**UNITEDSTATES**

**SECURITIES AND EXCHANGE COMMISSION**

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

# **FORM 10-Q**

**x****        Quarterly Report Pursuantto Section 13 or 15(d)of the Securities Exchange Act of 1934**

# **For thequarterly period ended June 30, 2006**

**or**

**o****        Transition Report Pursuantto Section 13 or 15(d)of the Securities Exchange Act of 1934**

**For the transition period from             to             **

## **Commission File No. 001-10924**

**CLAYTON WILLIAMS ENERGY, INC.**

(Exact name of Registrantas 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**

**Notapplicable**

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

Indicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theRegistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days.

Indicate by check mark whether the registrant is a large acceleratedfiler, an accelerated filer, or a non-accelerated filer.  See definition of “accelerated filer andlarge accelerated filer” in Rule 12b-2 of the Exchange Act.       x   Yes    o  No
| Large accelerated filer   o | Accelerated filer   x | Non-accelerated filer   o |
|--------------------------------------------|--------------------------------------|------------------------------------------|

 

Indicate by check mark whether the registrant is a shell company (asdefined in Rule 12b-2 of the Exchange Act).    o   Yes   x      No

There were 10,849,551 shares of Common Stock, $.10par value, of the registrant outstanding as of August 7, 2006.

 

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**CLAYTON WILLIAMS ENERGY, INC.**

**TABLE OFCONTENTS**
| ** ** | ** ** | **PART I. FINANCIAL INFORMATION**                                                                       | ** ** | ** ** |
|------------|------------|---------------------------------------------------------------------------------------------------------|------------|------------|
|       |       |                                                                                                    |       |       |
| Item 1.    |       | Financial Statements                                                                                    |       |       |
|       |       |                                                                                                    |       |       |
|       |       | Consolidated  Balance Sheets as of June 30, 2006 and December 31, 2005                             |       |       |
|       |       |                                                                                                    |       |       |
|       |       | Consolidated Statements of  Operations for the three months and six months ended June 30, 2006 and 2005 |       |       |
|       |       |                                                                                                    |       |       |
|       |       | Consolidated  Statement of Stockholders’ Equity for the six months ended June 30, 2006             |       |       |
|       |       |                                                                                                    |       |       |
|       |       | Consolidated  Statements of Cash Flows for the six months ended June 30, 2006 and 2005                  |       |       |
|       |       |                                                                                                    |       |       |
|       |       | 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 1A.   |       | Risk Factors                                                                                            |       |       |
|       |       |                                                                                                    |       |       |
| Item  4.   |       | Submission  of Matters to a Vote of Securities Holders                                                  |       |       |
|       |       |                                                                                                    |       |       |
| Item 6.    |       | Exhibits                                                                                                |       |       |
|       |       |                                                                                                    |       |       |
|       |       | Signatures                                                                                              |       |       |

 

 

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**CLAYTON WILLIAMS ENERGY, INC.**

**CONSOLIDATED BALANCE SHEETS**

**(Dollarsin thousands)**

 

**ASSETS**

 
| ** **                                                 | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                 | ** ** | **2006**          | ** ** | **2005**              | ** ** |
| ** **                                                 | ** ** | **(Unaudited)**   | ** ** | ** **            | ** ** |
| CURRENT ASSETS                                             |       |              |       |                  |       |
| Cash and cash  equivalents                                 |       | $                 | 16,869     |                  | $          | 5,935 |   |
| Accounts  receivable:                                      |       |              |       |                  |       |
| Oil and gas  sales, net                                    |       | 23,648            |       | 28,317                |       |
| Joint interest  and other, net                             |       | 10,561            |       | 6,972                 |       |
| Affiliates                                                 |       | 1,248             |       | 254                   |       |
| Inventory                                                  |       | 46,069            |       | 43,753                |       |
| Deferred income  taxes                                     |       | 426               |       | 439                   |       |
| Fair value of  derivatives                                 |       | 3,850             |       | 191                   |       |
| Prepaids and  other                                        |       | 1,987             |       | 2,581                 |       |
|                                                       |       | 104,658           |       | 88,442                |       |
| PROPERTY AND EQUIPMENT                                     |       |              |       |                  |       |
| Oil and gas  properties, successful efforts method         |       | 1,138,718         |       | 1,037,862             |       |
| Natural gas  gathering and processing systems              |       | 18,052            |       | 18,034                |       |
| Contract  drilling equipment                               |       | 31,607            |       | —                |       |
| Other                                                      |       | 14,862            |       | 12,396                |       |
|                                                       |       | 1,203,239         |       | 1,068,292             |       |
| Less accumulated  depreciation, depletion and amortization |       | (624,914          | )          | (594,225              | )          |
| Property and  equipment, net                               |       | 578,325           |       | 474,067               |       |
|                                                       |       |              |       |                  |       |
| OTHER ASSETS                                               |       |              |       |                  |       |
| Debt issue costs                                           |       | 8,260             |       | 8,557                 |       |
| Advances to  drilling rig joint venture                    |       | —            |       | 10,329                |       |
| Fair value of  derivatives                                 |       | 5,099             |       | 127                   |       |
| Other                                                      |       | 15,886            |       | 5,813                 |       |
|                                                       |       | 29,245            |       | 24,826                |       |
|                                                       |       | $                 | 712,228    |                  | $          | 587,335 |   |

 

The accompanying notesare an integral part of these consolidated financial statements.

 

3

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**CLAYTON WILLIAMS ENERGY, INC.**

**CONSOLIDATEDBALANCE SHEETS**

**(Dollars in thousands)**

 

**LIABILITIES AND STOCKHOLDERS’ EQUITY**

** **
| ** **                                                                                                                                                           | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                           | ** ** | **2006**          | ** ** | **2005**              | ** ** |
| ** **                                                                                                                                                           | ** ** | **(Unaudited)**   | ** ** | ** **            | ** ** |
| CURRENT LIABILITIES                                                                                                                                                  |       |              |       |                  |       |
| Accounts  payable:                                                                                                                                                   |       |              |       |                  |       |
| Trade                                                                                                                                                                |       | $                 | 52,884     |                  | $          | 59,861 |   |
| Oil and gas  sales                                                                                                                                                   |       | 12,334            |       | 18,236                |       |
| Affiliates                                                                                                                                                           |       | 1,877             |       | 2,857                 |       |
| Current  maturities of long-term debt                                                                                                                                |       | 3,174             |       | 19                    |       |
| Fair value of  derivatives                                                                                                                                           |       | 35,968            |       | 33,670                |       |
| Accrued  liabilities and other                                                                                                                                       |       | 9,952             |       | 9,611                 |       |
|                                                                                                                                                                 |       | 116,189           |       | 124,254               |       |
| NON-CURRENT LIABILITIES                                                                                                                                              |       |              |       |                  |       |
| Long-term debt                                                                                                                                                       |       | 348,430           |       | 235,700               |       |
| Deferred income  taxes                                                                                                                                               |       | 41,919            |       | 37,042                |       |
| Fair value of  derivatives                                                                                                                                           |       | 41,755            |       | 49,705                |       |
| Other                                                                                                                                                                |       | 21,976            |       | 20,343                |       |
|                                                                                                                                                                 |       | 454,080           |       | 342,790               |       |
|                                                                                                                                                                 |       |              |       |                  |       |
| COMMITMENTS AND  CONTINGENCIES                                                                                                                                       |       |              |       |                  |       |
|                                                                                                                                                                 |       |              |       |                  |       |
| STOCKHOLDERS’ EQUITY                                                                                                                                            |       |              |       |                  |       |
| Preferred stock,  par value $.10 per share, authorized – 3,000,000 shares; issued – none                                                                   |       | —            |       | —                |       |
| Common stock,  par value $.10 per share, authorized – 30,000,000 shares; issued and  outstanding – 10,849,551 shares in 2006 and 10,815,575 shares in 2005 |       | 1,085             |       | 1,082                 |       |
| Additional  paid-in capital                                                                                                                                          |       | 107,431           |       | 107,108               |       |
| Retained  earnings                                                                                                                                                   |       | 33,443            |       | 12,101                |       |
|                                                                                                                                                                 |       | 141,959           |       | 120,291               |       |
|                                                                                                                                                                 |       | $                 | 712,228    |                  | $          | 587,335 |   |

 

The accompanying notesare an integral part of these consolidated financial statements.

 

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**CLAYTON WILLIAMS ENERGY, INC.**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

**(Unaudited)**

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

 
| ** **                                   | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|----------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                   | ** ** | **2006**                                        | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| REVENUES                                     |       |                                            |       |                                          |       |   |   |   |   |
| Oil and gas  sales                           |       | $                                               | 66,443     |                                          | $          | 63,301 |   | $ | 126,624 |   | $ | 124,797 |   |
| Natural gas  services                        |       | 2,789                                           |       | 2,550                                         |       | 5,985 |   | 5,131 |   |
| Drilling rig  services                       |       | 374                                             |       | —                                        |       | 374 |   | — |   |
| Gain on sales of  property and equipment     |       | 735                                             |       | 467                                           |       | 752 |   | 2,079 |   |
| Total revenues                               |       | 70,341                                          |       | 66,318                                        |       | 133,735 |   | 132,007 |   |
|                                         |       |                                            |       |                                          |       |   |   |   |   |
| COSTS AND EXPENSES                           |       |                                            |       |                                          |       |   |   |   |   |
| Production                                   |       | 15,931                                          |       | 13,856                                        |       | 30,896 |   | 26,427 |   |
| Exploration:                                 |       |                                            |       |                                          |       |   |   |   |   |
| Abandonments and  impairments                |       | 3,329                                           |       | 6,430                                         |       | 16,172 |   | 17,700 |   |
| Seismic and  other                           |       | 2,587                                           |       | 1,665                                         |       | 5,688 |   | 2,453 |   |
| Natural gas  services                        |       | 2,261                                           |       | 2,374                                         |       | 5,090 |   | 4,791 |   |
| Drilling rig  services                       |       | 216                                             |       | —                                        |       | 216 |   | — |   |
| Depreciation,  depletion and amortization    |       | 15,982                                          |       | 12,288                                        |       | 30,692 |   | 24,580 |   |
| Accretion of  abandonment obligations        |       | 417                                             |       | 288                                           |       | 796 |   | 567 |   |
| General and  administrative                  |       | 4,252                                           |       | 3,134                                         |       | 8,319 |   | 5,652 |   |
| Loss on sales of  property and equipment     |       | —                                          |       | —                                        |       | 13 |   | 32 |   |
| Total costs and  expenses                    |       | 44,975                                          |       | 40,035                                        |       | 97,882 |   | 82,202 |   |
|                                         |       |                                            |       |                                          |       |   |   |   |   |
| Operating income                             |       | 25,366                                          |       | 26,283                                        |       | 35,853 |   | 49,805 |   |
|                                         |       |                                            |       |                                          |       |   |   |   |   |
| OTHER INCOME (EXPENSE)                       |       |                                            |       |                                          |       |   |   |   |   |
| Interest expense                             |       | (4,961                                          | )          | (2,566                                        | )          | (9,300 | ) | (4,932 | ) |
| Gain (loss) on  derivatives                  |       | 245                                             |       | (9,837                                        | )          | (1,327 | ) | (44,926 | ) |
| Other                                        |       | 450                                             |       | 650                                           |       | 1,068 |   | 1,096 |   |
| Total other  income (expense)                |       | (4,266                                          | )          | (11,753                                       | )          | (9,559 | ) | (48,762 | ) |
|                                         |       |                                            |       |                                          |       |   |   |   |   |
| Income before income  taxes                  |       | 21,100                                          |       | 14,530                                        |       | 26,294 |   | 1,043 |   |
| Income tax expense                           |       | (3,094                                          | )          | (4,580                                        | )          | (4,912 | ) | (85 | ) |
| Minority interest                            |       | (40                                             | )          | —                                        |       | (40 | ) | — |   |
|                                         |       |                                            |       |                                          |       |   |   |   |   |
| NET INCOME                                   |       | $                                               | 17,966     |                                          | $          | 9,950 |   | $ | 21,342 |   | $ | 958 |   |
|                                         |       |                                            |       |                                          |       |   |   |   |   |
| Net income per common  share:                |       |                                            |       |                                          |       |   |   |   |   |
| Basic                                        |       | $                                               | 1.66       |                                          | $          | 0.92 |   | $ | 1.97 |   | $ | 0.09 |   |
| Diluted                                      |       | $                                               | 1.59       |                                          | $          | 0.90 |   | $ | 1.89 |   | $ | 0.09 |   |
|                                         |       |                                            |       |                                          |       |   |   |   |   |
| Weighted average common  shares outstanding: |       |                                            |       |                                          |       |   |   |   |   |
| Basic                                        |       | 10,850                                          |       | 10,800                                        |       | 10,845 |   | 10,796 |   |
| Diluted                                      |       | 11,286                                          |       | 11,089                                        |       | 11,294 |   | 11,068 |   |

 

The accompanying notesare an integral part of these consolidated financial statements.

 

5

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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, 2005                   |       | 10,815                |       | $              | 1,082      |        | $          | 107,108 |   | $ | 12,101 |   |
| Net income and  total comprehensive income    |       | —                |       | —         |       | —      |       | 21,342 |   |
| Issuance of  stock through compensation plans |       | 35                    |       | 3              |       | 323         |       | — |   |
| BALANCE,  June 30, 2006                       |       | 10,850                |       | $              | 1,085      |        | $          | 107,431 |   | $ | 33,443 |   |

 

The accompanying notesare an integral part of these consolidated financial statements.

 

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**CLAYTON WILLIAMS ENERGY, INC.**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(Unaudited)**

**(In thousands)**

** **
| ** **                                                                     | ** ** | **Six Months Ended  June 30,** | ** ** |
|--------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                     | ** ** | **2006**                                      | ** ** | **2005** | ** ** |
| CASH FLOWS FROM  OPERATING ACTIVITIES                                          |       |                                          |       |   |   |
| Net income                                                                     |       | $                                             | 21,342     |   | $ | 958 |   |
| Adjustments to  reconcile net income to cash provided by operating activities: |       |                                          |       |   |   |
| Depreciation,  depletion and amortization                                      |       | 30,692                                        |       | 24,580 |   |
| Exploration  costs                                                             |       | 16,172                                        |       | 17,700 |   |
| Accretion of  abandonment obligations                                          |       | 796                                           |       | 567 |   |
| Gain on sales of  property and equipment, net                                  |       | (739                                          | )          | (2,047 | ) |
| Deferred income  taxes                                                         |       | 4,912                                         |       | (44 | ) |
| Non-cash  employee compensation                                                |       | 1,151                                         |       | 720 |   |
| Unrealized  (gain) loss on derivatives                                         |       | (14,283                                       | )          | 35,221 |   |
| Settlements on  derivatives with financing elements                            |       | 15,508                                        |       | 9,796 |   |
| Amortization of  debt issue costs                                              |       | 735                                           |       | — |   |
| Minority  interest, net of tax                                                 |       | 40                                            |       | — |   |
|                                                                           |       |                                          |       |   |   |
| Changes in  operating working capital:                                         |       |                                          |       |   |   |
| Accounts  receivable                                                           |       | 86                                            |       | (1,137 | ) |
| Accounts payable                                                               |       | 143                                           |       | (8,827 | ) |
| Other                                                                          |       | 493                                           |       | (8,205 | ) |
| Net cash  provided by operating activities                                     |       | 77,048                                        |       | 69,282 |   |
|                                                                           |       |                                          |       |   |   |
| CASH FLOWS FROM  INVESTING ACTIVITIES                                          |       |                                          |       |   |   |
| Additions to  property and equipment                                           |       | (134,857                                      | )          | (79,001 | ) |
| Additions to  equipment of Larclay JV                                          |       | (31,607                                       | )          | — |   |
| Proceeds from  sales of property and equipment                                 |       | 684                                           |       | 2,151 |   |
| Other                                                                          |       | (886                                          | )          | (418 | ) |
| Net cash used in  investing activities                                         |       | (166,666                                      | )          | (77,268 | ) |
|                                                                           |       |                                          |       |   |   |
| CASH FLOWS FROM  FINANCING ACTIVITIES                                          |       |                                          |       |   |   |
| Proceeds from  long-term debt                                                  |       | 79,700                                        |       | 12,100 |   |
| Proceeds from  long-term debt of Larclay JV                                    |       | 36,197                                        |       | — |   |
| Repayments of  other long-term debt                                            |       | (12                                           | )          | — |   |
| Proceeds from  sale of common stock                                            |       | 175                                           |       | — |   |
| Settlements on  derivatives with financing elements                            |       | (15,508                                       | )          | (9,796 | ) |
| Net cash  provided by financing activities                                     |       | 100,552                                       |       | 2,304 |   |
|                                                                           |       |                                          |       |   |   |
| NET INCREASE (DECREASE)  IN CASH AND CASH EQUIVALENTS                          |       | 10,934                                        |       | (5,682 | ) |
|                                                                           |       |                                          |       |   |   |
| CASH AND CASH  EQUIVALENTS                                                     |       |                                          |       |   |   |
| Beginning of  period                                                           |       | 5,935                                         |       | 16,359 |   |
|                                                                           |       |                                          |       |   |   |
| End of period                                                                  |       | $                                             | 16,869     |   | $ | 10,677 |   |
|                                                                           |       |                                          |       |   |   |
| SUPPLEMENTAL  DISCLOSURES                                                      |       |                                          |       |   |   |
| Cash paid for interest,  net of amounts capitalized                            |       | $                                             | 8,394      |   | $ | 5,343 |   |

 

The accompanying notesare an integral part of these consolidated financial statements.

 

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**CLAYTON WILLIAMS ENERGY, INC.**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

**June 30, 2006**

**(Unaudited)**

 

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

Clayton WilliamsEnergy, Inc. (a Delaware corporation) and its subsidiaries (collectively, the “Company”or “CWEI”) is an independent oil and gas company engaged in the exploration forand development and production of oil and natural gas primarily in its coreareas in Texas, Louisiana and NewMexico.  Approximately 45% 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.

Substantially all of the Company’s oil and gas production is sold undershort-term contracts which are market-sensitive.  Accordingly, the Company’s financialcondition, results of operations, and capital resources are highly dependentupon prevailing market prices of, and demand for, oil and natural gas.  These commodity prices are subject to widefluctuations and market uncertainties due to a variety of factors that arebeyond the control of the Company.  Thesefactors include the level of global demand for petroleum products, foreignsupply of oil and gas, the establishment of and compliance with productionquotas by oil-exporting countries, weather conditions, the price andavailability of alternative fuels, and overall economic conditions, bothforeign and domestic.

**2.****                 Presentation**

The preparation of these consolidated financial statements in conformitywith accounting 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.

The consolidated financial statements include the accounts of ClaytonWilliams Energy, Inc., its wholly-owned subsidiaries and the accounts of theLarclay JV (see Note 4).  The Companyalso accounts for its undivided interests in oil and gas limited partnershipsusing the proportionate consolidation method, whereby its share of assets,liabilities, revenues and expenses are consolidated with other operations.  All significant intercompany transactions andbalances associated with the consolidated operations have been eliminated.

In the opinion of management, the Company’s unaudited consolidatedfinancial statements as of June 30, 2006 and for the interim periods ended June30, 2006 and 2005 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 endingDecember 31, 2006.

Certain information and footnote disclosures normally included infinancial statements prepared in accordance with accounting principlesgenerally accepted in the United States have been condensed or omitted in thisForm 10-Q pursuant to the rules and regulations of the Securities andExchange Commission (“SEC”).  Theseconsolidated financial statements should be read in conjunction with theaudited consolidated financial statements and notes thereto included in theCompany’s Form 10-K for the year ended December 31, 2005.

8

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

Emerging Issues Task Force Issue 04-5 (“EITF 04-5”), which becameeffective January 1, 2006, requires companies to fully consolidate any limitedpartnerships that the company controls as general partner.  EITF 04-5 presumes that a sole generalpartner in a limited partnership controls the limited partnership; however, thepresumption of control can be overcome if the limited partners have (i) thesubstantive ability to remove the sole general partner or otherwise dissolvethe limited partnership or (ii) substantive participating rights.  For this purpose, the EITF has concluded thata general partner lacks control if the limited partners can remove the generalpartner with a simple majority vote.  TheCompany has entered into contracts with 17 oil and gas limited partnerships ofwhich the Company is the sole general partner. Generally, these contracts require the Company to abstain from votingany of its limited partnership units in matters related to the removal of theCompany as general partner.  As a result,the limited partners in all of the oil and gas partnerships in which theCompany serves as general partner can remove the Company as general partnerwith a simple majority vote. Accordingly, the Company will continue consolidating its proportionate shareof all of these limited partnerships. The adoption of EITF 04-5 had no affect on the Company’sconsolidated financial statements.

In June 2006, the Financial Accounting Standards Board (“FASB”) issuedFASB Interpretation No. 48 “Accounting for Uncertainty in Income Taxes” (“FIN 48”)to clarify the manner in which enterprises account for uncertainties in theirprovisions for income taxes.  Generally,the standard presented by FIN 48 is a “more likely than not” standard andis intended to enhance the relevancy and comparability of financial reportingby companies.  FIN 48 is effectivefor fiscal years beginning after December 31, 2006.  The Company is currently reviewingFIN 48 to determine its application to the Company’s consolidatedfinancial statements.

**4.****                 Investmentin Larclay JV**

In April 2006, the Company formed a joint venture (“Larclay JV”) withLariat Services, Inc. (“Lariat”) to construct, own and operate 12 new drillingrigs.  The Company and Lariat each own a50% interest in Larclay JV.  The rigs arebeing constructed on behalf of Larclay JV by Lariat, as operationsmanager.  Construction of all the rigs isexpected to be completed by February 28, 2007 at a cost of approximately$75 million.  A lender has provideda $75 million secured term loan to Larclay JV to finance the construction andequipping of the rigs.  Pursuant to theterm loan, the Company has issued a $19 million letter of credit to thelender as additional collateral during the construction period.  Upon the earlier of compliance with specifiedcollateral ratios or February 28, 2007, the lender will release the letter ofcredit in exchange for a $19.5 million guaranty from the Company.  After completion of the construction period,outstanding advances under the term loan must not exceed 75% of the appraisedvalue of the rigs.  If proceeds availableto Larclay JV under the term loan are not sufficient to fully finance the costof the rigs, the Company will be required to loan funds to Larclay JV at thesame interest rate as the term loan.  TheLarclay JV term loan bears interest at a floating rate based on a LIBORaverage, plus 3.25%, and provides for monthly interest payments through March2007 and monthly principal and interest payments thereafter sufficient toretire the principal balance by 35% in the first year, 25% in each of the nexttwo years, and 15% in the fourth year. Two voluntary prepayments of $10 million each may be made in 2008 and2009 without a prepayment penalty.  TheLarclay JV term loan prohibits Larclay JV from making any cash distributions tothe Company or Lariat until the balance on the term loan is fully repaid, andrepayments by Larclay JV of any loans by the Company or Lariat are subordinatedto the loans outstanding under the term loan and are subject to otherrestrictions.

Also in April 2006, the Company entered into a three-year drillingcontract with Larclay JV assuring the availability of each rig for use in theordinary course of the Company’s exploration and development

9

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drilling program throughout the term of the drilling contract.  The provisions of the drilling contractrequire that the Company contract for each rig on a well-by-well basis at thencurrent market rates.  If a rig is notneeded by the Company at any time during the term of the contract, Larclay JVmay contract with Lariat, affiliates of Lariat or other third party operatorsfor the use of such rig, subject to certain restrictions.  If a rig is idle, the Company will payLarclay JV an idle rig rate ranging from $8,100 per day to $10,300 per day(plus crew labor expenses, if applicable), depending on the size of therig.  The Company’s gross idle rigobligations under this drilling contract, excluding crew labor, if any,aggregates $114 million.

Although the Company and Lariat own equal interests in Larclay JV, theCompany meets the definition of the primary beneficiary of Larclay JV’sexpected cash flows under FASB Interpretation No. 46R, “Consolidation ofVariable Interest Entities — an interpretation of ARB No. 51 (as amended)”(“FIN 46R”).  As the primary beneficiaryunder FIN 46R, the Company is required to include the accounts of Larclay JV inthe Company’s consolidated financial statements.  As of June 30, 2006, Lariat’s equityownership in the net assets of LarclayJV was $561,000, which is recorded as minority interest and included in othernon-current liabilities in the accompanying consolidated financialstatements.  The Company’s share ofintercompany accounts with Larclay JV have been eliminated.

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

Long-term debt consists of the following:
|                                             | ** ** | **June 30,**       | ** ** | **December 31,** | ** ** |
|---------------------------------------------|------------|-------------------------|------------|-----------------------|------------|
| ** **                                  | ** ** | **2006**                | ** ** | **2005**              | ** ** |
| ** **                                  | ** ** | **(In thousands)** | ** ** |
| 73⁄4% Senior Notes  due 2013             |       | $                       | 225,000    |                  | $          | 225,000 |   |
| Secured bank  credit facility, due May 2009 |       | 90,400                  |       | 10,700                |       |
| Secured term  loan of Larclay JV            |       | 36,197                  |       | —                |       |
| Other                                       |       | 7                       |       | 19                    |       |
|                                        |       | 351,604                 |       | 235,719               |       |
| Less current maturities(a)                  |       | (3,174                  | )          | (19                   | )          |
|                                        |       | $                       | 348,430    |                  | $          | 235,700 |   |

 

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(a)      Includescurrent portion of term loan of Larclay JV of $3,167 at June 30, 2006.

*73⁄4%Senior Notes due 2013*

In July 2005, the Company issued, in a privateplacement, $225 million of aggregate principal amount of 73⁄4% Senior Notesdue 2013 (“Senior Notes”).  The SeniorNotes were issued at face value and 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 typicaltransaction expenses, net proceeds of approximately $217 million were usedto repay all amounts outstanding under the secured bank credit facilities andfor general corporate purposes, including the funding of planned exploration anddevelopment activities.

At any time prior to August 1, 2008, the Company mayredeem up to 35% of the aggregate principal amount of the Senior Notes with theproceeds of certain equity offerings at a redemption price of 107.75% of theprincipal amount, plus accrued and unpaid interest.  In addition, prior to August 1, 2009, theCompany may redeem some or all of the Senior Notes at a redemption price equalto 100% of the principal amount of the Senior Notes to be redeemed, plus amake-whole premium, plus any accrued and unpaid interest.  On and after August 1, 2009, the Company mayredeem some or all of the Senior Notes at redemption prices (expressed aspercentages of principal amount) equal to 103.875% for the twelve-month periodbeginning on August 1, 2009, 101.938% for the twelve-month periodbeginning on August 1, 2010, 

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and 100.00% beginning on August 1, 2011, for anyperiod thereafter, in each case plus accrued and unpaid interest.

The Indenture governing the Senior Notes restricts theability of the Company and its restricted subsidiaries to:  (i) borrow money; (ii) issueredeemable and preferred stock; (iii) pay distributions or dividends;(iv) make investments; (v) create liens without securing the SeniorNotes; (vi) enter into agreements that restrict dividends fromsubsidiaries; (vii) sell certain assets or merge with or into othercompanies; (viii) enter into transactions with affiliates;(ix) guarantee indebtedness; and (x) enter into new lines ofbusiness.  The Company was in compliancewith these covenants at June 30, 2006.

*Secured Bank Credit Facility*

The Company’s secured bank credit facility providesfor a revolving loan facility in an amount not to exceed the lesser of theborrowing base, as established by the banks, or that portion of the borrowingbase determined by the Company to be the elected borrowing limit.  Theborrowing base, which is based on the discounted present value of future netrevenues from oil and gas production, is subject to redetermination at anytime, but at least semi-annually in May and November, and is made at thediscretion of the banks.  If, at any time, the redetermined borrowing baseis less than the amount of outstanding indebtedness, the Company will berequired to (i) pledge additional collateral, (ii) prepay the excess in notmore than five equal monthly installments, or (iii) elect to convert the entireamount of outstanding indebtedness to a term obligation based on amortizationformulas set forth in the loan agreement.  Substantially all of the Company’soil and gas properties are pledged to secure advances under the creditfacility.  In June 2006, the borrowingbase established by the banks was increased from $150 million to$200 million, with no monthly commitment reductions.  After allowingfor outstanding letters of credit totaling $19.8 million, the Company had$89.8 million available under the credit facility at June 30, 2006.

The revolving credit facility provides for interest atrates based on the agent bank’s prime rate plus margins ranging from .25% to1%, or if elected by the Company based on LIBOR plus margins ranging from 1.5%to 2.25%.  The Company also pays acommitment fee on the unused portion of the revolving credit facility.  Interest and fees are payable at leastquarterly.  The effective annual interestrate on borrowings under the combined credit facility, excluding bank fees andamortization of debt issue costs, for the six months ended June 30, 2006 was7.4%.

The loan agreement applicable to the revolving creditfacility contains financial covenants that are computed quarterly.  The working capital covenant requires theCompany to maintain a ratio of current assets to current liabilities of atleast 1 to 1.  Another financial covenantunder the credit facility requires the Company to maintain a ratio ofindebtedness to cash flow of no more than 3 to 1.  The computations of current assets, currentliabilities, cash flow and indebtedness are defined in the loan agreement.  The Company was in compliance with allfinancial and non-financial covenants at June 30, 2006.

*Secured Term Loan of Larclay JV*

In connection with the Company’s investment in LarclayJV (see Note 4), Larclay JV obtained a $75 million secured term loanfacility from a lender to finance the construction and equipping of 12 newdrilling rigs.  The Larclay JV term loanis secured by substantially all of the assets of Larclay JV and a$19 million letter of credit from the Company, which letter of credit willbe replaced prior to February 28, 2007 by a $19.5 million guaranty from theCompany.  Although the Company is not amaker on the Larclay JV term loan, it has provided the letter of creditand guaranty as credit support for the Larclay JV term loan and isrequired to fully consolidate the accounts of Larclay JV under FIN 46R.  At June 30, 2006, the effective interestrate on the Larclay JV term loan was 8.3%. Larclay JV capitalized $338,000 of interest expense related to theconstruction phase of the drilling rigs.

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**6.****                ****Other Non-Current Liabilities**

Other non-current liabilities consist of thefollowing:
|                          | ** ** | **June 30,**       | ** ** | **December 31,** | ** ** |
|--------------------------|------------|-------------------------|------------|-----------------------|------------|
| ** **               | ** ** | **2006**                | ** ** | **2005**              | ** ** |
| ** **               | ** ** | **(In thousands)** | ** ** |
| Abandonment  obligations |       | $                       | 20,522     |                  | $          | 19,447 |   |
| Minority  interest       |       | 561                     |       | —                |       |
| Other                    |       | 893                     |       | 896                   |       |
|                     |       | $                       | 21,976     |                  | $          | 20,343 |   |

 

Changes in abandonment obligationsfor the six months ended June 30, 2006 and 2005 are as follows:
|                                                   | ** ** | **Six Months Ended** | ** ** |
|---------------------------------------------------|------------|--------------------------------|------------|
| ** **                                        | ** ** | **June 30,**              | ** ** |
| ** **                                        | ** ** | **2006**                       | ** ** | **2005** | ** ** |
| ** **                                        | ** ** | **(In thousands)**        | ** ** |
| Beginning of  period                              |       | $                              | 19,447     |   | $ | 16,147 |   |
| Additional abandonment obligations from new wells |       | 410                            |       | 236 |   |
| Sales or abandonments of properties               |       | (114                           | )          | (279 | ) |
| Revisions of previous estimates                   |       | (17                            | )          | — |   |
| Accretion expense                                 |       | 796                            |       | 567 |   |
| End of period                                     |       | $                              | 20,522     |   | $ | 16,671 |   |

 

**7.****                 CompensationPlans**

*Stock-Based Compensation*

In January 2006, the Company adoptedStatement of Financial Accounting Standards No. 123 (revised 2004) “Share-BasedPayments” (“SFAS 123R”). SFAS 123R requires that the cost from all share-based paymenttransactions, including stock options, be recognized in the financialstatements at fair value.  UnderSFAS 123R, compensation expense related to the grant of stock options willbe determined based on the grant date fair value of future awards.  Prior to adoption of SFAS 123R, theCompany accounted for stock-based compensation utilizing the intrinsic valuemethod prescribed by Accounting Principles Board Opinion No. 25 “Accountingfor Stock Issued to Employee” (“APB 25”) and related interpretations.

The Company has accounted for options whichwere repriced in 1999 as variable stock options under APB 25 wherebycompensation expense has been recognized through December 31, 2005 forunexercised options based on changes in the market value of the Company’scommon stock.  In accordance withSFAS 123R, the Company ceased accounting for these options as variablestock options upon the adoption date. The Company adopted SFAS 123R using the modified prospectiveapplication method.  Since all of theCompany’s outstanding options were fully vested at January 31, 2006, nofuture compensation expense will be recognized under SFAS 123R unless theoptions are modified, and the Company did not recognize any cumulative effectof a change in accounting principles upon adoption of SFAS 123R.

Compensation expense related to stock-basedcompensation plans for the six months ended June 30, 2006 and 2005 was notsignificant.

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The Company has reserved 1,798,200 sharesof common stock for issuance under the 1993 Stock Compensation Plan (“1993 Plan”).  The Plan provides for the issuance ofnonqualified stock options with an exercise price which is not less than themarket value of the Company’s common stock on the date of grant.  All options granted through June 30, 2006expire 10 years from the date of grant and become exercisable based on varyingvesting schedules.

The Company has reserved 86,300 shares ofcommon stock for issuance under the Outside Directors Stock Option Plan (“DirectorsPlan”).  Since the inception of theDirectors Plan, the Company has issued options covering 44,000 shares of commonstock at option prices ranging from $3.25 to $41.74 per share.  All outstanding options expire 10 years fromthe grant date and are fully exercisable upon issuance.

The following table sets forth certaininformation regarding the Company’s stock option plans as of and for the sixmonths ended June 30, 2006:
| ** **                      | ** ** | ** ** | ** ** | ** **   | ** ** | **Weighted**    | ** ** | ** **    | ** ** |
|---------------------------------|------------|------------|------------|--------------|------------|-----------------|------------|---------------|------------|
| ** **                      | ** ** | ** ** | ** ** | **Weighted** | ** ** | **Average**     | ** ** | ** **    | ** ** |
| ** **                      | ** ** | ** ** | ** ** | **Average**  | ** ** | **Remaining**   | ** ** | **Aggregate** | ** ** |
| ** **                      | ** ** | ** ** | ** ** | **Exercise** | ** ** | **Contractual** | ** ** | **Intrinsic** | ** ** |
| ** **                      | ** ** | **Shares** | ** ** | **Price**    | ** ** | **Term**        | ** ** | **Value**     | ** ** |
| Outstanding at  January 1, 2006 |       | 1,338,551  |       | $            | 19.53      |            |       |          |       |   |
| Granted                         |       | 4,000      |       | $            | 41.74      |            |       |          | $          | — |   |
| Exercised                       |       | (30,566    | )          | $            | 5.72       |            |       |          | $          | 1,374,305 |   |
| Outstanding at  June 30, 2006   |       | 1,311,985  |       | $            | 19.91      |            | 5.5        |          | $          | 19,187,975 |   |
|                            |       |       |       |         |       |            |       |          |       |
| Vested at June  30, 2006        |       | 1,311,985  |       | $            | 19.91      |            | 5.5        |          | $          | 19,187,975 |   |
| Exercisable at June 30,  2006   |       | 1,311,985  |       | $            | 19.91      |            | 5.5        |          | $          | 19,187,975 |   |

 

The following pro forma information, asrequired by Statement of Financial Accounting Standards No. 123 “Accountingfor Stock-Based Compensation” (“SFAS 123”), as amended by Statementof Financial Accounting Standards No. 148 (“SFAS 148”), presents netincome and earnings per share information as if the stock options issued sinceDecember 31, 1994 were accounted for using the fair value method underSFAS 123.  The fair value of stockoptions issued for each year was estimated at the date of grant using the Black-Scholesoption pricing model.

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The SFAS 123 pro forma information forthe six months ended June 30, 2005 is as follows:
| ** **                                                                                                          | ** ** | **Six Months**                                  | ** ** |
|---------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                                                          | ** ** | **Ended**                                            | ** ** |
| ** **                                                                                                          | ** ** | **June 30, 2005**                          | ** ** |
| ** **                                                                                                          | ** ** | **(In thousands,  except per share)** | ** ** |
| Net income, as  reported                                                                                            |       | $                                                    | 958        |   |
| Add: Stock-based employee compensation expense  included in net income, net of tax                                  |       | 182                                                  |       |
| Deduct: Stock-based employee compensation expense  determined under fair value based method (SFAS 123R), net of tax |       | (2,920                                               | )          |
| Net loss, pro  forma                                                                                                |       | $                                                    | (1,780     | ) |
|                                                                                                                |       |                                                 |       |
| Basic:                                                                                                              |       |                                                 |       |
| Net income per common share, as reported                                                                            |       | $                                                    | .09        |   |
| Net loss per common share, pro forma                                                                                |       | $                                                    | (.16       | ) |
|                                                                                                                |       |                                                 |       |
| Diluted:                                                                                                            |       |                                                 |       |
| Net income per common share, as reported                                                                            |       | $                                                    | .09        |   |
| Net loss per  common share, pro forma                                                                               |       | $                                                    | (.16       | ) |

 

*After-PayoutWorking Interest Incentive Plan*

The CompensationCommittee of the Board of Directors has adopted an incentive plan for officers,key employees and consultants, excluding Mr. Williams, who promote theCompany’s drilling and acquisition programs. Management’s objective in adopting this plan is to further align theinterests of the participants with those of the Company by granting theparticipants an after-payout working interest in the production developed,directly or indirectly, by the participants. The plan generally provides for the creation of a series of partnershipsbetween the Company and the participants to which the Company contributes aportion of its working interest in wells drilled within certain areas.  The Company pays all costs and receives allrevenues until payout of its costs, plus interest.  At payout, the participants receive 99% ofall subsequent revenues and pay 99% of all subsequent expenses attributable tothe partnerships’ interests.

Between 3% and 6%of the Company’s working interests in certain specified wells drilled by theCompany subsequent to October 2002 are subject to this arrangement.  The Company records its allocable share ofthe assets, liabilities, revenues, expenses and oil and gas reserves of thesepartnerships in its consolidated financial statements.  To date, two of these partnerships achievedpayout.  Aggregate cash distributions ofapproximately $181,000 were paid to the participants during the six monthsended June 30, 2006.  During the sixmonths ended June 30, 2006, the Company recognized $1 million of non-cashcompensation expense for the estimated value of the after-payout interestssubject to this arrangement.

**8.****                 Derivatives**

# *Commodity Derivatives*

From time to time, the Company utilizes commodityderivatives, consisting of swaps, floors and collars, to attempt to optimizethe price received for its oil and gas production.  When using swaps to hedge oil and natural gasproduction, the Company receives a fixed price for the respective commodity andpays a floating market price as defined in each contract (generally NYMEXfutures prices), resulting in a net amount due to or from thecounterparty.  In floor transactions, theCompany receives a fixed price (put strike price) if the market price fallsbelow the put strike price for the respective commodity.  If the market price is greater than the putstrike price, no payments are due from either party.  Costless collars 

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area combination 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 the Company receives the fixedprice and pays the market price.  If themarket price is between the call and the put strike prices, no payments are duefrom either party.

The following summarizes information concerning theCompany’s net positions in open commodity derivatives applicable to periodssubsequent to June 30, 2006.  Thesettlement prices of commodity derivatives are based on NYMEX futures prices.

**Collars:**
| ** **            | ** ** | **Gas**            | ** ** | **Oil**   | ** ** |
|-----------------------|------------|--------------------|------------|-----------|------------|
| ** **            | ** ** | **MMBtu (a)** | ** ** | **Floor** | ** ** | **Ceiling** | ** ** | **Bbls** | ** ** | **Floor** | ** ** | **Ceiling** | ** ** |
| Production  Period:   |       |               |       |      |       |   |   |   |   |   |   |   |   |
| 3rd Quarter 2006 |       | 456,000            |       | $         | 4.00       |   | $ | 5.21 |   | 150,000 |   | $ | 23.00 |   | $ | 25.32 |   |
| 4th Quarter 2006 |       | 456,000            |       | $         | 4.00       |   | $ | 5.21 |   | 150,000 |   | $ | 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 |   |
|                  |       | 4,022,000          |       |      |       |   |   | 1,254,000 |   |   |   |   |   |

 

**Swaps:**
| ** **            | ** ** | **Gas**            | ** ** | **Oil**   | ** ** |
|-----------------------|------------|--------------------|------------|-----------|------------|
| ** **            | ** ** | **MMBtu (a)** | ** ** | **Price** | ** ** | **Bbls** | ** ** | **Price** | ** ** |
| Production Period:    |       |               |       |      |       |   |   |   |   |
| 3rd Quarter 2006 |       | —             |       | $         | —     |   | 75,000 |   | $ | 71.60 |   |
| 4th Quarter 2006 |       | 1,050,000          |       | $         | 10.03      |   | 75,000 |   | $ | 71.60 |   |
| 2007                  |       | 5,350,000          |       | $         | 10.23      |   | 600,000 |   | $ | 72.55 |   |
| 2008                  |       | 3,660,000          |       | $         | 9.53       |   | — |   | $ | — |   |
|                  |       | 10,060,000         |       |      |       | 750,000 |   |   |   |

 

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(a)       One MMBtu equals one Mcf ata Btu factor of 1,000.

Subsequent to June 30, 2006, the Companyclosed certain fixed-price oil swaps covering 300,000 barrels fromJanuary 2007 through December 2007 at a price of $80.45 per barrel, resultingin an aggregate loss of approximately $2.4 million.

The Company is a party to interest rate swapsthat were acquired in connection with the acquisition of Southwest Royalties,Inc. in May 2004.  Under thesederivatives, the Company pays a fixed rate for the notional principal balancesand receives a floating market rate based on LIBOR.  The following summarizes informationconcerning the Company’s net positions in open interest rate swaps applicableto periods subsequent to June 30, 2006.

**Interest Rate Swaps:**
| ** **                            | ** ** | **Principal** | ** ** | **Libor** | ** ** |
|---------------------------------------|------------|---------------|------------|-----------|------------|
| ** **                            | ** ** | **Balance**   | ** ** | **Rates** | ** ** |
| Period:                               |       |          |       |      |       |
| July 1, 2006 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       | % |

 

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*Accounting For Derivatives*

 

The Company accounts forits derivatives in accordance with Statement of Financial Accounting StandardsNo. 133 “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”),as amended.  The Company did notdesignate any of its currently open commodity or interest rate derivatives ascash flow hedges; therefore, all changes in the fair value of these contractsprior to maturity, plus any realized gains or losses at maturity, are recordedas other income (expense) in the Company’s statements of operations.  For the six months ended June 30, 2006,the Company reported a $1.3 million loss on derivatives, consisting of a$14.3 million gain related to changes in mark-to-market valuations and a$15.6 million cash charge for settled contracts.  For the six months ended June 30, 2005,loss on derivates was $44.9 million, consisting of a $35.2 millionnon-cash charge related to changes in mark-to-market valuations and a$9.7 million cash charge for settled contracts.

**9.****                 FinancialInstruments**

Cash and cash equivalents,receivables, accounts payable and accrued liabilities were each estimated tohave a fair value approximating the carrying amount due to the short maturityof those instruments.  Indebtedness underthe secured bank credit facilities was estimated to have a fair valueapproximating the carrying amount since the stated interest rate is generallymarket sensitive.  Abandonmentobligations are carried at net present value which approximates their fairvalue since the discount rate is based on the Company’s credit-adjusted,risk-free rate.  The fair value of othernoncurrent liabilities approximate their carrying value.

The fair values ofderivatives as of June 30, 2006 and December 31, 2005 are set forth below.  The associated carrying values at these datesare equal to their estimated fair values.
|                           | ** ** | **June 30,**       | ** ** | **December 31,** | ** ** |
|---------------------------|------------|-------------------------|------------|-----------------------|------------|
| ** **                | ** ** | **2006**                | ** ** | **2005**              | ** ** |
| ** **                | ** ** | **(In thousands)** | ** ** |
| Assets  (liabilities):    |       |                    |       |                  |       |
| Commodity derivatives     |       | $                       | (69,201    | )                     | $          | (82,635 | ) |
| Interest rate derivatives |       | 427                     |       | (422                  | )          |
| Net assets  (liabilities) |       | $                       | (68,774    | )                     | $          | (83,057 | ) |

 

**10.****          IncomeTaxes**

In May 2006, the State of Texas adopted House Bill 3, which modified thestate’s franchise tax structure, replacing the previous tax based on capital orearned surplus with a margin tax (the “Texas Margin Tax”) effective with franchisetax reports filed on or after January 1, 2008. The Texas Margin Tax is computed by applying the applicable tax rate (1%for the Company’s business sector) to the profit margin, which is generallydetermined by total revenue less either cost of goods sold or compensation, asapplicable.  Although House Bill 3 statesthat the Texas Margin Tax is not an income tax, the Company believes thatStatement of Financial Accounting Standards No. 109 “Accounting for IncomeTaxes” (“SFAS 109”) applies to the Texas Margin Tax.  Accordingly, the Company has computed itsconsolidated deferred tax liability based on its current interpretation of theTexas Margin Tax, resulting in a reduction of deferred tax expense during thequarter ended June 30, 2006 of $4.1 million.

The Company’s effective federal and state income tax rate for the sixmonths ended June 30, 2006 of 18.6% differed from the statutory federal rate of35% due to reductions in the tax provision related to the adoption of the TexasMargin Tax and statutory depletion, offset in part by certain non-deductibleexpenses.

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**11.****         ****Commitments**

The Company is presently obligated under firm orders for two drillingrigs and related equipment in an aggregate amount of $24 million, of whichcash deposits totaling $7.1 million have been paid to certain equipmentsuppliers as of June 30, 2006.  Thetotal cost of the rigs, when completed and fully equipped, will beapproximately $27 million.  The rigsare scheduled for delivery in mid-2007 and are expected to be utilized to drillthe Company’s deep Bossier prospects in East Texas and North Louisiana.

In addition to the Larclay JV drilling contract discussed inNote 4, the Company has also entered into two long-term drilling contractswith third party drilling contractors and is obligated to make payments underthese contracts totaling $13 million in 2006 and $16 million in 2007.

**12.****         ****Oil and Gas Properties**

The following sets forth the capitalized costs foroil and gas properties as of June 30, 2006 and December 31, 2005.
|                                                       | ** ** | **2006**                | ** ** | **2005**  | ** ** |
|-------------------------------------------------------|------------|-------------------------|------------|-----------|------------|
| ** **                                            | ** ** | **(In thousands)** | ** ** |
| Proved  properties                                    |       | $                       | 1,013,847  |      | $          | 957,962 |   |
| Unproved  properties                                  |       | 124,871                 |       | 79,900    |       |
| Total  capitalized costs                              |       | 1,138,718               |       | 1,037,862 |       |
| Accumulated  depreciation, depletion and amortization |       | (599,529                | )          | (570,386  | )          |
| Net capitalized  costs                                |       | $                       | 539,189    |      | $          | 467,476 |   |

 

In April 2005, the Financial Accounting Standards Board issued StaffPosition No. 19-1 (“FSP 19-1”).  FSP 19-1 amends the present guidance inStatement of Financial Accounting Standards No. 19, paragraphs 31 and 34,regarding when exploratory drilling costs pending determination of provedreserves can be carried as an asset of an oil and gas company that uses thesuccessful efforts method of accounting. The Company was required to adopt FSP 19-1, including itsdisclosures, effective July 1, 2005.  Theadoption of FSP 19-1 did not have a significant impact on the Company’sresults of operations.  At June 30, 2006and December 31, 2005, the Company had capitalized $16.6 million and$10.3 million, respectively, of exploratory drilling costs applicable towells that were pending determination of proved reserves.  Of the $10.3 million costs atDecember 31, 2005, $1.2 million was expensed as a dry hole during thesix months ended June 30, 2006, $8.1 million was subsequently deemedproductive and the remaining $1 million exploratory drilling costs werestill pending determination of proved reserves.

**13.****         ****Guarantor Financial Information**

In July 2005, Clayton WilliamsEnergy, Inc. (“Issuer”) issued $225 million of Senior Notes (seeNote 5).  All of the Issuer’swholly-owned and active subsidiaries (“Guarantor Subsidiaries”) have jointlyand severally, irrevocably and unconditionally guaranteed the performance andpayment when due of all obligations under the Senior Notes.  Larclay JV, a 50%-owned drilling rigjoint venture formed in April 2006 (see Note 4), has not guaranteed theSenior Notes and is referred to in this Note 13 as a Non-Guarantor Entity.

The following financial information sets forth the Company’s condensedconsolidating financial statements as of and for the periods indicated.

17

----

**Condensed Consolidating Balance Sheet**

**June 30, 2006**

**(Unaudited)**

**(Dollars in thousands)**

** **
| ** **                                       | ** ** | ** ** | ** ** | ** **       | ** ** | **Non-**      | ** ** | ** **       | ** ** | ** **       | ** ** |
|--------------------------------------------------|------------|------------|------------|------------------|------------|---------------|------------|------------------|------------|------------------|------------|
| ** **                                       | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Guarantor** | ** ** | **Adjustments/** | ** ** | ** **       | ** ** |
| ** **                                       | ** ** | **Issuer** | ** ** | **Subsidiaries** | ** ** | **Entity**    | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                       | ** ** | ** ** | ** ** | ** **       | ** ** | ** **    | ** ** | ** **       | ** ** | ** **       | ** ** |
| Current assets                                   |       | $          | 193,425    |             | $          | 97,301        |       | $                | 8,274      |             | $          | (194,342 | ) | $ | 104,658 |   |
|                                             |       |       |       |             |       |          |       |             |       |             |       |
| Property and equipment,  net                     |       | 271,416    |       | 275,532          |       | 31,463        |       | (86              | )          | 578,325          |       |
|                                             |       |       |       |             |       |          |       |             |       |             |       |
| Investments in  subsidiaries                     |       | 65,494     |       | —           |       | —        |       | (65,494          | )          | —           |       |
|                                             |       |       |       |             |       |          |       |             |       |             |       |
| Other assets                                     |       | 28,290     |       | 349              |       | 606           |       | —           |       | 29,245           |       |
|                                             |       |       |       |             |       |          |       |             |       |             |       |
| Total assets                                     |       | $          | 558,625    |             | $          | 373,182       |       | $                | 40,343     |             | $          | (259,922 | ) | $ | 712,228 |   |
|                                             |       |       |       |             |       |          |       |             |       |             |       |
| Current liabilities                              |       | $          | 119,822    |             | $          | 184,517       |       | $                | 6,192      |             | $          | (194,342 | ) | $ | 116,189 |   |
|                                             |       |       |       |             |       |          |       |             |       |             |       |
| Non-current  liabilities:                        |       |       |       |             |       |          |       |             |       |             |       |
| Long-term debt                                   |       | 315,400    |       | —           |       | 33,030        |       | —           |       | 348,430          |       |
| Fair value of  derivatives                       |       | 974        |       | 40,781           |       | —        |       | —           |       | 41,755           |       |
| Other                                            |       | 13,500     |       | 49,834           |       | —        |       | 561              |       | 63,895           |       |
|                                             |       | 329,874    |       | 90,615           |       | 33,030        |       | 561              |       | 454,080          |       |
|                                             |       |       |       |             |       |          |       |             |       |             |       |
| Stockholders’ equity                        |       | 108,929    |       | 98,050           |       | 1,122         |       | (66,141          | )          | 141,959          |       |
| Total liabilities and stockholders’  equity |       | $          | 558,625    |             | $          | 373,182       |       | $                | 40,343     |             | $          | (259,922 | ) | $ | 712,228 |   |

 

**Condensed Consolidating Balance Sheet**

**December 31, 2005**

**(Dollars in thousands)**

** **
| ** **                                       | ** ** | ** ** | ** ** | ** **       | ** ** | **Non-**        | ** ** | ** **       | ** ** | ** **       | ** ** |
|--------------------------------------------------|------------|------------|------------|------------------|------------|-----------------|------------|------------------|------------|------------------|------------|
| ** **                                       | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Guarantor**   | ** ** | **Adjustments/** | ** ** | ** **       | ** ** |
| ** **                                       | ** ** | **Issuer** | ** ** | **Subsidiaries** | ** ** | **Entity**      | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                       | ** ** | ** ** | ** ** | ** **       | ** ** | **(Unaudited)** | ** ** | ** **       | ** ** | ** **       | ** ** |
| Current assets                                   |       | $          | 188,007    |             | $          | 96,327          |       | $                | —     |             | $          | (195,892 | ) | $ | 88,442 |   |
|                                             |       |       |       |             |       |            |       |             |       |             |       |
| Property and equipment,  net                     |       | 195,987    |       | 278,080          |       | —          |       | —           |       | 474,067          |       |
|                                             |       |       |       |             |       |            |       |             |       |             |       |
| Investments in  subsidiaries                     |       | 65,005     |       | —           |       | —          |       | (65,005          | )          | —           |       |
|                                             |       |       |       |             |       |            |       |             |       |             |       |
| Other assets                                     |       | 24,491     |       | 335              |       | —          |       | —           |       | 24,826           |       |
|                                             |       |       |       |             |       |            |       |             |       |             |       |
| Total assets                                     |       | $          | 473,490    |             | $          | 374,742         |       | $                | —     |             | $          | (260,897 | ) | $ | 587,335 |   |
|                                             |       |       |       |             |       |            |       |             |       |             |       |
| Current liabilities                              |       | $          | 126,299    |             | $          | 193,864         |       | $                | —     |             | $          | (195,909 | ) | $ | 124,254 |   |
|                                             |       |       |       |             |       |            |       |             |       |             |       |
| Non-current  liabilities:                        |       |       |       |             |       |            |       |             |       |             |       |
| Long-term debt                                   |       | 235,700    |       | —           |       | —          |       | —           |       | 235,700          |       |
| Fair value of  derivatives                       |       | 610        |       | 49,095           |       | —          |       | —           |       | 49,705           |       |
| Other                                            |       | 8,280      |       | 49,105           |       | —          |       | —           |       | 57,385           |       |
|                                             |       | 244,590    |       | 98,200           |       | —          |       | —           |       | 342,790          |       |
|                                             |       |       |       |             |       |            |       |             |       |             |       |
| Stockholders’ equity                        |       | 102,601    |       | 82,678           |       | —          |       | (64,988          | )          | 120,291          |       |
| Total liabilities and  stockholders’ equity |       | $          | 473,490    |             | $          | 374,742         |       | $                | —     |             | $          | (260,897 | ) | $ | 587,335 |   |

 

18

----

**Condensed Consolidating Statement of Operations**

**Three Months Ended June 30, 2006**

**(Unaudited)**

**(Dollars in thousands)**

** **
| ** **               | ** ** | ** ** | ** ** | ** **       | ** ** | **Non-**      | ** ** | ** **       | ** ** | ** **       | ** ** |
|--------------------------|------------|------------|------------|------------------|------------|---------------|------------|------------------|------------|------------------|------------|
| ** **               | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Guarantor** | ** ** | **Adjustments/** | ** ** | ** **       | ** ** |
| ** **               | ** ** | **Issuer** | ** ** | **Subsidiaries** | ** ** | **Entity**    | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **               | ** ** | ** ** | ** ** | ** **       | ** ** | ** **    | ** ** | ** **       | ** ** | ** **       | ** ** |
| Total revenue            |       | $          | 42,268     |             | $          | 28,123        |       | $                | 747        |             | $          | (797 | ) | $ | 70,341 |   |
| Costs and  expenses      |       | 27,743     |       | 17,356           |       | 587           |       | (711             | )          | 44,975           |       |
| Operating income  (loss) |       | 14,525     |       | 10,767           |       | 160           |       | (86              | )          | 25,366           |       |
|                     |       |       |       |             |       |          |       |             |       |             |       |
| Other income  (expense)  |       | 531        |       | (4,758           | )          | (39           | )          | —           |       | (4,266           | )          |
|                     |       |       |       |             |       |          |       |             |       |             |       |
| Income tax  expense      |       | (3,094     | )          | —           |       | —        |       | —           |       | (3,094           | )          |
|                     |       |       |       |             |       |          |       |             |       |             |       |
| Minority  interest       |       | (40        | )          | —           |       | —        |       | —           |       | (40              | )          |
|                     |       |       |       |             |       |          |       |             |       |             |       |
| Net income  (loss)       |       | $          | 11,922     |             | $          | 6,009         |       | $                | 121        |             | $          | (86 | ) | $ | 17,966 |   |

** **

**Condensed Consolidating Statement of Operations**

**Six Months Ended June 30, 2006**

**(Unaudited)**

**(Dollars in thousands)**

** **
| ** **               | ** ** | ** ** | ** ** | ** **       | ** ** | **Non-**      | ** ** | ** **       | ** ** | ** **       | ** ** |
|--------------------------|------------|------------|------------|------------------|------------|---------------|------------|------------------|------------|------------------|------------|
| ** **               | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Guarantor** | ** ** | **Adjustments/** | ** ** | ** **       | ** ** |
| ** **               | ** ** | **Issuer** | ** ** | **Subsidiaries** | ** ** | **Entity**    | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **               | ** ** | ** ** | ** ** | ** **       | ** ** | ** **    | ** ** | ** **       | ** ** | ** **       | ** ** |
| Total revenue            |       | $          | 79,282     |             | $          | 55,156        |       | $                | 747        |             | $          | (1,450 | ) | $ | 133,735 |   |
| Costs and  expenses      |       | 64,525     |       | 34,134           |       | 587           |       | (1,364           | )          | 97,882           |       |
| Operating income  (loss) |       | 14,757     |       | 21,022           |       | 160           |       | (86              | )          | 35,853           |       |
|                     |       |       |       |             |       |          |       |             |       |             |       |
| Other income  (expense)  |       | (3,760     | )          | (5,760           | )          | (39           | )          | —           |       | (9,559           | )          |
|                     |       |       |       |             |       |          |       |             |       |             |       |
| Income tax  expense      |       | (4,912     | )          | —           |       | —        |       | —           |       | (4,912           | )          |
|                     |       |       |       |             |       |          |       |             |       |             |       |
| Minority  interest       |       | (40        | )          | —           |       | —        |       | —           |       | (40              | )          |
|                     |       |       |       |             |       |          |       |             |       |             |       |
| Net income  (loss)       |       | $          | 6,045      |             | $          | 15,262        |       | $                | 121        |             | $          | (86 | ) | $ | 21,342 |   |

 

**Condensed Consolidating Statement ofOperations**

**Three Months Ended June 30, 2005**

**(Unaudited)**

**(Dollars inthousands)**

** **
| ** **               | ** ** | ** ** | ** ** | ** **       | ** ** | **Non-**      | ** ** | ** **       | ** ** | ** **       | ** ** |
|--------------------------|------------|------------|------------|------------------|------------|---------------|------------|------------------|------------|------------------|------------|
| ** **               | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Guarantor** | ** ** | **Adjustments/** | ** ** | ** **       | ** ** |
| ** **               | ** ** | **Issuer** | ** ** | **Subsidiaries** | ** ** | **Entity**    | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **               | ** ** | ** ** | ** ** | ** **       | ** ** | ** **    | ** ** | ** **       | ** ** | ** **       | ** ** |
| Total revenue            |       | $          | 41,796     |             | $          | 25,008        |       | $                | —     |             | $          | (486 | ) | $ | 66,318 |   |
| Costs and  expenses      |       | 27,084     |       | 13,437           |       | —        |       | (486             | )          | 40,035           |       |
| Operating income  (loss) |       | 14,712     |       | 11,571           |       | —        |       | —           |       | 26,283           |       |
| Other income  (expense)  |       | (3,927     | )          | (7,826           | )          | —        |       | —           |       | (11,753          | )          |
| Income tax  expense      |       | (4,580     | )          | —           |       | —        |       | —           |       | (4,580           | )          |
|                     |       |       |       |             |       |          |       |             |       |             |       |
| Net income (loss)        |       | $          | 6,205      |             | $          | 3,745         |       | $                | —     |             | $          | — |   | $ | 9,950 |   |

** **

19

----

**Condensed Consolidating Statement ofOperations**

**Six Months Ended June 30, 2005**

**(Unaudited)**

**(Dollars inthousands)**

** **
| ** **               | ** ** | ** ** | ** ** | ** **       | ** ** | **Non-**      | ** ** | ** **       | ** ** | ** **       | ** ** |
|--------------------------|------------|------------|------------|------------------|------------|---------------|------------|------------------|------------|------------------|------------|
| ** **               | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Guarantor** | ** ** | **Adjustments/** | ** ** | ** **       | ** ** |
| ** **               | ** ** | **Issuer** | ** ** | **Subsidiaries** | ** ** | **Entity**    | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **               | ** ** | ** ** | ** ** | ** **       | ** ** | ** **    | ** ** | ** **       | ** ** | ** **       | ** ** |
| Total revenue            |       | $          | 85,544     |             | $          | 47,465        |       | $                | —     |             | $          | (1,002 | ) | $ | 132,007 |   |
| Costs and  expenses      |       | 56,659     |       | 26,545           |       | —        |       | (1,002           | )          | 82,202           |       |
| Operating income  (loss) |       | 28,885     |       | 20,920           |       | —        |       | —           |       | 49,805           |       |
|                     |       |       |       |             |       |          |       |             |       |             |       |
| Other income  (expense)  |       | (7,439     | )          | (41,323          | )          | —        |       | —           |       | (48,762          | )          |
|                     |       |       |       |             |       |          |       |             |       |             |       |
| Income tax  expense      |       | (85        | )          | —           |       | —        |       | —           |       | (85              | )          |
|                     |       |       |       |             |       |          |       |             |       |             |       |
| Net income  (loss)       |       | $          | 21,361     |             | $          | (20,403       | )          | $                | —     |             | $          | — |   | $ | 958 |   |

 

**Condensed Consolidating Statement ofCash Flows**

**Six Months Ended June 30, 2006**

**(Unaudited)**

**(Dollars inthousands)**

** **
| ** **                                 | ** ** | ** ** | ** ** | ** **       | ** ** | **Non-**      | ** ** | ** **       | ** ** | ** **       | ** ** |
|--------------------------------------------|------------|------------|------------|------------------|------------|---------------|------------|------------------|------------|------------------|------------|
| ** **                                 | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Guarantor** | ** ** | **Adjustments/** | ** ** | ** **       | ** ** |
| ** **                                 | ** ** | **Issuer** | ** ** | **Subsidiaries** | ** ** | **Entity**    | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                 | ** ** | ** ** | ** ** | ** **       | ** ** | ** **    | ** ** | ** **       | ** ** | ** **       | ** ** |
| Operating  activities                      |       | $          | 34,485     |             | $          | 39,977        |       | $                | 2,514      |             | $          | 72 |   | $ | 77,048 |   |
| Investing  activities                      |       | (123,978   | )          | (11,509          | )          | (31,607       | )          | 428              |       | (166,666         | )          |
| Financing  activities                      |       | 92,353     |       | (27,887          | )          | 36,586        |       | (500             | )          | 100,552          |       |
|                                       |       |       |       |             |       |          |       |             |       |             |       |
| Net increase in  cash and cash equivalents |       | 2,860      |       | 581              |       | 7,493         |       | —      |       | 10,934           |       |
|                                       |       |       |       |             |       |          |       |             |       |             |       |
| Cash at  beginning of  the period     |       | 4,302      |       | 1,633            |       | —        |       | —           |       | 5,935            |       |
|                                       |       |       |       |             |       |          |       |             |       |             |       |
| Cash at end of the  period                 |       | $          | 7,162      |             | $          | 2,214         |       | $                | 7,493      |             | $          | — |   | $ | 16,869 |   |

 

**Condensed Consolidating Statement ofCash Flows**

**Six Months Ended June 30, 2005**

**(Unaudited)**

**(Dollars inthousands)**

** **
| ** **                                            | ** ** | ** ** | ** ** | ** **       | ** ** | **Non-**      | ** ** | ** **       | ** ** | ** **       | ** ** |
|-------------------------------------------------------|------------|------------|------------|------------------|------------|---------------|------------|------------------|------------|------------------|------------|
| ** **                                            | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Guarantor** | ** ** | **Adjustments/** | ** ** | ** **       | ** ** |
| ** **                                            | ** ** | **Issuer** | ** ** | **Subsidiaries** | ** ** | **Entity**    | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                            | ** ** | ** ** | ** ** | ** **       | ** ** | ** **    | ** ** | ** **       | ** ** | ** **       | ** ** |
| Operating  activities                                 |       | $          | 33,103     |             | $          | 36,179        |       | $                | —     |             | $          | — |   | $ | 69,282 |   |
| Investing  activities                                 |       | (53,261    | )          | (24,007          | )          | —        |       | —           |       | (77,268          | )          |
| Financing  activities                                 |       | 20,600     |       | (18,296          | )          | —        |       | —           |       | 2,304            |       |
|                                                  |       |       |       |             |       |          |       |             |       |             |       |
| Net increase  (decrease) in cash and cash equivalents |       | 442        |       | (6,124           | )          | —        |       | —           |       | (5,682           | )          |
|                                                  |       |       |       |             |       |          |       |             |       |             |       |
| Cash at  beginning of  the period                |       | 2,732      |       | 13,627           |       | —        |       | —           |       | 16,359           |       |
|                                                  |       |       |       |             |       |          |       |             |       |             |       |
| Cash at end of the  period                            |       | $          | 3,174      |             | $          | 7,503         |       | $                | —     |             | $          | — |   | $ | 10,677 |   |

 

**14.          Subsequent Event**

 

In August 2006, an affiliated partnership, West Coast EnergyProperties, L.P. (“WCEP”), acquired certain producing oil and gas assets inCalifornia and Texas for aggregate cash consideration of

20

----

$58.1 million.  Approximately 75%of the purchase price relates to properties in three fields in southernCalifornia, and the remaining 25% relates primarily to properties located inMitchell County, Texas.

WCEP is a Texas limited partnership formed to facilitate thisacquisition, the general partner of which is a limited liability companycontrolled by the Company and the limited partner of which is an affiliate ofGE Capital Structured Finance Group.  Underthe partnership agreement, the general partner contributed approximately $6.2million to the partnership for an initial partnership interest of 5%, whichinterest can increase to 37.63%, and ultimately to 49%, upon the achievement ofcertain target rates of return.

The Company financed its equity contribution to the general partnerthrough borrowings on its revolving credit facility.

21

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**Item 2 -  Management’s Discussion and Analysis ofFinancial Condition and Results of Operations**

The following discussion is intended to provide information relevant toan understanding of our financial condition, changes in our financial conditionand our results of operations and cash flows and should be read in conjunctionwith our consolidated financial statements and notes thereto included elsewherein this Form 10-Q and in our Form 10-K for the year endedDecember 31, 2005.

**Overview**

We are an oil andnatural 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,administrative costs and interest expense, plus offer us a return on ourcapital investment.  From time to time,we may also acquire producing properties if we believe the acquired assets offerus the potential for reserve growth through additional developmental orexploratory drilling activities.

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 trained personnel,resulting in rate increases.  Whileprofit margins still remain favorable, operating metrics per Mcfe, such asfinding costs, production costs and overhead costs, are rising.

**Key Factors to Consider**

The following summarizes the key factorsconsidered by management in the review of our financial condition and operatingperformance for the second quarter of 2006 and the outlook for the remainder of2006.

·           We have spent$120.1 million on exploration and development activities during the firstsix months of 2006, most of which was on exploratory prospects, and wecurrently plan to spend approximately $213.9 million for the year2006.  These levels of expenditures aresignificantly higher than our anticipated cash flow from operations in 2006.

·           We increasedborrowings under our revolving credit facility from $66.7 million atMarch 31, 2006 to $90.4 million at June 30, 2006 to partially financeour exploration and development activities. Borrowings have increased $79.7 million from levels at December 31,2005.

·           We recorded a $245,000 net gain onderivatives during the second quarter of 2006. Cash settlements tocounterparties accounted for a $7.5 million loss offset by a$7.8 million gain for changes in mark-to-market valuations.  Since we do not presently designate ourderivatives as cash flow hedges under applicable accounting standards, werecognize the full effect of changing prices on mark-to-market valuations as acurrent charge or credit to our results of operations.

22

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·           At June 30, 2006, ourcapitalized unproved oil and gas properties totaled $124.9 million, ofwhich approximately $108 million was attributable to unprovedacreage.  Unproved properties are subjectto a valuation impairment to the extent the carrying cost of a prospect exceedsits estimated fair value.  Therefore, ourresults of operations in future periods may be adversely affected by unprovedproperty impairments.

·           We formed a joint ventureto construct, own and operate 12 new drilling rigs (“Larclay JV”) in April2006 and included the accounts of Larclay JV in our consolidated financialstatements beginning in the second quarter of 2006.

**RecentExploration and Developmental Activities**

***Overview***

As shown in “Liquidity and Capital Resources —Capital Expenditures,” we incurred expenditures for exploration and developmentactivities of $120.1 million during the first six months of 2006.  Approximately 40% of these expenditures werelease purchases and seismic and other exploration costs.

We are actively acquiring leases in NorthLouisiana and East Texas in order to establish a significant acreage positionfor future exploratory and, if successful, developmental drillingactivities.  We believe that the reservepotential in these areas is significant and warrants this investment in acreage.

***South Louisiana***

The following table sets forth certaininformation about our exploratory well activities in South Louisiana subsequentto December 31, 2005.
| ** **    | ** ** | ** **               | ** ** | **Working**  | ** ** | **Current**                      |
|---------------|------------|--------------------------|------------|--------------|------------|----------------------------------|
| **Spud Date** | ** ** | **Well Name (Prospect)** | ** ** | **Interest** | ** ** | **Status**                       |
| January 2006  |       | Borah #1 (Cypress Isle)  |       | 75           | %          | Dry                              |
| February 2006 |       | SL 195 QQ #2 (Floyd)     |       | 81.3         | %          | Waiting on production facilities |
| February 2006 |       | SL 195 QQ #3 (Floyd)     |       | 75           | %          | Waiting on production facilities |
| March 2006    |       | SL 195 QQ #4 (Floyd)     |       | 75           | %          | Waiting on production facilities |
| March 2006    |       | A. J. Beshel #1 (Beshel) |       | 100          | %          | Waiting on production facilities |
| April 2006    |       | Cobena #1 (Boa II)       |       | 62.5         | %          | Drilling                         |
| May 2006      |       | SL 195 QQ #5 (Floyd)     |       | 75           | %          | Waiting on completion            |
| June 2006     |       | SL 195 QQ #8 (Floyd)     |       | 75           | %          | Waiting on completion            |

 

We completed the first four wells on theFloyd prospect in Plaquemines Parish as gas wells.  We have drilled and logged two additionalwells on the Floyd prospect which we expect to complete once a completion rigbecomes available.  We presently plan todrill up to four additional wells on this acreage.  Under the terms of a farmout agreement, webear 100% of the costs on these wells before casing point to earn a 75% workinginterest in the drilled acreage. 

***North Louisiana***

In May 2006, we began drilling the AtkinsEstate #1 (Frazier Creek), an 11,900-foot exploratory well in ClaiborneParish targeting the Cotton Valley/Hosston formations.  In July 2006, we began drilling the RobersonN. #1 (Terryville), a 14,500-foot exploratory well in Lincoln Parish alsotargeting the Cotton

23

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Valley/Hosston formations.  In addition, we have participated in 11 non-operatedCotton Valley/Hosston wells in which our working interests have ranged from 3%to 44%.  Currently, eight of the wellsare producing, one is being completed, one is being drilled, and one was dry.

***Other***

We have leased approximately 35,000 net acresfor our Bossier exploration program in East Texas, and we plan to spud ourfirst Bossier well in East Texas during the fourth quarter 2006.

We are currently drilling the Focus RanchFederal 12 #1 well, an 8,500-foot exploratory well in RouttCounty, Colorado targeting the Niobraro formation.

**Supplemental Information**

The following unaudited information is intended tosupplement the consolidated financial statements included in this Form 10-Qwith data that is not readily available from those statements.
| ** **                                       | ** ** | **Three Months Ended** | ** ** |
|--------------------------------------------------|------------|----------------------------------|------------|
| ** **                                       | ** ** | **June 30,**                | ** ** |
| ** **                                       | ** ** | **2006**                         | ** ** | **2005** | ** ** |
| **Oil and  Gas Production Data:**                | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Gas (MMcf)                                       |       | 4,016                            |       | 4,547 |   |
| Oil (MBbls)                                      |       | 555                              |       | 615 |   |
| Natural gas liquids (MBbls)                      |       | 50                               |       | 67 |   |
| Total (MMcfe)                                    |       | 7,646                            |       | 8,639 |   |
|                                             |       |                             |       |   |   |
| **Average  Realized Prices (a):**                | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Gas ($/Mcf)                                      |       | $                                | 6.78       |   | $ | 6.62 |   |
| Oil ($/Bbl)                                      |       | $                                | 66.78      |   | $ | 50.35 |   |
| Natural gas liquids ($/Bbl):                     |       | $                                | 37.56      |   | $ | 31.73 |   |
|                                             |       |                             |       |   |   |
| **Losses  on Settled Derivative Contracts (a):** | ** ** | ** **                       | ** ** | ** ** | ** ** |
| ($ in thousands, except per unit)           |       |                             |       |   |   |
| Gas:    Net  realized loss        |       | $                                | (887       | ) | $ | (1,271 | ) |
|  Per unit produced ($/Mcf)                  |       | $                                | (0.22      | ) | $ | (0.28 | ) |
| Oil:     Net realized loss   |       | $                                | (6,700     | ) | $ | (4,763 | ) |
| Per unit produced ($/Bbl)                        |       | $                                | (12.07     | ) | $ | (7.74 | ) |
|                                             |       |                             |       |   |   |
| **Average  Daily Production:**                   | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Natural Gas (Mcf):                               |       |                             |       |   |   |
| Permian Basin                                    |       | 15,744                           |       | 16,063 |   |
| Louisiana                                        |       | 15,428                           |       | 14,604 |   |
| Austin Chalk (Trend)                             |       | 2,757                            |       | 2,103 |   |
| Cotton Valley Reef Complex                       |       | 9,723                            |       | 16,618 |   |
| Other                                            |       | 480                              |       | 579 |   |
| Total                                            |       | 44,132                           |       | 49,967 |   |
| Oil (Bbls):                                      |       |                             |       |   |   |
| Permian Basin                                    |       | 3,274                            |       | 3,281 |   |
| Louisiana                                        |       | 933                              |       | 1,494 |   |
| Austin Chalk (Trend)                             |       | 1,833                            |       | 1,920 |   |
| Other                                            |       | 59                               |       | 63 |   |
| Total                                            |       | 6,099                            |       | 6,758 |   |
| Natural Gas Liquids (Bbls):                      |       |                             |       |   |   |
| Permian Basin                                    |       | 227                              |       | 220 |   |
| Austin Chalk (Trend)                             |       | 265                              |       | 392 |   |
| Other                                            |       | 57                               |       | 124 |   |
| Total                                            |       | 549                              |       | 736 |   |

 

(Continued)

24

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| ** **                                | ** ** | **Three Months Ended** | ** ** |
|-------------------------------------------|------------|----------------------------------|------------|
| ** **                                | ** ** | **June 30,**                | ** ** |
| ** **                                | ** ** | **2006**                         | ** ** | **2005** | ** ** |
| **Exploration  Costs (in thousands):**    | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Abandonment and impairment costs:         |       |                             |       |   |   |
| Louisiana                                 |       | $                                | 2,879      |   | $ | 205 |   |
| Permian Basin                             |       | 115                              |       | 684 |   |
| Montana                                   |       | 297                              |       | — |   |
| Mississippi                               |       | —                           |       | 876 |   |
| Cotton Valley Reef Complex                |       | 3                                |       | 154 |   |
| South Texas                               |       | —                           |       | 4,511 |   |
| Other                                     |       | 35                               |       | — |   |
| Total                                     |       | 3,329                            |       | 6,430 |   |
| Seismic and other                         |       | 2,587                            |       | 1,665 |   |
| Total exploration costs                   |       | $                                | 5,916      |   | $ | 8,095 |   |
|                                      |       |                             |       |   |   |
| **Oil and Gas Costs ($/Mcfe  Produced):** | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Production costs                          |       | $                                | 2.08       |   | $ | 1.60 |   |
| Oil and gas depletion                     |       | $                                | 1.98       |   | $ | 1.34 |   |
|                                      |       |                             |       |   |   |
| **Net  Wells Drilled (b):**               | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Exploratory Wells                         |       | 5.2                              |       | 7.5 |   |
| Developmental  Wells                      |       | —                           |       | 15.9 |   |

 
| ** **                                      | ** **                                                                                 | **Six Months Ended** | ** ** |
|-------------------------------------------------|--------------------------------------------------------------------------------------------|--------------------------------|------------|
| ** **                                      | ** **                                                                                 | **June 30,**              | ** ** |
| ** **                                      | ** **                                                                                 | **2006**                       | ** ** | **2005** | ** ** |
| **Oil and  Gas Production Data:**               | ** **                                                                                 | ** **                     | ** ** | ** ** | ** ** |
| Gas (MMcf)                                      |                                                                                       | 7,479                          |       | 9,308 |   |
| Oil (MBbls)                                     |                                                                                       | 1,110                          |       | 1,234 |   |
| Natural gas liquids (MBbls)                     |                                                                                       | 98                             |       | 133 |   |
| Total (MMcfe)                                   |                                                                                       | 14,727                         |       | 17,510 |   |
|                                            |                                                                                       |                           |       |   |   |
| **Average  Realized Prices(a):**                | ** **                                                                                 | ** **                     | ** ** | ** ** | ** ** |
| Gas ($/Mcf)                                     |                                                                                       | $                              | 6.99       |   | $ | 6.41 |   |
| Oil ($/Bbl)                                     |                                                                                       | $                              | 63.41      |   | $ | 49.08 |   |
| Natural gas liquids ($/Bbl):                    |                                                                                       | $                              | 38.21      |   | $ | 29.63 |   |
|                                            |                                                                                       |                           |       |   |   |
| **Losses  on Settled Derivative Contracts(a):** | ** **                                                                                 | ** **                     | ** ** | ** ** | ** ** |
| ($in thousands, except per unit)                |                                                                                       |                           |       |   |   |
| Gas:    Net realized loss        |                                                                                       | $                              | (3,065     | ) | $ | (562 | ) |
|  Per unit produced ($/Mcf)                 |                                                                                       | $                              | (0.41      | ) | $ | (.06 | ) |
| Oil:     Net realized loss  |                 | $                              | (12,595    | ) | $ | (8,983 | ) |
| Per unit produced ($/Bbl)                       |                                                                                       | $                              | (11.35     | ) | $ | (7.28 | ) |

 

(Continued)

25

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| ** **                                | ** ** | **Six Months Ended** | ** ** |
|-------------------------------------------|------------|--------------------------------|------------|
| ** **                                | ** ** | **June 30,**              | ** ** |
| ** **                                | ** ** | **2006**                       | ** ** | **2005** | ** ** |
| **Average  Daily Production:**            | ** ** | ** **                     | ** ** | ** ** | ** ** |
| Natural Gas (Mcf):                        |       |                           |       |   |   |
| Permian Basin                             |       | 14,789                         |       | 16,110 |   |
| Louisiana                                 |       | 12,465                         |       | 14,935 |   |
| Austin Chalk (Trend)                      |       | 3,007                          |       | 2,329 |   |
| Cotton Valley Reef Complex                |       | 10,576                         |       | 17,312 |   |
| Other                                     |       | 483                            |       | 739 |   |
| Total                                     |       | 41,320                         |       | 51,425 |   |
| Oil (Bbls):                               |       |                           |       |   |   |
| Permian Basin                             |       | 3,244                          |       | 3,305 |   |
| Louisiana                                 |       | 1,011                          |       | 1,485 |   |
| Austin Chalk (Trend)                      |       | 1,827                          |       | 1,976 |   |
| Other                                     |       | 51                             |       | 52 |   |
| Total                                     |       | 6,133                          |       | 6,818 |   |
| Natural Gas Liquids (Bbls):               |       |                           |       |   |   |
| Permian Basin                             |       | 244                            |       | 227 |   |
| Austin Chalk (Trend)                      |       | 262                            |       | 365 |   |
| Other                                     |       | 35                             |       | 143 |   |
| Total                                     |       | 541                            |       | 735 |   |
| **Exploration  Costs (in thousands):**    | ** ** | ** **                     | ** ** | ** ** | ** ** |
| Abandonment and impairment costs:         |       |                           |       |   |   |
| Louisiana                                 |       | $                              | 10,886     |   | $ | 1,477 |   |
| Permian Basin                             |       | 2,317                          |       | 975 |   |
| Montana                                   |       | 2,230                          |       | — |   |
| Mississippi                               |       | 679                            |       | 3,337 |   |
| Cotton Valley Reef Complex                |       | 14                             |       | 7,400 |   |
| South Texas                               |       | —                         |       | 4,511 |   |
| Other                                     |       | 46                             |       | — |   |
| Total                                     |       | 16,172                         |       | 17,700 |   |
| Seismic and other                         |       | 5,688                          |       | 2,453 |   |
| Total exploration costs                   |       | $                              | 21,860     |   | $ | 20,153 |   |
|                                      |       |                           |       |   |   |
| **Oil and  Gas Costs ($/Mcfe Produced):** |       |                           |       |   |   |
| Production costs                          |       | $                              | 2.10       |   | $ | 1.51 |   |
| Oil and gas depletion                     |       | $                              | 1.98       |   | $ | 1.32 |   |
|                                      |       |                           |       |   |   |
| **Net Wells  Drilled(b):**                | ** ** | ** **                     | ** ** | ** ** | ** ** |
| Exploratory Wells                         |       | 12.8                           |       | 10.8 |   |
| Developmental  Wells                      |       | 1.7                            |       | 24.8 |   |

 

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(a)                          No derivativeswere designated as cash flow hedges in 2006 or 2005.  All gains or losses on settled derivativeswere included in loss on derivatives.

(b)                         Excludes wellsbeing drilled or completed at the end of each period.

**Operating Results – Three-Month Periods**

The following discussion compares our resultsfor the three months ended June 30, 2006 to the comparative period in2005.  Unless otherwise indicated, referencesto 2006 and 2005 within this section refer to the respective quarterly period.

26

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***Oil and gas operating results***

Oil and gas sales in 2006 increased 5% from2005.  Oil and gas sales increased$3.1 million, of which price variances accounted for a $10.1 millionincrease and production variances accounted for a $7 million decrease.

Production in 2006 (on an Mcfe basis) was 11%lower than 2005.  Our oil productiondecreased 10% in 2006 from 2005 due primarily to the loss of production fromone well in Louisiana, coupled with normal production declines on otherwells.  Our gas production decreased 12%in 2006 from 2005 due primarily to production declines in the Cotton ValleyReef Complex area due to formation performance.

In 2006, our realized oil price was 33%higher than 2005, while our realized gas price was 2% 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 $1.60 per Mcfe in 2005 to $2.08 per Mcfe in 2006.  The increase in operating costs in 2006 wasdue primarily to higher oilfield service costs and an increase in workoveractivities, combined with a production decline of 11% on an Mcfe basis for thecurrent period.  It is likely that thesefactors will continue to contribute to higher production costs in futureperiods.

Depreciation, depletion, and amortization (“DD&A”)expense increased from $12.3 million in 2005 to $16 million in2006.  DD&A expense attributable tooil and gas properties increased $3.6 million, of which rate variancesaccounted for a $4.9 million increase and production variances accountedfor a $1.3 million decrease.  On anMcfe basis, DD&A expense increased 48% from $1.34 per Mcfe in 2005 to $1.98per Mcfe in 2006.  Depletion rates foreach depletable group are a function of net capitalized costs and estimatedreserve quantities.

General and administrative (“G&A”)expenses increased from $3.1 million in 2005 to $4.3 million in 2006due primarily to higher personnel costs and professional fees derived from theincrease in overall drilling and exploration activities.  In 2006, we also recorded a $500,000 non-cashcompensation charge related to our after payout working interest incentiveplan.

***Explorationcosts***

Since we follow the successful efforts methodof accounting, 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 2006, we chargedto expense $5.9 million of exploration costs, as compared to$8.1 million in 2005.  Most of these costs were incurred in Louisianaas a result of the abandonment of the Borah #1 (Cypress Isle) and due toseismic costs associated with exploration activities.

We plan to spend approximately $213.9 millionon exploration and development activities in fiscal 2006, of whichapproximately 85% is expected to be allocated to exploration activities. Since exploratory drilling involves a high degree of risk, it is likely that asignificant portion of the remaining costs in fiscal 2006 will be charged toexploration costs. However, we cannot predict our success rates and,accordingly, cannot predict our exploration costs related to abandonment andimpairment costs.

At June 30, 2006, our capitalizedunproved oil and gas properties totaled $124.9 million, of whichapproximately $108 million was attributable to unproved acreage.  Unproved properties are subject to avaluation impairment to the extent the carrying cost of a prospect exceeds itsestimated fair value.

27

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Therefore, our results of operations infuture periods may be adversely affected by unproved property impairments.

***Interest expense***

Interest expense increased from$2.6 million in 2005 to $5 million in 2006 due primarily to higheraverage levels of indebtedness.  Theaverage daily principal balance outstanding under our bank credit facility for2006 was $80.5 million compared to $191.2 million for 2005.  In addition, we issued in July 2005$225 million of 73⁄4% Senior Notes due 2013 (the “Senior Notes”) which bear interest at afixed rate of 7.75%.

***Gain/Loss on derivatives***

We recorded a net gain on derivatives of$245,000 in 2006 compared to a loss of $9.8 million for 2005.  We did not designate any derivative contractsin 2006 or 2005 as cash flow hedges; therefore all cash settlements and changesresulting from mark-to-market valuations have been recorded as losses onderivatives.  Cash settlements were $7.5 millionin 2006, as compared to $6.1 million in 2005.  We recorded a gain on derivatives of$7.8 million in 2006 compared to a loss of $3.7 million in 2005resulting from mark-to-market valuations.

**Operating Results – Six-Month Periods**

The following discussion compares our resultsfor the six months ended June 30, 2006 to the comparative period in 2005.  Unless otherwise indicated, references to2006 and 2005 within this section refer to the respective six-monthperiod.

***Oil and gas operating results***

Oil and gas sales in 2006 increased 1% from2005.  Oil and gas sales increased$1.8 million, of which price variances accounted for a $21.1 millionincrease and production variances accounted for a $19.3 million decrease.

Production in 2006 (on an Mcfe basis) was 16%lower than 2005.  Our oil productiondecreased 10% in 2006 from 2005 due primarily to the loss of production fromone well in Louisiana, coupled with normal production declines on existingwells.  Our gas production decreased 20%in 2006 from 2005 due primarily to production declines in the Cotton ValleyReef Complex area due to formation performance.

In 2006, our realized oil price was 29%higher than 2005, while our realized gas price was 9% 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 $1.51 per Mcfe in 2005 to $2.10 per Mcfe in 2006.  The increase in operating costs in 2006 wasdue primarily to higher oilfield service costs and an increase in workoveractivities, combined with a production decline of 16% on an Mcfe basis for thecurrent period.  It is likely that thesefactors will continue to contribute to higher production costs in futureperiods.

DD&A expense attributable to oil and gasproperties increased $6 million, of which rate variances accounted for a$9.7 million increase and production variances accounted for a$3.7 million decrease.  On

28

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an Mcfe basis, DD&A expense increased 50%from $1.32 per Mcfe in 2005 to $1.98 per Mcfe in 2006.  Depletion rates for each depletable group area function of net capitalized costs and estimated reserve quantities.

G&A expenses increased from$5.7 million in 2005 to $8.3 million in 2006 due to higher personnelcosts and professional fees derived from the increase in overall drilling andexploration activities and a $1 million non-cash compensation charge in 2006related to our after payout working interest incentive plan.

***Explorationcosts***

Since we follow the successful efforts methodof accounting, 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 2006, we chargedto expense $21.9 million of exploration costs, as compared to $20.2 millionin 2005.  Most of these costs were incurred in Louisiana, the PermianBasin and Montana. 

We plan to spend approximately $213.9 millionon exploration and development activities in fiscal 2006, of whichapproximately 85% is expected to be allocated to exploration activities. Since exploratory drilling involves a high degree of risk, it is likely that asignificant portion of the remaining costs in fiscal 2006 will be charged toexploration costs. However, we cannot predict our success rates and,accordingly, cannot predict our exploration costs related to abandonment andimpairment costs.

At June 30, 2006, our capitalizedunproved oil and gas properties totaled $124.9 million, of whichapproximately $108 million was attributable to unproved acreage.  Unproved properties are subject to avaluation impairment to the extent the carrying cost of a prospect exceeds itsestimated fair value.  Therefore, ourresults of operations in future periods may be adversely affected by unprovedproperty impairments.

***Interest expense***

Interest expense increased from$4.9 million in 2005 to $9.3 million in 2006 due primarily to higheraverage levels of indebtedness.  Theaverage daily principal balance outstanding under our bank credit facility for2006 was $62.1 million compared to $187.2 million for 2005.  In addition, we issued in July 2005$225 million of Senior Notes which bear interest at a fixed rate of 7.75%.

***Gain/Loss on derivatives***

We recorded a loss on derivatives of$1.3 million in 2006 compared to a loss of $44.9 million for2005.  We did not designate anyderivative contracts in 2006 or 2005 as cash flow hedges; therefore all cashsettlements and changes resulting from mark-to-market valuations have been recordedas losses on derivatives.  Cash settlementswere $15.6 million in 2006, as compared to $9.7 million in 2005.  We recorded a gain on derivatives of $14.3million in 2006 compared to a loss of $35.2 million in 2005 resulting from mark-to-marketvaluations.

29

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**Liquidity and Capital Resources**

***Overview***

Our primary financial resource is our base ofoil and gas reserves.  We pledge ourproducing oil and gas properties to a group of banks to secure our revolvingcredit facility.  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 onthe borrowing base established for the revolving credit facility by issuing$225 million of aggregate principal amount of Senior Notes and using thenet proceeds to repay all amounts outstanding on the revolving credit facilityand the senior term credit facility. However, we have recently drawn advances under the revolving creditfacility to partially finance our exploration and development activities.  At June 30, 2006, we had $90.4 millionoutstanding on the revolving credit facility.

In this section, we will describe our currentplans for capital spending, identify the capital resources available to financeour capital spending, and discuss the principal factors that can affect ourliquidity and capital resources.

***Capital expenditures***

Our planned expenditures for exploration anddevelopment activities during 2006 total $213.9 million, as summarized byarea in the following table.
|                       | ** ** | **Actual**                  | ** ** | **Total**                       | ** ** | ** **        | ** ** |
|-----------------------|------------|-----------------------------|------------|---------------------------------|------------|-------------------|------------|
| ** **            | ** ** | **Expenditures**            | ** ** | **Planned**                     | ** ** | ** **        | ** ** |
| ** **            | ** ** | **Six Months**         | ** ** | **Expenditures**                | ** ** | ** **        | ** ** |
| ** **            | ** ** | **Ended**                   | ** ** | **Year Ended**             | ** ** | **Percentage**    | ** ** |
| ** **            | ** ** | **June 30, 2006** | ** ** | **December 31, 2006** | ** ** | **of Total** | ** ** |
| ** **            | ** ** | **(In thousands)**     | ** ** | ** **                      | ** ** |
| ** **            | ** ** | ** **                  | ** ** | ** **                      | ** ** |
| North Louisiana       |       | $                           | 23,800     |                            | $          | 48,000            |       | 22 | % |
| South Louisiana       |       | 53,500                      |       | 97,800                          |       | 46                | %          |
| East Texas  (Bossier) |       | 16,500                      |       | 21,000                          |       | 10                | %          |
| Permian Basin         |       | 17,500                      |       | 26,600                          |       | 12                | %          |
| Utah/Montana          |       | 5,000                       |       | 8,700                           |       | 4                 | %          |
| Austin Chalk  (Trend) |       | 2,100                       |       | 6,400                           |       | 3                 | %          |
| Other                 |       | 1,700                       |       | 5,400                           |       | 3                 | %          |
|                  |       | $                           | 120,100    |                            | $          | 213,900           |       | 100 | % |

 

30

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Our actual expenditures during fiscal 2006may be substantially 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 2006.

Approximately 85% 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 other opportunitiesto increase our oil and gas reserves, including the evaluation of new prospectsfor exploratory and developmental drilling activities and potentialacquisitions of proved oil and gas properties.

At our current level of planned activity for2006, we project that more than half of the cash needed to finance our plannedexpenditures for exploration and development activities in fiscal 2006 will beprovided by operating activities.  To theextent that actual costs exceed our cash provided by operating activities, weplan to utilize the revolving credit facility to finance such excess.  We borrowed $79.7 million under ourrevolving credit facility during the six months of 2006 and expect to borrowadditional amounts during the remainder of fiscal 2006.

*Drilling Rig Joint Venture*

In April 2006, we invested $500,000 in a joint venture (“Larclay JV”)with Lariat Services, Inc. (“Lariat”) to construct, own and operate 12 newdrilling rigs.  CWEI and Lariat each owna 50% interest in Larclay JV.  The rigsare being constructed on behalf of Larclay JV by Lariat, as operationsmanager.  Construction of all the rigs isexpected to be completed by February 28, 2007 at a cost of approximately$75 million.  A lender has provideda $75 million secured term loan to Larclay JV to finance the construction andequipping of the rigs.  Pursuant to theterm loan, we have issued a $19 million letter of credit to the lender asadditional collateral during the construction period.  Upon the earlier of compliance with specifiedcollateral ratios or February 28, 2007, the lender will release the letter ofcredit in exchange for a $19.5 million guaranty from us.  After completion of the construction period,outstanding advances under the term loan must not exceed 75% of the appraisedvalue of the rigs.  If proceeds availableto Larclay JV under the term loan are not sufficient to fully finance the costof the rigs, we will be required to loan funds to Larclay JV at the sameinterest rate as the term loan.  TheLarclay JV term loan bears interest at a floating rate based on a LIBORaverage, plus 3.25%, and provides for monthly interest payments through March2007 and monthly principal and interest payments thereafter sufficient toretire the principal balance by 35% in the first year, 25% in each of the nexttwo years, and 15% in the fourth year. Two voluntary prepayments of $10 million each may be made in 2008 and2009 without a prepayment penalty.  TheLarclay JV term loan prohibits Larclay JV from making any cash distributions tous or to Lariat until the balance on the term loan is fully repaid, andrepayments by Larclay JV of any loans by us or by Lariat are subordinated tothe loans outstanding under the term loan and are subject to otherrestrictions.

Also in April 2006, we entered into a three-year drilling contract withLarclay JV assuring the availability of each rig for use in the ordinary courseof our exploration and development drilling program throughout the term of thedrilling contract.  The provisions of thedrilling contract require that we contract for each rig on a well-by-well basisat then current market rates.  If a rigis not needed by us at any time during the term of the contract, Larclay JV maycontract with Lariat, affiliates of Lariat or other third party operators forthe use of such rig, subject to certain restrictions.  If a rig is idle, we will pay Larclay JV an

31

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idle rig rate ranging from $8,100 per day to $10,300 per day (plus crewlabor expenses, if applicable), depending on the size of the rig.

Our gross idle rig commitment under the drillingcontract with Larclay JV, excluding crew labor, if any, aggregatesapproximately $114 million over the three-year term of the contract.  We plan to mitigate our exposure to our idlerig commitment by permitting Larclay JV to contract with other operators toutilize specific rigs which we do not expect to use in our drillingprogram.  As we utilize the Larclay JVrigs in the ordinary course of our drilling program, the cost of such rigs willbe included in our exploration and development expenditures.

In addition to the rigs we have committed touse pursuant to the drilling contract with Larclay JV described above, we aredirectly committed under firm orders for two drilling rigs and relatedequipment in an aggregate amount of $24 million, of which cash depositstotaling $7.1 million have been paid to certain equipment suppliers as ofJune 30, 2006.  The total cost ofthe rigs, when completed and fully equipped, will be approximately$27 million.  The rigs are scheduledfor delivery in mid-2007 and are expected to be utilized to drill our deepBossier prospects in East Texas and North Louisiana.

We have also entered into two drilling contracts with third partydrilling contractors and are obligated to make payments under these contractstotaling $13 million in 2006 and $16 million in 2007.

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

Substantially all of our cash flow fromoperating activities is derived from the production of our oil and gasreserves.  We use this cash flow to fundour on-going exploration and development activities in search of new oil andgas reserves.  Variations in cash flowfrom operating activities may impact our level of exploration and developmentexpenditures.

Cash flow provided by operating activitiesfor the six months ended June 30, 2006 was 11% higher than the same period in2005 due to the combined effects of several factors.  Oil and gas sales, net of production costs,general and administrative costs and interest expense, were $9.7 millionlower in the first half of 2006 as compared to the same period in 2005.  However, changes in operating working capitalresulted in a net increase in operating cash flow of $18.9 million.  Our primary source of cash from operatingactivities is our oil and gas sales, net of production costs.  Our cash flow provided by operating activitiesis subject to material variation from changes in oil and gas production levelsand product prices.  Higher oil and gasprices also resulted in an increase in cash required to settle derivativecontracts, excluding those contracts that contain a financing element as in thecase of the contracts assumed in our acquisition of Southwest Royalties, Inc.in May 2004.  Interest expense increasedin 2006 due primarily to higher levels of indebtedness resulting from theissuance of the Senior Notes.

***Credit facility***

A group of banks have provided us with arevolving credit facility on which we have historically relied for both ourshort-term liquidity (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.

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At the beginning of 2006, we had anoutstanding balance under the revolving credit facility of $10.7 million,and the borrowing base was $150 million, providing us with available fundsof $138.5 million after accounting for outstanding letters of credit.  In June 2006, the borrowing base wasincreased to $200 million.  During thesix months ended June 30, 2006, we generated cash flow from operatingactivities of $77 million.  We alsospent $166.7 million on capital expenditures and other investments andpaid $15.5 million to settle derivatives with financing elements.  To finance the excess of exploration overcash flow, we borrowed $79.7 million on the revolving credit facility.

Using the revolving credit facility forboth our short-term liquidity and long-term financing needs can cause unusualfluctuations in our reported working capital, depending on the timing of cashreceipts and expenditures.  On a daily basis,we use most of our available cash to pay down our outstanding balance on therevolving credit facility, which is classified as a non-current liability sincewe currently have no required principal reductions.  As we use cash to pay a non-currentliability, our reported working capital decreases.  Conversely, as we draw on the revolvingcredit facility for funds to pay current liabilities (such as payables fordrilling and operating costs), our reported working capital increases.  Also, volatility in oil and gas prices cancause significant fluctuations in reported working capital as we record changesin the fair value of derivatives from period to period.  For these reasons, the working capitalcovenant related to the revolving credit facility requires us to (i) includethe amount of funds available under this facility as a current asset,(ii) exclude current assets and liabilities related to the fair value ofderivatives, and (iii) exclude current maturities of vendor financeobligations, if any, when computing the working capital ratio at any balancesheet date.

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 $35.8 million at December 31, 2005 to$11.5 million at June 30, 2006 due primarily to a combination of factors,including decreases in accounts payable and increases in inventory.  After giving effect to the adjustments, ourworking capital computed for loan compliance purposes was a positive$110.4 million at June 30, 2006, as compared to a positive$136.2 million at December 31, 2005. The following table reconciles our GAAP working capital to the workingcapital computed for loan compliance purposes at June 30, 2006 andDecember 31, 2005.
|                                                                                        | ** ** | **June 30,**       | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------|------------|
| ** **                                                                             | ** ** | **2006**                | ** ** | **2005**              | ** ** |
| ** **                                                                             | ** ** | **(In thousands)** | ** ** |
| ** **                                                                             | ** ** | ** **              | ** ** |
| Working capital  (deficit) per GAAP                                                    |       | $                       | (11,531    | )                     | $          | (35,812 | ) |
| Add funds  available under the revolving credit facility                               |       | 89,796                  |       | 138,496               |       |
| Exclude fair  value of derivatives classified as current assets or current liabilities |       | 32,118                  |       | 33,479                |       |
| Working capital per loan  covenant                                                     |       | $                       | 110,383    |                  | $          | 136,163 |   |

 

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

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financial andnon-financial covenants at June 30, 2006, our increased leverage andreduced liquidity may result in our failing to comply with one or more of thesecovenants in the future.  If we fail to meet any of these loan covenants,we would ask the banks to allow us sufficient time to obtain additional capitalresources through alternative means.  Ifa suitable arrangement could not be reached with the banks, the banks couldaccelerate the indebtedness and seek to foreclose on the pledged assets.  However, the issuance of the Senior Notesdescribed below significantly increases our liquidity and reduces ourdependence on the revolving credit facility.

The banks redeterminethe borrowing base under the revolving credit facility at least twice a year,in May and November.  The May 2006borrowing base review resulted in an increase from $150 million to$200 million which was finalized in June 2006.  If at any time, the borrowing base is lessthan the amount of outstanding indebtedness, we will be required to(i) pledge additional collateral, (ii) prepay the excess in not morethan five equal monthly installments, or (iii) elect to convert the entireamount of outstanding indebtedness to a term obligation based on amortizationformulas set forth in the loan agreement. In connection with the issuance of the Senior Notes, the borrowing basewas reduced to $132.5 million in July 2005, and all outstanding balanceson our revolving credit facility were repaid. However, we have recently drawn advances under the revolving creditfacility to partially finance our exploration and development activities.  At June 30, 2006, we had $90.4 millionoutstanding on the revolving credit facility.

***73⁄4% Senior Notes due 2013***

In July 2005, we issued, in a private placement,$225 million of aggregate principal amount of Senior Notes.  The Senior Notes were issued at face valueand will 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 repayamounts outstanding on our secured credit facilities and for general corporatepurposes, including the funding of planned exploration and developmentactivities.

At any time prior to August 1, 2008, we may redeem upto 35% of the aggregate principal amount of the Senior Notes with the proceedsof certain equity offerings at a redemption price of 107.75% of the principalamount, plus accrued and unpaid interest. In addition, prior to August 1, 2009, we may redeem some or all of theSenior Notes at a redemption price equal to 100% of the principal amount of theSenior Notes to be redeemed, plus a make-whole premium, plus any accrued andunpaid interest.  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 onAugust 1, 2011, for any period thereafter, in each case plus accrued and unpaidinterest.

The Indenture governing the Senior Notes restricts ourability and the ability of our restricted subsidiaries to:  (i) borrow money; (ii) issueredeemable and preferred stock; (iii) pay distributions or dividends;(iv) make investments; (v) create liens without securing the Notes;(vi) enter into agreements that restrict dividends from subsidiaries;(vii) sell certain assets or merge with or into other companies;(viii) enter into transactions with affiliates; (ix) guaranteeindebtedness; and (x) enter into new lines of business.  These covenants are subject to a number ofimportant exceptions and qualifications. We were in compliance with these covenants at June 30, 2006.

***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

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capital resources, such as asset sales,vendor financing arrangements, and/or public or private issuances of commonstock.  We could also issue senior orsubordinated debt or preferred stock in a public or a private placement if wechoose to raise capital through either of these markets.  While we believe we would be able to obtainfunds through one or more of these alternatives, if needed, there can be noassurance that these capital resources would be available on terms acceptableto us.

**Item 3-********                               Quantitativeand Qualitative Disclosure About 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 and Gas Prices**

Our financial condition, results ofoperations, and capital resources are highly dependent upon the prevailingmarket prices of, and demand for, oil and natural gas.  These commodity prices are subject to widefluctuations and market uncertainties due to a variety of factors that arebeyond our control.  These factorsinclude the level of global demand for petroleum products, foreign supply ofoil and gas, the establishment of and compliance with production quotas byoil-exporting countries, weather conditions, the price and availability ofalternative fuels, and overall economic conditions, both foreign anddomestic.  We cannot predict future oiland gas prices with any degree of certainty. Sustained weakness in oil and gas prices may adversely affect ourfinancial condition and results of operations, and may also reduce the amountof net oil and gas reserves that we can produce economically.  Any reduction in reserves, includingreductions due to price fluctuations, can reduce the borrowing base under ourrevolving credit facility and adversely affect our liquidity and our ability toobtain 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, 2005 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, 2006 by$11 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 fromeither party.  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.

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The decision to initiate or terminatecommodity hedges is made by management based on its expectation of futuremarket price movements.  We have no setgoals for the percentage of our production we hedge and we do not use anyformulas or triggers 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 informationconcerning our net positions in open commodity derivatives applicable toperiods subsequent to June 30, 2006.  Thesettlement prices of commodity derivatives are based on NYMEX futures prices.

**Collars:**
| ** **            | ** ** | **Gas**            | ** ** | **Oil**   | ** ** |
|-----------------------|------------|--------------------|------------|-----------|------------|
| ** **            | ** ** | **MMBtu (a)** | ** ** | **Floor** | ** ** | **Ceiling** | ** ** | **Bbls** | ** ** | **Floor** | ** ** | **Ceiling** | ** ** |
| Production  Period:   |       |               |       |      |       |   |   |   |   |   |   |   |   |
| 3rd Quarter 2006 |       | 456,000            |       | $         | 4.00       |   | $ | 5.21 |   | 150,000 |   | $ | 23.00 |   | $ | 25.32 |   |
| 4th Quarter 2006 |       | 456,000            |       | $         | 4.00       |   | $ | 5.21 |   | 150,000 |   | $ | 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 |   |
|                  |       | 4,022,000          |       |      |       |   |   | 1,254,000 |   |   |   |   |   |

 

**Swaps:**
| ** **            | ** ** | **Gas**            | ** ** | **Oil**   | ** ** |
|-----------------------|------------|--------------------|------------|-----------|------------|
| ** **            | ** ** | **MMBtu (a)** | ** ** | **Price** | ** ** | **Bbls** | ** ** | **Price** | ** ** |
| Production  Period:   |       |               |       |      |       |   |   |   |   |
| 3rd Quarter 2006 |       | —             |       | $         | —     |   | 75,000 |   | $ | 71.60 |   |
| 4th Quarter 2006 |       | 1,050,000          |       | $         | 10.03      |   | 75,000 |   | $ | 71.60 |   |
| 2007                  |       | 5,350,000          |       | $         | 10.23      |   | 600,000 |   | $ | 72.55 |   |
| 2008                  |       | 3,660,000          |       | $         | 9.53       |   | — |   | $ | — |   |
|                  |       | 10,060,000         |       |      |       | 750,000 |   |   |   |

 

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(a)       One MMBtu equals one Mcfat a Btu factor of 1,000.

Subsequent to June 30, 2006, we closedcertain fixed-price oil swaps covering 300,000 barrels at a price of$80.45 per barrel, from January 2007 through December 2007 resulting in anaggregate loss of approximately $2.4 million.

We use a sensitivity analysis technique toevaluate the hypothetical effect that changes in the market value of oil andgas may have 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 $6.2 million.

**Interest Rates**

We are party to interest rate swaps that wereacquired in connection with the acquisition of Southwest Royalties, Inc. in May2004.  Under these derivatives, we pay afixed rate for the notional principal balances and receives a floating marketrate based on LIBOR.  The followingsummarizes information concerning our net positions in open interest rate swapsapplicable to periods subsequent to June 30, 2006.

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| ** **                            | ** ** | **Principal** | ** ** | **Libor** | ** ** |
|---------------------------------------|------------|---------------|------------|-----------|------------|
| ** **                            | ** ** | **Balance**   | ** ** | **Rates** | ** ** |
| Period:                               |       |          |       |      |       |
| July 1, 2006 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 precedingtable expose us to market risks for decreases in interest rates during theperiods shown.

**Item 4 -          Controls and Procedures**

#### **Disclosure Controls 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 haveevaluated the effectiveness of our disclosure controls and procedures as of theend of the period covered by this report;

·                  This evaluationwas conducted under the supervision and with the participation of ourmanagement, including our chief executive and chief financial officers; and

·                  It is theconclusion of our chief executive and chief financial officers that thesedisclosure controls and procedures operate such that material information flowsto the appropriate collection and disclosure points in a timely manner and areeffective in ensuring that material information is accumulated and communicatedto our management and is made known to the chief executive and chief financialofficers, particularly during the period in which this report was prepared, asappropriate to allow timely decisions regarding required disclosures.

#### **Changes in Internal Control Over FinancialReporting**

No changes in internal control over financialreporting were made during the quarter ended June 30, 2006 that have materiallyaffected, or are reasonably likely to materially affect, our internal controlover financial reporting.

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**PARTII.  FINANCIAL INFORMATION**

 

**Item 1A -       Risk Factors**

In evaluating all forward-looking statements,you should specifically consider various factors that may cause actual resultsto vary from those contained in the forward-looking statements.  Our risk factors are included in our AnnualReport on Form 10-K for the year ended December 31, 2005, asfiled with the U.S. Securities and Exchange Commission on March 16, 2006and available at www.sec.gov.  Therehave been no material changes to these risk factors since the filing of ourForm 10-K.

**Item 4 -          Submission of Matters to a Vote ofSecurities Holders**

On May 10, 2006, we held our AnnualMeeting of Stockholders to (a) elect three directors to the Board of Directorsfor a term of three years, and (b) advise on the selection of KPMG LLP as ourindependent auditors for 2006.  At such meeting, Stanley S. Beard and MelG. Riggs were reelected as directors, and stockholders advised that KPMG LLPshould be selected as our independent auditors for 2006.

The following is a summary of the votes castat the Annual Meeting:
| **Results of  Voting**               | ** ** | **Votes For** | ** ** | **Withheld** | ** ** |
|--------------------------------------|------------|---------------|------------|--------------|------------|
| 1.  Election  of Directors |       |          |       |         |       |
| Stanley S. Beard                     |       | 8,807,813     |       | 509,149      |       |
| Mel G. Riggs                         |       | 8,810,790     |       | 506,172      |       |

 
|                                                           | ** ** | **Votes For** | ** ** | **Withheld** | ** ** | **Abstentions** | ** ** |
|-----------------------------------------------------------|------------|--------------------|------------|--------------|------------|-----------------|------------|
| 2.  Advisory  vote on the selection of KPMG LLP |       | 9,258,059          |       | 27,130       |       | 31,773          |       |

 

**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††         |

 

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| 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**       |   | Limited Liability Company Agreement, dated April 21,  2006, by and between Clayton Williams Energy, Inc. and Lariat Services, Inc.,  with respect to the formation of Larclay GP, LLC, a Texas limited liability  company, filed as Exhibit 10.1 to our Current Report on Form 8-K  filed with the Commission on April 26, 2006††         |
|         |   |                                                                                                                                                                                                                                                                                                                                                     |
| 10.2**       |   | Agreement of Limited Partnership, dated April 21,  2006, by and among Larclay GP, LLC, Clayton Williams Energy, Inc. and  Lariat Services, Inc., with respect to the formation of Larclay L.P., a Texas  limited partnership, filed as Exhibit 10.2 to our Current Report on  Form 8-K filed with the Commission on April 26, 2006†† |
|         |   |                                                                                                                                                                                                                                                                                                                                                     |
| 10.3**       |   | Drilling Contract for Multiple Rigs, dated April 21,  2006, by and between Clayton Williams Energy, Inc. and Larclay L.P., filed as  Exhibit 10.3 to our Current Report on Form 8-K filed with the  Commission on April 26, 2006††                                                                                                        |
|         |   |                                                                                                                                                                                                                                                                                                                                                     |
| 10.4**       |   | Subordination Agreement, dated April 21, 2006, by  and among Clayton Williams Energy, Inc., Lariat Services, Inc. and Merrill  Lynch Capital, as agent, filed as Exhibit 10.4 to our Current Report on  Form 8-K filed with the Commission on April 26, 2006††                                                                            |
|         |   |                                                                                                                                                                                                                                                                                                                                                     |
| 10.5**       |   | Consent and Agreement, dated April 21, 2006, by and  among Clayton Williams Energy, Inc., Lariat Services, Inc. and Merrill Lynch  Capital, as agent, filed as Exhibit 10.5 to our Current Report on Form 8-K  filed with the Commission on April 26, 2006††                                                                              |
|         |   |                                                                                                                                                                                                                                                                                                                                                     |
| 10.6**       |   | Letter of Credit, dated April 21, 2006, issued in  favor of Merrill Lynch Capital, as agent, filed as Exhibit 10.6 to our  Current Report on Form 8-K filed with the Commission on April 26,  2006††                                                                                                                                      |
|         |   |                                                                                                                                                                                                                                                                                                                                                     |
| 10.7**       |   | Form of Unconditional Limited Guaranty, to be issued  by Clayton Williams Energy, Inc. in favor of Merrill Lynch Capital, as agent,  filed as Exhibit 10.7 to our Current Report on Form 8-K filed with  the Commission on April 26, 2006††                                                                                               |
|         |   |                                                                                                                                                                                                                                                                                                                                                     |
| 10.8**† |   | Agreement of Limited Partnership of Floyd Prospect  II, L.P., dated May 15, 2006, filed as Exhibit 10.1 to our Current  Report on Form 8-K filed with the Commission on May 17, 2006††                                                                                                                                          |
|         |   |                                                                                                                                                                                                                                                                                                                                                     |
| 10.9**       |   | Third Amendment to Amended and Restated Credit  Agreement,, dated June 30, 2006, filed as Exhibit 10.1 to our Current  Report on Form 8-K filed with the Commission on July 14, 2006††                                                                                                                                          |

 

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| 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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| *            |   | Filed herewith                                                                                                |
|--------------|--------|---------------------------------------------------------------------------------------------------------------|
| **           |   | Incorporated by reference to the filing indicated                                                             |
| †       |   | Identifies an Exhibit that consists of or includes a  management contract or compensatory plan or arrangement |
| †† |   | Filed under our Commission File No. 001-10924                                                            |

 

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**CLAYTON WILLIAMS ENERGY, INC.**

**SIGNATURES**

 

Pursuant to the requirements of the Securities Exchange Act of 1934, theRegistrant has duly caused this report to be signed on its behalf by theundersigned thereto duly authorized.

 
| ** ** |           |   | **CLAYTON WILLIAMS ENERGY, INC.**          |
|------------|----------------|--------|--------------------------------------------|
| ** ** |           |   |                                       |
| ** ** |           |   |                                       |
| Date:      | August 8, 2006 |   | By:                                        | */s/ L. Paul Latham* |
|       |           |   | L. Paul Latham                             |
|       |           |   | Executive Vice  President and Chief        |
|       |           |   |   Operating  Officer                  |
|       |           |   |                                       |
|       |           |   |                                       |
| Date:      | August 8, 2006 |   | By:                                        | */s/ Mel G. Riggs* |
|       |           |   | Mel G. Riggs                               |
|       |           |   | Senior Vice  President and Chief Financial |
|       |           |   |   Officer                             |

 

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