplored with 3D seismic techniques and to have potential for
substantial oil and gas reserves, (ii) maintain its state-of-the-art 3D seismic
capabilities through selective hardware and software acquisitions and
exploitation of proprietary technology, and (iii) continue to pursue exploration
and development alliances with industry participants in order to spread funding
requirements and exploration risks.

     Before its business plan changed, the Company had sought to pursue its
strategy in phases.  First, the Company would identify areas with high oil and
gas potential that are underexplored with advanced 3D seismic techniques.
Second, the Company would secure seismic rights and implement a 3D seismic
acquisition program using third party contractors or obtain access to third
party seismic data for in-house processing and analysis.  Third, through the use
of its advanced 3D seismic processing techniques and the integration of
geological and other data, the Company's staff of geophysicists and geologists
would identify and rank potential drilling prospects. Fourth, the Company would
secure lease positions or other drilling rights for its identified potential
prospects through private landowner negotiations, state and federal public lease
sales or negotiations with industry participants holding lease positions or
drilling rights.  Upon securing drilling rights, the prospects could then be
drilled by contracting with industry participants.  The Company intended to
pursue relationships with industry participants who are experienced operators in
the prospect area. Generally, the Company intended to retain nonoperating
interests in its drilling prospects through "farmout" arrangements and prospect
sales with retained interests, while permitting a more experienced operator to
manage the drilling and production activities.

     The Company believes it is one of the few independent oil and gas
exploration companies to have performed both 3D seismic data processing and
seismic interpretation in-house.  Most independent exploration companies use
outside contractors to process their 3D data.  The Company believes processes
such as pre-stack migration analysis can be most effectively and efficiently
accomplished by integrating seismic survey design, data processing and
interpretation in-house.

     During 1998, the Company had completed all the stages of this strategy on
its West Cameron Seismic Project (the "Project") and had begun to market for
sale interests in various Project prospects to
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industry participants. This Project has recently been the principal focus of the
Company's exploration efforts and is located in southern Cameron Parish,
Louisiana in an area known as the Louisiana Transition Zone. The Louisiana
Transition Zone is an area of shoreline, near shore and within shallow coastal
and bay waters where the combination of marine and land seismic and processing
techniques are difficult and expensive. See "Louisiana Transition Zone".
However, due mostly to potential prospect buyers' concerns over uncertainties of
ownership interests in Project prospects prior to the arbitration ruling
described in "Legal Proceedings - Cheniere Litigation" and market conditions
thereafter, the Company has not generated sufficient sales of Project prospects
and, therefore, has not produced adequate levels of cash inflows during the near
term. Because market conditions for selling interests in prospects have
significantly deteriorated, the Company has recently altered its business plan
with a view to focusing its efforts on (1) conserving cash resources including,
but not limited to, employee terminations and negotiations of deferred or
foregone compensation with key executives, (2) concentrating exploration efforts
strictly on marketing sellable Project prospects and (3) seeking alternate
sources of capital for possible drilling participation and general working
capital. The Company believes that this strategy will permit it to operate with
existing cash resources into the year 2000 and withstand the current downturn in
the oil and gas exploration industry. Should the Company be successful in
selling interests in its prospects, an interest in the Project itself or raising
alternate capital resources, sufficient capital may be available in the Company
to expand its operations.

     Recent Director and Officer Resignations. Recently, Messrs. Charles 
Bradley, Harry C. Johnson, Edward R. Prince, Jr. and Phillip A. Tuttle 
voluntarily resigned their positions as directors of the Company. In addition, 
Messrs. Edward R. Prince, Jr. and John Misitigh voluntarily resigned their 
positions as executive officers of the Company. None of the directors or 
officers who resigned has indicated that their resignation was based on a 
disagreement over matters of policies, practices or procedures of the Company. 
The remaining sole director and executive officer of the Company is Mr. Sam B. 
Myers, Jr.
 
SEISMIC TECHNOLOGY

     Traditionally, seismic analysis has involved the acquisition, processing
and interpretation of seismic data collected along a single line of seismic
detectors and sources.  Processing the resulting data created a two dimensional
cross-section ("2D seismic") of the earth's subsurface beneath this line.  The
advent of high speed, large storage capacity computers and advanced geophysical
software development has permitted the acquisition, processing and
interpretation of seismic data collected in an areal array, usually from
multiple relatively closely spaced grids of seismic detectors and sources.
Processing the resulting data creates a 3D seismic image of the earth's
subsurface.  3D seismic provides a substantially improved image for
interpretation and analysis over the cross-section created by 2D seismic.  As a
result of the adoption of 3D seismic technology, the industry's success rate
with respect to the drilling of prospects has risen.

     Basic 3D seismic imaging and analysis are now routinely used by a majority
of the companies involved in oil and gas exploration.  The goal of 3D seismic
processing is to image a cube of the subsurface for detailed structural and
stratigraphic interpretation.  Three common processes used in 3D seismic
processing are Dip-Moveout ("DMO"), Common Depth Point stacking ("CDP") and
post-stack migration, which adjust the collected seismic data to more accurately
image the subsurface.  Continuing improvements in computer speed and capacity
have resulted in the development of more advanced 3D processing techniques such
as pre-stack migration which the Company has utilized in processing its Project
data.  This processing technique generally improves the imaging of the
subsurface.

     Wavefield Imaging Technology represents a further advancement of 3D seismic
survey design, processing and analysis.  Wavefield Imaging Technology permits
the Company to use more broadly spaced seismic receivers in its surveys thereby
reducing the cost of data acquisition for certain surveys.  In its West Cameron
Seismic Project seismic survey, the Company estimates that it acquired the
survey for approximately one half the cost of a conventional transition zone
survey.  Under the survey configuration used by the Company in its West Cameron
Seismic Survey, the Wavefield Imaging Technology is limited to analysis of
seismic objectives below 8,000 feet.  The technology may also be applied in the
analysis of shallower objectives by increasing receiver and sound source
densities, although with diminishing cost advantages.

     On July 1, 1997, the Company acquired all of the outstanding capital stock
of Wavefield Image, Inc. ("Wavefield"), the owner of the Wavefield Imaging
Technology.  As a result of this acquisition, the Company owns the Wavefield
Imaging Technology and a related United States patent subject to licenses
granted previously by Wavefield.  Prior to its acquisition, Wavefield granted
partial or restricted licenses for the Wavefield Imaging Technology to one major
oil company and one foreign company and offered a 

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license to another foreign company. Currently, the Company is not aware of any
other company, including the licensees, employing Wavefield Imaging Technology
in the design of its seismic surveys and processing of its seismic data.


GEOLOGIC AND GEOPHYSICAL EXPERTISE

     The Company believes that in-house expertise is a critical factor in
enabling the Company to effectively and efficiently use the most recent
developments in 3D seismic imaging and interpretation.  For this reason the
Company employed 7 highly experienced geophysicists and 3 geologists during 1998
for the purpose of processing and interpreting the 3D seismic data. After
certain cost reducing actions that resulted in employee terminations, the
Company currently employs 2 geophysicists and 1 geologist whose primary
responsibility is to market prospects for sale. These experts have an average of
approximately 30 years of experience in the industry.


LOUISIANA TRANSITION ZONE

     The Company's principal exploration efforts are focused in the Louisiana
Transition Zone, a narrow trend paralleling the coastline of Louisiana.  It is
approximately six miles wide (three miles on either side of the beach) and
extends approximately 300 miles from the Sabine River eastward to the
Mississippi River. Water depths in the Louisiana Transition Zone extend to
approximately 40 feet.  The Louisiana Transition Zone contains the Miocene Trend
which has produced many of the largest oil and gas fields developed in the
continental United States and its territorial waters.  Productive zones within
the Miocene Trend have excellent reservoir characteristics and have historically
exhibited multiple pay zones, which allow a single strategically placed well
bore to drain multiple reservoirs.  The western portion of the Louisiana
Transition Zone contains the gas prolific Planulina sands.

     The Louisiana Transition Zone is populated with salt domes with numerous
radial and tangential faults surrounding the salt domes.  The use of advanced 3D
seismic technology is essential to the exploration of such salt features and
fault blocks.  Until the last three years, there have been relatively few 3D
seismic surveys conducted in the Louisiana Transition Zone because of the
relatively high cost of such surveys compared to land or deepwater surveys.  The
high cost is a result of the problems associated with seismic surveys in coastal
transition zones as discussed above. Activities in this area are controlled by
sophisticated landowners onshore and the State of Louisiana within three miles
of the beach offshore.  Permits for 3D acquisition require the consent of all
landholders and all leaseholders.  Such consents are not required in federal
waters.  Thus, seismic contractors have been reluctant to conduct speculative 3D
surveys due to the difficulty of permitting acreage in the Louisiana Transition
Zone.  Due to these limitations, this zone was considered a "seismically blind"
area and was thus reflected on virtually every onshore and offshore 2D seismic
coverage map for the State of Louisiana as an area of "no seismic coverage."
Given the past scarcity of high quality 3D seismic surveys, which span both
onshore and offshore areas, the Company believes that this zone has the
potential for containing substantial undeveloped oil and gas reserves.  Many of
these prospective areas in the Louisiana Transition Zone are located in shallow
waters near existing pipeline infrastructure.  As a result, reserves underlying
these areas are generally less costly to develop and connect to pipeline
infrastructure than reserves in deeper water areas.


WEST CAMERON SEISMIC PROJECT

     In August 1996, the Company commenced the West Cameron Seismic Project (the
"Project"), an extensive 3D seismic exploration program conducted over
approximately 230 square miles in a part of the Louisiana Transition Zone in
western Cameron Parish, Louisiana.

     Options, Permits and Leases.  In connection with the Project, the Company
negotiated seismic options covering approximately 36,718 gross acres (33,225 net
acres) and secured seismic permits covering approximately 119,557 gross acres
(119,075 net acres).  One of the permits was an exclusive permit obtained from
the State of Louisiana that covered 51,000 non-leased acres in state waters.  In
connection 

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with the exclusive seismic permit, for eighteen months, commencing
February 1996, the Company had the exclusive right to acquire seismic data on
the State's acreage and nominate any of the acreage for competitive lease bids.
On August 11, 1997, the Company paid $391,877 to the State of Louisiana to
extend the deadline for delivery of the survey to February 18, 1998.  Prior to
the February 18, 1998 deadline, the Company nominated certain properties for
bid.  In Louisiana, a public auction of leases is held approximately 120 days
after the property is nominated for bid and the auction is generally announced
approximately 45 days prior to the auction date.  A bidder at the auction may
bid on all or only a portion of the property nominated for bid.  Under the
Company's seismic permit, the State of Louisiana is required to keep the
information obtained from the survey confidential for a period of ten years.
The Company timely delivered seismic data to the State of Louisiana in January
1998 in compliance with the terms of the exclusive seismic permit.

     In connection with the Project during the first half of 1998, the Company
acquired approximately 12,000 gross acres on nine separate prospects through
State of Louisiana lease sales, private land negotiations and a Federal lease
sale. The Company's Project leases have expiration dates ranging from 2001 to
2003.  The one Federal offshore lease provides for a minimum royalty of 16.667%,
has a primary lease term of five years that covers approximately 3,100 acres,
and is administered by the Minerals Management Service.  The annual rental on
this federal lease is $5.00 per acre.  Louisiana state leases are administered
by the State Mineral Board of the State of Louisiana and generally provide for:
(i) a minimum royalty of 23%; (ii) a five year primary term; and (iii) annual
rentals in an amount equal to 50% of the original lease acquisition cost.
Generally, title to state and federal leases is merchantable in all respects and
operations thereon are not normally subject to litigation resulting from the
legal doctrine of adverse possession or any other similar challenge to title.
Leases obtained from private landowners are on three year terms. Delay rental
obligations vary pursuant to the terms of such leases.

     Data Acquisition and Analysis. Advanced seismic processing techniques,
including initial iterations of pre-stack migration, amplitude variation with
offset (AVO) and seismic inversion were applied to the data by year-end 1997.
During 1998, the data was processed through pre-stack time migration, and a high
quality result was achieved.  A preliminary effort was made to further improve
the imaging of the data by performing pre-stack depth migration.  Interpretation
of the data to identify potential drilling prospects began in late 1997 and
continues to the present time. These interpretations led to the acquisition of
oil and gas leases within the Project which the Company is currently marketing.
The data is currently being interpreted by the Company's exploration staff to
identify new prospects. There can be no assurance that the Company will have 
sufficient resources to assemble such additional prospects.

     Cheniere Exploration Agreement and Litigation. In April 1996, the Company
executed an Exploration Agreement (the "Cheniere Agreement") with Cheniere
Energy Operating Co., Inc., a wholly owned subsidiary of Cheniere Energy, Inc.
and formerly known as FX Energy, Inc., (collectively "Cheniere") covering the
area of Project land and waters in western Cameron Parish, Louisiana.  In
exchange for earning a 50% interest, Cheniere agreed to fund certain Project
costs including, but not limited to, 3D seismic acquisition costs, including the
purchase of seismic rights or lease options on the related onshore acreage of
the Project, the purchase of other 3D seismic data, and processing of seismic
data over the Project area.

     On April 17, 1998, Zydeco Exploration, Inc., a wholly owned subsidiary of
the Company, filed a petition with the American Arbitration Association for
arbitration in order to resolve certain disputes that arose with Cheniere.  The
arbitration claim sought to resolve differences over Cheniere's funding
obligations, the parties' ownership in various leases and prospects, the scope
of pre-drilling activities that Cheniere can conduct within the Project area,
the dissemination by Cheniere of confidential seismic data covering the Project
area, and a wide variety of related issues. Cheniere filed a counterclaim in the
arbitration action, and the pleadings were amended to include the Company as
well as Zydeco Exploration, Inc. (collectively "Zydeco").

     On December 9, 1998 the three-member arbitration panel issued its decision
in the arbitration proceedings brought by Zydeco against Cheniere.  In its
ruling, the panel confirmed Zydeco's position as program manager but recognized
Cheniere's independent right to identify prospects and acquire leases in the
West Cameron Seismic Project area.  The arbitration panel directed that Cheniere
has the right to 

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participate with a 50% working interest in most of the leases acquired by Zydeco
or in prospects designated by Zydeco. Cheniere, however, must exercise its right
of participation and pay its share of such costs within a thirty-day period
following Zydeco's formal notice of prospect designation. For each prospect,
Zydeco has the sole right to undertake the management and control of all
prospect development for a reasonable period not to exceed 90 days following
such formal notice. The arbitration panel also ruled that project seismic costs
generally incurred after December 31, 1997, are not reimbursable to Zydeco as
seismic costs. The Company believed that such costs, either in part or in whole,
should be recouped from Cheniere as prospect costs. In addition, if certain
criteria are met, then sale proceeds from certain marketing activities would be
paid to Cheniere until Cheniere recoups $13.5 million of its investment in the
project. Zydeco and Cheniere would share any such sales above that amount
equally. Neither party received any damage awards or recovery of legal costs.

     As a result of the arbitration panel's decision, Zydeco and Cheniere
informally agreed to share responsibilities and ownership for certain
activities incurred in the maintenance, marketing and sale of prospects
generated and assembled by the parties.  Except for the costs of one prospect
and certain other activities, neither party would seek reimbursement from the
other for seismic and prospect costs generally incurred prior to the arbitration
ruling.  After considering the arbitration panel's ruling and the two parties'
informal agreement, Cheniere's and Zydeco's shares of third party and
processing costs incurred pursuant to the terms of the Cheniere Agreement were
approximately $16,423,398 and $5,216,773, respectively, from inception to
December 31, 1998.  Project seismic costs amounting to $1,146,688 that
previously had been attributable to Cheniere were charged by the Company to
exploration expense. In addition, the Company acquired approximately $5,753,010
in unproved leases during 1998.


PROPRIETARY RIGHTS AND LICENSES

     The Company believes that its success will depend primarily on the
innovative skills, technical competence, and sales and marketing abilities of
its personnel. See "Employees" and "Risk Factors--Dependence on Key Personnel."
The Company has obtained licenses to use all software currently used in its
business. On December 2, 1997, the Company was issued a patent on the Wavefield
Imaging Technology by the United States Patent and Trademark Office. As
discussed above, prior to the Wavefield acquisition, the Company acquired a non-
exclusive license to use the Wavefield Imaging Technology throughout the world
and an exclusive license to use it in the Louisiana Transition Zone. See
"--Seismic Technology."


COMPETITION AND MARKETS

     Competition for the acquisition of proved undeveloped acreage, as well as
producing properties, is intense.  Commencing in the latter half of 1998,
competition for selling drillable prospects has also become intense.  The
Company competes with many other entities including major integrated oil and gas
companies as well as numerous independent oil and gas companies and other
producers of energy sources and fuels.  Should the Company decide and have the
resource to acquire additional leases within the Project, a substantial portion
of acreage is subject to competitive closed bidding at federal and state lease
sales.  Currently, the Company has very limited resources to compete in such
sales.  Many of the Company's competitors have substantially greater financial
resources and other competitive advantages over the Company, and therefore may
be better able to compete and bid for leases, particularly in regions other than
the Gulf Coast.  In addition, such competitors may have financial resources and
other competitive advantages that may make them better able to market prospects
or offer more advantageous sale terms than the Company.

     The availability of a ready market for hydrocarbons and the price of any
hydrocarbons produced will depend on many factors beyond the control of the
Company, including the extent of domestic production and imports of foreign oil,
the marketing of competitive fuels, the proximity and capacity of natural gas
pipelines, the availability of transportation and other market facilities, the
demand for hydrocarbons, the political conditions in the Middle East, the effect
of federal and state regulation of allowable rates of production, taxation and
the conduct of drilling operations, and federal regulation of 

                                       5
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natural gas. In the past, as a result of excess deliverability of natural gas,
many pipeline companies curtailed the amount of natural gas taken from producing
wells, shut-in some producing wells, significantly reduced gas taken under
existing contracts, refused to make payments under applicable "take-or-pay"
provisions, and refused to contract for gas available from some newly completed
wells. The Company can give no assurance that such problems will not affect
these markets again. In addition, the ongoing restructuring of the natural gas
pipeline industry will eliminate the gas purchasing activity of traditional
interstate gas transmission pipeline buyers. See "--Governmental Regulation" and
"Risk Factors--Competitive Industry."

     The Company's principal oil and gas exploration assets consist of interests
in oil and gas prospects in its West Cameron Seismic Project and associated
seismic data.  The Company's business plan has been to market interests in these
prospects to industry participants.  Due primarily to the decrease in oil prices
during 1998 and the consequent reductions in funds available for drilling
exploratory prospects as well as changed industry outlook on projected returns
from oil and gas exploratory drilling, the demand for participations in
independently generated oil and gas prospects in the Gulf Coast region has been
adversely affected.  The Company's efforts to market its West Cameron prospects
have been similarly adversely affected.  This situation is not likely to recover
substantially until the industry outlook on energy commodity prices and
projected returns on oil and gas drilling changes favorably.

     Producers of natural gas, therefore, will be required to develop new
markets among gas marketing companies, end users of natural gas, and local
distribution companies.  All of these factors, together with economic factors in
the marketing area, generally may affect the supply and/or demand for oil and
gas and thus the prices available for sales of oil and gas.


GOVERNMENTAL REGULATION

     The Company's oil and gas exploration, development, production, and related
operations are subject to extensive rules and regulations promulgated by federal
and state agencies.  Failure to comply with such rules and regulations could
result in substantial penalties being imposed on the Company.  The regulatory
burden on the oil and gas industry increases the Company's cost of doing
business and affects its profitability.  Because such rules and regulations are
frequently amended or reinterpreted, the Company is unable to predict the future
cost or impact of complying with such rules and regulations.

     Production.  In most, if not all, areas where the Company may conduct
activities, there may be statutory provisions regulating the production of oil
and natural gas under which administrative agencies may promulgate rules in
connection with the operation and production of both oil and gas wells,
determine the reasonable market demand for oil and gas, and establish allowable
rates of production.  Such regulations may restrict the rate at which the
Company's wells produce oil or gas at levels below the rate at which such wells
would be produced in the absence of such regulations, with the result that the
amount or timing of the Company's revenues could be adversely affected.

     Louisiana State Regulation.  The State of Louisiana imposes numerous
requirements relating to the exploration and production of oil and gas,
including permits for seismic or drilling operations, drilling bonds, and
reports concerning operations.  The State of Louisiana also has statutes or
regulations addressing conservation matters, including provisions for the
unitization or pooling of oil and gas properties, the establishment of maximum
rates of production from wells, and the U.S. Department of Interior Minerals
Management Service's(the "MMS") regulations of spacing, plugging, and
abandonment of such wells.

     Offshore Leasing.  The Company has acquired oil and gas leases in the Gulf
of Mexico, which have been granted by the Federal government and are
administered by the MMS.  Such leases were issued through competitive bidding,
contain relatively standardized terms, and require compliance with detailed MMS
regulations and orders pursuant to the Outer Continental Shelf Lands Act (the
"OCSLA") (which are subject to change by the MMS).  For offshore operations,
lessees must obtain the MMS's approval for exploration plans and development and
production plans prior to the commencement of such operations.  In addition to
permits required from other agencies such as the Coast Guard, the Army Corps of
Engineers, and 

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the Environmental Protection Agency (the "EPA"), lessees must obtain a permit
from the MMS prior to the commencement of drilling. The MMS has promulgated
regulations requiring offshore production facilities located on the Outer
Continental Shelf to meet stringent engineering and construction specifications.
Similarly, the MMS has promulgated other regulations governing the plugging and
abandoning of wells located offshore and the removal of all production
facilities. With respect to any Company operations conducted on offshore federal
leases, liability may generally be imposed under the OCSLA for the costs of
clean-up and damages caused by pollution resulting from such operations, other
than damages caused by acts of war or the negligence of third parties. Under
certain circumstances, including but not limited to, conditions deemed a threat
or harm to the environment, the MMS may also require any Company operations on
federal leases to be suspended or terminated in the affected area.

     Under the OCSLA, all oil and natural gas pipelines operating on the Outer
Continental Shelf must provide "open and non-discriminatory" access to both
owner and non-owner shippers.  Consequently, the Company's gathering and
transportation facilities located on the Outer Continental Shelf must be made
available to third parties.

     Bonding and Financial Responsibility Requirements.  The Company is required
to obtain bonding, or otherwise demonstrate financial responsibility, at varying
levels by governmental agencies in connection with obtaining state or federal
leases or acting as operator on such leases. These bonds may cover such
obligations as plugging and abandonment of nonproductive wells, removal of
related production facilities, and pollution liabilities on federal and state
leases. A substantially larger bond than the $300,000 bond currently issued on
behalf of the Company is required in order to act as operator on Federal
offshore leases. The Company will have to satisfy these increased bonding
requirements in the event that it elects to operate any wells on Federal leases.
The Company expects to be able to enter into participation arrangements on its
prospects with industry participants who are qualified to act as operators on
Federal leases. However, no such arrangements can be assured of occurring. In
addition, the State of Louisiana recently adopted financial responsibility
requirements with respect to plugging and abandonment liabilities on Louisiana
leases.

     Natural Gas Marketing and Transportation.  The interstate transportation of
natural gas is regulated by the Federal Energy Regulatory Commission (the
"FERC") under the Natural Gas Act of 1938 and, to a lesser extent, the Natural
Gas Policy Act of 1978. Since the early 1990s, FERC's regulatory efforts have
centered largely around its generic rulemaking proceeding, Order No. 636.
Through Order No. 636 and successor orders, FERC has undertaken to restructure
the interstate pipeline industry with the goal of providing enhanced access to,
and competition among, alternative gas suppliers. By requiring interstate
pipelines to "unbundle" their sales services and to provide their customers with
direct access to any upstream pipeline capacity held by pipelines, Order No. 636
has enabled pipeline customers to choose the levels of transportation and
storage service they require, as well as gas directly from third-party merchants
other than the pipelines. In general, Order No. 636 has facilitated the
transportation of gas and the direct access to end-user markets.

     With the completion of the Order No. 636 implementation process on the FERC
level, FERC's natural gas regulatory efforts have turned towards a number of
other important policies, all of which could significantly affect the marketing
of gas. Some of the more notable of these regulatory initiatives include (i) two
new generic initiatives seeking industry input regarding the pricing,
availability, and terms of service for both the short-term and long-term natural
gas capacity markets, (ii) FERC's ongoing efforts, aided by the participation of
various industry segments through the rulemaking process that resulted in Order
No. 587 and its successor orders, to implement uniform standards for pipeline
electronic bulletin boards, electronic data exchange, and basic business
and operational practices of the pipelines, (iii) the issuance of a merger
policy statement, as well as the consideration and relatively expedient approval
of a surge in merger applications (especially a number of so called
"convergence" mergers between electric utilities and gas companies), (iv)
increased acceptance of market and other non-cost-based rates, such as
negotiated rates, for interstate pipeline transmission and storage capacity, (v)
a newly modified rate-of-return on equity policy for interstate pipelines, and
(vi) the examination, through a number of formal rulemaking proceedings, of
certain general topics affecting the current energy industry (including a review
of regulations governing communications, a proposed collaborative process for
energy facility applications, an updated landowner

                                       7
<PAGE>
 
notification procedure for pipeline environmental assessments, and the proposed
elimination of a number of outdated filing and reporting requirements for
pipeline certification applications).

     In addition to natural gas regulatory concerns, the FERC's unbundling of
the wholesale electric industry through generic rulemaking proceedings in Order
Nos. 888 and 889 and their successor orders may impact the natural gas industry.
The unbundling of the wholesale electricity industry, along with the recent
trend toward the implementation of regional system operators and associated
power exchanges, have already been recognized as forcing electric utilities to
seek out more competitive sources of (or alternatives to) supplies for their
gas-fired generation units.

     Oil Sales and Transportation Rates. FERC regulates the transportation of
oil in interstate commerce pursuant to the Interstate Commerce Act. Sales of
crude oil, condensate, and gas liquids by the Company are not regulated and are
made at market prices.  However, the price a company receives from the sale of
these products is affected by the cost of transporting the products to market.
Effective as of January 1, 1995, FERC implemented regulations establishing an
indexing system for transportation rates for oil pipelines, which would
generally index such rates to inflation, subject to certain conditions and
limitations.  Under the new regulations petroleum pipelines are able to change
their rates within prescribed ceiling levels that are tied to the Producer Price
Index for Finished Goods, minus one percent.  Rate increases made pursuant to
the index will be subject to protest, but such protests must show that the
portion of the rate increase resulting from application of the index is
substantially in excess of the pipeline's increase in costs.  The new indexing
methodology can be applied to any existing rate, even if the rate is under
investigation.  If such rate is subsequently adjusted, the ceiling level
established under the index must be likewise adjusted.

     In the order adopting the new regulations, FERC said that as a general rule
pipelines must utilize the indexing methodology to change their rates. FERC
indicated, however, that it was retaining cost-of-service ratemaking, market-
based rates, and settlements as alternatives to the indexing approach.  A cost-
of-service proceeding will be instituted to determine just and reasonable
initial rates for new services.  A pipeline can also follow a cost-of-service
approach when seeking to increase its rates above index levels for
uncontrollable circumstances.  A pipeline can seek to charge market-based rates
if it can establish that it lacks market power.  Finally, a pipeline can
establish rates pursuant to settlement if agreed upon by all current shippers.

     On May 10, 1996, the D.C. Circuit affirmed the new regulations.  The Court
held that by establishing a general indexing methodology along with limited
exceptions to indexed rates, FERC had reasonably balanced its dual
responsibilities of ensuring just and reasonable rates and streamlining
ratemaking through generally applicable procedures.  Because of the novelty and
uncertainty surrounding the indexing methodology, as well as the possibility of
the use of cost-of-service ratemaking and market-based rates, the Company is not
able to predict with certainty what effect, if any, these regulations will have
on it.  However, other factors being equal, the regulations may tend to increase
transportation costs or reduce wellhead prices for such commodities.

     Environmental.  The Company's operations are subject to numerous laws and
regulations governing the discharge of materials into the environment or
otherwise relating to environmental protection.  These laws and regulations may
require the acquisition of a permit before drilling commences, restrict the
types, quantities, and concentration of various substances that can be released
into the environment in connection with drilling and production activities,
limit or prohibit drilling activities on certain lands lying within wilderness,
wetlands, and other protected areas, and impose substantial liabilities for
pollution resulting from the Company's operations.  Moreover, the recent trend
toward stricter standards in environmental legislation and regulation is likely
to continue.  For instance, legislation has been proposed in Congress from time
to time that would reclassify certain oil and gas exploration and production
wastes as "hazardous wastes" which would make the reclassified wastes subject to
much more stringent handling, disposal, and clean-up requirements.  If such
legislation were to be enacted, it could have a significant impact on the
operating costs of the Company, as well as the oil and gas industry in general.
Initiatives to further regulate the disposal of oil and gas wastes are also
pending in certain states, and these various initiatives could have a similar
impact on the Company.

                                       8
<PAGE>
 
     The Comprehensive Environmental Response, Compensation, and Liability Act
("CERCLA"), also known as the "Superfund" law, imposes liability, without regard
to fault or the legality of the original conduct, on certain classes of persons
that are considered to have contributed to the release of a "hazardous
substance" into the environment.  These persons include the owner or operator of
the disposal site or sites where the release occurred and companies that
disposed of or arranged for the disposal of the hazardous substances found at
the site.  Persons who are or were responsible for releases of hazardous
substances under CERCLA may be subject to joint and several liability for the
costs of cleaning up the hazardous substances that have been released into the
environment and for damages to natural resources.  It is not uncommon for
neighboring landowners and other third parties to file claims for personal
injury and property damage.


RISK FACTORS

  Limited Production and High Dependence on 3D Seismic and Exploratory Drilling
Activities. The Company's producing activities to date have been limited.  Such
activities presently consist of a working interest in one well and an overriding
royalty interest in another well.  Both wells are located offshore Louisiana.
No oil and gas reserves have been assigned by the Company at December 31, 1998
to the well in which it has a working interest.  Currently, the Company's focus
is directed to increasing its reserves, and thereby increasing its revenues, net
income and cash flow, by relying on certain 3D seismic methods to identify
potential hydrocarbon accumulations which will then require the successful
drilling of such prospects.  There is no assurance that those 3D seismic methods
will identify potential hydrocarbon accumulations or that drilling will
successfully test these prospects.  The use of 3D seismic technology involves
numerous risks in the acquisition, processing and interpretive phases including,
but not necessarily limited to, acquiring seismic shooting rights over a
prospective area, availability of trained seismic crews, subsurface conditions
which may affect the quality of the acquisition of data, surface conditions, and
availability of data from any nearby previously drilled wells.  Drilling
involves numerous risks, including the risk that no commercially productive oil
or gas reservoirs will be encountered.  The cost of drilling, completing, and
operating wells is often uncertain and drilling operations may be curtailed,
delayed, or abandoned as a result of a variety of factors, including unexpected
drilling conditions, excessive pressure or irregularities in formations,
equipment failures or accidents, weather conditions, and shortages or delays in
the delivery of equipment.

  High Dependence on Sales of Prospects.  Recently, the Company has experienced
difficulty in selling prospects developed and assembled from its Project.  It
believes that the lack of sales has been caused by market conditions within the
oil and gas industry as well as initial uncertainties with respect to ownership
interests.  The Company anticipated that sales of these Project interests would
account for a substantial source of funds for the period commencing in the
second half of 1998 and continuing into 1999, and such has not been the case.
Despite past market conditions, the Company is continuing its marketing efforts
to sell interests in prospects.  However, there can be no assurance that the
Company will be successful in selling such significant interests or in receiving
sufficient funds for continuing operations.

  Each non-producing oil and gas lease acquired by the Company requires annual
delay rental payments to maintain lease ownership rights.  Because most of the
Company's Project leases were acquired during the first half of 1998,
significant delay rental payments are due during the first half of 1999. The
Company contemplates that some portion of these leases may be retained by either
paying the delay rental obligation or negotiating such obligation with a
potential buyer.  In addition, the Company and Cheniere Energy, Inc. have agreed
to share the responsibilities of marketing and maintaining Project leases.
There is no assurance that, absent negotiated prospect sales agreements that
provide for a buyer to pay rentals, the Company and/or Cheniere will make some
or all of such delay rental payments. The Company cannot predict what leases, if
any, that it and/or Cheniere may decide to relinquish through non-payment of a
delay rental when due, the impact of such action on the marketability of the
prospect in which the lease was held or the cost of potentially reacquiring such
lease.

  Lack of Diversification; Oil and Gas Industry Conditions; and Volatility of
Prices for Oil and Gas. As an independent energy company, the Company's
revenues, profits and ability to market its prospects will be substantially
dependent on the
                                       9
<PAGE>
 
oil and gas industry in general and the prevailing prices for oil and gas in
particular. Historically, the markets for oil and gas have been volatile and are
likely to continue to be volatile in the future. Prices for oil and gas are
subject to wide fluctuations in response to relatively minor changes in supply
of and demand for oil and gas, market uncertainty, and a variety of additional
factors that are beyond the control of the Company. These factors include
political conditions in the Middle East, the domestic and foreign supply of oil
and gas, the price of foreign imports, the level of consumer demand, weather
conditions, domestic and foreign government regulations, the price and
availability of alternative fuels, and overall economic conditions. Accordingly,
it is impossible to predict future oil and gas price movements with any
certainty. Declines in oil and gas prices would adversely affect the company's
cash flow, liquidity, and profitability, and reduce the amount of the Company's
oil and gas reserves that can be economically produced. In addition, various
factors, including the availability and capacity of gas gathering systems and
pipelines, the effect of federal regulations on production and transportation,
general economic conditions, and changes in supply and demand, may adversely
affect the Company's ability to market its oil and gas production.

  High Dependence upon Lease Acquisition Activities.  Due to available capital
resources, the Company does not expect to acquire any new leases in the near
term. However, its business demands that it continually evaluate its lease
holdings and potential new lease acquisitions.  Should the Company seek
additional lease holdings, then such activities may include attempts to acquire
leases from federal agencies, state agencies or private individuals and
companies.  Both the United States Department of the Interior and the State of
Louisiana award oil and gas leases on a competitive bidding basis.  It is
expected that other major and independent oil and gas companies having financial
resources significantly greater than those of the Company will bid against the
Company for the purchase of oil and gas leases.  Accordingly, there can be no
assurance that the Company will be successful in acquiring any leases on which
it bids.

  Limited Operating Revenues; Need for Additional Financing.  The Company
presently has limited operating revenues and does not expect to generate
substantial operating revenues in the immediate future.  The Company expects
that it will need substantial additional capital if it chooses to expand
operations and to acquire additional oil and gas leases, producing properties,
or to participate in the drilling of wells on prospects.  Additional capital may
be secured from a combination of funding sources that may include borrowings
from financial institutions, vendor financings, production payment financings,
debt offerings, additional offerings of the Company's stock and alliances with
other industry participants.  The Company's ability to access additional capital
may depend on a variety of factors including, but not limited to, sales of its
existing prospects, favorable drilling results on its prospects and the status
of various capital markets at the time such additional capital is sought. The
decline in oil prices over the past year and the poor performance of stock
prices of public independent oil and gas companies has recently substantially
limited available capital for companies like Zydeco.  Accordingly, there can be
no assurances that capital will be available to the Company from any source, at
the time required or that, if available, it will be on terms acceptable to the
Company.  Should sufficient financing not be available because costs are higher
than estimated or otherwise, the Company would have to consider alternatives
such as a sale or merger of the Company or liquidation of its assets.  The
Company believes it has sufficient capital to sustain its reduced level of
operations into the year 2000.

  Competitive Industry.  The Company operates in a highly competitive industry.
The Company competes with major and independent oil and gas companies for the
acquisition of oil and gas leases as well as for the equipment and labor
required to explore, develop and operate such properties.  Many of these
competitors have financial, technical, human, and other resources greater than
those of the Company.

  Operating Risks.  The Company's oil and gas operations are subject to all of
the risks and hazards typically associated with the exploration for, and the
development and production of, oil and gas in the Gulf of Mexico and any other
areas in which the Company may, in the future, conduct such activities.  Risks
in drilling operations include blowouts, oil spills, fires, and offshore risks
such as capsizing, collision, hurricanes, and other adverse weather and sea
conditions.  Such risks can result in personal injury and loss of life and
substantial damage to or destruction of oil and gas wells, platforms, production
facilities, or other property, suspension of operations, and liabilities to
third parties, any and all of which could adversely affect the Company.  In
addition, the Company's operations could result in liability for oil spills,
discharge of hazardous materials, and other environmental damages.

                                       10
<PAGE>
 
  In accordance with customary industry practices, the Company maintains
insurance against some, but not all, of such risks and some, but not all, of
such losses.  There can be no assurance, however, that any insurance the Company
intends to carry will be available to the Company when applied for or, if
available and carried, will be adequate to cover the Company's liability in all
circumstances.  The occurrence of an event not fully covered by insurance could
have a material and adverse effect on the financial position and results of
operations of the Company.  In addition, the Company may be liable for
environmental damages caused by previous owners of any property which may be
purchased by the Company, which liabilities would not be covered by insurance.

  Many of the oil and gas leases the Company has acquired are located offshore
in water depths of less than 130 feet.  Drilling operations offshore in such
water depths are by their nature more remote, exposed, and, consequently, more
difficult than typical drilling operations conducted on land, and, as a result,
could result in significantly higher drilling, completion, and connection costs.

  Risks of Turnkey Contracts.  The Company intends to have other industry
participants operate its wells and will attempt to obtain, wherever possible and
desirable, turnkey contracts, subject to availability, for the drilling of wells
on any of its prospects.  In the event a turnkey contract is not economically
beneficial to the Company or is otherwise unobtainable from proven industry
participants, the Company may contract for drilling operations on either a
footage or day rate basis. In this instance, the Company may be liable for
significant cost overruns attributable to downhole drilling problems that
otherwise would have been covered by a turnkey contract had one been negotiated.

  Dependence on Key Personnel.  The Company believes that its success will be
highly dependent on its ability to retain key employees.  Should the Company
return to a mid-1998 level of operations, then it also believes that its success
will be highly dependent upon its ability to attract skilled managers and
employees.  In the event that the Company cannot obtain or retain the services
of such key personnel, there could be a material adverse effect on the Company's
business and prospects. See "Employees" and "The Company--Recent Director and 
Officer Resignations."

  Governmental Regulations.  The Company's business will be regulated by certain
federal, state, and local laws and regulations relating to the development,
production, marketing, and transportation of oil, gas, and related products as
well as certain environmental and safety matters.  These laws may be changed
from time to time in response to economic or political conditions.  Matters
subject to regulation include permits for drilling operations, drilling and
abandonment bonds, reports concerning operations, the spacing of wells,
unitization and pooling of properties, and taxation.  From time to time,
regulatory agencies have imposed price controls and limitations on production by
restricting the rate of flow of oil and gas wells below actual production
capacity in order to conserve supplies of oil and gas.  In addition, the
production, handling, storage, transportation, and disposal of oil and gas, by-
products therefrom, and other substances and materials produced or used in
connection with oil and gas operations are subject to regulation under federal,
state, and local laws and regulations primarily relating to protection of human
health and the environment.  These laws and regulations have continually imposed
increasingly strict requirements for water and air pollution control and solid
waste management.  The Company believes the trend of more expansive and stricter
environmental legislation and regulations will continue and such legislation may
result in costs to the Company in the future.  Amendments to laws regulating the
disposal of oil and gas exploration and production wastes have been considered
by Congress and may be adopted.  Moreover, from time to time new and additional
taxes, such as a BTU tax or a gasoline tax, have been proposed on energy
consumption.  Such legislation or taxes, if enacted, could have a significant
adverse impact on the Company's operating costs.

FACILITIES

  The Company leases approximately 19,600 square feet of office space in
Houston, Texas under two leases expiring in 1999. One lease, approximating
12,200 square feet, expired on January 31, 1999 while the other lease will
expire October 31, 1999.

                                       11
<PAGE>
 
EMPLOYEES

     As of December 31, 1998, the Company had 12 full-time employees, including
5 geophysicists and 1 landman.  None of the Company's employees are employed
pursuant to a collective bargaining agreement, and the Company has not
experienced any work stoppages.  One employee of the Company has an employment
agreement with the Company, while another employee who had an employment
agreement resigned in December 1998.  The Company considers its relations with
its employees to be good.

     At the time of this report, the Company had reduced the number of its
employees to 9 full-time individuals, including 2 geophysicists, 1 geologist and
one landman. See "The Company" and "Geological and Geophysical Expertise."



ITEM 2.   PROPERTIES

PROSPECTS AND LEASES

     Undeveloped Properties.  The following table summarizes the Company's
working interest ownership of undeveloped acreage.  Undeveloped acreage is
considered to be those lease acres on which the Company has a working interest
but ownership in no wells that have been drilled or completed to a point that
would permit the production of commercial quantities of oil or gas.  Gross
acreage represents the total acreage under lease, while net acreage is the
Company's working interest share of such leased acreage.

 
 
                                            Gross                 
                                         Undeveloped   Net Acreage
          State/Location                   Acreage      To Zydeco 
          -----------------              -----------   -----------
                                                                  
          Louisiana                            3,441         2,164
                                                                  
          Texas                                   81            81
                                                                  
          Gulf of Mexico                      13,667        11,735
                                              ------        ------
          Total                               17,189        13,980 
                                              ======        ======
 
          -----------
          If Cheniere Energy, Inc. elects participation in each lease held in
          the West Cameron Seismic Project pursuant to the terms of the Cheniere
          Exploration Agreement and the arbitration ruling dated December 9,
          1998 by the arbitration panel convened to hear the Cheniere litigation
          matters, the above "Net Acreage to Zydeco", would total 9,079.

     Lease Terms.  Most of the leased acres currently held by the Company are
under federal or State of Louisiana offshore leases.  The Company's leases have
expiration dates ranging from 1999 to 2003.  Federal offshore leases provide for
minimum royalties of 16.67%, have a primary lease term of five years, and are
administered by the MMS.  Annual rentals on Federal leases are $5.00 per acre.
In general, the Company's federal leases consist of portions of 5,000 acre lease
blocks.  If production is not established or an extension is not obtained during
the primary term, the lease terminates.  Louisiana state leases are administered
by the State Mineral Board of the State of Louisiana and generally provide for:
(i) a minimum royalty of 20%; (ii) a five year primary term; and (iii) annual
rentals in an amount equal to 50% of the original lease acquisition cost.
Generally, title to state and federal leases is merchantable in all respects and
operations thereon are not normally subject to litigation resulting from the
legal doctrine of adverse possession or any other similar challenge to title.
Leases obtained from private landowners are on three year terms.  Delay rental
obligations vary pursuant to the terms of such leases.

                                       12
<PAGE>
 
OIL AND GAS RESERVES

     The Company engaged Petroleum Professionals International, LP ("PPI") and
Ryder Scott Company, Petroleum Engineers ("Ryder Scott") to estimate the proved
oil and gas reserves of the Company's properties for the years ended December
31, 1998 and 1997, respectively.  Both PPI and Ryder Scott are independent oil
and gas reserve engineering firms.  These firms were also asked to estimate the
future net revenues to be derived from such properties. In preparing their
respective reports, these firms reviewed and examined such geological, economic,
engineering, and other data provided by the Company as considered necessary
under the circumstances, and examined the reasonableness of certain economic
assumptions regarding estimated operating and development costs and recovery
rates in light of economic circumstances as of December 31, 1998 and 1997.  As
of December 31, 1998, the proved oil reserves were estimated to be 269 Bbls and
the proved gas reserves were estimated to be 105,571 Mcf.

     There are numerous uncertainties inherent in estimating quantities of
reserves and in projecting future rates of production and timing of development
expenditures, including many factors beyond the control of the producer.  The
reserve data set forth in this Annual Report on Form 10-K represent only
estimates.  Reserve engineering is a subjective process of estimating
underground accumulations of oil and gas that cannot be measured in an exact
way, and the accuracy of any reserve estimate is a function of the quality and
quantity of available data and of engineering and geological interpretation and
judgment.  As a result, estimates of different engineers often vary.  In
addition, results of drilling, testing, and production subsequent to the date of
an estimate may justify revision of such estimate.  Accordingly, reserve
estimates at a specific point in time are often different from the quantities of
oil and gas that are ultimately recovered, which differences may be significant.
Additionally, the estimates of future net revenues from proved reserves of the
Company and the present value of future net revenues are based upon certain
assumptions about future production levels, prices, and costs that may not prove
correct over time.  The meaningfulness of such estimates is highly dependent
upon the accuracy of the assumptions upon which they were based.


STATISTICAL INFORMATION - OIL AND GAS PROPERTIES

     PRODUCTION. The following table summarizes the sales volumes of the
Company's net oil and gas production in the United States in barrels of oil and
thousands of cubic feet of natural gas for each of the three years ended
December 31, 1998, 1997, and 1996, respectively:

 
 
                                           YEAR ENDED DECEMBER 31,
                                        ----------------------------
                                          1998       1997      1996
                                        --------    ------    ------
SALES VOLUMES
  Natural Gas (Mcf)                      165,762   336,730   372,678
  Crude Oil (Bbl)                          1,187     9,377    20,186


     The sales volumes in the table represent sales of "net production", i.e.,
production which is net to the Company and produced to its interest after
deducting royalty and other similar interests.

     AVERAGE PRICES AND PRODUCTION COSTS. For each of the last three years,
average unit prices and unit production costs are set forth below with respect
to the Company's net share of production of oil and gas in the United States:

                                       13
<PAGE>
 
<TABLE>
<CAPTION>
                                                               YEAR ENDED DECEMBER 31,
                                                             --------------------------
                                                               1998     1997      1996
                                                             -------   ------    ------
<S>                                                          <C>       <C>      <C>
AVERAGE SALES PRICES                                       
  Natural Gas ($/Mcf)                                         $ 2.25   $ 2.59    $ 2.60
  Crude Oil ($/Bbl)                                           $13.71   $20.69    $22.39
                                                           
Lease Operating Expense ($/NBOE)/(1)/                         $  .60   $  .31    $  .27
Depletion, Depreciation, & Amortization ($/NBOE)/(1)          $    -   $ 1.20    $ 1.73
 
</TABLE>

------------
     (1)  Net barrels of oil equivalent (NBOE) assuming natural gas converted at
          six Mcf per equivalent barrel.

  ACREAGE AND WELL SUMMARY.  The information presented below relates to
properties in the United States in which the Company has "working interests"
which bear the cost of operations.  The Company's total gross and net interests
in productive wells and in developed acres at December 31, 1998, are summarized
as follows:
 
                                  GROSS              NET   
                              ------------      ------------
                               OIL    GAS         OIL   GAS
                              -----  -----      ------ -----
     Productive Wells/(1)/        -     1           -   .08 
 
     Developed Acres/(2)/           349                28

_______________
  /(1)/  "Productive Wells" are producing wells and wells capable of
          production, and include gas wells awaiting pipeline connections or
          necessary governmental certifications to commence deliveries and oil
          wells to be connected to production facilities.  No oil and gas
          reserves have been assigned by the Company at December 31, 1998 to the
          well in which it has a working interest.

   /(2)/  "Developed Acres" include all acreage (on a leasehold basis in the
          United States) as to which proved reserves are attributed, whether or
          not currently producing, but exclude all producing acreage as to which
          the Company's interest is limited to royalty, overriding royalty, and
          other similar interests.


 DRILLING AND PRESENT ACTIVITIES. The following table summarizes the oil and gas
drilling activities of the Company in the United States for each of the three
years ended December 31, 1998, 1997, and 1996, respectively:

                                       14
<PAGE>
 
<TABLE>
<CAPTION>
                                                      Year Ended December 31, 1998
                                              --------------------------------------------
                                                   1998             1997         1996
                                              --------------   -----------   -------------
                                              Gross     Net    Gross   Net   Gross    Net
                                              -----     ----   -----   ---   -----   -----
<S>                                           <C>       <C>    <C>     <C>   <C>     <C>
Development Wells Drilled (1) (2):        
  Productive                                      -        -       -     -       -       -
  Dry                                             -        -       -     -       -       -
                                                      
Exploratory Wells Drilled (1) (2):                    
  Productive                                      -        -       -     -       -       -
  Dry                                             -        -       -     -     1.0   0.375
                                               ----     ----   -----   ---   -----   -----                                          
  Total                                           -        -       -     -     1.0   0.375
                                               ====     ====   =====   ===   =====   ===== 
</TABLE>

--------------
     (1)  "Wells Drilled" refers to the number of wells completed at any time
          during the fiscal year, regardless of when drilling was initiated.
          The term "completed" refers to the installation of permanent equipment
          for the production of oil or gas, or, in the case of a dry hole, to
          the reporting of abandonment to the appropriate agency.

     (2)  A dry hole is an exploratory or a development well found to be
          incapable of producing either oil or gas in sufficient quantities to
          justify completion as an oil or gas well.  A productive well is an
          exploratory or a development well that is not a dry hole.

     At December 31, 1998, the Company was not participating in any drilling
wells. However, the Company participated in one well that commenced drilling
subsequent to December 31, 1998. After reaching total depth, the Company
declined to participate in a completion attempt. The Company will classify this
well as an exploratory dry hole in 1999.



ITEM 3.   LEGAL PROCEEDINGS

     Cheniere Litigation - On April 17, 1998, Zydeco Exploration, Inc. filed a
petition with the American Arbitration Association for arbitration in order to
resolve certain disputes that arose with Cheniere.  The arbitration claim sought
to resolve differences over Cheniere's funding obligations, the parties'
ownership in various leases and prospects, the scope of pre-drilling activities
that Cheniere can conduct within the West Cameron Seismic Project (the
"Project") area, the dissemination by Cheniere of confidential seismic data
covering the Project area, and a variety of related issues.  Cheniere filed a
counterclaim in the arbitration action, and the pleadings were amended to
include the Company as well as Zydeco Exploration, Inc (together "Zydeco").  The
parties sought conflicting declaratory and injunctive relief and damages from
each other.  In addition, on April 22, 1998, Zydeco initiated a civil suit in
state district court in Harris County, Texas against two individuals who are
parties to confidentiality agreements with Zydeco and who are employees of
Cheniere.  Through this litigation, Zydeco sought and obtained a Temporary
Restraining Order on April 22, 1998, restraining the individuals from breaching
the terms of their confidentiality agreements with Zydeco.  Cheniere intervened
in the litigation on April 27, 1998.  On May 4, 1998, Zydeco, Cheniere and the
two individuals agreed to the entry of an Agreed Temporary Injunction.  The
agreed Temporary Injunction expired on June 15, 1998, and the dispute, which led
to the filing of the civil suit, was included in the arbitration action by
agreement of the parties.

     On December 9, 1998 the three-member arbitration panel seated to rule in
this matter issued its decision in the arbitration proceedings brought by Zydeco
against Cheniere.  In its ruling, the panel confirmed Zydeco's position as
program manager but recognized Cheniere's independent right to identify
prospects and acquire leases in the West Cameron Seismic Project area.  The
arbitration panel directed that Cheniere has the right to participate with a 50%
working interest in most of the leases acquired by Zydeco 

                                       15
<PAGE>
 
or in prospects designated by Zydeco. Cheniere, however, must exercise its right
of participation and pay its share of such costs within a thirty-day period
following Zydeco's formal notice of prospect designation. For each prospect,
Zydeco has the sole right to undertake the management and control of all
prospect development for a reasonable period not to exceed 90 days following
such formal notice. The arbitration panel also ruled that project seismic costs
generally incurred after December 31, 1997 are not reimbursable to Zydeco as
seismic costs. The Company believed that such costs, either in part or in whole,
should be recouped from Cheniere as prospect costs. In addition, if certain
criteria are met, then sale proceeds from certain marketing activities would be
paid to Cheniere until Cheniere recoups $13.5 million of its investment in the
project. Zydeco and Cheniere would share any such sales above that amount
equally. Neither party received any damage awards or recovery of legal costs.

     As a result of the arbitration panel's decision, Zydeco and Cheniere
informally agreed to share responsibilities and ownership for certain activities
incurred in the maintenance, marketing and sale of prospects generated and
assembled by the parties. Except for the costs of one prospect and certain other
activities, neither party would seek reimbursement from the other for seismic
and prospect costs generally incurred prior to the arbitration ruling.

     Other - The Company is a party to various other legal proceedings
consisting of routine litigation incidental to its business, but believes that
any potential liabilities resulting from these proceedings are immaterial.

ITEM 4.   SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

     No matters were submitted to a vote of the stockholders of the Company
during the fourth quarter of 1998.

                                       16
<PAGE>

                                   PART II
 
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
        MATTERS

  The Common Stock and the Warrants have traded on The Nasdaq National Market
since August 19, 1997, and on the Nasdaq SmallCap Market since December 23, 1995
under the symbols "ZNRG" and "ZNRGW"; prior to that date they were quoted on the
OTC Bulletin Board under the symbols "TNER" and "TNERW", respectively. Prior to
December 23, 1995, the Units were quoted on the OTC Bulletin Board under the
symbol "TNERU"; the Units are no longer quoted on the OTC Bulletin Board. There
is very limited trading of the Units and pricing information is not readily
available. The high and low sales prices of the Common Stock, the Warrants, and
the Units during each quarter are presented in the table below. The quotes
represent "inter-dealer" prices without retail markups, markdown, or commissions
and may not necessarily represent actual transactions.

<TABLE>
<CAPTION>
                                    Common Stock           Warrants             Units(1)
                                 -----------------    ----------------    ----------------
                                  High        Low      High       Low      High       Low 
                                 ------      ----     ------     -----    ------     -----
<S>                              <C>        <C>        <C>       <C>       <C>       <C>  
                                                                                          
Three Months Ended                                                                        
   March 31, 1997                $7.875     $6.125    $3.000    $1.625      N/A       N/A 
   June 30, 1997                  6.750      4.500     2.250     1.000      N/A       N/A
   September 30, 1997             5.750      4.125     2.125     0.875      N/A       N/A
   December 31, 1997              4.516      2.000     1.625     0.625      N/A       N/A
                                                                                          
Three Months Ended                                                                        
   March 31, 1998                 3.250      1.938     1.188     0.688      N/A       N/A
   June 30, 1998                  2.875      1.500     1.000     0.250      N/A       N/A
   September 30, 1998             2.750      0.750     0.969     0.125      N/A       N/A
   December 31, 1998              1.297      0.500     0.391     0.047      N/A       N/A 
 
</TABLE>


------------------
(1)  The Units have not been quoted after December 23, 1995.

   The Company is currently not in compliance with the continued listing
requirements of the Nasdaq National Market. The Company has received separate
notifications from The Nasdaq Stock Market, Inc. that its Common Stock has
failed to maintain a minimum closing bid price as well as a market value of
public float of $5,000,000 during recent reviews of trade dates. If the
Company's Common Stock does not comply with the closing bid requirement for a
minimum of ten consecutive trading days, before June 9, 1999, then the Company's
Common Stock and Warrants will be delisted at the opening of business on
June 11, 1999. Likewise, if the Company's Common Stock does not comply with the
minimum market value of public float requirement for a minimum of ten
consecutive trading days, before June 23, 1999, then the Company's Common Stock
and Warrants will be delisted at the opening of business on June 25, 1999. The
Company has the right to request a hearing on these matters to stay the
delisting of the Company's securities. Should the Company's stock be delisted
from The Nasdaq National Market, the Company intends to pursue an application
for a listing on either The Nasdaq SmallCap Market or the OTC Bulletin Board.

   As of March 22, 1999, there were 10,357,096 shares of the Company's Common
Stock outstanding held by approximately 75 holders of record.  The Company
believes there are approximately 1,800 beneficial owners of the Common Stock.

                                       17
<PAGE>
 
DIVIDEND POLICY

   The Company has never paid a cash dividend on its Preferred Stock (prior to
its conversion) or its Common Stock. The Company currently intends to retain its
existing working capital and potential future earnings to finance the growth and
development of its business and does not anticipate paying any cash dividends on
the Common Stock in the foreseeable future. Any future change in the Company's
dividend policy will be made at the discretion of the Company's Board of
Directors in light of the financial condition, capital requirements, earnings,
and prospects of the Company and any restrictions under any credit agreements,
as well as other factors the Board of Directors may deem relevant.


SALES OF UNREGISTERED SECURITIES

   On December 2, 1997, the Company issued 150,000 shares of Common Stock to the
former shareholders of Wavefield Image, Inc.  The merger agreement pursuant to
which the Company acquired Wavefield in July 1997 obligated the Company to issue
such shares upon the issuance of a U.S. patent claiming certain aspects of the
Wavefield Imaging Technology.  Such a patent was issued on December 2, 1997.
The shares were issued to 4 individuals, all former shareholders of Wavefield,
in reliance on Section 4(2) of the Securities Act of 1933, as amended.


ITEM 6.  SELECTED FINANCIAL DATA

   The selected financial data set forth below are derived from the Consolidated
Financial Statements of the Company that have been audited by Arthur Andersen
LLP, independent public accountants, whose current report contained an
additional paragraph modifying its opinion to raise substantial doubt about the
ability of the Company to continue as a going concern for the periods indicated.
The financial data should be read in conjunction with "Management's Discussion
and Analysis of Financial Condition and Results of Operations" and the Company's
Consolidated Financial Statements and Notes thereto included elsewhere in this
report.

                                       18
<PAGE>
 
<TABLE>
<CAPTION>
                                                                                                                   PERIOD FROM
                                                                                                                    INCEPTION
                                                            YEAR ENDED DECEMBER 31,                              (MARCH 17, 1994)
                                      --------------------------------------------------------------------            THROUGH
                                        1998                 1997               1996                1995        DECEMBER 31, 1994
                                      --------             -------           ---------            --------     -------------------
<S>                                 <C>                 <C>                 <C>                 <C>                 <C>
SUMMARY OPERATIONS DATA: 
 Operating Revenues                 $    783,501         $   958,304         $ 1,470,046         $   586,752        $        -
 Operating Costs and Expenses        (10,692,469)         (7,433,982)         (3,577,385)         (1,736,584)         (110,242)
                                    ------------         -----------         -----------         -----------        ----------
 Operating Loss                       (9,908,968)         (6,475,678)         (2,107,339)         (1,149,832)         (110,242)
 Other Income (Expense), Net             297,230             323,551             249,207             (23,814)          (22,639)
                                    ------------         -----------         -----------         -----------        ----------
 Net Loss                           $ (9,611,738)        $(6,152,127)        $(1,858,132)        $(1,173,646)       $ (132,881)
                                    ============         ===========         ===========         ===========        ==========
 Weighted Average Shares                                                                                        
  of Common Stock Outstanding 
  (Basic and Diluted)                 10,365,106           7,951,438           6,168,798           3,906,706         4,468,777
                                    ============         ===========         ===========         ===========        ==========
 Loss Per Share of Common                                                                                       
  Stock Outstanding                                                                                             
  (Basic and Diluted)               $      (0.93)        $     (0.77)        $     (0.30)        $     (0.30)       $    (0.03)
                                    ============         ===========         ===========         ===========        ==========
                                                                                                                
                                                                    DECEMBER 31,
                                       ---------------------------------------------------------------------
                                         1998                1997                1996                1995                        
                                       -------             --------            --------            ---------
 
SUMMARY BALANCE SHEET DATA:
 Cash and Cash Equivalents          $  1,912,970         $12,200,306         $ 6,906,650         $   517,781    
 Marketable Securities                         -                   -             845,852          10,938,674    
 Properties, Equipment, and                                                                                     
  Software - Net                       3,295,315             949,690           1,371,235             699,279    
 Total Assets                          6,689,658          15,676,450           9,911,602          12,582,405    
 Total Stockholders' Equity            5,178,230          15,186,968           6,339,407           8,188,618    
</TABLE>

                                       19
<PAGE>
 
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND 
        RESULTS OF OPERATIONS

OVERVIEW

     Formed in December 1995, the Company is an independent oil and gas
exploration company engaged in acquiring leases, drilling and producing reserves
utilizing focused geologic concepts and advanced 3D seismic and computer-aided
exploration ("CAEX") technology, including enhanced structural and stratigraphic
depth imaging and attribute analysis.  The Company has developed comprehensive
in-house technology, software and expertise enabling it to use recent advances
in such 3D seismic and CAEX technology.  Currently, the Company's efforts are
focused primarily in the Louisiana Transition Zone, a narrow trend paralleling
the coastline of Louisiana.  This trend is approximately six miles wide (three
miles on either side of the beach) and extends about 300 miles from the Sabine
River eastward to the Mississippi River.

     During 1996, the Company negotiated seismic options covering approximately
36,718 gross acres (33,225 net acres) and secured other seismic permits covering
approximately 119,557 gross acres (119,075 net acres) in the Louisiana
Transition Zone. At the core of this project, named the West Cameron Seismic
Project (the "Project") was a 51,000-acre exclusive seismic permit obtained from
the State of Louisiana. Pursuant to the terms of the State of Louisiana permit,
the state is required to keep the information obtained from the survey
confidential for a period of ten years. The Company began onshore leasing and
permitting in February 1996. Seismic data acquisition for this Project commenced
over approximately 230 square miles during the second half of 1996 and was
completed in July 1997. The Company timely delivered seismic data to the State
of Louisiana in January 1998 in compliance with the terms of the exclusive
seismic permit. The seismic processing phase of this Project immediately
commenced during mid 1997 and was completed in October 1998. The interpretive
phase also commenced during mid 1997 and continued throughout 1998. For the
Project's initial leasing phase, the major portion of 1998 lease acquisitions
occurred during the first half of the year and aggregated more than 12,000 gross
acres through State of Louisiana lease sales, private land negotiations and a
federal lease sale. For the near term, the Company intends to continue marketing
its prospects with a view toward selling an interest in such prospects or an
interest in the Project to industry participants. Depending on the Company's
available cash and acquisition of additional sources of capital, it believes
that the interpretive phase of this Project will continue well into 1999 and
that it will continue to evaluate its lease acquisition activity throughout
1999.

     In April 1996, the Company executed an Exploration Agreement (the "Cheniere
Agreement") with Cheniere Energy Operating Co., Inc., a wholly owned subsidiary
of Cheniere Energy, Inc. and formerly known as FX Energy, Inc., (collectively
"Cheniere") covering the area of Project land and waters in western Cameron
Parish, Louisiana.  In exchange for earning a 50% interest, Cheniere agreed to
fund certain Project costs including, but not limited to, 3D seismic acquisition
costs, including the purchase of seismic rights or lease options on the related
onshore acreage of the Project, the purchase of other 3D seismic data, and
processing of seismic data over the Project area.

     On April 17, 1998, Zydeco Exploration, Inc. filed a petition with the
American Arbitration Association for arbitration in order to resolve certain
disputes that arose with Cheniere.  The arbitration claim sought to resolve
differences over Cheniere's funding obligations, the parties' ownership in
various leases and prospects, the scope of pre-drilling activities that Cheniere
can conduct within the Project area, the dissemination by Cheniere of
confidential seismic data covering the Project area, and a variety of related
issues.  Cheniere filed a counterclaim in the arbitration action, and the
pleadings were amended to include the Company as well as Zydeco Exploration,
Inc. (together "Zydeco"). The parties sought conflicting declaratory and
injunctive relief and damages from each other. In addition, on April 22, 1998,
Zydeco initiated a civil suit in state district court in Harris County, Texas
against two individuals who are parties to confidentiality agreements with
Zydeco and who are employees of Cheniere. Through this litigation, Zydeco sought
and obtained a Temporary Restraining Order on April 22, 1998, restraining the
individuals from breaching the terms of their confidentiality agreements with
Zydeco. Cheniere intervened in the litigation on April 27, 1998. On May 4, 1998,
Zydeco, Cheniere and the two individuals agreed to the entry

                                       20
<PAGE>
 
of an Agreed Temporary Injunction. The agreed Temporary Injunction expired on
June 15, 1998, and the dispute, which led to the filing of the civil suit, was
included in the arbitration action by agreement of the parties.

     On December 9, 1998 the three-member arbitration panel issued its decision
in the arbitration proceedings brought by Zydeco against Cheniere.  In its
ruling, the panel confirmed Zydeco's position as program manager but recognized
Cheniere's independent right to identify prospects and acquire leases in the
Project area.  The arbitration panel directed that Cheniere have the right to
participate with a 50% working interest in most of the leases acquired by Zydeco
or in prospects designated by Zydeco.  Cheniere, however, must exercise its
right of participation and pay its share of such costs within a thirty-day
period following Zydeco's formal notice of prospect designation.  For each
prospect, Zydeco has the sole right to undertake the management and control of
all prospect development for a reasonable period not to exceed 90 days following
such formal notice.  The arbitration panel also ruled that project seismic costs
generally incurred after December 31, 1997, are not reimbursable to Zydeco as
seismic costs.  The Company believed that such costs, either in part or in
whole, should be recouped from Cheniere as prospect costs.  In addition, if
certain criteria are met, then sale proceeds from certain marketing activities
would be paid to Cheniere until Cheniere recoups $13.5 million of its investment
in the project.  Zydeco and Cheniere would share any such sales above that
amount equally.  Neither party received any damage awards or recovery of legal
costs.

     As a result of the arbitration panel's decision, Zydeco and Cheniere
informally agreed to share responsibilities and ownership for certain activities
incurred in the maintenance, marketing and sale of prospects generated and
assembled by the parties. Except for the costs of one prospect and certain other
activities, neither party would seek reimbursement from the other for seismic
and prospect costs generally incurred prior to the arbitration ruling. After
considering the arbitration panel's ruling and the two parties' informal
agreement, Cheniere's and Zydeco's share of third party and processing costs
incurred pursuant to the terms of the Cheniere Agreement was approximately
$16,423,398 and $5,216,773, respectively, from inception to December 31, 1998.
The Company charged project seismic costs amounting to $1,146,688 that
previously had been attributable to Cheniere to exploration expense. In
addition, the Company acquired approximately $5,753,010 of unproved leases
during 1998.

     In order to conserve its cash resources, the Company through terminations
and resignations reduced the number of its employees by a combined total of
approximately 17 in December 1998 and March 1999.  In addition, the Chairman of
the Board, whose annual salary is $150,000, has declined taking a salary
effective March 15, 1999.  The Vice Chairman's annual salary of $150,000 has
been deferred indefinitely, effective January 1, 1999.

     The Company accounts for its oil and gas exploration and production
activities using the successful efforts method of accounting.  Under this
method, acquisition costs for proved and unproved properties are capitalized
when incurred.  Exploration costs, including geological and geophysical costs
and the costs of carrying and retaining unproved properties, are expensed.
Exploratory drilling costs are initially capitalized, but charged to expense if
and when the well is determined not to have found proved reserves.  Costs of
productive wells, developmental dry holes, and productive leases are capitalized
and amortized on a property-by-property basis using the units-of-production
method.  The estimated costs of future plugging, abandonment, restoration, and
dismantlement are considered as a component of the calculation of depreciation,
depletion, and amortization.  Unproved properties with significant acquisition
costs are assessed periodically on a property-by-property basis and any
impairment in value is charged to expense.

     On July 1, 1997, the Company acquired Wavefield Image, Inc., the owner and
licensor of the rights to the Wavefield Imaging Technology.  A patent in respect
of the Wavefield Imaging Technology was issued by the United States Patent and
Trademark Office on December 2, 1997, see "Business--Seismic Technology".

     On August 26, 1997, the Company completed an offering of 3,680,000 shares
of Common Stock and warrants to purchase 320,000 shares of Common Stock (the
"Offering").  Proceeds from the Offering were approximately $14.1 million, net
of Offering expenses of approximately $1.6 million.

                                       21
<PAGE>
 
RESULTS OF OPERATIONS

YEAR ENDED DECEMBER 31, 1998 COMPARED TO YEAR ENDED DECEMBER 31, 1997

     Compared to a loss of $6,152,127, or $.77 per share, in the year ended
December 31, 1997, the Company posted a loss of $9,611,738, or $.93 per share,
for the year ended December 31, 1998.  The $3,459,611 increase in the net loss
is mostly attributable to a combination of a charge for the impairment of
unproved leases, an increase in legal fees and a decline in geological and
geophysical expenses.

     The Company recorded an impairment of $3,000,000 in the 1998 fourth quarter
in order to recognize a decline in the value of unproved leases that it had
acquired mostly during the first half of 1998.  There was no comparable
impairment in 1997.  Because it will continue to evaluate its lease holdings and
its ability to make delay rental payments during 1999, the Company may be
required to recognize additional impairments and/or writeoffs as a result of its
future reviews.

     Geological and geophysical expenses declined $1,396,876 from $4,958,060 in
1997 to $3,561,184 in 1998 due mostly to lower Project seismic costs.  This
decline was primarily due to the completion of the substantially more expensive
data acquisition phase during the 1997 third quarter.  The Company did not incur
any material expenses for data acquisition during 1998.  The significantly less
expensive seismic processing and interpretive phases commenced during mid 1997
with the processing phase completed during the 1998 fourth quarter and the
interpretive phase continuing into 1999.  Partly offsetting the decline in
levels of Project seismic expenses, the Company's share of such expenses
increased from 50% to 100% pursuant to the arbitration panel's ruling for
Project seismic costs generally incurred after December 31, 1997.  The Company
expects that the overall level of exploration expenses will decline
significantly during the near term due to a combination of a lower level of
Project costs and the Company's restructured activities.  However, because the
Company utilizes the successful efforts method of accounting, exploration
expenses typically vary materially from period to period based upon exploration
program activities, the Company's cost participation and other factors.  During
the first quarter of 1999, the Company declined to participate in a completion
attempt of an exploratory well drilled during such period.  As a result, the
Company will record a dry hole expense of approximately $500,000 during such
period.

     General and administrative expenses rose $1,426,709 from $1,560,861 in 1997
to $2,987,570 in 1998 principally due to increased legal expenses. The Company
had no comparable legal expenses in 1997 and does not expect any additional like
expenses in the near term.  Most of the balance of the general and
administrative expense increase is attributable to increases in personnel that
were made during the second half of 1997.  Research and development expenses
also increased by $281,230 due to the commencement of research and development
activity during mid 1997.  However, due to employee terminations, resignations
and other restructuring costs, the Company expects declines in both general and
administrative expenses and research and development expenses during 1999.

     Oil and gas revenues decreased from $1,066,689 in 1997 to $389,798 in 1998
due mostly to a 51% decline in gas sales volumes and an 87% decline in oil sales
volumes.  Gas sales volumes fell from 336,730 thousand cubic feet ("Mcf") in
1997 to 165,762 Mcf in 1998.  In addition, oil sales volumes fell from 9,377
barrels of oil ("Bbls") to 1,187 Bbls in the respective periods. The decline in
such sales volumes is mostly due to natural production declines in the two
producing wells in which the Company has an interest.   Although it expects that
the production rates of these wells will continue to decline during the near
term, the Company cannot ascertain whether the rates experienced in 1998 will
continue throughout 1999.  The Company has not assigned any oil and gas reserves
at December 31, 1998 to one of these wells.

     During 1998, the Company recorded gains on the sales of properties
amounting to $346,321 versus net losses of $108,385 in 1997.  Because the
Company expects to continue to market and sell some portion or all of its
interest in prospects to other industry participants, the Company will continue
to record gains or losses for these transactions.  However, the timing of such
sales and the extent of their gain or loss are due to a number of factors such
as, but not limited to, the timing and cost of lease acquisitions, the
availability of 

                                       22
<PAGE>
 
leaseholds in particular prospect areas and market conditions, both generally
and in the oil and gas industry, at the time of sale.

     The increase in the net loss per share from $.77 in 1997 to $.93 in 1998
was also affected by an increase in the weighted average number of the Company's
Common Shares (basic and diluted) due to the issuance of 3,680,000 shares in the
Offering in August 1997.


YEAR ENDED DECEMBER 31, 1997 COMPARED TO YEAR ENDED DECEMBER 31, 1996

     The Company recorded a loss of $6,152,127, or $.77 per share, in the year
ended December 31, 1997 compared to a loss of $1,858,132 or $.30 per share, in
the year ended December 31, 1996.  The increase in the loss is primarily due to
a $3,402,930 increase in exploration expenses in 1997 over 1996.  However, also
contributing to the increase in the loss from 1996 to 1997 were a drop of
$355,538 in oil and gas revenues and increases of $304,372 in general and
administrative expenses and $128,010 in research and development expense.

     The increase in exploration expenses was primarily due to the Company's
participation under the Cheniere Exploration Agreement governing activities on
the Project.  The Company's 50% share of costs directly attributable to this
project amounted to $3,124,408 in 1997.  The Company had no comparable
exploration expense in 1996 because, pursuant to the terms of such agreement,
Cheniere paid nearly all of this project's 1996 costs.  The remainder of the
exploration expenses increase is principally due to other geological and
geophysical expenses which are mostly composed of salaries and related payroll
burdens of the Company's exploration department staff.  Other geological and
geophysical expenses increased approximately $278,522 in 1997 over 1996
primarily due to an increase of the exploration staff from four individuals in
late 1996 to ten individuals by mid 1997.  General and administrative expenses
also increased because of additional personnel costs and increased rent due to a
move to a larger office space in mid 1996.  In addition, the Company commenced a
research and development program in mid 1997.  The Company had no comparable
research and development expense in 1996.

     Total revenues decreased $511,742 in 1997 from 1996 due to a combination of
decreased oil and gas sales and a loss on the sale of the Company's interest in
the Bay Marchand prospect area.  However, the Company recorded a gain of
$137,000 in 1998 and a gain of $100,000 in 1999 pursuant to the contingent
provisions of such prospect's sales agreement.  Oil and gas sales dropped from
$1,422,227 in 1996 to $1,066,689 in 1997 primarily due to sales volumes of oil
and gas declining 54% and 10%, respectively.  The decline in such sales volumes
is attributable to natural production declines of the two wells in which the
Company has interests.  The Company has not assigned any oil and gas reserves at
December 31, 1997 to one of these wells.  Compared to a $16,319 gain on sales of
properties in 1996, the Company recorded a $108,385 loss on sales of properties
in 1997.

     The increase in the net loss per share from $.30 in 1996 to $.77 in 1997
was also affected by an increase in the weighted average number of the Company's
Common Shares (basic and diluted) due to the issuance of 3,680,000 shares in the
Offering in August 1997.


LIQUIDITY AND CAPITAL RESOURCES

     The Company has incurred net losses and negative cash flows from operations
since its inception in 1994.  In 1998, 1997 and 1996, the Company incurred net
losses of $9,611,738, $6,152,127 and $1,858,132, respectively. The Company is
principally engaged in one industry and geographic segment, oil and gas
exploration and production, and has concentrated its exploration efforts since
early 1996 in an area of the Louisiana Transition Zone, known as the West
Cameron Seismic Project (the "Project").  Since inception of the Project, the
Company and Cheniere have expended approximately $21,640,171 pursuant to the
terms of the Project's agreement.  In addition, during 1998 the Company expended
approximately $5,753,010 on unproved property costs, almost all of which were on
prospects within the Project.  The source of funding for these activities has
come from funds generated from public and private equity offerings, cash flow
from 

                                       23
<PAGE>
 
the Company's operations, and cash payments made to it under the Cheniere
Exploration Agreement. Sources of funds include approximately $24.1 million from
the sale of securities in 1993, 1994, 1995 and 1997, and $16.4 million provided
under the Cheniere Exploration Agreement. The Company does not currently hold
any funds advanced under that agreement.

     During early 1998, the Company anticipated that near term cash needs would
be satisfied from a combination of available cash, sales of interests in Project
prospects, sale(s) of interests in the Project itself and payments by Cheniere
mandated by the arbitration panel convened to rule in the Cheniere litigation
matters.  The Company expected that cash inflows principally from prospect sales
as well as available cash would be sufficient to bridge most of its interim cash
needs.  In the short term and thereafter, other sources of cash may have been
sought through the issuance of additional equity securities, including the
exercise of outstanding warrants and options on the Company's common stock.
Also, in the event of successful oil and gas well completions, the Company
anticipated that revenues from oil and gas sales as well as potential credit
facilities could provide additional sources of cash.

     However, due mostly to potential buyers' concerns over uncertainties of
ownership interests before the arbitration ruling and market conditions
thereafter, the Company has not generated significant sales of Project prospects
and, therefore, has not produced sufficient levels of cash inflows during the
near term.  Since the last half of 1998 and into the first half of 1999, market
conditions for selling interests in prospects have significantly deteriorated.
Furthermore, the arbitration ruling did not mandate any immediate cash payments
from Cheniere to the Company.

     During mid 1998 subsequent to the acquisition of most of its current
inventory of Project leases, the Company commenced marketing activities with a
view to selling interests in Project prospects that were ready for sale.  The
Company understands that during this period suitable buyers were available and
that such buyers were conducting exploration activities including the
acquisition of prospects and the drilling of wells on such prospects.  It
believes that its marketing efforts were unsuccessful mostly because of
uncertainties over the Cheniere litigation, primarily those matters relating to
the Company's and Cheniere's Project lease ownership interests.  Subsequent to
the arbitration ruling in December 1998, the Company and Cheniere tentatively
agreed to the resolution of certain matters in order that they could recommence
their prospect marketing activities.  However, market conditions have
considerably deteriorated to the point that significantly fewer industry
participants are actively acquiring oil and gas prospect interests.

     Although the Company believes that it will ultimately sell interests in its
prospects, there can be no assurance that it will sell such interests in the
near term and at sales prices that will be sufficient to permit it to expand its
operations to levels comparable to the period before its restructuring.  The
Company cannot ascertain the duration of the current depressed market nor if it
will be able to obtain alternate capital sources if an extended downturn exists
into the year 2000.  In addition, because each non-producing oil and gas lease
acquired by the Company requires annual delay rental payments, if the Company
does not successfully market Project prospects in the near term it may forfeit
its interest in some number of leases due to insufficient cash resources to meet
such commitments at the time such delay rentals are due.  Because of these
factors and its belief that such sale prices may not be sufficient to exceed the
carrying value of the applicable prospects, the Company has recognized an
unproved property impairment of $3,000,000 in the accompanying financial
statements for 1998.

     Due to the adverse factors presented above, the Company has had to rely
principally on available cash to continue its operations.  However, in order to
conserve its remaining cash resources, the Company has instituted certain cost
reducing actions, including, but not limited to, employee terminations and
negotiations of deferred or foregone compensation with key executives.  By
restructuring its operations for the near term the Company has narrowed its
business strategy to focus its activities almost entirely on the marketing of
prospects in order to achieve sufficient liquidity to maintain levels of
operations.

     The Company does not expect to generate operating cash flow or net income
in 1999 unless it sells substantial interests in Project prospects or interests
in the Project itself. The Company contemplates that the sale of such interests
would include prospect development commitments and financing provided by the
purchasers coupled with retained interests and back-in rights to the Company,
and additional cash 

                                       24
<PAGE>
 
consideration to the Company for recoupment of costs incurred in identifying
such prospective interests. As generally required by the successful efforts
method of accounting, the Company has expensed all of its costs in the Project
as of December 31, 1998, and accordingly, any payments for the recoupment of 
non-capitalized costs would be treated as income to the Company. There can be no
assurance that the Company will be successful in the selling of significant
interests or in receiving payments for the recoupment of the Company's costs
incurred to date on this Project. In addition, there can be no assurance that
the Company will have sufficient cash available or be able to acquire new cash
resources if the Company is not successful in selling its desired level of
interests in a Project prospect or on terms that require little or no cash
resources for prospect commitments. The Company does not presently maintain any
credit facilities.

  The Company currently maintains a $300,000 bond required to hold its present
federal oil and gas leases.  This bond is collateralized by a United States
Treasury Note.  In the event that the Company would act as operator on a federal
offshore lease or is otherwise required to increase its bonding by federal or
state authorities, significant amounts of capital may be required for additional
collateral to satisfy bonding requirements.

  The Company is unaware of any possible exposure from actual or potential
claims or lawsuits involving environmental matters.  As such, no liability is
accrued at December 31, 1998.


YEAR 2000 COMPLIANCE

     The Year 2000 Issue is the result of computer programs being written using
two digits rather than four to define a specific year.  Absent corrective
actions, a computer program that has date-sensitive software may recognize a
date using "00" as the year 1900 rather than the year 2000. This could result in
system failures, miscalculations or the corruption of databases, any of which
could cause disruptions to various activities and operations.  The Company has
initiated assessments to identify the work efforts required to assure that
systems supporting the business successfully operate beyond the turn of the
century. The Company's program is designed to minimize the possibility of
serious Year 2000 interruptions, which worst case scenarios include the
interruption of a significant part of the Company's business as a result of
critical information systems failures.

     There are two major components to the Company's computer based systems.
One system is an office wide local area network ("LAN") comprised of several
personal computer ("PC") based servers and numerous PC workstations.  This
system contains numerous applications including, but not limited to, geological
and geophysical interpretive programs, general office applications and
accounting software.  The other "system" is comprised of several networked
workstations (called "UNIX systems") currently utilized by the Company in its
geological and geophysical interpretive process.  The Company employs geological
and geophysical programs from both systems in such process.  The Company does
not rely significantly on outside parties for goods and services and thus does
not expect any material impact from failures of outside parties due to Year 2000
issues.

     The Company has reviewed both systems and believes that its LAN system is
materially compliant on Year 2000 issues.  It does not expect to incur any
material costs on its LAN system directly on Year 2000 issues and does not
expect that any failures that could occur from such issues will materially
affect its business.  With regards to its UNIX systems, the Company has
identified two areas that will require modifications for Year 2000 compliance if
the Company continues its UNIX systems use.  The Company does not consider the
costs of modifications to one of these two areas to be material, but estimates
that the cost to bring the other area into Year 2000 compliance will be a
minimum of $75,000 and a maximum of $150,000.  During 1999, the Company will
review whether to maintain its UNIX systems capability and incur the costs of
modification.  The Company has not accrued any costs as of December 31, 1998 to
bring any of its systems into compliance.  If the Company chooses to maintain
its UNIX systems capability, then it will  recognize the cost of modifications
at that time.

                                       25
<PAGE>
 
ITEM 7A.  QUANTITATIVE & QUALITATIVE DISCLOSURES ABOUT MARKET RISK

     The Company is exposed to market risk, including adverse changes in
commodity prices.

     The Company operates principally in one industry and geographic segment - 
oil and gas exploration and production with a focus on marketing its Project
prospects.   The Company's primary market risk exposure is in the industry
impact of the fluctuation of pricing of crude oil and natural gas, which is
driven by the prevailing worldwide spot prices. Historically, prices received
for oil and gas production have been volatile and unpredictable.  Pricing
volatility is expected to continue and could adversely impact the Company's
ability to market its Project prospects. See Item 1 - "Risk Factors."

ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

     The financial statements required by this Item are incorporated under Item
14 in Part IV of this report.


ITEM 9.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND 
         FINANCIAL DISCLOSURE

     None.


                                    PART III
                                        
ITEM 10.    DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT*

ITEM 11.    EXECUTIVE COMPENSATION*

ITEM 12.    SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT*

ITEM 13.    CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS*

--------------
*    Items 10, 11, 12, and 13 are incorporated by reference to the registrant's
     Definitive Proxy Statement to be filed with the Commission pursuant to
     Regulation 14A under the Securities Exchange Act of 1934 within 120 days
     after the close of the registrant's fiscal year.



                                    PART IV
                                        

ITEM 14.  EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K

(a)(1)  FINANCIAL STATEMENTS

        See "Index to Consolidated Financial Statements" set forth on page F-1.

(a)(2)  FINANCIAL STATEMENT SCHEDULES

        Not applicable.

                                       26
<PAGE>
 
(a)(3)  EXHIBITS

        See pages E-1 through E-3 for a listing of exhibits.

        The exhibits to this report have been included only with the copies of
        this report filed with the Securities and Exchange Commission. Copies of
        individual exhibits will be furnished to stockholders upon written
        request to Chief Accounting Officer, Zydeco Energy, Inc., 1710 Two Allen
        Center, 1200 Smith Street, Houston, Texas 77002 with payment of a
        reasonable fee.


(b)     REPORTS ON FORM 8-K

        The Company filed a Current Report on Form 8-K dated December 16, 1998,
        that announced the ruling by a three member arbitration panel in the
        arbitration proceedings brought by the Company against Cheniere Energy,
        Inc. and the terminations and resignations of 13 Company employees or
        approximately 52% of its total workforce.

                                       27
<PAGE>
 
                                  SIGNATURES

     Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized, in the City of
Houston, State of Texas.

                                        ZYDECO ENERGY, INC.
                                        (Registrant)
 
 
 
Date:  March 30, 1999                   By: /s/ SAM B. MYERS JR.
                                            ---------------------------------
                                                Sam B. Myers, Jr.
                                            Chairman of the Board, President
                                                  CEO and COO


     Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.

<TABLE> 
<CAPTION> 

Signature                                                      Title                                Date
---------                                                      -----                                ----
<S>                                        <C>                                                  <C>        

/s/ SAM B. MYERS, JR.                      Chairman of the Board, Director, President,          March 30, 1999
----------------------------------         CEO And COO (Principal Executive Officer and 
Sam B. Myers, Jr.                          Principal Financial and Accounting Officer)
 
</TABLE> 

                                      28

<PAGE>
 
                   INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
 
                                                                             Page
                                                                             ----
<S>                                                                           <C>
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS...................................   F-2
CONSOLIDATED FINANCIAL STATEMENTS
     Consolidated Balance Sheets as of December 31, 1998 and 1997..........   F-3
     Consolidated Statements of Operations for the Three Years
          Ended December 31, 1998..........................................   F-4
     Consolidated Statements of Stockholders' Equity for the Three Years
          Ended December 31, 1998..........................................   F-5
     Consolidated Statements of Cash Flows for the Three Years
          Ended December 31, 1998..........................................   F-6
     Notes to Consolidated Financial Statements............................   F-7
 
</TABLE>

                                      F-1
<PAGE>
 
                    REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
                                        

TO THE STOCKHOLDERS AND THE BOARD OF DIRECTORS OF ZYDECO ENERGY, INC.:

We have audited the accompanying consolidated balance sheets of Zydeco Energy,
Inc. (a Delaware corporation) and subsidiaries as of December 31, 1998, and
1997, and the related consolidated statements of operations, stockholders'
equity and cash flows for each of the three years in the period ended December
31, 1998.  These financial statements are the responsibility of the Company's
management.  Our responsibility is to express an opinion on these financial
statements based on our audits.

We conducted our audits in accordance with generally accepted auditing
standards.  Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement.  An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements.  An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of Zydeco Energy, Inc. and
subsidiaries as of December 31, 1998, and 1997, and the results of their
operations and their cash flows for each of the three years in the period ended
December 31, 1998, in conformity with generally accepted accounting principles.

The accompanying financial statements have been prepared assuming that the
Company will continue as a going concern.  As discussed in Note 2 to the
consolidated financial statements, the Company has suffered recurring losses
from operations and has substantially used most of its capital resources which
raises substantial doubt about its ability to continue as a going concern.
Management's plans in regard to these matters are also described in Note 2.  The
financial statements do not include any adjustments relating to the
recoverability or classification of asset carrying amounts or the amount or
classification of liabilities that might result should the Company be unable to
continue as a going concern.


                                                   ARTHUR ANDERSEN LLP

Houston, Texas
March 21, 1999

                                      F-2
<PAGE>
 

                     ZYDECO ENERGY, INC. AND SUBSIDIARIES
                          CONSOLIDATED BALANCE SHEETS

<TABLE> 
<CAPTION> 
                                                                                             December 31,
                                                                                   ----------------------------------
                                                                                        1998               1997
                                                                                   ---------------    ---------------
<S>                                                                                <C>                <C> 
                                        ASSETS
Current Assets
      Cash and Cash Equivalents                                                     $ 1,912,970        $12,200,306
      Oil and Gas Revenue Receivables                                                    47,916            151,957
      Exploration Receivable                                                                  -            102,524
      Prepaid Expenses                                                                   50,235            974,139
      Other Current Assets                                                              141,664             54,376
                                                                                    -----------        -----------
          Total Current Assets                                                        2,152,785         13,483,302

Oil & Gas Properties, Using Successful Efforts Method of Accounting
      Proved Properties                                                                 334,972            334,972
      Unproved Properties                                                             2,796,471             27,600
Equipment and Software, at Cost                                                       2,331,361          2,254,139
                                                                                    -----------        -----------
                                                                                      5,462,804          2,616,711
Less: Accumulated Depreciation, Depletion, and Amortization                          (2,167,489)        (1,667,021)
                                                                                    -----------        -----------
                                                                                      3,295,315            949,690
Investment in Wavefield Imaging Technology                                              928,229            933,409
Operating Bond and Other Assets                                                         313,329            310,049
                                                                                    -----------        -----------
TOTAL ASSETS                                                                        $ 6,689,658        $15,676,450
                                                                                    ===========        ===========

                         LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities
      Accounts Payable                                                              $ 1,181,387          $ 436,941
      Accrued Liabilities                                                               330,041             52,541
                                                                                 ---------------    ---------------
          Total Current Liabilities                                                   1,511,428            489,482

Commitments and Contingencies (Note 11)

Stockholders' Equity
      Common Stock, Par Value $.001 Per Share; 50,000,000 Shares Authorized;
          11,338,351 and 11,318,351 Shares Issued;  10,357,096
          and 10,537,096 Shares Outstanding, Respectively                                11,338             11,318
      Additional Paid-In Capital                                                     24,531,668         24,499,688
      Accumulated Deficit                                                           (18,928,524)        (9,316,786)
      Less Treasury Stock, at Cost; 981,255 and 781,255
          Shares, Respectively                                                         (436,252)            (7,252)
                                                                                 ---------------    ---------------
          Total Stockholders' Equity                                                  5,178,230         15,186,968
                                                                                 ---------------    ---------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY                                          $ 6,689,658        $15,676,450
                                                                                 ===============    ===============
</TABLE> 

The accompanying notes are an integral part of these financial statements.

                                      F-3

<PAGE>
 
                     ZYDECO ENERGY, INC. AND SUBSIDIARIES
                     CONSOLIDATED STATEMENTS OF OPERATIONS

<TABLE> 
<CAPTION> 
                                                                  Years Ended December 31,
                                                    ------------------------------------------------------
                                                         1998               1997                1996
                                                    ---------------    ---------------     ---------------
<S>                                                 <C>                <C>                 <C> 
Revenues                                          
      Oil and Gas Sales                               $   389,798       $ 1,066,689          $ 1,422,227
      Gain/(Loss) on Sales of Properties                  346,321          (108,385)              16,319
      Other                                                47,382                 -               31,500
                                                      -----------       -----------          -----------
                                                          783,501           958,304            1,470,046
Expenses                                                                                     
      Exploration Expenses                                                                   
          Geological and Geophysical                    3,561,184         4,958,060              967,957
          Impairment of Unproved Properties             3,000,000                 -                    -
          Dry Hole and Other Costs                        148,285           112,393              699,566
      Production Costs                                     17,170            20,413               22,508
      Research and Development Costs                      409,240           128,010                    -
      Depreciation, Depletion, and Amortization           569,020           654,245              630,865
      General and Administrative                        2,987,570         1,560,861            1,256,489
                                                      -----------       -----------          -----------
                                                       10,692,469         7,433,982            3,577,385
                                                                                             
Operating Loss                                         (9,908,968)       (6,475,678)          (2,107,339)
                                                                                             
Other Income (Expense)                                                                       
      Interest Income                                     297,352           336,513              293,414
      Interest Expense                                       (122)          (12,962)             (44,207)
                                                      -----------       -----------          -----------
                                                          297,230           323,551              249,207
                                                                                             
Net Loss                                              $(9,611,738)      $(6,152,127)          (1,858,132)
                                                      ===========       ===========          ===========
Per Common Share-                                                                            
          Weighted Average Number of                                                         
          Common Shares Outstanding                                                          
          (Basic and Diluted)                          10,365,106         7,951,438            6,168,798
                                                      ===========       ===========          ===========
Net Loss Per Common Share                                                                    
          (Basic and Diluted)                             $ (0.93)          $ (0.77)             $ (0.30)
                                                      ===========       ===========          ===========
</TABLE> 

The accompanying notes are an integral part of these financial statements.

                                      F-4

<PAGE>
 
                     ZYDECO ENERGY, INC. AND SUBSIDIARIES
                CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY


<TABLE> 
<CAPTION> 
                                             Convertible                                                                        
                                           Preferred Stock                      Common Stock                     Additional     
                                      --------------------------  -----------------------------------------       Paid-in       
                                         Shares        Amount        Shares Outstanding          Amount            Capital      
                                      ------------  ------------  ------------------------   --------------  -------------------
<S>                                   <C>           <C>            <C>                       <C>             <C> 
Balance at December 31, 1995             781,255       $ 781             5,781,275             $ 6,563          $ 9,495,053 
                                                                                                                            
Net Loss                                       -           -                     -                   -                    - 
Options & Warrants Exercised for                                                                                            
   Common Stock                                -           -                31,154                  31                8,890 
Adjustment for Fractional Shares                                                                                            
   Paid in Cash                                -           -                   (34)                  -                    - 
Conversion of Preferred Stock to                                                                                            
   Common Stock                         (781,255)       (781)              781,255                 781                    - 
                                        ---------      ------           -----------            --------         ------------
Balance at December 31, 1996                   -           -             6,593,650               7,375            9,503,943 
                                                                                                                            
Net Loss                                       -           -                     -                   -                    - 
Options & Warrants Exercised for                                                                                            
   Common Stock                                -           -                13,450                  13               18,486 
Issuance of Common Stock Related                                                                                            
   to the Wavefield Image, Inc.                                                                                             
   Acquisition                                 -           -               250,000                 250              924,750 
Issuance of Common Stock Related                                                                                            
   to the Public Offering                      -           -             3,680,000               3,680           15,636,420 
Costs of the Offering                          -           -                     -                   -           (1,583,911)
Adjustment for Fractional Shares                                                                                            
   Paid in Cash                                -           -                    (4)                  -                    - 
                                        ---------      ------           -----------            --------         ------------
Balance at December 31, 1997                   -           -            10,537,096              11,318           24,499,688 
                                                                                                                            
Net Loss                                       -           -                     -                   -                    - 
Options Exercised for Common Stock             -           -                20,000                  20               31,980 
Acquisition of Treasury Stock                  -           -              (200,000)                  -                    - 
                                        =========      ======           ===========            ========         ============
Balance at December 31, 1998                   -       $   -            10,357,096             $11,338          $24,531,668 
                                        =========      ======           ===========            ========         ============
</TABLE> 


<TABLE> 
<CAPTION> 
                                                                               Total
                                      Accumulated         Treasury         Stockholders'
                                         Deficit             Stock             Equity
                                    -----------------  ----------------   ----------------
<S>                                 <C>                <C>                <C> 
Balance at December 31, 1995         $ (1,306,527)       $  (7,252)         $ 8,188,618
                                                                            
Net Loss                               (1,858,132)               -           (1,858,132)
Options & Warrants Exercised for                                            
   Common Stock                                 -                -                8,921
Adjustment for Fractional Shares                                            
   Paid in Cash                                 -                -                    -
Conversion of Preferred Stock to                                            
   Common Stock                                 -                -                    -
                                     -------------       ----------         ------------
Balance at December 31, 1996           (3,164,659)          (7,252)           6,339,407
                                                                            
Net Loss                               (6,152,127)               -           (6,152,127)
Options & Warrants Exercised for                                            
   Common Stock                                 -                -               18,499
Issuance of Common Stock Related                                            
   to the Wavefield Image, Inc.                                             
   Acquisition                                  -                -              925,000
Issuance of Common Stock Related                                            
   to the Public Offering                       -                -           15,640,100
Costs of the Offering                           -                -           (1,583,911)
Adjustment for Fractional Shares                                            
   Paid in Cash                                 -                -                    -
                                     -------------       ----------         ------------
Balance at December 31, 1997           (9,316,786)          (7,252)          15,186,968
                                                                            
Net Loss                               (9,611,738)               -           (9,611,738)
Options Exercised for Common Stock              -                -               32,000
Acquisition of Treasury Stock                   -         (429,000)            (429,000)
                                     =============       ==========         ============
Balance at December 31, 1998         $(18,928,524)       $(436,252)         $ 5,178,230
                                     =============       =========          ============
</TABLE>                                                                  



The accompanying notes are an integral part of these financial statements.

                                      F-5

<PAGE>
 
                     ZYDECO ENERGY, INC. AND SUBSIDIARIES
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE> 
<CAPTION> 
                                                                                 Years Ended December 31,
                                                                    ---------------------------------------------------
                                                                         1998               1997             1996
                                                                    ----------------   ---------------  ---------------
<S>                                                                  <C>               <C>              <C> 
Cash Flows from Operating Activities:
Net Loss                                                               $ (9,611,738)     $ (6,152,127)    $ (1,858,132)
Adjustments to Reconcile Net Loss to Net Cash
   Used in Operating Activities:
    Depreciation, Depletion, and Amortization                               569,020           654,245          630,865
    Impairment of Unproved Leases                                         3,000,000             6,570           28,005
    (Gain)/Loss on Sales of Properties                                     (346,321)          108,385          (16,319)
    Exploration and Dry Hole Costs                                        3,709,469         5,063,884        1,639,519
    Changes in Operating Assets and Liabilities
       (Increase) Decrease in Oil & Gas Revenue Receivables                 104,041           176,018         (260,951)
       (Increase) Decrease in Other Current Assets                          (67,003)           33,104         (105,193)
       Increase (Decrease) in Accounts Payable                              790,568           (18,763)        (185,288)
       Increase (Decrease) in Accrued Liabilities                            39,978           (72,276)        (123,095)
       Other                                                                 (6,721)           (6,085)               -
                                                                       ------------      ------------     ------------
    Net Cash Used in Operating Activities                                (1,818,707)         (207,045)        (250,589)

Cash Flows from Investing Activities:
    Additions to Oil and Gas Properties                                $ (5,753,010)        $ (37,347)      $ (507,377)
    Exploration and Dry Hole Costs                                       (2,557,121)       (5,044,471)      (1,639,519)
    Proceeds from the Sale of Properties                                    365,944           373,335           16,319
    Cost Recovery on Exploration Agreement                                        -                 -                -
    Net Change in Exploration Obligation                                    280,741        (1,051,461)          90,214
    Distributions to Exploration Participant                                      -        (2,114,638)        (217,704)
    Increase In Prepaid Computer Lease                                            -          (909,880)               -
    Purchases of Equipment and Software                                    (418,313)         (320,205)        (818,497)
    Investment in Wavefield Imaging Technology                               12,972           (25,272)               -
    Proceeds from the Sale of (Investment in) Marketable
       Securities, Net                                                            -           845,852       10,092,822
                                                                       ------------      ------------      -----------
    Net Cash Provided by (Used in) Investing Activities                  (8,068,787)       (8,284,087)       7,016,258

Cash Flows from Financing Activities:
    Treasury Stock Purchase                                            $   (429,000)     $          -      $         -
    Principal Payments of Capital Lease Obligations                               -          (157,537)        (160,693)
    Repayments of Short-Term Debt                                                 -                 -         (225,028)
    Proceeds from Options and Warrants Exercised                             32,000            18,499            8,921
    Proceeds from Common Stock Issuances, Net                                (2,842)       13,923,826                -
                                                                       ------------       -----------      ----------- 
    Net Cash Provided by (Used in) Financing Activities                    (399,842)       13,784,788         (376,800)
                                                                       ------------       -----------      ----------- 
Net Increase (Decrease) in Cash and Cash Equivalents                   $(10,287,336)      $ 5,293,656      $ 6,388,869
Cash and Cash Equivalents at Beginning of Year                           12,200,306         6,906,650          517,781
                                                                       ------------       -----------      ----------- 
Cash and Cash Equivalents at End of Year                               $  1,912,970       $12,200,306      $ 6,906,650
                                                                       ============       ===========      ===========
Cash Paid/(Received) during the Year for:
    Interest                                                                  $ 122          $ 12,962         $ 46,296
</TABLE> 

The accompanying notes are an integral part of these financial statements.

                                      F-6

<PAGE>
 
                     ZYDECO ENERGY, INC. AND SUBSIDIARIES
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


1.   ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES.

     Organization.  Zydeco Energy, Inc. was incorporated in Delaware in June
     1993, as a "special purpose acquisition corporation" under the name TN
     Energy Services Acquisition Corp. ("TN Energy"), for the purpose of raising
     funds and acquiring an operating business engaged in the energy services
     industry.  Other than its efforts to acquire an energy services business,
     TN Energy did not engage in any business activities prior to December 1995.
     On December 20, 1995, TN Energy acquired all the outstanding common stock
     and preferred stock of Zydeco Exploration, Inc. ("Zydeco") pursuant to a
     merger (the "TN Acquisition") and changed its name to Zydeco Energy, Inc.
     As used herein, unless the context indicates otherwise, the term "Company"
     refers to Zydeco Energy, Inc., and its wholly-owned subsidiaries, Zydeco
     Exploration, Inc., Wavefield Image, Inc., and Eastern Energy, Inc.

     The Company is engaged in identifying drilling prospects, acquiring leases,
     drilling, and producing reserves from those properties utilizing advanced
     3D seismic technology.  The Company's current focus is to explore for oil
     and gas in the Louisiana Transition Zone, the region of land and shallow
     waters within a few miles of the Louisiana shoreline.  The Company's future
     operations are dependent upon a variety of factors, including, but not
     limited to, sale of oil and gas prospects, successful application of 3D
     seismic evaluation and interpretation expertise in developing oil and gas
     prospects, profitable exploitation of future prospects, and the Company's
     ability to access capital sources necessary for continued growth.  See
     "Note 2 - Financial Results and Liquidity."

     SIGNIFICANT ACCOUNTING POLICIES

     Basis of Presentation.  For accounting purposes, the TN Acquisition has
     been treated as a recapitalization of Zydeco with Zydeco as the acquiror
     (reverse acquisition).  The consolidated financial statements include the
     accounts of the Company, and its wholly-owned subsidiaries, Zydeco
     Exploration, Inc., Wavefield Image, Inc. (since July 1, 1997) (see "Note 4
     - Acquisitions") and Eastern Energy, Inc. (since March 4, 1998).  All
     significant intercompany transactions have been eliminated in
     consolidation.

     In connection with the Company's exploration agreements (See "Note 3 -
     Exploration Agreements"), advances to the Company are treated as
     exploration obligations and expenditures made by the Company pursuant to
     the exploration agreement are charged against the related exploration
     obligation. No costs or expenses incurred pursuant to the exploration
     agreement is recognized by the Company until the Company, pursuant to the
     terms of the exploration agreement, begins sharing in such costs.

     Cash and Cash Equivalents.  The Company considers all highly liquid
     investments purchased with original maturities of three months or less to
     be cash equivalents.

     Oil and Gas Properties.  The Company accounts for its oil and gas
     exploration and production activities using the successful efforts method
     of accounting.  Under this method, acquisition costs for proved and
     unproved properties are capitalized when incurred.  Exploration costs,
     including geological and geophysical costs and the costs of carrying and
     retaining unproved properties, are expensed.  Exploratory drilling costs
     are initially capitalized, but charged to expense if and when the well is
     determined not to have found proved reserves.  Costs of productive wells,
     developmental dry holes and productive leases are capitalized and amortized
     on a property-by-property basis using the units-of-production method.  The
     estimated costs of future plugging, abandonment, restoration and
     dismantlement are considered as a component of the calculation of
     depreciation, depletion, and amortization.  Unproved properties with
     significant acquisition costs are assessed periodically, as conditions
     warrant, on a property-by-property basis and any impairment in value is
     charged to expense.

                                      F-7
<PAGE>
 
                     ZYDECO ENERGY, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

     Equipment.  Hardware and software associated with the 3D seismic technology
     equipment, office furniture and equipment, and leasehold improvements are
     recorded at cost, and the related depreciation is calculated on a straight-
     line basis over the estimated useful lives of the assets, which range from
     2 to 7 years.

     Impairment of Long-Lived Assets.  In accordance with the provisions of
     Statement of Financial Accounting Standards (SFAS) No. 121, "Accounting for
     the Impairment of Long-Lived Assets and for Long-Lived Assets to be
     Disposed of", management reviews its long-lived assets (i.e., proved oil
     and gas properties) whenever events or changes in circumstances indicate
     that the carrying amounts of such assets may not be recoverable.  If the
     carrying amounts of any of the Company's proved oil and gas properties are
     greater than their projected undiscounted future cash flows, an impairment
     loss to adjust such assets to fair value is recognized. The determination
     of future cash flows may be based on a variety of factors including, but
     not limited to, current proved oil and gas reserve estimates and current
     oil and gas prices and costs. Management's estimates of fair value may also
     reflect a discount factor on future cash flows consistent with the rate
     used by the Company in other fair-value determinations. Through December
     31, 1998, no material loss has been recognized.

     Income Taxes. The Company follows SFAS No. 109 "Accounting for Income
     Taxes" which requires the asset and liability approach to accounting for
     income taxes. Under this approach, deferred income taxes are determined
     based upon differences between the financial statement and tax bases of the
     Company's assets and liabilities and operating loss carryforwards using
     enacted tax rates in effect for the years in which the differences are
     expected to reverse. Deferred tax assets are recognized if it is more
     likely than not that the future tax benefit will be realized.

     Oil and Gas Revenues.  Oil and gas revenues are recorded using the
     entitlements method of accounting, whereby the Company recognizes oil and
     gas revenues as its entitled share is produced.  Individually and in the
     aggregate, the Company has no material gas imbalances as of December 31,
     1998.

     Earnings Per Share.  Basic earnings per common share is based on the
     weighted average number of shares of common stock outstanding during the
     period.  Diluted earnings per share is computed based on the weighted
     average shares of common stock plus the assumed issuance of common stock
     for all potentially dilutive securities.  The Company's common stock
     options, common stock warrants, and convertible preferred stock are
     potential common shares but were anti-dilutive in all periods presented.

     Treasury Stock.  Treasury stock is recorded at cost. Of the 981,255 common
     shares held in treasury, 781,255 common shares were purchased in January
     1995 at a cost of $7,252 from an officer of the Company in consideration
     for an overriding royalty interest in certain properties in which the
     Company had an interest at the time of the treasury stock purchase.  The
     Company had no proved reserves at the time of the transaction.  This cost
     was determined on the basis of a pro-rata allocation of the Company's
     accumulated cost in unproved properties at the time of the transaction in
     comparison to the net revenue interest transferred. The remaining 200,000
     common shares were purchased on January 15, 1998 from a former employee at
     the then current market price.

     Use of Estimates.  The preparation of financial statements in conformity
     with generally accepted accounting principles requires management to make
     estimates and assumptions that affect the reported amounts of assets and
     liabilities and disclosure of contingent assets and liabilities at the date
     of the financial statements and the reported amounts of revenues and
     expenses during the reporting period.  Actual results could differ from
     those estimates.  Significant estimates with regard to these financial
     statements include the estimate of proved oil and gas reserve volumes and
     the related discounted future net cash flows therefrom.  See "Note 14 - Oil
     and Gas Producing Activities".

     Reclassifications.  Certain reclassifications of prior period amounts have
     been made to conform with current year presentation.

                                      F-8
<PAGE>
 
                     ZYDECO ENERGY, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


2.   FINANCIAL RESULTS AND LIQUIDITY

     The Company has incurred net losses of $9,611,738, $6,152,127 and
     $1,858,132 in 1998, 1997 and 1996, respectively. The Company is principally
     engaged in one industry and geographic segment, oil and gas exploration and
     production, and has concentrated its exploration efforts since early 1996
     in an area of the Louisiana Transition Zone, known as the West Cameron
     Seismic Project ("Project"). Since inception of the Project, the Company
     and Cheniere have expended $21,640,171 pursuant to the terms of that
     Project's agreement. In addition, during 1998 the Company expended
     $5,753,010 on unproved property costs, almost all of which were on
     prospects within the Project. See Note 3 - "Exploration Agreements" for a
     description of that activity. The source of funding for these activities
     has come from funds generated from public and private equity offerings,
     cash flow from the Company's operations, and cash payments made to it under
     the Cheniere Exploration Agreement. Sources of funds include approximately
     $24.1 million from the sale of securities in 1993, 1994, 1995 and 1997, and
     $16.4 million provided under the Cheniere Exploration Agreement.

     During early 1998, the Company anticipated that near term cash needs would
     be satisfied from a combination of available cash, sales of interests in
     Project prospects, sale(s) of interests in the Project itself and payments
     by Cheniere mandated by the arbitration panel convened to rule in the
     Cheniere litigation matters.  The Company expected that cash inflows
     principally from prospect sales as well as available cash would be
     sufficient to bridge most of its interim cash needs.  In the short term and
     thereafter, other sources of cash may have been sought through the issuance
     of additional equity securities, including the exercise of outstanding
     warrants and options on the Company's common stock.  Also, in the event of
     successful oil and gas well completions, the Company anticipated that
     revenues of oil and gas sales as well as potential credit facilities could
     provide additional sources of cash.

     During mid 1998 subsequent to the acquisition of most of its current
     inventory of Project leases, the Company commenced marketing activities
     with a view to selling interests in Project prospects that were ready for
     sale.  The Company understands that during this period suitable buyers were
     available and that such buyers were conducting exploration activities
     including the acquisition of prospects and the drilling of wells on such
     prospects.  It believes that its marketing efforts were unsuccessful mostly
     because of uncertainties over the Cheniere litigation, primarily those
     matters related to the Company's and Cheniere's Project lease ownership
     interests.  Subsequent to the arbitration ruling in December 1998, the
     Company and Cheniere informally agreed to the resolution of certain
     matters in order that they could recommence their prospect marketing
     activities.  However, market conditions have considerably deteriorated to
     the point that a significantly fewer industry participants are actively
     acquiring oil and gas prospect interests.

     Although the Company believes that it will ultimately sell interests in its
     prospects, there can be no assurance that it will sell such interests in
     the near term and at sales prices that will be sufficient to permit it to
     expand its operations to levels comparable to the period before its
     restructuring.  The Company cannot ascertain the duration of the current
     depressed market nor if it will be able to obtain alternate capital sources
     if an extended downturn exists into the year 2000. In addition, because
     each non-producing oil and gas lease acquired by the Company requires
     annual delay rental payments, the Company may forfeit its interest in some
     number of leases due to insufficient cash resources to meet such
     commitments at the time such delay rentals are due. Because of these
     factors and its belief that such sale prices may not be sufficient to
     exceed the carrying value of the applicable prospects, the Company has
     recognized an unproved property impairment of $3,000,000 in the
     accompanying financial statements for 1998.

                                      F-9
<PAGE>
 
                     ZYDECO ENERGY, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


     Due to the adverse factors presented above, the Company has had to rely
     principally on available cash to continue its operations.  However, in
     order to conserve its remaining cash resources, the Company has instituted
     certain cost reducing actions, including, but not limited to, employee
     terminations and negotiations of deferred or foregone compensation to key
     executives.  By restructuring its operations, for the near term the Company
     has altered its business strategy to more narrowly focus its activities
     almost entirely on the marketing of prospects in order to achieve
     sufficient liquidity to maintain minimum levels of operations.

     Should the Company be successful in selling interests in its prospects or
     an interest in the Project itself in the near term, sufficient capital may
     be raised to expand its operations. In addition, the Company will continue
     to seek other sources of capital including, but not limited to, the
     issuance of equity securities. There can be no assurance that the Company
     will be successful in selling interests in its prospects, the Project or
     issuing equity securities or obtaining any other form of financing. The
     uncertainties about the Company's future cash flows and the lack of firm
     commitments for additional capital at this time raise substantial doubt
     about the ability of the Company to continue as a going concern. The
     accompanying financial statements do not include any adjustments relating
     to the recoverability or classification of asset carrying amounts or the
     amount or classification of liabilities that might result should the
     Company be unable to continue as a going concern.


3.   EXPLORATION AGREEMENTS.

     Fortune Exploration Agreement. In February 1995, Zydeco entered into an
     Exploration Agreement (the "Fortune Agreement") with a predecessor of
     Fortune Petroleum Corporation ("Fortune"). Under the Fortune Agreement,
     Fortune advanced $4.8 million in a series of payments to purchase a 50%
     interest in certain potential prospects ("Prospects") owned by the Company
     and to fund the initial development of the potential Prospects. At
     December 31, 1997, inception-to-date expenditures under the Fortune
     Agreement aggregated approximately $2,256,823, net of interest earned of
     $209,731 and revenue from the farmout and sale of interests of $277,154.
     Pursuant to the terms of the Fortune Agreement, in June 1997, at the
     request of Fortune, the Company returned $2,153,645 to Fortune,
     representing the unexpended funds previously advanced to the Company under
     the Fortune Agreement. The Company retained its undivided working interest
     in each of the properties acquired under the Fortune Agreement.
     Substantially all the cost of lease acquisition and seismic data
     acquisition had been incurred at the time of Fortune's election. The
     Company does not expect to incur any significant additional expenditures
     pursuant to the terms of such agreement.

     Cheniere Exploration Agreement and Litigation.  In April 1996, the Company
     executed an Exploration Agreement (the "Cheniere Agreement") with Cheniere
     Energy Operating Co., Inc., a wholly owned subsidiary of Cheniere Energy,
     Inc. and formerly known as FX Energy, Inc., (collectively "Cheniere")
     covering an area of land and waters in western Cameron Parish, Louisiana
     ("Project").  The Cheniere Agreement, as amended, provided for Cheniere to
     fund the first $13.5 million of costs plus 50% of costs in excess of $13.5
     million of the Project.  The costs covered by the Cheniere Agreement
     included, but were not limited to, 3D seismic acquisition costs, including
     the purchase of seismic rights or lease options on the related onshore
     acreage of the Project, the purchase of other 3D seismic data, and
     processing of seismic data over the Project area.

     On April 17, 1998, Zydeco Exploration, Inc. filed a petition with the
     American Arbitration Association for arbitration in order to resolve
     certain disputes that arose with Cheniere. The arbitration claim sought to
     resolve differences over Cheniere's funding obligations, the parties'
     ownership in various leases and prospects, the scope of pre-drilling
     activities that Cheniere can conduct within the Project area, the
     dissemination by Cheniere of confidential seismic data covering the Project
     area, and a wide variety of related issues. Cheniere filed a counterclaim
     in the arbitration action, and the pleadings were amended to include Zydeco
     Energy, Inc. as well as Zydeco Exploration, Inc. (collectively "Zydeco").

                                     F-10
<PAGE>
 
                     ZYDECO ENERGY, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


     On December 9, 1998, the three-member arbitration panel issued its decision
     in the arbitration proceedings brought by Zydeco against Cheniere. In its
     ruling, the panel confirmed Zydeco's position as program manager but
     recognized Cheniere's independent right to identify prospects and acquire
     leases in the West Cameron Seismic Project area.  The arbitration panel
     directed that Cheniere has the right to participate with a 50% working
     interest in most of the leases acquired by Zydeco or in prospects
     designated by Zydeco.  Cheniere, however, must exercise its right of
     participation and pay its share of such costs within a thirty-day period
     following Zydeco's formal notice of prospect designation.  For each
     prospect, Zydeco has the sole right to undertake the management and control
     of all prospect development for a reasonable period not to exceed 90 days
     following such formal notice.  The arbitration panel also ruled that
     project seismic costs generally incurred after December 31, 1997, are not
     reimbursable to Zydeco as seismic costs.  The Company believed that such
     costs, either in part or in whole, should be recouped from Cheniere as
     prospect costs.  In addition, if certain criteria are met, then sale
     proceeds from certain marketing activities would be paid to Cheniere until
     Cheniere recoups $13.5 million of its investment in the project.  Zydeco
     and Cheniere would share any such sales above that amount equally.  Neither
     party received any damage awards or recovery of legal costs.

     As a result of the arbitration panel's decision, Zydeco and Cheniere
     informally agreed to share responsibilities and ownership for certain
     activities incurred in the maintenance, marketing and sale of prospects
     generated and assembled by the parties.  Except for the costs of one
     prospect and certain other activities, neither party would seek
     reimbursement from the other for seismic and prospect costs generally
     incurred prior to the arbitration ruling.  After considering the
     arbitration panel's ruling and the two parties' informal agreement,
     Cheniere's and Zydeco's share of third party and processing costs incurred
     pursuant to the terms of the Cheniere Agreement was approximately
     $16,423,398 and $5,216,773, respectively, from inception to December 31,
     1998.  Project seismic costs amounting to $1,146,688 that previously had
     been attributable to Cheniere were charged to exploration expense.  In
     addition, the Company paid approximately $5,753,010 for unproved leases
     during 1998.

4.   ACQUISITIONS.

     On December 20, 1995, the shareholders of TN Energy approved a merger with
     Zydeco (the "Merger").  Pursuant to the Merger Agreement, each outstanding
     share of common stock of Zydeco, par value $.000333 per share, was
     converted into the right to receive 1.56251 shares of Common Stock of TN
     Energy, par value $.001 per share; each share of convertible preferred
     stock of Zydeco, par value $5.00 per share, was converted into the right to
     receive 1.56251 shares of Convertible Preferred Stock of TN Energy, par
     value $.001 per share, and any fractional shares settled in cash.

     In addition, TN Energy assumed Zydeco's existing stock options issued in
     connection with Zydeco's 1995 Employee Stock Option Plan (the "Plan"),
     substituting shares of Common Stock of TN Energy as the shares subject to
     purchase under the Plan.  Further, TN Energy assumed each existing common
     stock warrant issued by Zydeco, substituting Common Stock of TN Energy as
     the shares subject to purchase under the warrants.  The number of shares
     subject to purchase under option and warrant agreements was adjusted by
     multiplying the number of Zydeco option or warrant shares by the exchange
     ratio of 1.56251 shares.  The exercise prices for Zydeco options and
     warrants were adjusted by dividing the stated exercise price by the
     exchange ratio.  After completion of the Merger, TN Energy changed its name
     to Zydeco 

                                     F-11
<PAGE>
 
                     ZYDECO ENERGY, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

     Energy, Inc. At the conclusion of the Merger on December 21, 1995, Zydeco
     Energy, Inc. had 5,781,275 shares of Common Stock outstanding and 781,255
     shares of Convertible Preferred Stock outstanding.

     The Merger was treated as a reverse acquisition for accounting purposes
     with Zydeco as the acquiror and TN Energy as the acquiree based upon
     Zydeco's then current officers and directors assuming management control of
     the resulting entity and the value and ownership interest being received by
     current Zydeco stockholders exceeding that received by TN Energy
     stockholders.  The Merger, for accounting purposes, was treated as if
     Zydeco issued additional capital stock to TN Energy shareholders for cash.
     The net assets of TN Energy on the date of the Merger were $7,971,525 and,
     accordingly, the shares of common stock of TN Energy on such date were
     recorded as an increase in common stock and additional paid-in capital.
     The costs incurred in connection with the Merger of approximately $669,700
     were charged to additional paid-in capital at December 31, 1995.

     On July 1, 1997, the Company acquired all of the outstanding capital stock
     of Wavefield Image, Inc. ("Wavefield"), a privately held company that
     develops and licenses a seismic data processing technique known as
     Wavefield Imaging Technology.  The Company utilized Wavefield Imaging
     Technology in its West Cameron Seismic Project pursuant to a license
     agreement entered in May 1996.  Pursuant to the terms of the acquisition
     agreement between the Company and the shareholders of Wavefield, the
     Company issued 100,000 shares of the Company's common stock at closing to
     the shareholders of Wavefield and an additional 150,000 shares of such
     stock to the former Wavefield shareholders in connection with the issuance
     of a patent on the Wavefield Imaging Technology by the United States Patent
     and Trademark Office.  In connection with the issuances of Common Stock,
     the Company recorded an investment in the Wavefield Imaging Technology of
     $950,068 based on the prices of the Company's Common Stock on July 1, 1997,
     and December 2, 1997, the date of the patent issuance.  The Company is
     amortizing this investment over approximately 19 years (the life of the
     patent received).  Amortization for 1998 was $46,389.  The historical
     operations of Wavefield were not significant to the Company's financial
     position or results of operations.  The acquisition through the issuance of
     Common Stock was a non-cash investing activity and accordingly, has been
     excluded from the Consolidated Statements of Cash Flows.


5.   INCOME TAXES.

     Significant components of the Company's deferred tax liabilities and assets
     are as follows:
                                                       December 31,
                                             ----------------------------------
                                                  1998               1997
                                             ---------------    ---------------
     Deferred Tax Liability                   $          -        $         -
                                              =============       ============
     Deferred Tax Assets                 
          Carryforwards                       $   2,522,586       $  2,052,298
          Book/Tax Differences in Basis  
             of Oil and Gas Assets                3,881,934          1,163,414
          Less Valuation Allowance               (6,404,520)        (3,215,712)
                                              -------------       ------------
     Total Deferred Tax Assets                $          -        $         -
                                              =============       ============
     Net Deferred Tax Liability               $          -        $         -
                                              =============       ============

     As of December 31, 1998, the Company had a net operating loss carryforward
     for federal income tax purposes of approximately $7,419,371, which will be
     available to reduce future taxable income. The full realization of the tax
     benefit associated with the carryforward depends predominantly upon the
     Company's ability to generate taxable income during the carryforward
     period. Because of the current uncertainty of realizing such tax asset in
     the future, a valuation allowance has been recorded equal to the amount of
     the

                                     F-12
<PAGE>
 
                     ZYDECO ENERGY, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

     net deferred tax asset, which caused the Company's effective tax rate
     to differ from the statutory income tax rate.  The net operating loss
     carryforward, if not utilized, will begin to expire in the year 2009.  In
     addition, the company has available $339,003 of statutory depletion as
     carryforward to apply against future taxable income.

6.   INDEBTEDNESS.

     Capital Lease - Computer Hardware.  In 1997, the Company completed its
     payments under a capital lease for certain computer hardware assumed from
     an affiliate of Mr. Sam B. Myers, Jr. in 1994.  Amortization expense,
     calculated on a three-year, straight-line basis, aggregated $474,284 as of
     December 31, 1997.  This lease had a stated interest rate of 19.45%.  The
     lease was collateralized by the computer equipment utilized under the
     lease.

     Operating Leases.  The Company incurred rental expense of $247,164,
     $151,006, and $125,734 in 1998, 1997, and 1996, respectively, in connection
     with its office leases. See "Note 8 - Related-Party Transactions".  In
     addition, on December 1, 1997, the Company prepaid $1,091,856 for a
     12-month operating lease, commencing on November 1, 1997, on a Hewlett-
     Packard SPP2000 supercomputer used in its 3D seismic processing. The
     Hewlett-Packard lease was not renewed. At December 31, 1998, future minimum
     lease payments for leases having initial or remaining noncancelable lease
     terms in excess of one year are presented below:

                      Year                   Amount
                  ------------           ----------------
                      1999                  $78,487
                      2000                  $ 7,843
                      2001                  $ 2,395
                      2002                  $     -
                      2003 and thereafter   $     -


7.   COMMON STOCK, CONVERTIBLE PREFERRED STOCK, AND WARRANTS.

     Common Stock Offering.  On August 26, 1997, the Company completed an
     offering of 3,680,000 shares of Common Stock and warrants to purchase
     320,000 shares of Common Stock (the "Offering").  Proceeds from the
     Offering were $14,056,189, net of Offering expenses of $1,583,911.

     In connection with the Offering, the Company sold to the Underwriters, for
     nominal consideration, warrants to purchase 320,000 shares of Common Stock
     from the Company ("1997 Underwriter Warrants").  The 1997 Underwriter
     Warrants are exercisable, in whole or in part, at an exercise price of
     $5.10 (120% of the Offering price) at any time during the four-year period
     commencing August 26, 1998.  The warrant agreement pursuant to which the
     1997 Underwriter Warrants were issued contains provisions providing for
     adjustment of the exercise price and the number and type of securities
     issuable upon exercise of the 1997 Underwriter Warrants should any one or
     more of certain specified events occur.  The 1997 Underwriter Warrants
     grant to the holders thereof demand and piggy-back registration rights for
     the securities issuable upon exercise of the 1997 Underwriter Warrants.

     Conversion of Preferred Stock.  Shares of Convertible Preferred Stock, par
     value $.001, issued in December 1994 were subject to conversion at a rate
     of one share of Common Stock for each share of Convertible Preferred Stock
     upon either (i) the occurrence of a successful public offering or (ii) in
     the event the closing price for the Common Stock equaled or exceeded $6.50
     for a period of 30 consecutive trading days.  The price of the Common Stock
     exceeded the minimum price for the required period in June 1996, and,
     accordingly, the Company exercised its option to convert all shares of
     Convertible Preferred Stock to Common Stock effective July 15, 1996.

                                     F-13
<PAGE>
 
                     ZYDECO ENERGY, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)



     Placement Warrants.  In connection with a 1994 Private Placement in
     December 1994, Zydeco issued 72,268 Common Stock purchase warrants
     ("Placement Warrants") to the participating placement agents, each of which
     entitles the holder to purchase one share of Common Stock at an exercise
     price of $1.60 per share at any time prior to their expiration on December
     2, 1999.  These warrants are subject to a cashless exercise provision
     (i.e., the exercise price may be satisfied by canceling a number of
     unexercised warrants valued by the difference between the exercise price
     and the market value of the shares).  The initial value of such warrants
     issued in connection with the private placement was immaterial.  No
     Placement Warrants had been exercised prior to 1996.  In 1997 and 1996,
     Placement Warrants were exercised for 1,888 and 29,592 shares of Common
     Stock, respectively, net of 573 and 9,575 warrant shares, respectively,
     tendered in satisfaction of the exercise price.  At December 31, 1998,
     there were 30,640 unexercised Placement Warrants outstanding.

     Redeemable Warrants.  On December 26, 1993, the Company sold 1,500,000
     units ("Units") in its initial public offering ("IPO").  Each Unit consists
     of one share of the Company's Common Stock, $.001 par value, and two
     redeemable Common Stock Purchase Warrants ("Redeemable Warrants").  Each
     Redeemable Warrant entitles the holder to purchase from the Company one
     share of Common Stock at an exercise price of $5.50, during the period
     commencing on the later of the consummation by the Company of a Business
     Combination or one year from the effective date of the IPO, or December 20,
     1995, and ending seven years from the effective date of the IPO, or
     December 13, 2000.  The Merger constituted a business combination under the
     terms of the Redeemable Warrants.  The Redeemable Warrants will be
     redeemable at a price of $.01 per warrant upon 30 days' notice at any time,
     only in the event that the last sale price of the Common Stock is at least
     $10.00 per share for 20 consecutive trading days ending on the third day
     prior to the date on which notice of redemption is given.

     The Company also issued, in connection with the IPO, an aggregate of
     $150,000 of promissory notes to certain accredited investors.  These notes
     bore interest at the rate of 10% per annum and were repaid on the
     consummation of the Public Offering with accrued interest thereon.  In
     addition, the investors were issued 300,000 Redeemable Warrants valued at a
     nominal amount.  At December 31, 1998, no Redeemable Warrants had been
     exercised.

     Unit Purchase Options.  Also on December 21, 1993, the Company sold to the
     underwriters in the IPO and their designees, for nominal consideration, the
     right to purchase up to 195,652 units ("Unit Purchase Options") as adjusted
     for the Offering completed on August 26, 1997.  Each Unit Purchase Option
     consists of one share of Common Stock and two Common Stock Purchase
     Warrants.  Each Common Stock Purchase Warrant entitled the holder to
     purchase one share of Common Stock under terms similar to the terms of the
     Redeemable Warrants except that the Common Stock Purchase Warrants are not
     redeemable.  The Unit Purchase Options were exercisable at $5.06 per unit
     ("Option Exercise Price"), as adjusted, until December 13, 1998, when they
     expired.  In addition, the Common Stock Purchase Warrants were exercisable
     at $5.50 per warrant, and expired on the same date as the Unit Purchase
     Options.  The Unit Purchase Options contained anti-dilution provisions
     providing for adjustment of the Option Exercise Price upon the occurrence
     of certain events, including the issuance of shares of Common Stock or
     other securities convertible into or exercisable for shares of Common Stock
     at a price per share less than the Option Exercise Price or the market
     price of the Common Stock, or in the event of any recapitalization,
     reclassification, stock dividend, stock split, stock combination, or
     similar transaction. No Unit Purchase Options were exercised prior to their
     expiration.

     Non-Redeemable Bridge Warrants.  In December 1995, in connection with
     arranging the Bridge Financing, the Company issued to the Bridge Lenders
     warrants to purchase 225,028 shares of Common Stock ("Non-Redeemable Bridge
     Warrants"), at an exercise price of $5.33 per share.  The terms of the Non-
     Redeemable Bridge Warrants are identical to the terms of the Redeemable
     Warrants, except that they are not redeemable and are subject to a cashless
     exercise provision.  At December 31, 1998, no Non-Redeemable Bridge
     Warrants had been exercised.

                                     F-14
<PAGE>
 
                     ZYDECO ENERGY, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


8.   RELATED-PARTY TRANSACTIONS.

     On December 30, 1998, the Company sold a 6.25% working interest
     participation in a prospect to a limited partnership whose president and a
     vice president are the children of the Company's Chairman. The agreement
     provides that the limited partnership pay to the Company a total
     consideration of $204,000 for this interest which included the turnkey cost
     of drilling this prospect's first well.  Pursuant to the terms of the
     agreement with such limited partnership, the basis of this partnership's
     participation in this prospect is on comparable terms of participation by
     an unrelated party.  In connection with the informal agreement with
     Cheniere discussed in Note 3 - "Exploration Agreements - Cheniere
     Exploration Agreement and Litigation", the Company and Cheniere agreed to
     share all proceeds attributable to the sale of Project prospects, including
     cash and promoted interests. Cheniere's estimated share of the total
     consideration paid by the limited partnership is approximately $64,000.
     Subsequent to December 31, 1998, this prospect's first well was drilled and
     amounts related to the turnkey portion were earned by the Company. The
     Company and the limited partnership did not participate in a completion
     attempt on this well. The Company will expense approximately $500,000 as
     dry hole expense in the 1999 first quarter, such amount net of the
     Company's share of the turnkey contribution. (See "Note 12 - Subsequent
     Events"). The agreement also provides that the limited partnership has a
     one-time option to acquire a 6.25% working interest participation in an
     adjacent prospect for $62,500 and to pay its pro-rata share of the second
     prospect's drilling costs on a promoted basis.

     In connection with the acquisition of Wavefield, the Company agreed to
     assume the remaining office lease obligation of a shareholder of Wavefield
     who became an officer of the Company.  The offices were used by Wavefield
     and the Wavefield shareholders.  The remaining term of the lease at
     December 31, 1998 was 10 months requiring the payment of monthly rentals of
     $5,585.  The Company expensed $66,367 and $33,510 during the years ended
     December 31, 1998 and 1997, respectively, related to the lease.

     In 1996, the Company licensed software and purchased related software
     maintenance services aggregating $325,768 from the subsidiary of an
     unaffiliated company.  Subsequently, in October 1996, an officer and
     director of the Company became a director of the unaffiliated parent
     company.  Software and services provided by the vendor aggregated $262,380
     for the year ended December 31, 1997.  The unaffiliated parent company sold
     its vendor subsidiary during 1997.

     The Company engaged the services of a law firm, including the services of a
     partner in the firm who is a relative of an officer and director of the
     Company.  The Company incurred costs of approximately $176,505, $220,343,
     and $109,902 to this firm during the years ended December 31, 1998, 1997,
     and 1996, respectively.

     Effective January 1, 1995, Zydeco assumed an obligation for office
     facilities under an operating lease agreement expiring in March 1997, from
     a Myers Affiliate where certain officers of the Company were, at the time,
     also officers and/or directors of the Myers Affiliate.  The lease agreement
     required base monthly payments of $3,122.  In connection with the
     relocation of the Company's offices in June 1996, the Company bought out
     the remaining nine month term under this lease for $24,615.  Rental expense
     related to this lease was $44,887 and is included in general and
     administrative expenses for the year ended December 31, 1996.

9.   STOCK OPTION PLANS.

     At December 31, 1998, the Company had three stock-based compensation plans,
     which are described below.  Each plan provides for the granting of options
     generally at not less than the per share market price on the date of grant.
     The Company applies APB Opinion 25 and related Interpretations in
     accounting for its plans.  Accordingly, no compensation cost has been
     recognized for its fixed stock option plans.  Had compensation cost for the
     Company's three stock-based compensation plans been determined based on the
     fair value at the grant dates for awards under those plans consistent with
     the method of SFAS No. 123 "Accounting for Stock-Based Compensation", the
     Company's net loss and net loss per common share would have been increased
     to the pro forma amounts indicated below:

                                     F-15
<PAGE>
 
                     ZYDECO ENERGY, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

<TABLE> 
<CAPTION> 
                                                      1998           1997           1996
                                                 ------------    ------------   ------------
<S>                                <C>           <C>             <C>            <C> 
     Net Loss                      As Reported   $ (9,611,738)   $(6,152,127)   $(1,858,132)
                                   Pro Forma     $(10,482,914)   $(6,854,165)   $(2,296,904)

     Net Loss Per Common Share     As Reported   $      (0.93)   $     (0.77)   $     (0.30)
       (Basic and Diluted)         Pro Forma     $      (1.01)   $     (0.86)   $     (0.37)
</TABLE> 

     For purposes of the above proforma disclosure, the fair value of each
     option grant is estimated on the date of grant using the Black-Scholes
     option-pricing model with the following weighted average assumptions used
     for grants in 1998, 1997, and 1996, respectively: no dividend yield for
     each of the three years, expected volatility of .56, .51, and .52,
     respectively, risk-free interest rates of 5.9%, 6.5% and 5.2%,
     respectively, and expected lives of 10 years for all options.  In
     connection with the above assumptions, the estimated weighted average fair
     value of options granted in 1998, 1997, and 1996, is $1.69, $3.85, and
     $4.07 per share, respectively.

     In February 1995, Zydeco's Board of Directors approved the 1995 Employee
     Stock Option Plan (the "Zydeco Plan") for certain employees of the Company
     and any subsequently incorporated subsidiaries of the Company.  Options to
     purchase 1,006,256 shares of stock at a price of $1.60 per share, as
     adjusted pursuant to the TN Acquisition, were granted in March 1995.  Such
     options are non-compensatory, vest over a four-year period and terminate no
     later than March 2005.

     On January 4, 1996, the Board of Directors approved and adopted the Zydeco
     Energy, Inc. 1996 Incentive Equity Plan (the "1996 Incentive Plan") and
     amended such plan on March 3, 1997.  The 1996 Incentive Plan authorizes the
     grant of various stock and stock-related awards to key management and other
     personnel on the basis of individual and corporate performance.  The 1996
     Incentive Plan, as amended, provides for the granting of stock options to
     purchase an aggregate of 950,000 shares of Common Stock, which are reserved
     for such purpose. Options under the 1996 Incentive Plan are non-
     compensatory, vest over a four-year period and terminate no later than ten
     years after the date of grant unless otherwise determined by the
     Compensation Committee.

     Also on January 4, 1996, the Board of Directors adopted the 1996 Non-
     employee Director Stock Option Plan (the "1996 Director Plan") and
     authorized and granted an aggregate of 45,000 shares of Common Stock to
     three non-employee directors.  The options vest one third on April 1, 1997,
     1998, and 1999, and have an exercise price of $6.69 per share.  The options
     terminate no later than ten years after the date of grant.  Both the 1996
     Incentive Plan and the 1996 Director Plan were approved by the Company's
     shareholders at the Annual Meeting on July 9, 1996.  The amended 1996
     Incentive Plan was approved by the Company's shareholders at the Annual
     Meeting on May 15, 1997.

     Information about the Company's stock option plans for each of the three
     years in the period ended December 31, 1998, is set forth below:

                                     F-16
<PAGE>
 
                     ZYDECO ENERGY, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

<TABLE> 
<CAPTION> 
                                           1998                      1997                   1996
                                 ----------------------   -----------------------  ----------------------
                                              Average                   Average                 Average
                                  Shares    Grant Price     Shares    Grant Price    Shares   Grant Price
                                --------- -------------   ---------  ------------  ---------  -----------
<S>                             <C>       <C>             <C>        <C>           <C>        <C> 
Outstanding at January 1        1,768,632     $3.33        1,444,694      $2.91     1,006,256      $1.60
  Granted                         221,000      2.21          504,000       5.55       540,000       6.06
  Exercised                       (20,000)     1.60          (11,562)      1.60        (1,562)      1.60
  Forfeited and Expired          (468,626)     4.73         (168,500)      6.55      (100,000)      6.69
                                ---------                  ---------                ---------           
Outstanding at December 31      1,501,006      2.75        1,768,632       3.33     1,444,694       2.91
                                =========                  =========                =========
Shares Exercisable at 
  December 31                   1,218,506      2.40          855,317       2.18       501,565       1.60
                                =========                  =========                =========
Shares Available for Future
  Grant                           464,000                    219,500                  555,000(1)
                                =========                  =========                =========
Average Fair Value of Shares
  Granted During Year           $    1.69                  $    3.85                $    4.07
                                ---------                  ---------                ---------
</TABLE> 

<TABLE> 
<CAPTION> 
                                     Shares Outstanding                 Shares Exercisable
                              ---------------------------------     --------------------------
                                           Weighted   Weighted                       Weighted
                                            Average    Average                        Average
      Range of                             Remaining    Grant                          Grant
    Grant Prices               Shares        Life       Price          Shares          Price
---------------------         ---------------------------------     --------------------------
<S>                           <C>           <C>          <C>         <C>             <C>  
$1.00 to      $3.00           1,098,256     7 years      $1.70          983,756         $1.61
 3.00 to       5.00               4,000     8 years       4.94            1,000          4.94
 5.00 to       7.00             398,750     8 years       5.76          233,750          5.69
                              ---------                               --------- 
 1.00 to       7.00           1,501,006     7 years       2.78        1,218,506          2.40
                              =========                               =========
</TABLE> 
------------
(1) Includes shares approved by the Company's shareholders at the May 15, 1997
    Annual Meeting of Shareholders.

                                     F-17
<PAGE>
 
                     ZYDECO ENERGY, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


10.  SEGMENT INFORMATION.

     In June 1997, the Financial and Accounting Standards Board issued SFAS No.
     131, "Disclosures About Segments of an Enterprise and Related Information."
     This standard requires that companies report certain information about
     operating segments in complete sets of financial statements and in
     condensed financial statements of interim periods for fiscal years
     beginning after December 15, 1997.  The Company adopted this statement for
     the fiscal year ending December 31, 1998. The Company operates principally
     in one industry and geographic segment - oil and gas exploration and
     production and as such the adoption of SFAS No. 131 had no impact on the
     Company's financial statements.

     Major Customers.  Oil and gas sales to two customers of $348,636 and
     $24,892 in 1998, to two customers of $829,732 and $236,957 in 1997, and to
     two customers of $1,030,424 and $391,803 in 1996, each constituted more
     than 10% of consolidated revenue for such years.

11.  COMMITMENTS AND CONTINGENCIES.

     In February 1996, the Company purchased an exclusive seismic option permit
     from the State of Louisiana covering approximately 51,000 acres of state
     waters in western Cameron Parish, Louisiana.  The Company initially paid
     $783,754 for the permit and in August 1997, paid $391,877 for a six-month
     extension of the permit.  Under the agreement with the state of Louisiana,
     the Company was obligated to deliver within 24 months a 3D seismic survey
     over the state acreage, which was delivered by the Company in January 1998.
     The State of Louisiana is required to keep the information obtained from
     the survey confidential for a period of ten years.

     In May 1996, the Company entered into a two year license agreement with
     Wavefield Image, Inc. to use a proprietary 3D seismic processing known as
     the Wavefield Imaging Technology, which required the payment of annual
     royalties.  In July 1997, the Company acquired 100% of the outstanding
     capital stock of Wavefield Image, Inc., the owner of this technology  (See
     "Note 4 - Acquisitions".)

12.  SUBSEQUENT EVENTS.

     On January 11, 1999, the Company and Cheniere sold a seismic option for
     $500,000 to an unaffiliated industry participant.  Pursuant to the terms of
     the seismic option agreement, the industry participant had 35 days to
     exercise the right to acquire an interest in any or all of three specific
     prospects developed from the Company's West Cameron Seismic Project.  The
     industry participant did not exercise its right of acquisition.  In
     accordance with the tentative agreement with Cheniere Energy, Inc. (See
     Note 3 - "Exploration Agreements"), the Company and Cheniere shared the
     option proceeds on the basis of 45% and 55%, respectively. The Company will
     record its $225,000 share of the proceeds in the 1999 first quarter as a
     reduction to its carrying value of unproved properties.

     On March 12, 1999, total drilling depth was reached in a well operated by
     the Company.  The Company subsequently declined to participate in a
     completion attempt and non-consented the proposed operation pursuant to the
     terms of that well's operating agreement.  The Company's estimated share of
     total well costs, amounting to approximately $500,000, will be expensed as
     dry hole expense in the 1999 first quarter.  The cost of the related
     prospect, amounting to approximately $277,000, was fully impaired as of
     December 31, 1998.

                                     F-18
<PAGE>
 
                     ZYDECO ENERGY, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


13.  QUARTERLY RESULTS OF OPERATIONS (UNAUDITED).

     Results of operations by quarter for the years ended December 31, 1998 and
     1997 are set forth in the following table.

<TABLE> 
<CAPTION> 
                                                                                   Quarter Ended
                                                           ----------------------------------------------------------------
                                                             March 31        June 30         September 30      December 31
                                                           ------------   -------------     --------------   --------------
<S>                                                        <C>            <C>                <C>             <C> 
     1998
        Operating Revenues                                $    124,140     $   113,506       $   147,113       $   398,742
        Operating Loss                                      (1,344,627)     (1,504,995)       (1,599,257)       (5,472,681)
        Net Loss                                            (1,205,774)     (1,407,172)       (1,558,434)       (5,440,358)

        Net Loss Per Common Share (Basic and Diluted)      $     (0.12)    $     (0.14)      $     (0.15)      $     (0.53)

      1997
        Operating Revenues                                 $   373,994     $   257,329       $   437,877       $  (110,896)
        Operating Loss                                        (617,148)     (1,746,203)       (2,040,287)       (2,072,040)
        Net Loss                                              (565,617)     (1,701,400)       (1,956,578)       (1,928,532)

        Net Loss Per Common Share (Basic and Diluted)      $     (0.09)    $     (0.26)      $     (0.24)      $     (0.18)
</TABLE> 

                                     F-19
<PAGE>
 
                     ZYDECO ENERGY, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

14.  OIL AND GAS PRODUCING ACTIVITIES.

     Results of Operations from Oil and Gas Producing Activities

     The results of operations for oil and gas producing activities for the
     years indicated are presented below:

<TABLE> 
<CAPTION> 
                                                                        Year Ended December 31,
                                                          -----------------------------------------------------
                                                               1998               1997               1996
                                                          ---------------     --------------     --------------
      <S>                                                 <C>                 <C>                <C> 
      Oil and Gas Sales                                    $    389,798        $  1,066,689       $ 1,422,227
      Production (Lifting) Costs                                (17,170)            (20,413)          (22,508)
      Dry Hole and Other Costs                                 (148,285)           (112,393)         (699,566)
      Impairment of Unproved Properties                      (3,000,000)                  -                 -
      Geological and Geophysical Expenses                    (3,561,184)         (4,958,060)         (967,957)
      Depreciation, Depletion, and Amortization (1)            (424,669)           (566,271)         (592,996)
      Income Tax Benefit (Provision)                                  -                   -                 -
                                                          -------------        ------------       -----------  
      Results of Operations from Oil                  
            and Gas Producing Activities                   $ (6,761,510)       $ (4,590,448)      $  (860,800)
                                                          =============        ============       ===========  

      (1)  Includes depreciation on seismic computer hardware and software.

</TABLE> 

     CAPITALIZED COSTS RELATED TO OIL AND GAS PRODUCING ACTIVITIES

     The following table presents total capitalized costs of proved and unproved
     oil and gas properties and associated accumulated depreciation, depletion,
     and amortization:

<TABLE> 
<CAPTION> 
                                                                                 December 31,
                                                                      -----------------------------------
                                                                           1998                1997
                                                                      ----------------    ---------------
     <S>                                                                  <C>                <C> 
     Proved Oil and Gas Properties, at Cost                              $    334,972        $   334,972
     Unproved Oil and Gas Properties                                        2,796,471             27,600
     Equipment and Software                                                 1,974,028          1,908,818
     Less - Accumulated Depreciation, Depletion, and Amortization          (1,969,652)        (1,521,693)
                                                                         ------------        -----------
     Net Capitalized Costs                                               $  3,135,819        $   749,697
                                                                         ============        =========== 
</TABLE> 

     COSTS INCURRED IN OIL AND GAS PROPERTY ACQUISITION, EXPLORATION AND
     DEVELOPMENT ACTIVITIES

     Presented below are costs incurred in oil and gas property acquisition,
     exploration and development activities:

<TABLE> 
<CAPTION> 
                                                                  Year Ended December 31,
                                                   -------------------------------------------------------
                                                        1998                 1997               1996
                                                   ----------------     ----------------    --------------
     <S>                                           <C>                  <C>                  <C> 
     Proved Property Acquisition Costs                $        -           $   34,188          $        7
     Unproved Property Acquistion Costs                5,753,010               27,600             507,370
     Exploration Costs                                 3,734,900            5,070,453           1,639,519
     Equipment and Software Additions                     92,378              565,163             569,973
                                                      -----------          -----------         ----------
     Total for Year                                   $9,580,288           $5,697,404          $2,716,869
                                                      ===========          ===========         ==========
</TABLE> 

                                     F-20
<PAGE>
 
                     ZYDECO ENERGY, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

     RESERVE QUANTITY INFORMATION (UNAUDITED)

     The following unaudited information has been provided pursuant to SFAS No.
     69, "Disclosures about Oil and Gas Producing Activities".  There are
     numerous uncertainties inherent in estimating quantities of proved reserves
     and in projecting future rates of production, including many factors beyond
     the control of the Company.  The estimation of reserve quantities results
     from a process that cannot be measured in an exact way and employs
     judgements made by the Company's independent petroleum engineering firms.
     Accordingly, reserve estimates are often different from quantities of oil
     and gas that are ultimately recovered.  The Company's proved oil and gas
     reserves were estimated by Petroleum Professionals International, LP as of
     December 31, 1998 and by Ryder Scott Company, Petroleum Engineers as of
     December 31, 1997 and 1996.

     PROVED DEVELOPED RESERVE QUANTITIES (UNAUDITED)

     The Company's oil and gas producing activities have been conducted solely
     in the United States.  The Company had no proved undeveloped reserves at
     December 31, 1998, 1997, and 1996.  The following table sets forth the
     changes in the Company's total proved reserves (all of which are developed)
     for the years ended December 31, 1998, 1997, and 1996:

<TABLE> 
<CAPTION> 
                                                                                  December 31,
                                                             -------------------------------------------------------
                                                                  1998                1997               1996
                                                             ---------------     ---------------    ----------------
                                                                                   Oil (Bbls)
     <S>                                                     <C>                 <C>                <C> 
     Total Proved Reserves:                               
          Proved Oil Reserves at the Beginning of the Year        2,614              10,052              15,899
          Extensions, Discoveries, and Other Additions                -                   -                   -
          Revisions of Previous Estimates                        (1,158)              1,939              14,339
          Production                                             (1,187)             (9,377)            (20,186)
                                                               ---------           --------            --------
          Proved Oil Reserves at the End of the Year                269               2,614              10,052
                                                               =========           ========            ========
                                                                                                       
                                                                              Gas (Mcf)                

          Proved Gas Reserves at the Beginning of the Year      104,000             243,000             492,000
          Extensions, Discoveries, and Other Additions                -                   -                   -
          Revisions of Previous Estimates                       167,333             197,730             123,678
          Production                                           (165,762)           (336,730)           (372,678)
                                                               ---------           --------            --------
          Proved Gas Reserves at the End of the Year            105,571             104,000             243,000
                                                               =========           ========            ========
     Proved Developed Reserves:                                                                        
          End of Year - Oil (Bbls)                                  269               2,614              10,052
                                                               =========           ========            ========
                        Gas (Mcf)                               105,571             104,000             243,000
                                                               =========           ========            ========
</TABLE> 

                                     F-21
<PAGE>
 
                     ZYDECO ENERGY, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


     STANDARDIZED MEASURE OF DISCOUNTED FUTURE NET CASH FLOWS RELATING TO PROVED
     OIL AND GAS RESERVE QUANTITIES (UNAUDITED)

     The information that follows has been developed by the Company pursuant to
     procedures prescribed by SFAS No. 69 and utilizes reserve data estimated by
     the Company's independent petroleum engineering firms. In addition to the
     above discussion of uncertainties in estimated reserve quantities, the
     following calculations are based on year-end prices, costs and statutory
     tax rates that relate to existing proved oil and gas reserves in which the
     Company has an interest and are discounted at 10%. Because future
     projections are inherently imprecise, material revisions to reserve
     estimates may occur in the future. Actual sales prices and costs incurred
     may vary from those used in the calculations due to a number of factors
     including, but not limited to, wide fluctuations in world and/or regional
     markets. In addition, production of the oil and gas reserves may not occur
     in the periods assumed. The standardized measure information may be useful
     for certain comparative purposes but is not intended to represent the
     market value of the Company's reserves or as an estimate of the Company's
     future cash flows. See "Note 1 - Organization and Summary of Significant
     Accounting Policies".

     The following table sets forth the standardized measure of discounted
     future net cash flows from to estimated future production of the Company's
     proved oil and gas reserves as of December 31:

<TABLE> 
<CAPTION> 
                                                              1998               1997                1996
                                                         ---------------    ---------------     ---------------
<S>                                                 <C>                <C>                 <C> 
     Future Cash Inflows                                      $ 224,307          $ 392,939         $ 1,116,568
     Future Production and Development Costs(1)                       -                  -             (72,225)
     Future Income Tax Expense                                        -                  -                   -
                                                         ---------------    ---------------     ---------------
     Undiscounted Future Net Cash Flows                         224,307            392,939           1,044,343
     Discount                                                   (14,627)           (14,942)            (44,525)
                                                         ---------------    ---------------     ---------------
    Standardized Measure of Discounted Future Net    
           Cash Flows                                         $ 209,680          $ 377,997           $ 999,818
                                                         ===============    ===============     ===============
</TABLE> 
----------
     (1) Estimated future costs associated with property development and
     plugging, abandonment, site restoration and dismantlement requirements at
     December 31, 1996 were approximately $32,500.  In addition, the Company
     maintains an overriding royalty interest in its only property with proved
     reserves at December 31, 1998 and 1997.  Accordingly, there are no future
     costs associated with such an overriding royalty interest.

                                     F-22
<PAGE>
 
                     ZYDECO ENERGY, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

     PRINCIPAL SOURCES OF CHANGE IN THE STANDARDIZED MEASURE OF DISCOUNTED
     FUTURE NET CASH FLOWS (UNAUDITED)

     The following table sets forth changes in the standardized measure of
     discounted future net cash flows for the years ended December 31:

<TABLE> 
<CAPTION> 
                                                          1998                1997              1996
                                                     ---------------     ---------------    --------------
     <S>                                                  <C>               <C>               <C> 
     Standardized Measure - Beginning of Year           $ 377,997         $   999,818        $ 1,307,337
     Sales, Net of Operating Costs                       (372,628)         (1,046,276)        (1,399,719)
     Net Changes in Prices and Production Costs          (132,609)           (215,759)           343,316
     Development Costs Incurred                                 -              32,500                  -
     Revisions of Quantity Estimates                      322,880             658,065            685,619
     Accretion of Discount                                 37,800              99,982            130,734
     Other                                                (23,760)           (150,333)           (67,469)
                                                        ---------         -----------        ----------- 
     Standardized Measure - End of the Year             $ 209,680         $   377,997        $   999,818
                                                        =========         ===========        =========== 
</TABLE> 

                                     F-23
<PAGE>
 
                                 EXHIBIT INDEX
                                        

<TABLE>
<CAPTION>

Exhibit No.         DESCRIPTION
-----------         -----------
<S>                 <C>
3.1+                Certificate of Incorporation and Certificates of Amendment thereto (filed as Exhibit 3.1 to
                      the Company's Annual Report on Form 10-K for the year ended December 31, 1995)
 
3.2+                Form of Amended and Restated Bylaws (filed as Exhibit 3.2 to the Company's Registration
                      Statement on Form S-1 (Reg. No. 33-65286))
 
4.1+                Form of Certificate representing shares of Common Stock (filed as Exhibit 4.1 to the Company's
                      Annual Report on Form 10-K for the year ended December 31, 1995)
 
4.2+                Form of Certificate evidencing Common Stock Purchase Warrants (filed as Exhibit 4.2 to the
                      Company's Annual Report on Form 10-K for the year ended December 31, 1995)
 
4.3+                Unit Purchase Option Granted to Underwriters by the Company (filed as Exhibit 4.3 to the
                      Company's Registration Statement on Form S-1 (Reg. No. 33-65286))
 
4.4+                Warrant Agreement between Continental Stock Transfer & Trust Company and the Company (filed as
                      Exhibit 4.4 to the Company's Registration Statement on Form S-1 (Reg. No. 33-65286))
 
4.5+                Certificate of Designation evidencing shares of Preferred Stock (filed as Exhibit 4.5 to the
                      Company's Annual Report on Form 10-K for the year ended December 31, 1995)
 
4.6+                Form of Certificate evidencing shares of Preferred Stock (filed as Exhibit 4.6 to the
                      Company's Annual Report on Form 10-K for the year ended December 31, 1995)
 
4.7+                Form of Stock Purchase Warrant granted by Zydeco and Letter to holders from the Company (filed
                      as Exhibit 4.7 to the Company's Annual Report on Form 10-K for the year ended December 31,
                      1995)
 
4.8+                Form of Warrant Agreement by and among the Company and Brean Murray & Co., Inc. and Gaines,
                      Berland Inc. (filed as Exhibit 4.8 to the Company's Registration Statement on Form S-1 (Reg.
                      No. 333-27679))
 
10.1+               Share Escrow Agreement between the Company and Continental Stock Transfer & Trust Company
                      (filed as Exhibit 10.6 to the Company's Registration Statement on Form S-1 (Reg. No. 33-65286))
 
10.2+               Warrant Agreement (filed as Exhibit 4.4 to the Company's Registration Statement on Form S-1
                      (Reg. No. 33-65286))
 
10.3+               Zydeco 1995 Employee Stock Option Plan and form of  letter to Optionees from the Company
                      (filed as Exhibit 10.3 to the Company's Annual Report on Form 10-K for the year ended December
                      31, 1995)
 
10.4+               Employment Agreement between Zydeco and Stephen W. Knecht (filed as Exhibit 

</TABLE> 
                                      E-1
<PAGE>
 
<TABLE> 
<CAPTION> 

<S>                 <C>

                      10.4 to the Company's Annual Report on Form 10-K for the year ended December 31, 1995)
 
 10.5+              Employment Agreement between Zydeco and John W. McTigue, Jr. (filed as Exhibit 10.5 to the
                      Company's Annual Report on Form 10-K for the year ended December 31, 1995)
 
 10.6+              Exploration Agreement between Zydeco and Lagniappe Exploration, Inc. (predecessor to Fortune
                      Petroleum, Inc.) (filed as Exhibit 10.6 to the Company's Annual Report on Form 10-K for the
                      year ended December 31, 1995)
 
 10.7+              Farmout Agreement between Zydeco and Bois D'Arc Exploration (filed as Exhibit 10.7 to the
                      Company's Annual Report on Form 10-K for the year ended December 31, 1995)
 
 10.8+              Farmout Agreement between Zydeco, Fortune and Southern Gas Company of Delaware (filed as
                      Exhibit 10.8 to the Company's Annual Report on Form 10-K for the year ended December 31, 1995)
 
 10.9+              Option Agreement dated February 7, 1996, between the Company and Norman Neidell concerning
                      certain Wave field Imaging Technology (filed as Exhibit 10.1 to the Company's Quarterly Report
                      on Form 10-Q for the three months ended March 31, 1996)
 
 10.10+             Exploration Agreement between Zydeco Exploration, Inc. and Cheniere Energy Operating Co., Inc.
                      (formerly FX Energy, Inc.) dated April 4, 1996 (filed as Exhibit 10.10 to the Company's
                      Quarterly Report on Form 10-Q for the three months ended June 30, 1996)
 
 10.11+             Master Geophysical Data Acquisition Agreement dated June 12, 1996, (executed August 5, 1996)
                      between Zydeco Exploration, Inc. and Grant Geophysical, Inc. (filed as Exhibit 10.11 to the
                      Company's Quarterly Report on Form 10-Q for the three months ended September 30, 1996)
 
 10.12+             Second Amendment to the Exploration Agreement between Zydeco Exploration, Inc. and Cheniere
                      Energy Operating Co., Inc. (formerly FX Energy, Inc.) dated August 5, 1996 (filed as Exhibit
                      10.12 to the Company's Quarterly Report on Form 10-Q for the three months ended September 30,
                      1996)
 
 10.13+             Third Amendment to the Exploration Agreement between Zydeco Exploration, Inc. and Cheniere
                     Energy Operating Co., Inc. (formerly FX Energy, Inc.) dated October 31, 1996 (filed as Exhibit
                     10.13 to the Company's Quarterly Report on Form 10-Q for the three months ended September 30,
                      1996)
 
 10.14+             Fourth Amendment to the Exploration Agreement between Zydeco Exploration, Inc. and Cheniere
                      Energy Operating Co., Inc. (formerly FX Energy, Inc.) dated November 29, 1996 (filed as
                      Exhibit 11.1 to the Company's Annual Report on Form 10-K for the year ended December 31, 1996)
 
 10.15+             Master Geophysical Data Acquisition Agreement dated March 14, 1997, between Zydeco
                      Exploration, Inc. and Grant Geophysical, Inc. (filed as Exhibit 10.15 to the Company's
                      Quarterly Report on Form 10-Q for the three months ended March 31, 1997)
 
 10.16+             1996 Incentive Equity Plan (filed on May 20, 1997, as Exhibit 99.1 to the Company's
                      Registration Statement on Form S-8)
 
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<S>                 <C>

 10.17+               1996 Non-employee Directors Stock Option Plan (filed on May 20, 1997, as Exhibit 99.1 to the
                      Company's Registration Statement on Form S-8)
 
 10.18+             Agreement and Plan of Merger dated July 1, 1997, by and between the Company, Wavefield Image,
                      Inc. and certain stockholders of Wavefield Image, Inc. (filed on May 20, 1997, as Exhibit 99.1
                      to the Company's Registration Statement on Form S-8)
 
 10.19+             Employment Agreement between Zydeco Energy, Inc. and Norman S. Neidell (filed on May 20, 1997,
                      as Exhibit 99.1 to the Company's Registration Statement on Form S-8)
 
 10.20+             Fifth Amendment to the Exploration Agreement between Zydeco Exploration, Inc. and Cheniere
                      Energy Operating Co., Inc. (formerly FX Energy, Inc.) dated April 28, 1997 (filed on May 20,
                      1997, as Exhibit 99.1 to the Company's Registration Statement on Form S-8)
 
 10.21+             Sixth Amendment to the Exploration Agreement between Zydeco Exploration, Inc. and Cheniere
                      Energy Operating Co., Inc. (formerly FX Energy, Inc.) dated July 21, 1997 (filed on May 20,
                      1997, as Exhibit 99.1 to the Company's Registration Statement on Form S-8)
 
 10.22+             Seventh Amendment to the Exploration Agreement between Zydeco Exploration, Inc. and Cheniere
                      Energy Operating Co., Inc. (formerly FX Energy, Inc.) dated August 28, 1997 (filed as Exhibit
                      10.22 to the Company's Quarterly Report on Form 10-Q for the three months ended September 30,
                      1997)
 
 10.23+             Eighth Amendment to the Exploration Agreement between Zydeco Exploration, Inc. and Cheniere
                      Energy, Inc. (formerly FX Energy, Inc.) dated October 30, 1997 (filed as Exhibit 10.23 to the
                      Company's Annual Report on Form 10-K for the year ended December 31, 1997)
 
 11.1               Computation of per share earnings
 
 21.1               List of Subsidiaries
 
 23.1               Consent of Arthur Andersen LLP
 
 23.2a              Consent of Ryder Scott Company

 23.2b              Consent of Petroleum Professionals International, LP

 27                 Financial Data Schedule
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+   Incorporated herein by reference to the indicated filing.

                                      E-3