**UNITEDSTATES**

**SECURITIES AND EXCHANGECOMMISSION**

# **WASHINGTON, D.C.20549**

# ** **

# **FORM 10-Q**

# ** **

| **ý****   Quarterly Report Pursuant to Section 13  or 15(d)**                                                                  |
|----------------------------------------------------------------------------------------------------------------------------------------------------|
| **of the Securities Exchange Act  of 1934**                                                                                                        |
|                                                                                                                                               |
| **For  the quarterly period ended September 30, 2005**                                                                                        |
| ** **                                                                                                                                         |
| **or**                                                                                                                                             |
|                                                                                                                                               |
| **o****   Transition  Report Pursuant to Section 13 or 15(d)**                                                                      |
| **of the Securities Exchange Act  of 1934**                                                                                                        |
|                                                                                                                                               |
| **For the transition period from                    to** |

 

## **Commission File No. 0-10924**

## ** **

**CLAYTON WILLIAMS ENERGY, INC.**

(Exact name of Registrant as specified in its charter)

 
| **Delaware**                                       | ** ** | **75-2396863**         |
|----------------------------------------------------|------------|------------------------|
| (State or other jurisdiction of                    |       | (I.R.S. Employer       |
| incorporation or organization)                     |       | Identification Number) |
|                                               |       |                   |
| **6 Desta Drive, Suite 6500, Midland, Texas** | ** ** | **79705-5510**         |
| (Address of principal executive offices)           |       | (Zip code)             |

 

Registrant’s Telephone Number, including area code:**   (432) 682-6324**

 

**Not applicable**

(Former name, former address and former fiscal year, if changed sincelast report)

 

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

 

Indicate by check mark whether theregistrant is an accelerated filer (as defined in Exchange Act Rule 12b-2).       Yes  ý   No  o

 

There were 10,813,552shares of Common Stock, $.10 par value, of the registrant outstanding as of November 7,2005.

 

 

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**CLAYTON WILLIAMS ENERGY, INC.**

**TABLE OF CONTENTS**

 
| ** ** | **PART I.  FINANCIAL INFORMATION**                                                                        | ** ** |
|------------|---------------------------------------------------------------------------------------------------------------------|------------|
| ** ** | ** **                                                                                                          | ** ** |
| Item 1.    | Financial Statements                                                                                                |       |
|       |                                                                                                                |       |
|       | Consolidated  Balance Sheets as of September 30, 2005 and December 31, 2004                               |       |
|       |                                                                                                                |       |
|       | Consolidated  Statements of Operations for the three months and nine months ended September 30,  2005 and 2004 |       |
|       |                                                                                                                |       |
|       | Consolidated  Statement of Stockholders’ Equity for the nine months ended September 30,  2005             |       |
|       |                                                                                                                |       |
|       | Consolidated  Statements of Cash Flows for the nine months ended September 30, 2005  and 2004                  |       |
|       |                                                                                                                |       |
|       | Notes  to Consolidated Financial Statements                                                                         |       |
|       |                                                                                                                |       |
| Item 2.    | Management’s Discussion and Analysis of Financial  Condition and Results of Operations                    |       |
|       |                                                                                                                |       |
| Item 3.    | Quantitative and Qualitative Disclosure  About Market Risks                                                         |       |
|       |                                                                                                                |       |
| Item 4.    | Controls and Procedures                                                                                             |       |
|       |                                                                                                                |       |
| ** ** | **PART II. OTHER INFORMATION**                                                                                 | ** ** |
| ** ** | ** **                                                                                                          | ** ** |
| Item 2.    | Unregistered Sales of Equity Securities  and Use of Proceeds                                                        |       |
|       |                                                                                                                |       |
| Item 6.    | Exhibits                                                                                                            |       |
|       |                                                                                                                |       |
|       | Signatures                                                                                                          |       |

 

2

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**CLAYTON WILLIAMS ENERGY, INC.**

### **CONSOLIDATED BALANCE SHEETS**

**(Dollars in thousands)**

 
| ** **                                                                                                                                                           | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                           | ** ** | **2005**               | ** ** | **2004**              | ** ** |
| ** **                                                                                                                                                           | ** ** | **(Unaudited)**        | ** ** | ** **            | ** ** |
| **ASSETS**                                                                                                                                                           |       |                   |       |                  |       |
| CURRENT ASSETS                                                                                                                                                       |       |                   |       |                  |       |
| Cash and cash equivalents                                                                                                                                            |       | $                      | 50,514     |                  | $          | 16,359 |   |
| Accounts receivable:                                                                                                                                                 |       |                   |       |                  |       |
| Oil and gas sales, net                                                                                                                                               |       | 27,790                 |       | 25,573                |       |
| Joint interest and other, net                                                                                                                                        |       | 5,978                  |       | 4,653                 |       |
| Affiliates                                                                                                                                                           |       | 485                    |       | 553                   |       |
| Inventory                                                                                                                                                            |       | 24,354                 |       | 5,202                 |       |
| Deferred income taxes                                                                                                                                                |       | 1,330                  |       | 625                   |       |
| Fair value of derivatives                                                                                                                                            |       | 200                    |       | 2,333                 |       |
| Prepaids and other                                                                                                                                                   |       | 3,415                  |       | 1,401                 |       |
|                                                                                                                                                                 |       | 114,066                |       | 56,699                |       |
| PROPERTY AND  EQUIPMENT                                                                                                                                              |       |                   |       |                  |       |
| Oil and gas properties, successful efforts method                                                                                                                    |       | 989,276                |       | 909,095               |       |
| Natural gas gathering and processing systems                                                                                                                         |       | 17,886                 |       | 17,286                |       |
| Other                                                                                                                                                                |       | 11,873                 |       | 11,839                |       |
|                                                                                                                                                                 |       | 1,019,035              |       | 938,220               |       |
| Less accumulated depreciation, depletion and  amortization                                                                                                           |       | (564,594               | )          | (539,860              | )          |
| Property and equipment, net                                                                                                                                          |       | 454,441                |       | 398,360               |       |
|                                                                                                                                                                 |       |                   |       |                  |       |
| OTHER ASSETS                                                                                                                                                         |       |                   |       |                  |       |
| Debt issue costs                                                                                                                                                     |       | 8,909                  |       | 3,575                 |       |
| Other                                                                                                                                                                |       | 4,583                  |       | 3,601                 |       |
|                                                                                                                                                                 |       | 13,492                 |       | 7,176                 |       |
|                                                                                                                                                                 |       |                   |       |                  |       |
|                                                                                                                                                                 |       | $                      | 581,999    |                  | $          | 462,235 |   |
| ** **                                                                                                                                                           | ** ** | ** **             | ** ** | ** **            | ** ** |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                        | ** ** | ** **             | ** ** | ** **            | ** ** |
| CURRENT  LIABILITIES                                                                                                                                                 |       |                   |       |                  |       |
| Accounts payable:                                                                                                                                                    |       |                   |       |                  |       |
| Trade                                                                                                                                                                |       | $                      | 64,740     |                  | $          | 51,014 |   |
| Oil and gas sales                                                                                                                                                    |       | 13,047                 |       | 11,223                |       |
| Affiliates                                                                                                                                                           |       | 1,202                  |       | 2,954                 |       |
| Current maturities of long-term debt                                                                                                                                 |       | 25                     |       | 31                    |       |
| Fair value of derivatives                                                                                                                                            |       | 41,976                 |       | 16,026                |       |
| Accrued liabilities and other                                                                                                                                        |       | 7,731                  |       | 3,017                 |       |
|                                                                                                                                                                 |       | 128,721                |       | 84,265                |       |
| NON-CURRENT  LIABILITIES                                                                                                                                             |       |                   |       |                  |       |
| Long-term debt                                                                                                                                                       |       | 225,003                |       | 177,519               |       |
| Deferred income taxes                                                                                                                                                |       | 36,120                 |       | 36,897                |       |
| Fair value of derivatives                                                                                                                                            |       | 57,140                 |       | 28,958                |       |
| Other                                                                                                                                                                |       | 17,821                 |       | 17,000                |       |
|                                                                                                                                                                 |       | 336,084                |       | 260,374               |       |
| COMMITMENTS AND  CONTINGENCIES                                                                                                                                       |       |                   |       |                  |       |
|                                                                                                                                                                 |       |                   |       |                  |       |
| STOCKHOLDERS’  EQUITY                                                                                                                                           |       |                   |       |                  |       |
| Preferred stock, par value $.10 per share,  authorized – 3,000,000 shares; issued and outstanding – none                                                   |       | —                 |       | —                |       |
| Common stock, par value $.10 per share, authorized –  30,000,000 shares; issued and outstanding – 10,812,208 shares in 2005 and  10,787,013 shares in 2004 |       | 1,081                  |       | 1,078                 |       |
| Additional paid-in capital                                                                                                                                           |       | 105,351                |       | 104,674               |       |
| Retained earnings                                                                                                                                                    |       | 10,762                 |       | 11,844                |       |
|                                                                                                                                                                 |       | 117,194                |       | 117,596               |       |
|                                                                                                                                                                 |       |                   |       |                  |       |
|                                                                                                                                                                 |       | $                      | 581,999    |                  | $          | 462,235 |   |

 

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

 

3

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**CLAYTON WILLIAMS ENERGY, INC.**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

**(Unaudited)**

**(In thousands, except per share)**

 
| ** **                                   | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                   | ** ** | **2005**                                   | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| REVENUES                                     |       |                                       |       |                                      |       |   |   |   |   |
| Oil and gas sales                            |       | $                                          | 65,739     |                                      | $          | 52,517 |   | $ | 190,536 |   | $ | 129,968 |   |
| Natural gas services                         |       | 2,572                                      |       | 2,074                                     |       | 7,703 |   | 6,973 |   |
| Gain on sales of property and equipment      |       | 16,832                                     |       | 88                                        |       | 18,911 |   | 154 |   |
| Total revenues                               |       | 85,143                                     |       | 54,679                                    |       | 217,150 |   | 137,095 |   |
|                                         |       |                                       |       |                                      |       |   |   |   |   |
| COSTS AND  EXPENSES                          |       |                                       |       |                                      |       |   |   |   |   |
| Production                                   |       | 16,981                                     |       | 12,372                                    |       | 43,408 |   | 27,502 |   |
| Exploration:                                 |       |                                       |       |                                      |       |   |   |   |   |
| Abandonments and impairments                 |       | 13,863                                     |       | 11,197                                    |       | 31,563 |   | 29,296 |   |
| Seismic and other                            |       | 5,123                                      |       | 1,350                                     |       | 7,576 |   | 5,087 |   |
| Natural gas services                         |       | 2,450                                      |       | 1,882                                     |       | 7,241 |   | 6,529 |   |
| Depreciation, depletion and amortization     |       | 11,568                                     |       | 11,583                                    |       | 36,148 |   | 29,354 |   |
| Accretion of abandonment obligations         |       | 291                                        |       | 413                                       |       | 858 |   | 853 |   |
| General and administrative                   |       | 5,483                                      |       | 2,493                                     |       | 11,135 |   | 8,080 |   |
| Loss on sales of property and equipment      |       | 100                                        |       | 156                                       |       | 132 |   | 156 |   |
| Total costs and expenses                     |       | 55,859                                     |       | 41,446                                    |       | 138,061 |   | 106,857 |   |
|                                         |       |                                       |       |                                      |       |   |   |   |   |
| Operating income                             |       | 29,284                                     |       | 13,233                                    |       | 79,089 |   | 30,238 |   |
|                                         |       |                                       |       |                                      |       |   |   |   |   |
| OTHER INCOME  (EXPENSE)                      |       |                                       |       |                                      |       |   |   |   |   |
| Interest expense                             |       | (5,503                                     | )          | (2,806                                    | )          | (10,435 | ) | (4,715 | ) |
| Change in fair value of derivatives          |       | (28,766                                    | )          | (24,580                                   | )          | (73,692 | ) | (27,982 | ) |
| Other                                        |       | 1,317                                      |       | 764                                       |       | 2,413 |   | 727 |   |
| Total other income (expense)                 |       | (32,952                                    | )          | (26,622                                   | )          | (81,714 | ) | (31,970 | ) |
|                                         |       |                                       |       |                                      |       |   |   |   |   |
| Loss before  income taxes                    |       | (3,668                                     | )          | (13,389                                   | )          | (2,625 | ) | (1,732 | ) |
| Income tax  benefit                          |       | (1,628                                     | )          | (4,201                                    | )          | (1,543 | ) | (226 | ) |
|                                         |       |                                       |       |                                      |       |   |   |   |   |
| NET LOSS                                     |       | $                                          | (2,040     | )                                         | $          | (9,188 | ) | $ | (1,082 | ) | $ | (1,506 | ) |
|                                         |       |                                       |       |                                      |       |   |   |   |   |
| Net loss per  common share:                  |       |                                       |       |                                      |       |   |   |   |   |
| Basic                                        |       | $                                          | (0.19      | )                                         | $          | (0.85 | ) | $ | (0.10 | ) | $ | (0.16 | ) |
| Diluted                                      |       | $                                          | (0.19      | )                                         | $          | (0.85 | ) | $ | (0.10 | ) | $ | (0.16 | ) |
|                                         |       |                                       |       |                                      |       |   |   |   |   |
| Weighted average  common shares outstanding: |       |                                       |       |                                      |       |   |   |   |   |
| Basic                                        |       | 10,810                                     |       | 10,769                                    |       | 10,800 |   | 9,560 |   |
| Diluted                                      |       | 10,810                                     |       | 10,769                                    |       | 10,800 |   | 9,560 |   |

 

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

 

4

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**CLAYTON WILLIAMS ENERGY, INC.**

**CONSOLIDATEDSTATEMENT OF STOCKHOLDERS’ EQUITY**

**(Unaudited)**

**(In thousands)**

 
| ** **                                   | ** ** | **Common Stock** | ** ** | **Additional** | ** ** | ** **  | ** ** |
|----------------------------------------------|------------|------------------|------------|----------------|------------|-------------|------------|
| ** **                                   | ** ** | **No. of**  | ** ** | **Par**        | ** ** | **Paid-In** | ** ** | **Retained** | ** ** |
| ** **                                   | ** ** | **Shares**       | ** ** | **Value**      | ** ** | **Capital** | ** ** | **Earnings** | ** ** |
| BALANCE, December 31, 2004              |       | 10,787           |       | $              | 1,078      |        | $          | 104,674 |   | $ | 11,844 |   |
| Net loss and total comprehensive loss        |       | —           |       | —         |       | —      |       | (1,082 | ) |
| Sales of restricted stock                    |       | 9                |       | 1              |       | 269         |       | — |   |
| Issuance of stock through compensation plans |       | 16               |       | 2              |       | 408         |       | — |   |
|                                         |       |             |       |           |       |        |       |   |   |
| BALANCE, September 30, 2005             |       | 10,812           |       | $              | 1,081      |        | $          | 105,351 |   | $ | 10,762 |   |

 

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

 

5

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**CLAYTON WILLIAMS ENERGY, INC.**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(Unaudited)**

**(In thousands)**

 
| ** **                                                                   | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                   | ** ** | **2005**                                  | ** ** | **2004** | ** ** |
| CASH FLOWS FROM  OPERATING ACTIVITIES                                        |       |                                      |       |   |   |
| Net loss                                                                     |       | $                                         | (1,082     | ) | $ | (1,506 | ) |
| Adjustments to reconcile net loss to cash provided  by operating activities: |       |                                      |       |   |   |
| Depreciation, depletion and amortization                                     |       | 36,148                                    |       | 29,354 |   |
| Exploration costs                                                            |       | 31,563                                    |       | 29,296 |   |
| (Gain) loss on sales of property and equipment                               |       | (18,779                                   | )          | 2 |   |
| Deferred income taxes                                                        |       | (1,465                                    | )          | (226 | ) |
| Non-cash employee stock compensation                                         |       | 2,468                                     |       | 272 |   |
| Change in fair value of derivatives                                          |       | 56,067                                    |       | 17,627 |   |
| Settlements on derivatives with financing elements                           |       | 17,428                                    |       | 4,646 |   |
| Amortization of debt issue costs                                             |       | 2,631                                     |       | — |   |
| Accretion of abandonment obligations                                         |       | 858                                       |       | 853 |   |
|                                                                         |       |                                      |       |   |   |
| Changes in operating working capital:                                        |       |                                      |       |   |   |
| Accounts receivable                                                          |       | (3,474                                    | )          | 6,243 |   |
| Accounts payable                                                             |       | 3,301                                     |       | 536 |   |
| Other                                                                        |       | 967                                       |       | (3,938 | ) |
| Net cash provided by operating activities                                    |       | 126,631                                   |       | 83,159 |   |
|                                                                         |       |                                      |       |   |   |
| CASH FLOWS FROM  INVESTING ACTIVITIES                                        | ** ** | ** **                                | ** ** | ** ** | ** ** |
| Additions to property and equipment                                          |       | (126,788                                  | )          | (93,593 | ) |
| Investment in Southwest Royalties, Inc.                                 |       | —                                    |       | (168,204 | ) |
| Proceeds from sales of property and equipment                                |       | 23,252                                    |       | 441 |   |
| Other                                                                        |       | (11,336                                   | )          | 354 |   |
| Net cash used in investing activities                                        |       | (114,872                                  | )          | (261,002 | ) |
|                                                                         |       |                                      |       |   |   |
| CASH FLOWS FROM  FINANCING ACTIVITIES                                        | ** ** | ** **                                | ** ** | ** ** | ** ** |
| Proceeds from long-term debt                                                 |       | 225,000                                   |       | 191,800 |   |
| Repayments of long-term debt                                                 |       | (177,500                                  | )          | (35,258 | ) |
| Proceeds from sale of common stock                                           |       | 288                                       |       | 30,008 |   |
| Settlements on derivatives with financing elements                           |       | (17,428                                   | )          | (4,646 | ) |
| Payment of debt issue costs                                                  |       | (7,964                                    | )          | (4,156 | ) |
| Net cash provided by financing elements                                      |       | 22,396                                    |       | 177,748 |   |
|                                                                         |       |                                      |       |   |   |
| NET INCREASE  (DECREASE) IN CASH AND CASH EQUIVALENTS                        |       | 34,155                                    |       | (95 | ) |
|                                                                         |       |                                      |       |   |   |
| CASH AND CASH  EQUIVALENTS                                                   |       |                                      |       |   |   |
| Beginning of period                                                          |       | 16,359                                    |       | 15,454 |   |
|                                                                         |       |                                      |       |   |   |
| End of period                                                                |       | $                                         | 50,514     |   | $ | 15,359 |   |
|                                                                         |       |                                      |       |   |   |
| SUPPLEMENTAL  DISCLOSURES                                                    |       |                                      |       |   |   |
| Cash paid for interest, net of amounts capitalized                           |       | $                                         | 5,138      |   | $ | 3,857 |   |

 

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

 

6

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**CLAYTON WILLIAMS ENERGY, INC.**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

**September 30, 2005**

**(Unaudited)**

 

**1.****                                      Natureof Operations**

 

ClaytonWilliams Energy, Inc. (a Delaware corporation) and its subsidiaries(collectively, the “Company” or “CWEI”) is an independent oil and gas companyengaged in the exploration for and development and production of oil andnatural gas primarily in its core areas in Texas, Louisiana and NewMexico.  Approximately 42% of the Company’soutstanding common stock is beneficially owned by its Chairman of the Board andChief Executive Officer, Clayton W. Williams (“Mr. Williams”).  Oil and gas exploration and production is theonly business segment in which the Company operates.

 

Substantiallyall of the Company’s oil and gas production is sold under short-term contractswhich are market-sensitive.  Accordingly,the Company’s financial condition, results of operations, and capital resourcesare highly dependent upon prevailing market prices of, and demand for, oil andnatural gas.  These commodity prices aresubject to wide fluctuations and market uncertainties due to a variety offactors that are beyond the control of the Company.  These factors include the level of globaldemand for petroleum products, foreign supply of oil and gas, the establishmentof and compliance with production quotas by oil-exporting countries, weatherconditions, the price and availability of alternative fuels, and overalleconomic conditions, both foreign and domestic.

 

**2.****                                     ****Presentation**

 

Thepreparation of these consolidated financial statements in conformity withaccounting principles generally accepted in the United States requiresmanagement of the Company to make estimates and assumptions that affect thereported amounts of assets and liabilities and disclosure of contingent assetsand liabilities at the date of the financial statements and the reportedamounts of revenues and expenses during the reporting periods.  Actual results could differ materially fromthose estimates.

 

In theopinion of management, the Company’s unaudited consolidated financialstatements as of September 30, 2005 and for the interim periods ended September 30,2005 and 2004 include all adjustments which are necessary for a fairpresentation in accordance with accounting principles generally accepted in theUnited States.  These interim results arenot necessarily indicative of the results to be expected for the year ending December 31,2005.

 

Certaininformation and footnote disclosures normally included in financial statementsprepared in accordance with accounting principles generally accepted in theUnited States have been condensed or omitted in this Form 10-Q pursuant tothe rules and regulations of the Securities and Exchange Commission (“SEC”).  These consolidated financial statementsshould be read in conjunction with the audited consolidated financialstatements and notes thereto included in the Company’s 2004 Form 10-K.

 

**3.****                                      RecentAccounting Pronouncements**

 

In June 2005,the Emerging Issues Task Force (“EITF”) reached consensus on Issue 04-5 regardingwhen a limited partnership should be consolidated by its general partner.  The proposed framework presumes that a solegeneral partner in a limited partnership controls the limited partnership.  The presumption of control can be overcome ifthe limited partners have (i) the substantive ability to remove the solegeneral partner or otherwise dissolve the limited partnership or (ii) substantiveparticipating rights.   The 

 

7

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EITF has concluded that ageneral partner lacks control if the limited partners can remove the generalpartner with a simple majority vote.  TheCompany is the general partner of several oil and gas limited partnerships andpresently consolidates its proportionate interest in the accounts of thesepartnerships.  The Company is currentlyreviewing the applicable provisions of the partnership agreements to determinethe impact that EITF 04-5 may have on its consolidated financialstatements.  For existing partnerships,EITF 04-5 will be effective for consolidated financial statements issuedby the Company after January 1, 2006. EITF 04-5 is effective for newly created or modified limitedpartnerships subsequent to June 29, 2005.

 

In December 2004,the FASB issued Statement of Financial Accounting Standards No. 123(revised 2004) “Share-Based Payments” (“SFAS 123R”).  SFAS 123R requires that the cost fromall share-based payment transactions, including stock options, be recognized inthe financial statements at fair value. The Company currently uses the intrinsic-value method to account for theseshare-based payments.  For public companies,SFAS 123R is effective for fiscal years beginning after June 15,2005.  The Company will adopt theprovisions of this statement in the first quarter of 2006 and is currentlyassessing the effect of SFAS 123R on the financial statements.

 

In April 2005,the FASB issued Staff Position No. 19-1 (“FSP 19-1”).  FSP 19-1 amends the present guidance inSFAS 19, paragraphs 31 and 34, regarding when exploratory drilling costspending determination of proved reserves can be carried as an asset of an oiland gas company that uses the successful efforts accounting method.  The Company was required to adopt FSP 19-1,including its disclosures, effective July 1, 2005.  The adoption of FSP 19-1 did not have asignificant impact on the Company’s results of operations.  At September 30, 2005 and December 31,2004, the Company had capitalized $0 and $5.4 million, respectively, ofexploratory drilling costs applicable to wells that were pending determinationof proved reserves.  Substantially all ofthe December 31, 2004 capitalized costs were subsequently classified asnon-productive.

 

**4.****                                      Acquisitionof Southwest Royalties, Inc.**

 

On May 21,2004, the Company acquired all the outstanding common stock of SouthwestRoyalties, Inc. (“SWR”) through a merger. Prior to the acquisition, SWR was a privately-held, Midland-based energycompany engaged in oil and gas exploration, production, development andacquisition activities in the United States. Most of SWR’s properties are located in the Permian Basin of west Texasand southeastern New Mexico.

 

Inconnection with the acquisition of SWR, the Company paid $57.1 million toholders of SWR common stock and common stock warrants and assumed andrefinanced approximately $113.9 million of SWR bank debt at closing.  In addition, the Company incurredapproximately $9.4 million of merger-related costs, including (i) theassumption of SWR’s obligations to its officers and employees pursuant tochange of control arrangements and (ii) investment banking, legal,accounting and other direct transaction costs related to the acquisition ofSWR.

 

TheCompany has accounted for the acquisition of SWR using the purchase method ofaccounting for business combinations. Under this method of accounting, CWEI is deemed to be the acquirer foraccounting purposes.  SWR’s assets andliabilities were revalued under the purchase method of accounting and recordedat their estimated fair values.

 

8

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Thefollowing table reflects the unaudited pro forma results of operations for thenine months ended September 30, 2004 as though the acquisition of SWR hadoccurred on January 1, 2004.  Thepro forma amounts are not necessarily indicative of the results that may bereported in the future.

 
| ** **                                      | ** ** | **Nine Months Ended**       | ** ** |
|-------------------------------------------------|------------|-----------------------------|------------|
| ** **                                      | ** ** | **September 30, 2004** | ** ** |
| ** **                                      | ** ** | **(In thousands, except**   | ** ** |
| ** **                                      | ** ** | **per share data)**         | ** ** |
| ** **                                      | ** ** | ** **                  | ** ** |
| Revenues                                        |       | $                           | 160,772    |   |
| Net loss from  continuing operations            |       | $                           | (12,703    | ) |
|                                            |       |                        |       |
| Net loss from  continuing operations per share: |       |                        |       |
| Basic                                           |       | $                           | (1.18      | ) |
| Diluted                                         |       | $                           | (1.18      | ) |

 

**5.****                                      Long-TermDebt**

 

Long-termdebt consists of the following:

 
| ** **                          | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|-------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                          | ** ** | **2005**               | ** ** | **2004**              | ** ** |
| ** **                          | ** ** | **(In thousands)**     | ** ** |
| 7 3/4%  Senior Notes due 2013       |       | $                      | 225,000    |                  | $          | — |   |
| Secured bank  credit facilities:    |       |                   |       |                  |       |
| Revolving loan, due May 2007   |       | —                 |       | 147,500               |       |
| Senior term loan, due May 2008 |       | —                 |       | 30,000                |       |
| Other                               |       | 28                     |       | 50                    |       |
|                                |       | 225,028                |       | 177,550               |       |
| Less current  maturities            |       | (25                    | )          | (31                   | )          |
|                                |       |                   |       |                  |       |
|                                |       | $                      | 225,003    |                  | $          | 177,519 |   |

 

*73⁄4% SeniorNotes due 2013*

 

In July 2005,the Company issued, in a private placement, $225 million of aggregateprincipal amount of 73⁄4% Senior Notes due 2013 (“Senior Notes”).  The Senior Notes were issued at face valueand bear interest at 73⁄4% per year, payable semi-annually on February 1 andAugust 1 of each year, beginning February 1, 2006.  After the payment of typical transactionexpenses, net proceeds of approximately $217 million were used to repayall amounts outstanding under the secured bank credit facilities and forgeneral corporate purposes, including the funding of planned exploration anddevelopment activities.

 

At anytime prior to August 1, 2008, the Company may redeem up to 35% of theaggregate principal amount of the Senior Notes with the proceeds of certainequity offerings at a redemption price of 107.75% of the principal amount, plusaccrued and unpaid interest.  Inaddition, prior to August 1, 2009, the Company may redeem some or all ofthe Senior Notes at a redemption price equal to 100% of the principal amount ofthe Senior Notes to be redeemed, plus a make-whole premium, plus any accruedand unpaid interest.  On and after August 1,2009, the Company may redeem some or all of the Senior Notes at redemptionprices (expressed as percentages of principal amount) equal to 103.875% for thetwelve-month period beginning on August 1, 2009, 101.938% for thetwelve-month period beginning on August 1, 2010, and 100.00% beginning on August 1,2011, for any period thereafter, in each case plus accrued and unpaid interest.

 

9

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TheIndenture governing the Senior Notes restricts the ability of the Company andits restricted subsidiaries to:  (i) borrowmoney; (ii) issue redeemable and preferred stock; (iii) paydistributions or dividends; (iv) make investments; (v) create lienswithout securing the Senior Notes; (vi) enter into agreements thatrestrict dividends from subsidiaries; (vii) sell certain assets or mergewith or into other companies; (viii) enter into transactions withaffiliates; (ix) guarantee indebtedness; and (x) enter into new linesof business.

 

*Secured Bank Credit Facilities*

 

Inconnection with the acquisition of SWR in May 2004 (see Note 4), theCompany entered into new credit facilities with a group of banks that providedfor an increase in borrowing capacity under the Company’s existing revolvingcredit facility and established a new senior term credit facility.  The borrowing base established under therevolving credit facility increased from $95 million to $180 million, and theCompany initially borrowed $75 million on the senior term credit facility.  With a portion of the net proceeds from theprivate placement of common stock in May 2004 (see Note 7), theCompany reduced the principal balance on the senior term credit facility to $50million.  In November 2004, thebanks increased the borrowing base under the revolving credit facility to$195 million, and the Company paid down the senior term credit facility to$30 million with proceeds from certain asset sales.  In connection with the issuance of the 73⁄4%Senior Notes due 2013 in July 2005, the borrowing base under the revolvingcredit facility was reduced to $132.5 million, and all outstandingbalances on the revolving credit facility and the senior term credit facilitywere repaid.

 

Therevolving credit facility provides for interest at rates based on the agentbank’s prime rate plus margins ranging from .25% to 1%, or if elected by theCompany based on LIBOR plus margins ranging from 1.5% to 2.25%.  The Company also pays a commitment fee on theunused portion of the revolving credit facility.  Initially, the senior term credit facilityprovided for interest at rates based on the agent bank’s prime rate plus amargin of 3.5%, or if elected by the Company based on LIBOR plus a marginof 5%.  Subsequently, the prime ratemargin was reduced to 2.5%, and the LIBOR margin was reduced to 4%.  Interest and fees are payable at leastquarterly.  The effective annual interestrate on borrowings under the combined credit facility, including bank fees andamortization of debt issue costs, for the nine months ended September 30,2005 was 7.5%.  Included in interestexpense for 2005 is a non-cash charge to write off $1.8 million of debtissue costs related to the early repayment of the senior term credit facilityand the reduction in the borrowing base on the revolving credit facility.

 

Theamount of funds available to the Company under the revolving credit facility isthe lesser of the borrowing base, as established by the banks, or that portionof the borrowing base determined by the Company to be the elected borrowinglimit.  The borrowing base, which isbased on the discounted present value of future net revenues from oil and gasproduction, is subject to redetermination at any time, but at leastsemi-annually in May and November, and is made at the discretion of thebanks.  At September 30, 2005, theborrowing base was $132.5 million, with no monthly commitment reductions.

 

Theloan agreement applicable to the revolving credit facility contains financialcovenants that are computed quarterly. The working capital covenant requires the Company to maintain a ratio ofcurrent assets to current liabilities of at least 1 to 1.  Another financial covenant under the creditfacility requires the Company to maintain a ratio of indebtedness to cash flowof no more than 3 to 1.  Thecomputations of current assets, current liabilities, cash flow and indebtednessare defined in the loan agreement.  TheCompany was in compliance with all financial and non-financial covenants at September 30,2005.

 

10

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**6.****                                      OtherNon-Current Liabilities**

 

Othernon-current liabilities consist of the following:

 
| ** **               | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|--------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **               | ** ** | **2005**               | ** ** | **2004**              | ** ** |
| ** **               | ** ** | **(In thousands)**     | ** ** |
| ** **               | ** ** | ** **             | ** ** |
| Abandonment  obligations |       | $                      | 17,017     |                  | $          | 16,147 |   |
| Other                    |       | 804                    |       | 853                   |       |
|                     |       | $                      | 17,821     |                  | $          | 17,000 |   |

 

Changesin abandonment obligations for the nine months ended September 30, 2005and 2004 are as follows:

 
| ** **                                                                            | ** ** | **Nine Months Ended**  | ** ** |
|---------------------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                            | ** ** | **September 30,** | ** ** |
| ** **                                                                            | ** ** | **2005**               | ** ** | **2004** | ** ** |
| ** **                                                                            | ** ** | **(In thousands)**     | ** ** |
| ** **                                                                            | ** ** | ** **             | ** ** |
| Beginning of  period                                                                  |       | $                      | 16,147     |   | $ | 8,849 |   |
| Abandonment obligations related to the acquisition  of Southwest Royalties, Inc. |       | —                 |       | 8,512 |   |
| Additional abandonment obligations from new wells                                     |       | 492                    |       | 387 |   |
| Sales or abandonments of properties                                                   |       | (507                   | )          | (170 | ) |
| Revisions of previous estimates                                                       |       | 27                     |       | 40 |   |
| Accretion expense                                                                     |       | 858                    |       | 853 |   |
| End of period                                                                         |       | $                      | 17,017     |   | $ | 18,471 |   |

 

**7.****                                      CommonStock**

 

In May 2004,the Company sold 1,380,869 shares of its common stock to certain institutionalinvestors at a price of $23.00 per share in a private placement that raisedapproximately $31.8 million in gross proceeds. After the payment of typical transaction expenses, net proceeds ofapproximately $30 million were used to repay a portion of the bankindebtedness incurred to finance the acquisition of SWR (see Note 4).

 

In aseries of seven monthly transactions from February 2005 through August 2005,the Company issued a total of 9,268 shares of its common stock to Mr. Williamsin lieu of net cash compensation aggregating $270,000.  These shares were deemed to be sales ofrestricted securities after it was determined that the Executive StockCompensation Plan described in Note 8 had expired effective February 1,2005.

 

**8.****                                      CompensationPlans**

 

*Executive Stock Compensation Plan*

 

ThroughJanuary 2005, the Company had a compensation plan which permitted theCompany to pay all or part of selected executives’ salaries and bonuses inshares of common stock in lieu of cash. This plan expired on February 1, 2005.  During January 2005, the Company issued1,728 shares of common stock to Mr. Williams in lieu of net cashcompensation of $36,000.

 

11

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*Stock-Based Compensation*

 

In June 2005,Mr. Williams was granted options to purchase 200,000 shares of commonstock at a price of $29.39 per share, which was the market value at the date ofgrant.  The Company accounts forstock-based compensation utilizing the intrinsic value method prescribed byAccounting Principles Board Opinion No. 25 “Accounting for Stock Issued toEmployees” (“APB 25”) and related interpretations.  The following pro forma information, asrequired by Statement of Financial Accounting Standards No. 123 “Accountingfor Stock-Based Compensation” (“SFAS 123”), as amended by Statement ofFinancial Accounting Standards No. 148 (“SFAS 148”), presents netincome and earnings per share information as if the stock options issued since December 31,1994 were accounted for using the fair value method.  The fair value of stock options issued foreach year was estimated at the date of grant using the Black-Scholes optionpricing model.

 

TheSFAS 123 pro forma information for the nine months ended September 30,2005 and 2004 is as follows:

 
| ** **                                                                                                         | ** ** | **Nine Months Ended**                 | ** ** |
|--------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                                                                         | ** ** | **September 30,**                | ** ** |
| ** **                                                                                                         | ** ** | **2005**                              | ** ** | **2004** | ** ** |
| ** **                                                                                                         | ** ** | **(In thousands, except per  share)** | ** ** |
| ** **                                                                                                         | ** ** | ** **                            | ** ** |
| Net loss, as  reported                                                                                             |       | $                                     | (1,082     | ) | $ | (1,506 | ) |
| Add: Stock-based employee compensation expense  (credit) included in net income, net of tax                        |       | 1,384                                 |       | (197 | ) |
| Deduct: Stock-based employee compensation expense  determined under fair value based method (SFAS 123), net of tax |       | (2,920                                | )          | (3,840 | ) |
| Net loss, pro  forma                                                                                               |       | $                                     | (2,618     | ) | $ | (5,543 | ) |
|                                                                                                               |       |                                  |       |   |   |
| Basic:                                                                                                             |       |                                  |       |   |   |
| Net loss per common share, as reported                                                                             |       | $                                     | (.10       | ) | $ | (.16 | ) |
| Net loss per common share, pro forma                                                                               |       | $                                     | (.24       | ) | $ | (.58 | ) |
|                                                                                                               |       |                                  |       |   |   |
| Diluted:                                                                                                           |       |                                  |       |   |   |
| Net loss per common share, as reported                                                                             |       | $                                     | (.10       | ) | $ | (.16 | ) |
| Net loss per common share, pro forma                                                                               |       | $                                     | (.24       | ) | $ | (.58 | ) |

 

Inaccordance with the issuance of Financial Accounting Standards BoardInterpretation No. 44 (“FIN 44”) to APB 25, the Company changedthe classification of 233,141 stock options repriced in April 1999 fromfixed stock options to variable stock options. The Company is required to recognize compensation expense on therepriced options to the extent that the quoted market value of the Company’scommon stock at the end of each period after July 1, 2000 exceeds theamended option price ($5.50 per share), except that the Company must recognizecompensation expense for options vested as of July 1, 2000 only to theextent that the quoted market value exceeds the market value on that date($31.94 per share).  As the repricedoptions are exercised, the cumulative amount of accrued compensation expensewill be credited to additional paid-in capital. Since this provision is based on changes in the quoted market value ofthe Company’s common stock, the Company’s future results of operations may besubject to significant volatility. Accrued compensation expense at September 30, 2005 and December 31,2004 is classified as a current liability in the accompanying consolidatedbalance sheet and is comprised of the following activity for the periods thenended.

 

12

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| ** **                                                                                  | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                  | ** ** | **2005**               | ** ** | **2004**              | ** ** |
| ** **                                                                                  | ** ** | **(In thousands)**     | ** ** |
| ** **                                                                                  | ** ** | ** **             | ** ** |
| Beginning of  period                                                                        |       | $                      | 685        |                  | $          | 958 |   |
| Compensation expense (credit)                                                               |       | 2,130                  |       | (245                  | )          |
| Amounts reclassified to additional paid-in capital  for options exercised during the period |       | (37                    | )          | (28                   | )          |
| End of period                                                                               |       | $                      | 2,778      |                  | $          | 685 |   |

 

*After-Payout Working Interest Incentive Plans*

 

In September 2002,the Compensation Committee of the Board of Directors adopted an incentive planfor officers, key employees and consultants, excluding Mr. Williams, whopromote the Company’s drilling and acquisition programs.  Management’s objective in adopting this planis to further align the interests of the participants with those of the Companyby granting the participants an after-payout working interest in the productiondeveloped, directly or indirectly, by the participants.  The plan provides for the creation of aseries of limited partnerships to which the Company, as general partner,contributes a portion of its working interest in wells drilled within certainareas, and the key employee and consultants, as limited partners, contributecash.  The Company pays all costs andreceives all revenues until payout of its costs, plus interest.  At payout, the limited partners receive 99%of all subsequent revenues and pay 99% of all subsequent expenses attributableto the partnerships’ interests.

 

Between3% and 6% of the Company’s working interests in substantially all wells drilledby the Company subsequent to October 2002 are subject to thisarrangement.  The Company consolidatesits proportionate share of partnership assets, liabilities, revenues, expensesand oil and gas reserves in its consolidated financial statements.  In April 2004, one of the partnershipsachieved payout, and the Company’s interest in the partnership was reduced to1%.  Aggregate cash distributions of$199,000 were paid to the limited partners of this partnership during the ninemonths ended September 30, 2005.

 

**9.****                                      Derivatives**

 

# ***Commodity Derivatives***

# ** **

Fromtime to time, the Company utilizes commodity derivatives, consisting of swaps,floors and collars, to attempt to optimize the price received for its oil andgas production.  When using swaps tohedge oil and natural gas production, the Company receives a fixed price forthe respective commodity and pays a floating market price as defined in eachcontract (generally NYMEX futures prices), resulting in a net amount due to orfrom the counterparty.  In floortransactions, the Company receives a fixed price (put strike price) if themarket price falls below the put strike price for the respectivecommodity.  If the market price isgreater than the put strike price, no payments are due from either party.  Costless collars are a combination of putsand calls, and contain a fixed floor price (put strike price) and ceiling price(call strike price).  If the market pricefor the respective commodity exceeds the call strike price or falls below theput strike price, then the Company receives the fixed price and pays the marketprice.  If the market price is betweenthe call and the put strike prices, no payments are due from either party.

 

Thefollowing summarizes information concerning the Company’s net positions in opencommodity derivatives applicable to periods subsequent to September 30,2005.  The settlement prices of commodityderivatives are based on NYMEX futures prices.

 

13

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**Floors:**

 
| ** **          | ** ** | **Gas**       | ** ** | **Oil**   | ** ** |
|---------------------|------------|---------------|------------|-----------|------------|
| ** **          | ** ** | **MMBtu (a)** | ** ** | **Floor** | ** ** | **Bbls** | ** ** | **Floor** | ** ** |
| Production  Period: |       |          |       |      |       |   |   |   |   |
| 4th Quarter 2005    |       | 1,840,000     |       | $         | 4.50       |   | 119,600 |   | $ | 28.00 |   |
|                     |            |               |            |           |            |  |  |  |  |  |  |

 

**Collars:**

 
| ** **           | ** ** | **Gas**       | ** ** | **Oil**   | ** ** |
|----------------------|------------|---------------|------------|-----------|------------|
| ** **           | ** ** | **MMBtu (a)** | ** ** | **Floor** | ** ** | **Ceiling** | ** ** | **Bbls** | ** ** | **Floor** | ** ** | **Ceiling** | ** ** |
| Production  Period:  |       |          |       |      |       |   |   |   |   |   |   |   |   |
| 4th Quarter 2005 (b) |       | 588,000       |       | $         | 4.00       |   | $ | 5.23 |   | 108,000 |   | $ | 23.00 |   | $ | 25.41 |   |
| 2006                 |       | 2,024,000     |       | $         | 4.00       |   | $ | 5.21 |   | 613,000 |   | $ | 23.00 |   | $ | 25.32 |   |
| 2007                 |       | 1,831,000     |       | $         | 4.00       |   | $ | 5.18 |   | 562,000 |   | $ | 23.00 |   | $ | 25.20 |   |
| 2008                 |       | 1,279,000     |       | $         | 4.00       |   | $ | 5.15 |   | 392,000 |   | $ | 23.00 |   | $ | 25.07 |   |
|                 |       |          |       |      |       |   |   |   |   |   |   |   |   |   |   |   |   |
|                 |       | 5,722,000     |       |      |       |   |   | 1,675,000 |   |   |   |   |   |

 

----

(a)                                  One MMBtu equals one Mcf at a Btu factor of1,000.

 

(b)                                 Excludes a closed hedge position for 54,000barrels of oil which will be settled during the fourth quarter of 2005 at aloss of $2.4 million.

 

In November 2005, the Company entered into aswap arrangement covering 1,140,000 barrels of 2006 oil production at a fixedprice of $62.30 per barrel.

 

*Interest Rate Derivatives*

 

The following summarizes information concerning ournet positions in open interest rate swaps applicable to periods subsequent to September 30,2005.

 

**Swaps:**

 
| ** **                                     | ** ** | **Principal** | ** ** | **Libor** | ** ** |
|------------------------------------------------|------------|---------------|------------|-----------|------------|
| ** **                                     | ** ** | **Balance**   | ** ** | **Rates** | ** ** |
| Period:                                        |       |          |       |      |       |
| October 1, 2005 to November 1, 2005  |       | $             | 60,000,000 |      | 2.97       | % |
| November 1, 2005 to November 1, 2006 |       | $             | 55,000,000 |      | 4.29       | % |
| November 1, 2006 to November 1, 2007 |       | $             | 50,000,000 |      | 5.19       | % |
| November 1, 2007 to November 1, 2008 |       | $             | 45,000,000 |      | 5.73       | % |

 

*Accounting For Derivatives*

 

The Company accounts for its derivatives inaccordance with Statement of Financial Accounting Standards No. 133 “Accountingfor Derivative Instruments and Hedging Activities” (“SFAS 133”), asamended.  The Company did not designateany of its currently open commodity or interest rate derivatives as cash flowhedges; therefore, all changes in the fair value of these contracts prior tomaturity, plus any realized gains or losses at maturity, are recorded as otherincome (expense) in the Company’s statements of operations.

 

Pursuantto SFAS 133, as amended by SFAS 149, the derivative instrumentsassumed in connection with the SWR acquisition (see Note 4) are deemed tocontain a significant financing element, and all cash flows associated with thesettlement of these positions are reported as a financing activity in the consolidatedstatements of cash flows.

 

14

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**10.****                               FinancialInstruments**

 

Cash and cash equivalents, receivables, accountspayable and accrued liabilities were each estimated to have a fair valueapproximating the carrying amount due to the short maturity of thoseinstruments.  Indebtedness under thesecured bank credit facilities was estimated to have a fair value approximatingthe carrying amount since the stated interest rate is generally marketsensitive.  Abandonment obligations arecarried at net present value which approximates their fair value since thediscount rate is based on the Company’s credit-adjusted, risk-free rate.  The fair value of other noncurrentliabilities approximate their carrying value.

 

The fair values of derivatives as of September 30,2005 and December 31, 2004 are set forth below.  The associated carrying values at these datesare equal to their estimated fair values.

 
| ** **                | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|---------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                | ** ** | **2005**               | ** ** | **2004**              | ** ** |
| ** **                | ** ** | **(In thousands)**     | ** ** |
| Liabilities:              |       |                   |       |                  |       |
| Commodity derivatives     |       | $                      | (98,233    | )                     | $          | (41,162 | ) |
| Interest rate derivatives |       | (485                   | )          | (1,489                | )          |
| Net liabilities           |       | $                      | (98,718    | )                     | $          | (42,651 | ) |

 

**11.****                               IncomeTaxes**

 

Deferredtax assets and liabilities are the result of temporary differences between thefinancial statement carrying values and the tax bases of assets andliabilities.  Significant components ofnet deferred tax liabilities at September 30, 2005 and December 31,2004 are as follows:

 
| ** **                                            | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                            | ** ** | **2005**               | ** ** | **2004**              | ** ** |
| ** **                                            | ** ** | **(In thousands)**     | ** ** |
| Deferred tax  assets:                                 |       |                   |       |                  |       |
| Net operating loss carryforwards                      |       | $                      | 1,504      |                  | $          | 7,915 |   |
| Accrued stock-based compensation                      |       | 972                    |       | 240                   |       |
| Fair value of derivatives                             |       | 34,553                 |       | 14,930                |       |
| Alternative minimum tax credit carryforwards          |       | 407                    |       | 279                   |       |
| Depletion carryforwards                               |       | 3,628                  |       | 3,209                 |       |
| Other                                                 |       | 5,274                  |       | 5,058                 |       |
|                                                  |       | 46,338                 |       | 31,631                |       |
| Deferred tax  liabilities:                            |       |                   |       |                  |       |
| Property and equipment                                |       | (81,128                | )          | (67,903               | )          |
|                                                  |       |                   |       |                  |       |
| Net deferred tax  liabilities                         |       | $                      | (34,790    | )                     | $          | (36,272 | ) |
| Components of  net deferred tax assets (liabilities): |       |                   |       |                  |       |
| Current assets                                        |       | $                      | 1,330      |                  | $          | 625 |   |
| Non-current liabilities                               |       | (36,120                | )          | (36,897               | )          |
|                                                  |       | $                      | (34,790    | )                     | $          | (36,272 | ) |

 

15

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Forthe nine months ended September 30, 2005 and 2004, the Company’s effectiveincome tax rates were different than the statutory federal income tax rates forthe following reasons:

 
| ** **                                   | ** ** | **Nine Months Ended**  | ** ** |
|----------------------------------------------|------------|------------------------|------------|
| ** **                                   | ** ** | **September 30,** | ** ** |
| ** **                                   | ** ** | **2005**               | ** ** | **2004** | ** ** |
| ** **                                   | ** ** | **(In thousands)**     | ** ** |
| Income tax  benefit at statutory rate of 35% |       | $                      | (919       | ) | $ | (606 | ) |
| Tax depletion in  excess of basis            |       | (419                   | )          | (369 | ) |
| State income  taxes                          |       | (205                   | )          | 800 |   |
| Revision of  previous tax estimates          |       | —                 |       | (51 | ) |
| Income tax benefit                           |       | $                      | (1,543     | ) | $ | (226 | ) |
|                                         |       |                   |       |   |   |
| Current                                      |       | $                      | (78        | ) | $ | 699 |   |
| Deferred                                     |       | (1,465                 | )          | (925 | ) |
| Income tax benefit                           |       | $                      | (1,543     | ) | $ | (226 | ) |

 

TheCompany derives an income tax benefit when employees and directors exerciseoptions granted under the Company’s stock compensation plans (seeNote 8).  Employee stock optionsthat are classified as fixed stock options under APB 25 do not result in acharge against book income when the option price is equal to or greater thanthe market price at date of grant. Therefore, any tax benefit from the exercise of fixed stock optionsresults in a permanent difference, which is recorded to additional paid-incapital when the tax benefit is realized.

 

Inconnection with the SWR merger, the Company acquired $29.3 million of tax losscarryforwards that are subject to limitations under Internal Revenue Code Section 382from a prior change in control that occurred in April 2002 and from thechange in control of SWR that occurred in connection with the Company’sacquisition of SWR in May 2004.  TheCompany has completed a review of the facts surrounding these changes incontrol and presently believes that it will be able to utilize all of SWR’s taxloss carryforwards.

 

At September 30,2005, the Company’s cumulative tax loss carryforwards were approximately$4 million.  Based upon currentcommodity prices and production volumes, as well as the availability of taxplanning strategies (such as elective capitalization of intangible drillingcosts), the Company believes that it is more likely than not that the Companywill be able to utilize these tax loss carryforwards before they expire(beginning in 2008).  Accordingly, no valuation allowance has beenprovided at September 30, 2005.

 

**12.****                              ****Commitments**

 

*Drilling Rig Joint Venture*

 

In October 2005,the Company entered into a letter agreement with a privately-held contractdrilling company (the “Co-Venturer”) which calls for the formation of a jointventure to acquire at least 12 new drilling rigs.  Each party will own a 50% interest in thejoint venture.  The Co-Venturer willserve as the operations manager of the joint venture, and the Company will beresponsible for financing the purchase of the rigs.  The total acquisition cost, includingconstruction and equipping of the rigs, is expected to be approximately $75 million.  The agreement contemplates that the jointventure will be able to finance 100% of the total acquisition costs of the rigsbased on a three-year loan amortization. If the joint venture is unable to obtain 100% financing, the Companywill be required to provide the balance either through loans to the jointventure on the same terms as the primary financing or otherwise through equityinvestments in

 

16

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the joint venture.  After initial construction and equipping, allcosts to maintain the equipment will be borne equally by the parties.

 

*Equipment Orders*

 

TheCompany has placed firm orders for tubing, casing, pumping units and otherequipment to be used in its exploration and development activities totalingapproximately $33 million.  Most of thesepurchases will be made during the fourth quarter of 2005.

 

17

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**Item 2 -****       Management’sDiscussion and Analysis of Financial Condition and Results of Operations**

 

The following discussion is intended to provideinformation relevant to an understanding of our financial condition, changes inour financial condition and our results of operations and cash flows and shouldbe read in conjunction with our consolidated financial statements and notesthereto included elsewhere in this Form 10-Q and in our Form 10-K forthe year ended December 31, 2004.

 

**Overview**

 

We are an oil and natural gas exploration,development, acquisition and production company.  Our basic business model is to find anddevelop oil and gas reserves through exploration and development activities,and sell the production from those reserves at a profit.  To be successful, we must, over time, be ableto find oil and gas reserves and then sell our discovered production at a pricethat is sufficient to cover our finding costs, operating expenses, administrativecosts and interest expense, plus offer us a return on our capital investment.

 

Fromtime to time, we may also acquire producing properties if we believe theacquired assets offer us the potential for reserve growth through additionaldevelopmental or exploratory drilling activities.  The acquisition of Southwest Royalties, Inc.(“SWR”) in May 2004 provided us with a number of well locations suitablefor developmental drilling and also enhanced our ability to conduct explorationactivities on or adjacent to some of the acquired properties.

 

We believe that the economic climate in thedomestic oil and gas industry continues to be suitable for our businessmodel.  Oil and gas prices have remainedstrong.  Supply and demand fundamentalscontinue to suggest that energy prices will remain high for the near term,providing us with the economic incentives necessary for us to assume the riskswe face in our search for oil and gas reserves.  On thedownside, however, we are also experiencing significant cost increases inalmost all areas of our business activities, especially in drilling andproduction costs.  High demand foroilfield services is being met with shortages in equipment and trainedpersonnel, resulting in rate increases. While profit margins still remain favorable, operating metrics per Mcfe,such as finding costs, production costs and overhead costs, are rising.

 

Finding quality domestic oil and gas reservesthrough exploration is a significant challenge and involves a high degree ofrisk.  Although our recent explorationresults have improved, our drilling successes in 2002 and 2003 were limited anddid not find sufficient reserves to replace our production through explorationactivities.  In order to grow our reservebase through our exploration program, we need to continue to improve ourdrilling success.  We will also continueto look for opportunities to complement our exploration program through thepurchase of proved reserves as we did in 2004 with the acquisition of SWR.

 

**Key Factors to Consider**

 

The following summarizes the key factors consideredby management in the review of our financial condition and operatingperformance for the third quarter of 2005 and the outlook for the remainder of2005.

 

•           We recorded a loss of$28.8 million related to the change in fair value of derivatives during thethird quarter of 2005. Cash settlements to counterparties accounted for $8 millionof this loss, and changes in mark-to-market valuations accounted for $20.8 million.  Since we do not presently designate ourderivatives as cash flow hedges under applicable accounting

 

18

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standards,we recognize the full effect of changing prices on mark-to-market valuations asa current charge or credit to our results of operations.

 

•           In August 2005, we sold our interests in two leases in the Breton Soundarea in the Gulf of Mexico (offshore Louisiana) for $21.3 million, subject to post-closing adjustments. We realized a gain of $16.8 million on this sale during the thirdquarter of 2005.

 

•           Exploration costs related to abandonments and impairments were $13.9 millionduring the third quarter of 2005, most of which was attributable to two dry holes in south Louisiana.

 

•           Higher oil and gas pricesresulted in a 25% increase in oil and gas sales for the third quarter of 2005as compared to the 2004 period despite a 15% decline in oil and gas productionfor the same periods.  Approximately halfof this decline was attributable to the loss of production in Louisiana as aresult of Hurricane Katrina in late August, a condition which we expect topersist at least through the end of 2005.

 

•           We currently plan to spend $174.9 million in 2005 on exploration anddevelopment activities, of which approximately 72% relates to exploratory prospects.  Wecannot predict our drilling success on exploratory prospects, and our futureresults of operations and financial condition could be adversely affected byunsuccessful exploratory drilling results.

 

•           In July 2005, we significantly improved our liquidity by issuing $225 millionof aggregate principal amount of 73⁄4% Senior Notes due 2013.  With net proceeds from the Senior Notes ofapproximately $217 million, we repaid all amounts outstanding under our securedbank credit facilities and currently have approximately $131.7 millionborrowing capacity available under our revolving credit facility.

 

**Recent Exploration andDevelopmental Activities**

 

***South Louisiana***

 

The following table sets forth certain informationabout our exploratory well activities in south Louisiana subsequent to December 31,2004.

 
| ** **         | ** ** | ** **                                                 | ** ** | **Working**  | ** ** | **Current**                      | ** ** |
|--------------------|------------|------------------------------------------------------------|------------|--------------|------------|----------------------------------|------------|
| **Spud Date**      | ** ** | **Well Name (Prospect)**                                   | ** ** | **Interest** | ** ** | **Status**                       | ** ** |
| ** **         | ** ** | ** **                                                 | ** ** | ** **   | ** ** | ** **                       | ** ** |
| August 2004   |       | McIlhenny #1 (Tabasco)                                     |       | 33           | %          | Dry                              |       |
| November 2004 |       | Orleans Levee District #1    (American Bay) |       | 45           | %          | Waiting on production facilities |       |
| February 2005 |       | State Lease 18065 #1 (Alabama)                             |       | 100          | %          | Waiting on production facilities |       |
| July 2005     |       | Ransom #1 (Keck)                                           |       | 50           | %          | Drilling                         |       |
| August 2005   |       | State Lease 17636 #1 (Natalie)                             |       | 30           | %          | Dry                              |       |
| August 2005   |       | LL&E #1 (Andrea)                                       |       | 70           | %          | Dry                              |       |

 

We are currently repairing or reconstructingproduction facilities for the Orleans Levee District #1 (American Bay) and theState Lease 18065 #1 (Alabama) that were damaged by Hurricane Katrina in August 2005.  We currently expect to be able to sellproduction from these wells beginning late fourth quarter of 2005 or earlyfirst quarter of 2006.  We abandoned theState Lease 17636 #1 (Natalie) in Terrebonne Parish and the LL&E #1(Andrea) in Cameron Parish in October 2005.  We recorded a pretax charge of$8.9 million during the third quarter of 2005 in connection with theseabandonments and will record an additional charge of approximately$1.6 million during the fourth quarter of 2005 for costs incurred on thesewells after September 30, 2005.

 

19

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***Permian Basin***

 

Subsequent to December 31, 2004, we havedrilled 25 gross (21.2 net) operated wells in various fields in the PermianBasin, all of which were completed as producers.  Several of these wells contributed favorablyto our fiscal 2005 production.  Inaddition, we are currently conducting drilling or completing operations on 8gross (7.2 net) wells in this area.

 

***Other***

 

We abandoned the Deer-Hamilton #1 well, a17,000-foot exploratory well in Nueces County, Texas targeting the Vicksburgformation, in August 2005.  Inaddition to a $4.5 million charge in the second quarter of 2005, werecorded a charge of $3.4 million during the third quarter of 2005 inconnection with this abandonment.

 

20

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** **

**SupplementalInformation**

 

Thefollowing unaudited information is intended to supplement the consolidatedfinancial statements included in this Form 10-Q with data that is notreadily available from those statements.

 
| ** **                                       | ** **                 | **Three Months Ended** | ** ** |
|--------------------------------------------------|----------------------------|------------------------|------------|
| ** **                                       | ** **                 | **September 30,** | ** ** |
| ** **                                       | ** **                 | **2005**               | ** ** | **2004** | ** ** |
| **Oil and  Gas Production Data:**                | ** **                 | ** **             | ** ** | ** ** | ** ** |
| Gas (MMcf)                                       |                       | 3,897                  |       | 4,531 |   |
| Oil (MBbls)                                      |                       | 537                    |       | 624 |   |
| Natural gas liquids (MBbls)                      |                       | 52                     |       | 77 |   |
| Total (MMcfe)                                    |                       | 7,431                  |       | 8,737 |   |
|                                             |                       |                   |       |   |   |
| **Average  Realized Prices (1):**                | ** **                 | ** **             | ** ** | ** ** | ** ** |
| Gas ($/Mcf)                                      |                       | $                      | 7.98       |   | $ | 5.32 |   |
| Oil ($/Bbl)                                      |                       | $                      | 59.95      |   | $ | 41.71 |   |
| Natural gas liquids ($/Bbl):                     |                       | $                      | 37.00      |   | $ | 28.79 |   |
|                                             |                       |                   |       |   |   |
| **Losses  on Settled Derivative Contracts (1):** | ** **                 | ** **             | ** ** | ** ** | ** ** |
| ($ in thousands, except per unit)           |                       |                   |       |   |   |
| Gas:                                             | Net realized  loss         |                   | $          | (2,023 | ) | $ | (2,923 | ) |
|                                             | Per unit  produced ($/Mcf) |                   | $          | (.52 | ) | $ | (.65 | ) |
| Oil:                                             | Net realized  loss         |                   | $          | (5,935 | ) | $ | (4,312 | ) |
|                                             | Per unit  produced ($/Bbl) |                   | $          | (11.05 | ) | $ | (6.91 | ) |
|                                             |                       |                   |       |   |   |   |   |   |
| **Average  Daily Production:**                   | ** **                 | ** **             | ** ** | ** ** | ** ** |
| Natural Gas (Mcf):                               |                       |                   |       |   |   |
| Permian Basin                                    |                       | 17,300                 |       | 14,656 |   |
| Louisiana                                        |                       | 8,528                  |       | 8,745 |   |
| Austin Chalk (Trend)                             |                       | 2,672                  |       | 3,021 |   |
| Cotton Valley Reef Complex                       |                       | 13,336                 |       | 21,579 |   |
| Other                                            |                       | 523                    |       | 1,249 |   |
| Total                                            |                       | 42,359                 |       | 49,250 |   |
| Oil (Bbls):                                      |                       |                   |       |   |   |
| Permian Basin                                    |                       | 3,131                  |       | 3,329 |   |
| Louisiana                                        |                       | 809                    |       | 1,295 |   |
| Austin Chalk (Trend)                             |                       | 1,839                  |       | 2,104 |   |
| Other                                            |                       | 58                     |       | 55 |   |
| Total                                            |                       | 5,837                  |       | 6,783 |   |
| Natural Gas Liquids (Bbls):                      |                       |                   |       |   |   |
| Permian Basin                                    |                       | 261                    |       | 321 |   |
| Austin Chalk (Trend)                             |                       | 220                    |       | 301 |   |
| Other                                            |                       | 84                     |       | 215 |   |
| Total                                            |                       | 565                    |       | 837 |   |

 

 

(Continued)

 

 

21

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| ** **                                | ** ** | **Three Months Ended** | ** ** |
|-------------------------------------------|------------|------------------------|------------|
| ** **                                | ** ** | **September 30,** | ** ** |
| ** **                                | ** ** | **2005**               | ** ** | **2004** | ** ** |
| **Exploration  Costs (in thousands):**    |       |                   |       |   |   |
| Abandonment and impairment costs:         |       |                   |       |   |   |
| Louisiana                                 |       | $                      | 9,434      |   | $ | 9,600 |   |
| Cotton Valley Reef Complex                |       | 5                      |       | 44 |   |
| Mississippi                               |       | 915                    |       | — |   |
| Permian Basin                             |       | 72                     |       | — |   |
| Nevada, Arizona, California and Utah      |       | —                 |       | 725 |   |
| Other                                     |       | 3,437                  |       | 828 |   |
| Total                                     |       | 13,863                 |       | 11,197 |   |
|                                      |       |                   |       |   |   |
| Seismic and other                         |       | 5,123                  |       | 1,350 |   |
| Total exploration costs                   |       | $                      | 18,986     |   | $ | 12,547 |   |
|                                      |       |                   |       |   |   |
| **Oil and  Gas Costs ($/Mcfe Produced):** |       |                   |       |   |   |
| Production costs                          |       | $                      | 2.29       |   | $ | 1.42 |   |
| Oil and gas depletion                     |       | $                      | 1.46       |   | $ | 1.24 |   |
|                                      |       |                   |       |   |   |
| **Net  Wells Drilled (2):**               |       |                   |       |   |   |
| Exploratory Wells                         |       | 3.7                    |       | 4.0 |   |
| Developmental Wells                       |       | 6.0                    |       | .9 |   |

 
| ** **                                       | ** **                 | **Nine Months Ended**  | ** ** |
|--------------------------------------------------|----------------------------|------------------------|------------|
| ** **                                       | ** **                 | **September 30,** | ** ** |
| ** **                                       | ** **                 | **2005**               | ** ** | **2004** | ** ** |
| **Oil and  Gas Production Data:**                | ** **                 | ** **             | ** ** | ** ** | ** ** |
| Gas (MMcf)                                       |                       | 13,205                 |       | 12,813 |   |
| Oil (MBbls)                                      |                       | 1,771                  |       | 1,464 |   |
| Natural gas liquids (MBbls)                      |                       | 185                    |       | 181 |   |
| Total (MMcfe)                                    |                       | 24,941                 |       | 22,683 |   |
|                                             |                       |                   |       |   |   |
| **Average  Realized Prices(1):**                 | ** **                 | ** **             | ** ** | ** ** | ** ** |
| Gas ($/Mcf)                                      |                       | $                      | 6.88       |   | $ | 5.39 |   |
| Oil ($/Bbl)                                      |                       | $                      | 52.39      |   | $ | 38.25 |   |
| Natural gas liquids ($/Bbl):                     |                       | $                      | 31.70      |   | $ | 25.93 |   |
|                                             |                       |                   |       |   |   |
| **Losses  on Settled Derivative Contracts (1):** | ** **                 | ** **             | ** ** | ** ** | ** ** |
| ($ in thousands, except per unit)           |                       |                   |       |   |   |
| Gas:                                             | Net realized  loss         |                   | $          | (2,585 | ) | $ | (3,873 | ) |
|                                             | Per unit  produced ($/Mcf) |                   | $          | (.20 | ) | $ | (.30 | ) |
| Oil:                                             | Net realized  loss         |                   | $          | (14,918 | ) | $ | (6,316 | ) |
|                                             | Per unit  produced ($/Bbl) |                   | $          | (8.42 | ) | $ | (4.31 | ) |

 

 

(Continued)

 

 

22

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| ** **                                | ** ** | **Nine Months Ended**  | ** ** |
|-------------------------------------------|------------|------------------------|------------|
| ** **                                | ** ** | **September 30,** | ** ** |
| ** **                                | ** ** | **2005**               | ** ** | **2004** | ** ** |
| **Average  Daily Production:**            | ** ** | ** **             | ** ** | ** ** | ** ** |
| Natural Gas (Mcf):                        |       |                   |       |   |   |
| Permian Basin                             |       | 16,512                 |       | 8,005 |   |
| Louisiana                                 |       | 12,777                 |       | 9,790 |   |
| Austin Chalk (Trend)                      |       | 2,443                  |       | 3,266 |   |
| Cotton Valley Reef Complex                |       | 15,972                 |       | 24,321 |   |
| Other                                     |       | 666                    |       | 1,381 |   |
| Total                                     |       | 48,370                 |       | 46,763 |   |
| Oil (Bbls):                               |       |                   |       |   |   |
| Permian Basin                             |       | 3,248                  |       | 2,130 |   |
| Louisiana                                 |       | 1,258                  |       | 911 |   |
| Austin Chalk (Trend)                      |       | 1,927                  |       | 2,244 |   |
| Other                                     |       | 54                     |       | 58 |   |
| Total                                     |       | 6,487                  |       | 5,343 |   |
| Natural Gas Liquids (Bbls):               |       |                   |       |   |   |
| Permian Basin                             |       | 238                    |       | 270 |   |
| Austin Chalk (Trend)                      |       | 316                    |       | 197 |   |
| Other                                     |       | 124                    |       | 194 |   |
| Total                                     |       | 678                    |       | 661 |   |
| **Exploration  Costs (in thousands):**    |       |                   |       |   |   |
| Abandonment and impairment costs:         |       |                   |       |   |   |
| Louisiana                                 |       | $                      | 10,911     |   | $ | 25,475 |   |
| Cotton Valley Reef Complex                |       | 7,405                  |       | 44 |   |
| Mississippi                               |       | 4,262                  |       | — |   |
| Permian Basin                             |       | 1,042                  |       | — |   |
| Nevada, Arizona, California and Utah      |       | —                 |       | 2,408 |   |
| Other                                     |       | 7,943                  |       | 1,369 |   |
| Total                                     |       | 31,563                 |       | 29,296 |   |
| Seismic and other                         |       | 7,576                  |       | 5,087 |   |
| Total exploration costs                   |       | $                      | 39,139     |   | $ | 34,383 |   |
|                                      |       |                   |       |   |   |
| **Oil and  Gas Costs ($/Mcfe Produced):** |       |                   |       |   |   |
| Production costs                          |       | $                      | 1.74       |   | $ | 1.21 |   |
| Oil and gas depletion                     |       | $                      | 1.36       |   | $ | 1.19 |   |
|                                      |       |                   |       |   |   |
| **Net  Wells Drilled (2):**               |       |                   |       |   |   |
| Exploratory Wells                         |       | 11.3                   |       | 9.1 |   |
| Developmental Wells                       |       | 21.9                   |       | 7.6 |   |

 

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(1)                          Hedginggains (losses) are only included in the determination of our average realizedprices if the underlying derivative contracts are designated as cash flowhedges under applicable accounting standards. We did not designate any of our 2004 or 2005 derivative contracts ascash flow hedges.  This means that ourderivatives for 2004 and 2005 have been marked-to-market through our statementof operations as other income/expense instead of through accumulated othercomprehensive income on our balance sheet. This also means that all realized gains/losses on these derivatives arereported in other income/loss instead of as a component of oil and gas sales.

 

(2)                          Excludeswells being drilled or completed at the end of each period.

 

23

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**Operating Results – Three-Month Periods**

 

The following discussion compares our results forthe three months ended September 30, 2005 to the comparative period in2004.  Unless otherwise indicated,references to 2005 and 2004 within this section refer to the respectivequarterly period.

 

***Oil and gas operating results***

 

Oil and gas sales in 2005 increased 25% from 2004due primarily to higher product prices, offset in part by a 15% decrease in oiland gas production on an Mcfe basis.  Oiland gas sales increased $13.2 million, of which price variances accounted for a$20.7 million increase and production variances accounted for a$7.5 million decrease.

 

Production in 2005 (on an Mcfe basis) was 15% lowerthan 2004.  Our oil production decreased14% in 2005 from 2004 due in part to lost production in Louisiana as a resultof Hurricane Katrina and normal production declines on existing wells.  Our gas production decreased 14% in 2005 from2004 due partially to lost gas production from the hurricane and by higher thannormal production declines in the Cotton Valley Reef Complex area due toformation performance.  We expect our oiland gas production for fiscal 2005 to be approximately equal to fiscal 2004levels without taking into account any new production from our explorationprogram or from acquisitions of proved reserves.

 

In 2005, our realized oil price was 44% higher than2004, while our realized gas price was 50% higher.  Historically, the markets for oil and gashave been volatile, and they are likely to continue to be volatile.

 

Oil and gas production costs on an Mcfe basisincreased from $1.42 per Mcfe in 2004 to $2.29 per Mcfe in 2005.  The increase in operating costs in 2005 wasdue primarily to higher oilfield service costs and an increase in workoveractivities.  It is likely that thesefactors will continue to contribute to higher production costs in futureperiods.

 

Depreciation, depletion, and amortization (“DD&A”)expense attributable to our oil and gas properties was virtually unchanged from2004 levels at $11.6 million.  Ratevariances accounted for a $1.7 million increase in DD&A expense and productionvariances accounted for a $1.7 million decrease.  On an Mcfe basis, DD&A expense increased18% from $1.24 per Mcfe in 2004 to $1.46 per Mcfe in 2005.  Depletion rates for each depletable group area function of net capitalized costs and estimated reserve quantities.

 

General and administrative (“G&A”) expenses,excluding non-cash stock-based employee compensation, increased 40% in 2005 ascompared to 2004 due primarily to higher personnel costs and professional feesderived from the increase in overall drilling and exploration activities.  G&A expenses for 2005 include a non-cashcharge of $1.9 million for stock-based employee compensation required byFinancial Accounting Standards Board Interpretation No. 44.  A$98,000 non-cash credit (reduction of expense) was required for the 2004period.  Since the amount of this non-cash provision or credit is based onthe quoted market value of our common stock, the future results of ouroperations may be subject to significant volatility based on changes in themarket price of our common stock.

 

24

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***Gain onproperty sales***

 

Gain on sales of property and equipment for 2005was $16.8 million, as compared to $88,000 in 2004.  In August 2005, we sold our interests intwo leases in the Breton Sound area in the Gulf of Mexico (offshore Louisiana)for $21.3 million, subject to post-closing adjustments.  We realized a gain of $16.8 million onthis sale during the third quarter of 2005.

 

***Exploration costs***

 

Since we follow the successful efforts method ofaccounting, our results of operations are adversely affected during anyaccounting period in which significant seismic costs, exploratory dry holecosts, and unproved acreage impairments are expensed.  In 2005, we chargedto expense $19 million of exploration costs, as compared to$12.5 million in 2004.  Most of these costs were incurred inLouisiana, Mississippi and south Texas.

 

We plan to spend approximately $174.9 millionon exploration and development activities in fiscal 2005, of which 72% isexpected to be allocated to exploration activities.  Since exploratorydrilling involves a high degree of risk, it is likely that a significantportion of the remaining costs in fiscal 2005 will be charged to explorationcosts. However, we cannot predict our success rates and, accordingly, cannotpredict our exploration costs related to abandonment and impairment costs.

 

***Interestexpense***

 

Interest expense increased from $2.8 millionin 2004 to $5.5 million in 2005 due primarily to recording a non-cash chargeof $1.8 million of debt issue costs related to the early repayment of oursenior term credit facility and the reduction in the borrowing base of ourrevolving credit facility and higher average levels of indebtedness.  In July 2005, we repaid all outstandingbalances on our bank indebtedness using proceeds from the issuance of$225 million of Senior Notes which bear interest at a fixed rate of7.75%.   Higher effective interest rateson our revolving credit facility and our senior term credit facility alsocontributed to the increase in interest expense.

 

***Change in fair value ofderivatives***

 

We recorded a loss of $28.8 million in 2005for the change in fair value of derivatives compared to a loss of$24.6 million for 2004.  We have notdesignated any derivative contracts in 2005 or 2004 as cash flow hedges;therefore all cash settlements and changes resulting from mark-to-marketvaluations are recorded as changes in fair value of derivatives.  For 2005, cash settlements were$8 million and non-cash mark-to-market adjustments were$20.8 million, as compared to cash settlements of $7.3 million andnon-cash mark-to-market adjustments of a $17.3 million loss for the 2004period.  Future gains or losses onchanges in derivatives will be impacted by the volatility of commodity andinterest rates, as well as the terms of any new derivative contracts.

 

**Operating Results – Nine-Month Periods**

 

The following discussion compares our results forthe nine months ended September 30, 2005 to the comparative period in 2004.  Unless otherwise indicated, references to2005 and 2004 within this section refer to the respective nine-monthperiod.

 

25

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***Oil and gas operating results***

 

Oil and gas sales in 2005 increased 47% from 2004due primarily to higher product prices and an increase in oil and gasproduction on an Mcfe basis.  Oil and gassales increased $60.6 million, of which price variances accounted for a$46.1 million increase and production variances accounted for a$14.5 million increase.

 

Production in 2005 (on an Mcfe basis) was 10%higher than 2004.  We increased our oilproduction 21% in 2005 primarily through the acquisition of SWR in May 2004and as a result of production from new wells in Louisiana.  Our gas production increased 3% in 2005 from2004 due primarily to additional gas production from the SWR acquisition andproduction from new wells in Louisiana, offset in part by higher than normalproduction declines in the Cotton Valley Reef Complex area due to formationperformance.  We expect our oil and gasproduction for fiscal 2005 to be approximately equal to fiscal 2004 levelswithout taking into account any new production from our exploration program orfrom acquisitions of proved reserves.

 

In 2005, our realized oil price was 37% higher than2004, while our realized gas price was 28% higher.  Historically, the markets for oil and gashave been volatile, and they are likely to continue to be volatile.

 

Oil and gas production costs on an Mcfe basisincreased from $1.21 per Mcfe in 2004 to $1.74 per Mcfe in 2005.  The increase in operating costs in 2005 was dueprimarily to higher oilfield service costs and an increase in workoveractivities.  In addition, added expenserelated to higher cost oil properties acquired in connection with the SWRmerger, as well as increased production tax costs related to higher productprices added to the increase in operating costs.  It is likely that these factors will continueto contribute to higher production costs in future periods.

 

DD&A expense attributable to our oil and gasproperties increased $6.8 million, of which rate variances accounted for$3.9 million and production variances accounted for $2.9 million.  On an Mcfe basis, DD&A expense increased14% from $1.19 per Mcfe in 2004 to $1.36 per Mcfe in 2005.  Depletion rates for each depletable group area function of net capitalized costs and estimated reserve quantities.

 

G&A expenses, excluding non-cash stock-basedemployee compensation, increased 7% in 2005 as compared to 2004 due primarilyto higher personnel costs and professional fees derived from the increase inoverall drilling and exploration activities. G&A expenses for 2005 include a non-cash charge of $2.1 millionfor stock-based employee compensation required by Financial AccountingStandards Board Interpretation No. 44.  A $303,000 credit (reductionof expense) was required for the 2004 period.  Since the amount of thisnon-cash provision or credit is based on the quoted market value of our commonstock, the future results of our operations may be subject to significantvolatility based on changes in the market price of our common stock.

 

***Gain onproperty sales***

 

Gain on sales of property and equipment for 2005was $18.9 million, as compared to $154,000 in 2004.  In August 2005, we sold our interests in two leases in the BretonSound area in the Gulf of Mexico (offshore Louisiana) for $21.3 million,subject to post-closing adjustments.  Werealized a gain of $16.8 million on this sale during the third quarter of2005.  The 2005 gain also includes the sale of various non-core wells and acreage.

 

26

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***Exploration costs***

 

Since we follow the successful efforts method ofaccounting, our results of operations are adversely affected during anyaccounting period in which significant seismic costs, exploratory dry holecosts, and unproved acreage impairments are expensed.  In 2005, we chargedto expense $39.1 million of exploration costs, as compared to $34.4 millionin 2004.  Most of these costs were incurred in the Cotton Valley ReefComplex, Mississippi, south Louisiana and south Texas.

 

We plan to spend approximately $174.9 millionon exploration and development activities in fiscal 2005, of which 72% isexpected to be allocated to exploration activities.  Since exploratorydrilling involves a high degree of risk, it is likely that a significantportion of the remaining costs in fiscal 2005 will be charged to explorationcosts. However, we cannot predict our success rates and, accordingly, cannotpredict our exploration costs related to abandonment and impairment costs.

 

***Interestexpense***

 

Interest expense increased from $4.7 millionin 2004 to $10.4 million in 2005 due primarily to higher levels ofindebtedness, an increase in interest rates and recording a non-cash charge of$1.8 million of debt issue costs related to the early repayment of the seniorterm credit facility and the reduction in the borrowing base on the revolvingcredit facility.  In July 2005, werepaid all outstanding balances on our bank indebtedness using proceeds fromthe issuance of $225 million of Senior Notes which bear interest at afixed rate of 7.75%.   Higher effectiveinterest rates on the revolving credit facility and the senior term creditfacility also contributed to the increase in interest expense.

 

***Change in fair value ofderivatives***

 

We recorded a loss of $73.7 million in 2005for the change in fair value of derivatives compared to a loss of$28 million for 2004.  We have notdesignated any derivative contracts in 2005 or 2004 as cash flow hedges;therefore all cash settlements and changes resulting from mark-to-marketvaluations are recorded as changes in fair value of derivatives.  For 2005, cash settlements were$17.6 million and non-cash mark-to-market adjustments were$56.1 million, as compared to cash settlements of $10.3 million andnon-cash mark-to-market adjustments of a $17.7 million loss for the 2004period.  Future gains or losses onchanges in derivatives will be impacted by the volatility of commodity andinterest rates, as well as the terms of any new derivative contracts.

 

27

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**Liquidity and Capital Resources**

 

***Overview***

 

Our primary financial resource is our base of oiland gas reserves.  We pledge ourproducing oil and gas properties to a group of banks to secure our revolvingcredit facility and, until July 2005, our senior term creditfacility.  The banks establish aborrowing base by making an estimate of the collateral value of our oil and gasproperties.  We borrow funds on therevolving credit facility as needed to supplement our operating cash flow as afinancing source for our capital expenditure program.  Our ability to fund our capital expenditureprogram is dependent upon the level of product prices and the success of ourexploration program in replacing our existing oil and gas reserves.  If product prices decrease, our operatingcash flow may decrease and the banks may require additional collateral orreduce our borrowing base, thus reducing funds available to fund our capitalexpenditure program.  The effects ofproduct prices on cash flow can be mitigated through the use of commodityderivatives.  If we are unable to replaceour oil and gas reserves through our exploration program, we may also suffer areduction in our operating cash flow and access to funds under the revolvingcredit facility.  Under extremecircumstances, product price reductions or exploration drilling failures couldallow the banks to seek to foreclose on our oil and gas properties, therebythreatening our financial viability.

 

In July 2005, we reduced our dependence on theborrowing base established for the revolving credit facility by issuing$225 million of aggregate principal amount of 73⁄4% Senior Notes due 2013(the “Senior Notes”) and using the net proceeds to repay all amountsoutstanding on the revolving credit facility and the senior term creditfacility.

 

In this section, we will describe our current plansfor capital spending, identify the capital resources available to finance ourcapital spending, and discuss the principal factors that can affect ourliquidity and capital resources.

 

***Capital expenditures***

 

Our total planned expenditures for exploration anddevelopment activities during fiscal 2005 are $174.9 million, assummarized by area in the following table.

 
| ** **             | ** ** | **Actual**                  | ** ** | **Total**                  | ** ** | ** **     | ** ** |
|------------------------|------------|-----------------------------|------------|----------------------------|------------|----------------|------------|
| ** **             | ** ** | **Expenditures**            | ** ** | **Planned**                | ** ** | ** **     | ** ** |
| ** **             | ** ** | **Nine Months**             | ** ** | **Expenditures**           | ** ** | ** **     | ** ** |
| ** **             | ** ** | **Ended**                   | ** ** | **Year Ended**             | ** ** | **Percentage** | ** ** |
| ** **             | ** ** | **September 30, 2005** | ** ** | **December 31, 2005** | ** ** | **of Total**   | ** ** |
| ** **             | ** ** | **(In thousands)**          | ** ** | ** **                 | ** ** |
| Permian Basin          |       | $                           | 55,600     |                       | $          | 81,200         |       | 47 | % |
| Louisiana              |       | 40,900                      |       | 54,700                     |       | 31             | %          |
| South and east  Texas  |       | 16,500                      |       | 17,500                     |       | 10             | %          |
| Utah/Montana           |       | 9,500                       |       | 12,500                     |       | 7              | %          |
| Mississippi /  Alabama |       | 4,900                       |       | 6,900                      |       | 4              | %          |
| Other                  |       | 800                         |       | 2,100                      |       | 1              | %          |
|                   |       | $                           | 128,200    |                       | $          | 174,900        |       | 100 | % |

 

28

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Our actual expenditures during fiscal 2005 may besubstantially higher or lower than these estimates since our plans forexploration and development activities may change during the year.  Other factors, such as prevailing productprices and the availability of capital resources, could also increase ordecrease the ultimate level of expenditures during fiscal 2005.

 

Approximately 72% of the planned expendituresrelate to exploratory prospects. Exploratory prospects involve a higher degree of risk than developmentalprospects.  To offset the higher risk, wegenerally strive to achieve a higher reserve potential and rate of return oninvestments in exploratory prospects.  Wedo not attempt to forecast our success rate on exploratory drilling.  Accordingly, these current estimates do notinclude costs we may incur to complete any future successful exploratory wellsand construct the required production facilities for these wells.  Also, we are actively searching for otheropportunities to increase our oil and gas reserves, including the evaluation ofnew prospects for exploratory and developmental drilling activities andpotential acquisitions of proved oil and gas properties.

 

During the third quarter of 2005, we spentapproximately $5.5 million to acquire producing properties in the PermianBasin.

 

We project that most of the cash needed to financeour planned expenditures for exploration and development activities in fiscal2005 will be provided by operating activities. To the extent that actual costs exceed our cash provided by operatingactivities, we plan to utilize the remaining proceeds from our Senior Notesoffering and the existing availability under the revolving credit facility tofinance such excess.

 

*DrillingRig Joint Venture*

 

In October 2005, we entered into a letteragreement with a privately-held contract drilling company (the “Co-Venturer”)which calls for the formation of a joint venture to acquire at least 12 newdrilling rigs.  Each party will own a 50%interest in the joint venture.  TheCo-Venturer will serve as the operations manager of the joint venture, and wewill be responsible for financing the purchase of the rigs.  The total acquisition cost, includingconstruction and equipping of the rigs, is expected to be approximately$75 million.  The agreementcontemplates that the joint venture will be able to finance 100% of the totalacquisition costs of the rigs based on a three-year loan amortization.  If the joint venture is unable to obtain 100%financing, we will be required to provide the balance either through loans tothe joint venture on the same terms as the primary financing or otherwisethrough equity investments in the joint venture.  We may use cash flow from operating activitiesand funds available to us under the revolving credit facility to meet ourobligations to this joint venture.

 

*EquipmentOrders*

 

During the nine months ended September 30,2005, we increased our inventory of tubing, casing, pumping units and other equipmentto be used in our on-going exploration and development activities by$19.2 million.  In addition, we haveplaced firm orders for similar equipment inventory totaling approximately$33 million, most of which will be filled during the fourth quarter of2005.  We plan to use cash flow fromoperating activities and funds available to us under the revolving creditfacility to finance the purchase of this equipment.

 

***Cash flow provided by operating activities***

 

Substantially all of our cash flow from operatingactivities is derived from the production of our oil and gas reserves.  We use this cash flow to fund our on-goingexploration and development activities in search of new oil and gas reserves.  Variations in cash flow from operatingactivities may impact our level of exploration and development expenditures.

 

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Cash flow provided by operating activities for thenine months ended September 30, 2005 was 52% higher than the same periodin 2004 due to the combined effects of several drivers.  The positive benefits of a 47% increase inoil and gas sales, driven primarily by higher oil and gas prices and anincrease in production, and an $18.8 million increase in gain on propertysales were offset in part by increases in production costs, costs of settlingcommodity hedges and interest expense. Our primary source of cash from operating activities is our oil and gassales, net of production costs.  Our cashflow provided by operating activities is subject to material variation fromchanges in oil and gas production levels and product prices.  Higher oil and gas prices also resulted in anincrease in cash required to settle derivative contracts, excluding thosecontracts that contain a financing element as in the case of the contractsassumed in the SWR acquisition.  Interestexpense increased in 2005 due primarily to higher levels of indebtedness resultingfrom the SWR acquisition and higher interest rates on the Senior Notes.

 

***Credit facilities***

 

A group of banks have provided us with a revolvingcredit facility on which we have historically relied for both our short-termliquidity (working capital) and our long-term financing needs.  The funds available to us at any time underthis revolving credit facility are limited to the amount of the borrowing baseestablished by the banks.  As long as wehave sufficient availability under this credit facility to meet our obligationsas they come due, we will have sufficient liquidity and will be able to fundany short-term working capital deficit.

 

At the beginning of 2005, we had an outstandingbalance under the revolving credit facility of $147.5 million, and theborrowing base was $195 million, providing us with available funds of $46.7 millionafter accounting for outstanding letters of credit.  During the nine months ended September 30,2005, we generated cash flow from operating activities of $126.6 millionand received proceeds from sales of property and equipment of$23.3 million.  We also spent$138.1 million on capital expenditures and other investments and paid$17.4 million to settle derivatives with financing elements.  With the issuance of the Senior Notes in July 2005,we borrowed $217 million, net of financing costs, repaid the balance on therevolving credit facility and repaid the remaining $30 million balance on thesenior term credit facility. Simultaneously, the borrowing base was reduced from $195 million to$132.5 million to give effect to the issuance of the Senior Notes.  Accordingly, the available funds under ourrevolving credit facility increased by $85 million to $131.7 million at September 30,2005.  Our available cash also increasedby $34.2 million.

 

Using the revolving credit facility for both our short-term liquidity and long-termfinancing needs can cause unusual fluctuations in our reported working capital,depending on the timing of cash receipts and expenditures.  On a daily basis, we use most of ouravailable cash to pay down our outstanding balance on the revolving creditfacility, which is classified as a non-current liability since we currentlyhave no required principal reductions. As we use cash to pay a non-current liability, our reported workingcapital decreases.  Conversely, as wedraw on the revolving credit facility for funds to pay current liabilities(such as payables for drilling and operating costs), our reported workingcapital increases.  Also, volatility inoil and gas prices can cause significant fluctuations in reported workingcapital as we record changes in the fair value of derivatives from period toperiod.  For these reasons, the workingcapital covenant related to the revolving credit facility requires us to (i) includethe amount of funds available under this facility as a current asset, (ii) excludecurrent assets and liabilities related to the fair value of derivatives, and (iii) excludecurrent maturities of vendor finance obligations, if any, when computing theworking capital ratio at any balance sheet date.

 

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Working capital computed for loan compliancepurposes differs from our working capital in accordance with generally acceptedaccounting principles (GAAP).  Sincecompliance with financial covenants is a material requirement under the creditfacilities, we consider the loan compliance working capital to be useful as ameasure of our liquidity because it includes the funds available to us underthe revolving credit facility and is not affected by the volatility in workingcapital caused by changes in fair value of derivatives.  Our reported working capital deficitdecreased from $27.6 million at December 31, 2004 to$14.7 million at September 30, 2005 due primarily to a combination offactors, including decreases in accounts payable, increases in inventory and increasesin current liabilities related to the fair value of derivatives.  After giving effect to the adjustments, ourworking capital computed for loan compliance purposes was a positive$158.8 million at September 30, 2005, as compared to a positive $32.9 millionat December 31, 2004.  The followingtable reconciles our GAAP working capital to the working capital computed forloan compliance purposes at September 30, 2005 and December 31, 2004.

 
| ** **                                                                             | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                             | ** ** | **2005**               | ** ** | **2004**              | ** ** |
| ** **                                                                             | ** ** | **(In thousands)**     | ** ** |
| ** **                                                                             | ** ** | ** **             | ** ** |
| Working capital  (deficit) per GAAP                                                    |       | $                      | (14,655    | )                     | $          | (27,566 | ) |
| Add funds  available under the revolving credit facility                               |       | 131,696                |       | 46,725                |       |
| Exclude fair  value of derivatives classified as current assets or current liabilities |       | 41,776                 |       | 13,693                |       |
| Working capital  per loan covenant                                                     |       | $                      | 158,817    |                  | $          | 32,852 |   |

 

Since we use thisrevolving credit facility for both short-term liquidity and long-term financingneeds, it is important that we comply in all material respects with the loanagreement, including financial covenants that are computed quarterly.  The working capital covenant requires us tomaintain positive working capital using the computations described above.  Another financial covenant under the creditfacility requires us to maintain a ratio of indebtedness to cash flow of nomore than 3 to 1.  While we were incompliance with all financial and non-financial covenants at September 30,2005, our increased leverage and reduced liquidity may result in our failing tocomply with one or more of these covenants in the future.  If we fail tomeet any of these loan covenants, we would ask the banks to allow us sufficienttime to obtain additional capital resources through alternative means.  If a suitable arrangement could not bereached with the banks, the banks could accelerate the indebtedness and seek toforeclose on the pledged assets. However, the issuance of the Senior Notes described below significantlyincreases our liquidity and reduces our dependence on the revolving creditfacility.

 

The banks redetermine theborrowing base under the revolving credit facility at least twice a year, in May andNovember.  If at any time, the borrowingbase is less than the amount of outstanding indebtedness, we will be requiredto (i) pledge additional collateral, (ii) prepay the excess in notmore than five equal monthly installments, or (iii) elect to convert theentire amount of outstanding indebtedness to a term obligation based onamortization formulas set forth in the loan agreement.  In connection with the issuance of the 73⁄4%Senior Notes due 2013, the borrowing base was reduced to $132.5 million inJuly 2005, and all outstanding balances on our revolving credit facilitywere repaid.

 

***73⁄4% Senior Notes due 2013***

 

In July 2005,we issued, in a private placement, $225 million of aggregate principalamount of Senior Notes.  The Senior Noteswere issued at face value and will bear interest at 73⁄4% per year, payablesemi-annually on February 1 and August 1 of each year, beginning February 1,2006.  After the payment of

 

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typical transaction expenses, netproceeds of approximately $217 million were used to repay amountsoutstanding on our secured credit facilities and for general corporatepurposes, including the funding of planned exploration and developmentactivities.

 

At anytime prior to August 1, 2008, we may redeem up to 35% of the aggregateprincipal amount of the Senior Notes with the proceeds of certain equityofferings at a redemption price of 107.75% of the principal amount, plusaccrued and unpaid interest.  Inaddition, prior to August 1, 2009, we may redeem some or all of the SeniorNotes at a redemption price equal to 100% of the principal amount of the SeniorNotes to be redeemed, plus a make-whole premium, plus any accrued and unpaidinterest.  On and after August 1,2009, we may redeem some or all of the Senior Notes at redemption prices(expressed as percentages of principal amount) equal to 103.875% for thetwelve-month period beginning on August 1, 2009, 101.938% for thetwelve-month period beginning on August 1, 2010, and 100.00% beginning on August 1,2011, for any period thereafter, in each case plus accrued and unpaid interest.

 

TheIndenture governing the Senior Notes restricts our ability and the ability ofour restricted subsidiaries to:  (i) borrowmoney; (ii) issue redeemable and preferred stock; (iii) paydistributions or dividends; (iv) make investments; (v) create lienswithout securing the Notes; (vi) enter into agreements that restrict dividendsfrom subsidiaries; (vii) sell certain assets or merge with or into othercompanies; (viii) enter into transactions with affiliates; (ix) guaranteeindebtedness; and (x) enter into new lines of business.  These covenants are subject to a number of importantexceptions and qualifications.

 

Since the Senior Noteshave an eight-year maturity and bear interest at a fixed rate of 73⁄4%, we expect our effective annual interestrate to increase in future periods. However, we believe it is likely that average variable interest rateswill exceed the fixed rate of the Senior Notes during this eight-year period.

 

***Alternative capital resources***

 

Although our base of oil and gas reserves, ascollateral for both of our credit facilities, has historically been our primarycapital resource, we have in the past, and we believe we could in the future,use alternative capital resources, such as asset sales, vendor financingarrangements, and/or public or private issuances of common stock.  We could also issue senior or subordinateddebt or preferred stock in a public or a private placement if we choose toraise capital through either of these markets. While we believe we would be able to obtain funds through one or more ofthese alternatives, if needed, there can be no assurance that these capitalresources would be available on terms acceptable to us.

 

## **Item3** -                               Quantitative and Qualitative DisclosureAbout Market Risks

## ** **

Our business is impacted by fluctuations incommodity prices and interest rates.  Thefollowing discussion is intended to identify the nature of these market risks,describe our strategy for managing such risks, and to quantify the potentialaffect of market volatility on our financial condition and results ofoperations.

 

**Oil andGas Prices**

 

Our financial condition, results of operations, andcapital resources are highly dependent upon the prevailing market prices of,and demand for, oil and natural gas. These commodity prices are subject to wide fluctuations and marketuncertainties due to a variety of factors that are beyond our control.  These factors include the level of globaldemand for petroleum products, foreign supply of oil and gas, the

 

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establishmentof and compliance with production quotas by oil-exporting countries, weatherconditions, the price and availability of alternative fuels, and overalleconomic conditions, both foreign and domestic. We cannot predict future oil and gas prices with any degree of certainty.  Sustained weakness in oil and gas prices mayadversely affect our financial condition and results of operations, and mayalso reduce the amount of net oil and gas reserves that we can produceeconomically.  Any reduction in reserves,including reductions due to price fluctuations, can reduce the borrowing baseunder our revolving credit facility and adversely affect our liquidity and ourability to obtain capital for our exploration and development activities.  Similarly, any improvements in oil and gasprices can have a favorable impact on our financial condition, results ofoperations and capital resources.  Basedon December 31, 2004 reserve estimates, we project that a $1.00 drop inthe price per Bbl of oil and a $.50 drop in the price per Mcf of gas wouldreduce our gross revenues for the year ending December 31, 2005 by$12.8 million.

 

From time to time, we utilize commodityderivatives, consisting primarily of swaps, floors and collars to attempt tooptimize the price received for our oil and natural gas production.  When using swaps to hedge our oil and naturalgas production, we receive a fixed price for the respective commodity and pay afloating market price as defined in each contract (generally NYMEX futuresprices), resulting in a net amount due to or from the counterparty.  In floor transactions, we receive a fixedprice (put strike price) if the market price falls below the put strike pricefor the respective commodity.  If themarket price is greater than the put strike price, no payments are due from eitherparty.  Costless collars are acombination of puts and calls, and contain a fixed floor price (put strikeprice) and ceiling price (call strike price). If the market price for the respective commodity exceeds the call strikeprice or falls below the put strike price, then we receive the fixed price andpay the market price.  If the marketprice is between the call and the put strike prices, no payments are due fromeither party.  The commodity derivativeswe use differ from futures contracts in that there is not a contractualobligation that requires or permits the future physical delivery of the hedgedproducts.  We do not enter into commodityderivatives for trading purposes.  Inaddition to commodity derivatives, we may, from time to time, sell a portion ofour gas production under short-term contracts at fixed prices.

 

The decision to initiate or terminate commodityhedges is made by management based on its expectation of future market pricemovements.  We have no set goals for thepercentage of our production we hedge and we do not use any formulas ortriggers in deciding when to initiate or terminate a hedge.  If we enter into swaps or collars and thefloating market price at the settlement date is higher than the fixed price orthe fixed ceiling price, we will forego revenue we would have otherwisereceived.  If we terminate a swap, collaror floor because we anticipate future increases in market prices, we may beexposed to downside risk that would not have existed otherwise.

 

The following summarizes information concerning ournet positions in open commodity derivatives applicable to periods subsequent toSeptember 30, 2005.  The settlementprices of commodity derivatives are based on NYMEX futures prices.

 

**Floors:**

 
| ** **          | ** ** | **Gas**          | ** ** | **Oil**   | ** ** |
|---------------------|------------|------------------|------------|-----------|------------|
| ** **          | ** ** | **MMBtu****(a)** | ** ** | **Floor** | ** ** | **Bbls** | ** ** | **Floor** | ** ** |
| Production  Period: |       |             |       |      |       |   |   |   |   |
| 4th Quarter 2005    |       | 1,840,000        |       | $         | 4.50       |   | 119,600 |   | $ | 28.00 |   |
|                     |            |                  |            |           |            |  |  |  |  |  |  |

 

33

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**Collars:**

 
| ** **           | ** ** | **Gas**       | ** ** | **Oil**   | ** ** |
|----------------------|------------|---------------|------------|-----------|------------|
| ** **           | ** ** | **MMBtu (a)** | ** ** | **Floor** | ** ** | **Ceiling** | ** ** | **Bbls** | ** ** | **Floor** | ** ** | **Ceiling** | ** ** |
| Production  Period:  |       |          |       |      |       |   |   |   |   |   |   |   |   |
| 4th Quarter 2005 (b) |       | 588,000       |       | $         | 4.00       |   | $ | 5.23 |   | 108,000 |   | $ | 23.00 |   | $ | 25.41 |   |
| 2006                 |       | 2,024,000     |       | $         | 4.00       |   | $ | 5.21 |   | 613,000 |   | $ | 23.00 |   | $ | 25.32 |   |
| 2007                 |       | 1,831,000     |       | $         | 4.00       |   | $ | 5.18 |   | 562,000 |   | $ | 23.00 |   | $ | 25.20 |   |
| 2008                 |       | 1,279,000     |       | $         | 4.00       |   | $ | 5.15 |   | 392,000 |   | $ | 23.00 |   | $ | 25.07 |   |
|                 |       |          |       |      |       |   |   |   |   |   |   |   |   |   |   |   |   |
|                 |       | 5,722,000     |       |      |       |   |   | 1,675,000 |   |   |   |   |   |

 

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(a)          One MMBtu equals one Mcf at a Btu factor of1,000.

 

(b)         The above table excludes a closed hedgeposition for 54,000 barrels of oil which will be settled during the fourthquarter of 2005 at a loss of $2.4 million.

 

In November 2005, we entered into a swapcovering 1.1 million barrels of 2006 oil production in 2005 at a fixedprice of $62.30 per barrel.

 

We use a sensitivity analysis technique to evaluatethe hypothetical effect that changes in the market value of oil and gas mayhave on the fair value of our commodity derivatives.  A $1 per barrel change in the price ofoil and a $.50 per MMBtu change in the price of gas would change the fair valueof our commodity derivatives by approximately $8 million.

 

**Interest Rates**

 

At September 30, 2005, substantially all ofour long-term debt bears interest at a fixed rate of 73⁄4%.  However, we expect to borrow funds in thefuture on the revolving credit facility which bears interest at a variablerate.

 

The following summarizes information concerning ournet positions in open interest rate swaps applicable to periods subsequent to September 30,2005.

 
| ** **                                     | ** ** | **Principal** | ** ** | **Libor** | ** ** |
|------------------------------------------------|------------|---------------|------------|-----------|------------|
| ** **                                     | ** ** | **Balance**   | ** ** | **Rates** | ** ** |
| Period:                                        |       |          |       |      |       |
| October 1, 2005 to November 1, 2005  |       | $             | 60,000,000 |      | 2.97       | % |
| November 1, 2005 to November 1, 2006 |       | $             | 55,000,000 |      | 4.29       | % |
| November 1, 2006 to November 1, 2007 |       | $             | 50,000,000 |      | 5.19       | % |
| November 1, 2007 to November 1, 2008 |       | $             | 45,000,000 |      | 5.73       | % |

 

The interest rate swaps in the preceding tableexpose us to market risks for decreases in interest rates during the periodsshown.

 

34

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**Item 4 -****                               Controlsand Procedures**

 

#### **DisclosureControls and Procedures**

#### ** **

Our Board of Directors has adopted a policydesigned to establish disclosure controls and procedures that are adequate toprovide reasonable assurance that we will be able to collect, process anddisclose both financial and non-financial information, on a timely basis, inour reports to the SEC and other communications with our stockholders.  Disclosure controls and procedures includeall processes necessary to ensure that material information is recorded,processed, summarized and reported within the time periods specified in the SEC’srules and forms, and is accumulated and communicated to our management,including our chief executive and chief financial officers, to allow timelydecisions regarding required disclosures.

 

With respect to our disclosure controls andprocedures:

 

•                  We have evaluated the effectivenessof our disclosure controls and procedures as of the end of the period coveredby this report;

•                  This evaluation was conducted underthe supervision and with the participation of our management, including ourchief executive and chief financial officers; and

•                  It is the conclusion of our chiefexecutive and chief financial officers that these disclosure controls andprocedures operate such that material information flows to the appropriatecollection and disclosure points in a timely manner and are effective inensuring that material information is accumulated and communicated to ourmanagement and is made known to the chief executive and chief financialofficers, particularly during the period in which this report was prepared, as appropriateto allow timely decisions regarding required disclosures.

 

#### **Changesin Internal Control Over Financial Reporting**

#### ** **

No changes in internal control over financialreporting were made during the quarter ended September 30, 2005 that havematerially affected, or are reasonably likely to materially affect, ourinternal control over financial reporting.

 

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##### **PART II.  OTHER INFORMATION**

##### ** **

#### **Item 2**-                               Unregistered Sales ofEquity Securities and Use of Proceeds

#### ** **

The Company issued shares of common stock of theCompany (the “Common Stock”) to Clayton W. Williams on the dates, in theamounts and for the consideration, paid in the form of services rendered to theCompany and in lieu of cash salary earned by and payable to Mr. Williamson those dates, as set forth below:

 

| **Date**               | ** ** | **Shares** | ** ** | **Price** | ** ** | **Consideration** | ** ** |
|------------------------|------------|------------|------------|-----------|------------|-------------------|------------|
|                   |       |       |       |      |       |              |       |
| February 28, 2005 |       | 1,257      |       | $         | 28.92      |              | $          | 36,353 |   |
|                   |       |       |       |      |       |              |       |
| March 31, 2005    |       | 1,530      |       | $         | 25.41      |              | $          | 38,887 |   |
|                   |       |       |       |      |       |              |       |
| April 29, 2005    |       | 1,644      |       | $         | 23.64      |              | $          | 38,887 |   |
|                   |       |       |       |      |       |              |       |
| May 31, 2005      |       | 1,384      |       | $         | 28.08      |              | $          | 38,887 |   |
|                   |       |       |       |      |       |              |       |
| June 30, 2005     |       | 1,274      |       | $         | 30.50      |              | $          | 38,887 |   |
|                   |       |       |       |      |       |              |       |
| July 29, 2005     |       | 1,127      |       | $         | 34.50      |              | $          | 38,887 |   |
|                   |       |       |       |      |       |              |       |
| August 31, 2005   |       | 1,052      |       | $         | 36.94      |              | $          | 38,887 |   |

 

These shares were issued on each salary paymentdate at the closing sale price of the Common Stock as reported on the NasdaqNational Market on the day immediately prior to the day of issuance.  These issuances were ratified by the Board ofDirectors of the Company in September 2005.

 

The issuances of these shares were determined to beexempt from registration under Section 4(2) of the Securities Act orRegulation D thereunder as transactions by an issuer not involving a publicoffering.  Mr. Williams was anaccredited investor on the date of each issuance and has represented hisintention to acquire the shares for investment only and not with a view to orfor resale in connection with any distribution thereof.  The issuance of these shares was made withoutgeneral solicitation or advertising, and there were no underwriters used inconnection with the sale of these securities. All of the shares are deemed to be restricted securities for thepurposes of the Securities Act and appropriate legends have been affixed to theshare certificates issued in these transactions.

 

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#### **Item 6** -                               Exhibits 

#### ** **

#### **Exhibits**

#### ** **

| 3.1**                             |   | Second Restated  Certificate of Incorporation of the Company, filed as Exhibit 3.1 to our  Form S-2 Registration Statement, Commission File No. 333-13441                                                                                                                          |
|-----------------------------------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                              |   |                                                                                                                                                                                                                                                                                              |
| 3.2**                             |   | Certificate of  Amendment of Second Restated Certificate of Incorporation of Clayton Williams  Energy, Inc., filed as Exhibit 3.1 to our Form 10-Q for the  period ended September 30, 2000                                                                                   |
|                              |   |                                                                                                                                                                                                                                                                                              |
| 3.3**                             |   | Bylaws of the Company,  filed as Exhibit 3.4 to our Form S-1 Registration Statement,  Commission  File No. 33-43350                                                                                                                                                                     |
|                              |   |                                                                                                                                                                                                                                                                                              |
| 3.4**                             |   | Corporate Bylaws  of Clayton Williams Energy, Inc., as amended, filed as Exhibit 3.1  to our Current Report on Form 8-K filed with the Commission on June 1,  2005††                                                                                                |
|                              |   |                                                                                                                                                                                                                                                                                              |
| 4.1**                             |   | Indenture, dated  July 20, 2005, among Clayton Williams Energy, Inc., the Subsidiary  Guarantors and Wells Fargo Bank, National Association, as Trustee, filed as Exhibit 4.1  to our Current Report on Form 8-K filed with the Commission on July 22,  2005†† |
|                              |   |                                                                                                                                                                                                                                                                                              |
| 4.2**                             |   | Registration  Rights Agreement dated July 20, 2005, among Clayton Williams Energy, Inc.,  the Subsidiary Guarantors and J.P. Morgan Securities Inc., filed as Exhibit 4.2  to our Current Report on Form 8-K filed with the Commission on July 22,  2005††     |
|                              |   |                                                                                                                                                                                                                                                                                              |
| 10.1**                            |   | First Amendment  to Amended and Restated Credit Agreement dated July 18, 2005, filed as Exhibit 10.1  to our Current Report on Form 8-K filed with the Commission on July 20,  2005††                                                                               |
|                              |   |                                                                                                                                                                                                                                                                                              |
| 10.2**                            |   | Letter agreement  dated October 20, 2005 between Clayton Williams Energy, Inc. and  Lariat Services, Inc., filed as Exhibit 10.1 to our Current Report  on Form 8-K filed with the Commission on October 27, 2005††                                       |
|                              |   |                                                                                                                                                                                                                                                                                              |
| 31.1*                   |   | Certification by  the President and Chief Executive Officer of the Company pursuant to Rule 13(a) - 14(a) of  the Securities Exchange Act of 1934                                                                                                                             |
|                              |   |                                                                                                                                                                                                                                                                                              |
| 31.2*                   |   | Certification by  the Chief Financial Officer of the Company pursuant to Rule 13(a) - 14(a) of  the Securities Exchange Act of 1934                                                                                                                                           |
|                              |   |                                                                                                                                                                                                                                                                                              |
| 32*      |   | Certifications by the Chief Executive Officer and Chief Financial  Officer of the Company pursuant to 18 U.S.C. § 1350                                                                                                                                                             |

 

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*                                         Filedherewith

**                                  Incorporatedby reference to the filing indicated

†                                          Identifiesan Exhibit that consists of or includes a management contract orcompensatory plan or arrangement

††                                    Filedunder our Commission File No. 001-10924

 

37

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**CLAYTON WILLIAMS ENERGY, INC.**

**SIGNATURES**

 

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

 

 
|                                                                                                                                           |   | **CLAYTON  WILLIAMS ENERGY, INC.**         |
|------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------------------------------|
| ** **                                                                                                                                     |   |                                       |
|                                                                                                                                           |   |                                       |
| Date:                    November 8,  2005 | By:    | */s/ L.  Paul Latham*                      |   |
|                                                                                                                                           |   | L. Paul Latham                             |
|                                                                                                                                           |   | Executive Vice  President and Chief        |
|                                                                                                                                           |   |  Operating  Officer                   |
|                                                                                                                                           |   |                                       |
|                                                                                                                                           |   |                                       |
| Date:                    November 8,  2005 | By:    | */s/ Mel  G. Riggs*                        |   |
|                                                                                                                                           |   | Mel G. Riggs                               |
|                                                                                                                                           |   | Senior Vice  President and Chief Financial |
|                                                                                                                                           |   |  Officer                              |

 

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