PEASE OIL AND GAS COMPANY AND SUBSIDIARIES


                   INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

                                                                          Page

Independent Auditor's Report..............................................F-2

Consolidated Balance Sheets - December 31, 1996 and 1995 .................F-3

Consolidated Statements of Operations -
For the Years Ended December 31, 1996 and 1995............................F-5

Consolidated Statements of Stockholders' Equity -
For the Years Ended December 31, 1996 and 1995............................F-6

Consolidated Statements of Cash Flows -
For the Years Ended December 31, 1996 and 1995............................F-7

Notes to Consolidated Financial Statements................................F-8





                                       F-1

<PAGE>






                          INDEPENDENT AUDITOR'S REPORT






Board of Directors
Pease Oil and Gas Company
Grand Junction, Colorado



We have audited the  accompanying  consolidated  balance sheets of Pease Oil and
Gas Company and  subsidiaries  as of December 31, 1996 and 1995, and the related
consolidated  statements of operations,  stockholders' equity and cash flows for
the years then ended.  These financial  statements are the responsibility of the
Company's  management.  Our  responsibility  is to  express  an opinion on these
financial statements based on our audits.

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

In our opinion, the consolidated  financial statements referred to above present
fairly, in all material  respects,  the financial  position of Pease Oil and Gas
Company and  subsidiaries  as of December 31, 1996 and 1995,  and the results of
their  operations  and their cash  flows for the years then ended in  conformity
with generally accepted accounting principles.



/s/ Hein + Associates LLP
HEIN + ASSOCIATES LLP


Denver, Colorado
February 21, 1997

                                       F-2

<PAGE>





                   PEASE OIL AND GAS COMPANY AND SUBSIDIARIES

                           CONSOLIDATED BALANCE SHEETS



                                                            DECEMBER 31,
                                                       1996               1995

                                     ASSETS
CURRENT ASSETS:
     Cash and equivalents ......................  $  1,995,860    $    677,275
     Trade receivables, net of allowance
        for bad debts of $25,000 and ...........
        $51,000, respectively ..................       599,648         963,315
     Inventory .................................       408,787         532,289
     Prepaid expenses and other ................        56,327          77,844
     Common stock subscription receivable,
        91,667 shares ..........................          --            68,750
                                                  ------------    ------------
               Total current assets ............     3,060,622       2,319,473
                                                  ------------    ------------

OIL AND GAS PROPERTIES, at cost
   (successful efforts method):
     Undeveloped properties ....................       351,727         377,606
     Wells in progress .........................       181,312            --
     Developed properties ......................     9,505,408       9,149,516
                                                  ------------    ------------
               Total oil and gas properties ....    10,038,447       9,527,122
     Less accumulated depreciation and depletion    (3,946,974)     (3,608,917)
                                                  ------------    ------------
               Net oil and gas properties ......     6,091,473       5,918,205
                                                  ------------    ------------

PROPERTY, PLANT AND EQUIPMENT, at cost:
     Gas plant .................................     4,099,285       4,095,227
     Service equipment and vehicles ............       879,313         855,025
     Buildings and office equipment ............       459,228         529,703
                                                  ------------    ------------
               Total property, plant and equipment   5,437,826       5,479,955
     Less accumulated depreciation .............    (1,376,154)     (1,034,731)
                                                  ------------    ------------
               Net property, plant and equipment     4,061,672       4,445,224
                                                  ------------    ------------

OTHER ASSETS:
     Debt issuance costs, net of accumulated
          amortization of $73,027 ..............
          and $29,167, respectively ............     1,093,479          20,833
     Non-compete agreements, net of accumulated
          amortization of $253,322 .............       306,678         352,674
     Other .....................................       274,830         383,317
                                                  ------------    ------------
               Total other assets ..............     1,674,987         756,824
                                                  ------------    ------------
TOTAL ASSETS ...................................  $ 14,888,754    $ 13,439,726
                                                  ============    ============



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


                                       F-3

<PAGE>


                   PEASE OIL AND GAS COMPANY AND SUBSIDIARIES

                           CONSOLIDATED BALANCE SHEETS
                                   (continued)


                                                          DECEMBER 31,
                                                     1996            1995
                      LIABILITIES AND STOCKHOLDERS' EQUITY

CURRENT LIABILITIES:
     Current maturities of long-term debt:
          Related parties ...................   $    285,895              $-
          Other .............................         45,944       1,100,474
     Accounts payable, trade ................        267,540       1,172,567
     Accrued production taxes ...............        288,122         303,287
     Other accrued expenses .................        265,427         243,325
                                                ------------    ------------

               Total current liabilities ....      1,152,928       2,819,653
                                                ------------    ------------

LONG-TERM LIABILITIES:
     Long-term debt, less current maturities:
          Convertible debentures, net of
            discount of $1,732,170 .               3,267,830          --
          Other ................................      19,945       1,223,159
     Accrued production taxes ..................     256,088         379,652
                                                ------------    ------------

               Total long-term liabilities .....   3,543,863       1,602,811
                                                ------------    ------------

COMMITMENTS AND CONTINGENCIES (Notes 3, 5, 6, and 11)

STOCKHOLDERS' EQUITY:
     Preferred Stock, par value $.01 per share,
          2,000,000 shares authorized, 179,938
          and 202,688 shares of Series A Cumulative
          Convertible Preferred Stock issued and
          outstanding (liquidation preference of
          $2,204,000 and $2,280,000, respectively)     1,799           2,027
     Common Stock, par value $.10 per share,
          25,000,000 shares authorized, issued and
          outstanding 7,526,817 shares and 7,180,804
          shares, respectively ..................    752,682         718,081
     Additional paid-in capital ............      19,112,104      16,560,194
     Accumulated deficit ...................      (9,674,622)     (8,263,040)
                                                 ------------    ------------

               Total stockholders' equity ..      10,191,963       9,017,262
                                                 ------------    ------------

TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY .    $ 14,888,754    $ 13,439,726
                                                ============    ============

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

                                       F-4

<PAGE>



                   PEASE OIL AND GAS COMPANY AND SUBSIDIARIES

                      CONSOLIDATED STATEMENTS OF OPERATIONS


                                                     FOR THE YEARS ENDED
                                                          DECEMBER 31,
                                                  1996              1995
REVENUE:
      Oil and gas sales                         $2,546,676        $2,623,782
      Natural gas marketing and trading          2,067,379         3,872,565
      Gas plant processing                         818,356         1,135,050
      Oil field services and supply                618,225         1,302,741
      Well administration and other income         115,028            97,678
                                                   -------           ------

             Total revenue                       6,165,664         9,031,816
                                                 ---------         ---------

OPERATING COSTS AND EXPENSES:
      Oil and gas production                     1,426,549         1,617,318
      Natural gas marketing and trading          1,745,446         3,404,169
      Gas plant processing                         464,512           942,867
      Oil field services and supply                553,343         1,391,588
      General and administrative                 1,092,342         1,059,306
      Consulting arrangement - related party       257,199            -
      Depreciation, depletion and amortization   1,055,639         1,292,314
      Dry holes, plugging, and abandonments        555,685            18,786
      Restructuring costs                             -              226,986
                                                   ------            -------

             Total operating costs and expense   7,150,715         9,953,334
                                                 ---------         ---------

LOSS FROM OPERATIONS                              (985,051)         (921,518)
                                                  --------          --------

OTHER INCOME (EXPENSES):
      Interest income                               41,148             8,444
      Interest expense:
         Amortization of debt issuance and
           discount costs                         (190,967)          (17,554)
             Other                                (311,461)         (288,881)
      Gain (loss) on sale of assets                 (6,660)           75,073
                                                    ------            ------
             Net                                  (467,940)         (222,918)
                                                   --------          --------

LOSS BEFORE INCOME TAXES                        (1,452,991)       (1,144,436)
      Income tax benefit                            41,409           379,000
                                                   ------            -------

NET LOSS                                        (1,411,582)         (765,436)

      Preferred stock dividends:
             Converted                             (22,750)         (117,000)
             In arrears                           (179,938)         (202,688)
                                                  --------          --------

               Total preferred stock dividends    (202,688)         (319,688)
                                                  --------          --------

               Loss before non-cash inducement  (1,614,270)       (1,085,124)

      Non-cash inducement in tender offer
       (Note 1)                                      -            (1,523,906)
                                                  ------           ----------

NET LOSS APPLICABLE TO COMMON STOCKHOLDERS     $(1,614,270)      $(2,609,030)
                                                ===========       ===========

NET LOSS PER COMMON SHARE:
      Before non-cash inducement                    $ (.22)           $ (.18)
      Non-cash inducement (Note 1)                    -                 (.24)
                                                     ------            ------
                                                    $ (.22)           $ (.42)
                                                     ======            ======

WEIGHTED AVERAGE NUMBER OF COMMON                7,278,000         6,190,000
                                                 =========         =========
  SHARES OUTSTANDING




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

                                       F-5

<PAGE>





                   PEASE OIL AND GAS COMPANY AND SUBSIDIARIES

                 CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
                 FOR THE YEARS ENDED DECEMBER 31, 1996 AND 1995



<TABLE>

<CAPTION>
                                                                                                Additional    Total
                                                  Preferred Stock            Common Stock       Paid-in     Stockholders
                                                 Shares      Amount      Shares       Amount    Capital       Equity
                                                ----------  ---------   ---------- ----------  -----------  -----------

<S>       <C> <C>                                <C>        <C>         <C>        <C>        <C>             <C>
BALANCES, 1/1/95                                 1,157,780  $ 11,578    2,286,028  $ 228,603  $16,744,348     $ 9,354,337

Conversion of preferred stock to
  common stock:
    In tender offer                               (933,492)   (9,335)   4,200,716    420,072     (410,737)          --
    Other                                          (21,600)     (216)      56,739      5,673       (5,457)          --

Acquisition of oil and gas properties for common
  stock                                              --         --         65,000      6,500       53,422          59,922
    Sale of common stock in private placement        --         --        500,000     50,000      325,000         375,000
 Issuance of common stock to directors and
  employees for services and other                   --         --         21,036      2,104       11,327          13,431
    Settlement of trade payable for common stock                                      63,206        6,321          57,961
    Cancellation of treasury shares                  --         --        (11,921)    (1,192)     (48,808)           --
    Net loss                                         --         --           --         --            --         (765,436)
                                                 --------     -------  -----------   -------     ----------       ---------
BALANCES, 12/31/95                                 202,688     2,027    7,180,804    718,081   16,560,194        9,017,262


Issuance of common stock to officers, directors,
  and employees for compensation                     --         --         51,490      5,149       57,162           62,311

   Fair value of warrants granted for debt issuance
     and discount costs                              --         --           --         --      2,319,775        2,319,775
   Conversion of debentures into common stock        --         --         82,353      8,235       61,765           70,000

   Issuance of common stock for engineering
     services                                        --         --         15,000      1,500       21,477           22,977

   Exercise of options and warrants to purchase
     common stock                                    --         --         67,500      6,750       57,625           64,375

   Conversion of note payable to director into
     common stock                                    --         --         60,000      6,000       54,000           60,000
   Conversion of preferred stock to common stock  (22,750)    (228)        69,670      6,967       (6,739)            --
   Offering costs                                    --         --           --         --        (13,155)         (13,155)
   Net loss                                          --         --           --         --           --         (1,411,582)
                                                --------     --------    --------     -------   ------------    -----------
BALANCES, 12/31/96                            $   179,938    $1,799     7,526,817    $752,682  $19,112,104     $10,191,963
                                               ============ =========  ===========   =========  ============   ============
</TABLE>


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

<PAGE>



                   PEASE OIL AND GAS COMPANY AND SUBSIDIARIES

                      CONSOLIDATED STATEMENTS OF CASH FLOWS


                                                        FOR THE YEARS ENDED
                                                             DECEMBER 31,
                                                       1996               1995
CASH FLOWS FROM OPERATING ACTIVITIES:
  Net loss                                          $(1,411,582)   $  (765,436)
  Adjustments to reconcile net loss to net cash
    provided by operating activities:
       Provision for depreciation and depletion       1,009,645      1,200,487
       Amortization of intangible assets and
         discount on convertible debt                   263,963        109,487
       Deferred income taxes                               --         (400,000)
          equipment                                       6,660        (75,073)
       Provision for bad debts                           21,497         35,176
       Dry holes and abandonments                       525,000            --
       Issuance of common stock for services             85,288         71,392
       Other                                            (54,942)       (41,770)
       Changes in operating assets and liabilities:
         (Increase) decrease in:
           Trade receivables                            342,170        625,286
           Inventory                                    124,502        296,824
           Prepaid expenses and other                   (14,316)        14,001
         Increase (decrease) in:
           Account payable                             (905,027)      (529,581)
           Accrued expenses                            (109,473)      (160,512)
       Net cash provided by (used in) operating        ---------      ---------
           activities                                  (143,615)       380,175
                                                       ---------      ---------

CASH FLOWS FROM INVESTING ACTIVITIES:
  Capital expenditures for property,
    plant and equipment                              (1,403,413)      (387,403)
  Proceeds from redemption of certificate of deposit     53,500         43,000
  Proceeds from sale of property and equipment          163,821        823,631
                                                     -----------      ----------

       Net cash provided by (used in) investing
          activities                                 (1,186,092)      (479,228)
                                                     -----------      ----------

CASH FLOWS FROM FINANCING ACTIVITIES:
   Proceeds from issuance of convertible debentures   5,000,000             -
   Repayment of long-term debt                        1,795,670)      (943,341)
   Proceeds from sale of common stock                   133,125        281,250
   Offering costs                                       (13,155)       (52,953)
   Debt issuance costs                                 (676,008)            -
                                                       ---------   -------------

       Net cash provided by (used in) financing
          activities                                  2,648,292       (715,044)

INCREASE (DECREASE) IN CASH AND EQUIVALENTS           1,318,585        144,359

CASH AND EQUIVALENTS, beginning of year                 677,275        532,916
                                                      ----------   -------------
CASH AND EQUIVALENTS, end of year                    $1,995,860       $677,275
                                                     ==========    =============
SUPPLEMENTAL DISCLOSURE OF CASH FLOW
   INFORMATION:
     Cash paid for interest                            $192,502       $273,735
                                                     ==========    ============

     Cash received (paid) for income taxes              $41,409       $(21,000)
                                                     ==========    ============
SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING
   AND FINANCING ACTIVITIES:

     Fair value of warrants granted for debt
        issuance costs                                 $600,000       $  -
     Fair value of warrants granted for discount
        on convertible debentures                     1,829,000          -
     Conversion of long-term debt to common stock       130,000          -
     Long-term debt incurred for purchase of vehicles     -             24,992
     Acquisition of oil and gas properties for
        common stock                                      -             59,922
     Common stock subscription receivable                 -             68,750

The accompanying notes are an integral part of these consolidated financial
statements.
<PAGE>

1.    NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:

Nature of Operations - Pease Oil and Gas Company (the  "Company")  explores for,
develops, produces and sells oil and natural gas; transports,  processes, sells,
markets and trades  natural  gas and  natural  gas  liquids at a gas  processing
plant; performs oil and gas well completion and operational services;  and sells
new,  used and  reconditioned  oil and gas  production  equipment  and oil field
supplies.  The Company conducts its business through the following  wholly-owned
subsidiaries:  Loveland Gas Processing Company, Ltd. ("LGPCo");  Pease Oil Field
Services, Inc.; Pease Oil Field Supply, Inc.; and Pease Operating Company, Inc.

Principles of Consolidation - The accompanying  financial statements include the
accounts  of  the  Company  and  its  wholly-owned  subsidiaries.  All  material
intercompany transactions and accounts have been eliminated in consolidation.

Cash and Equivalents - For purposes of the statements of cash flows, the Company
considers all highly liquid  investments  purchased with an original maturity of
three months or less to be cash equivalents.

Oil and Gas Producing  Activities - The Company follows the "successful efforts"
method  of  accounting  for its oil and gas  properties.  Under  this  method of
accounting,  all  property  acquisition  costs  and  costs  of  exploratory  and
development  wells are  capitalized  when  incurred,  pending  determination  of
whether the well has found proved reserves. If an exploratory well has not found
proved  reserves,  the costs of drilling  the well are  charged to expense.  The
costs of development wells are capitalized  whether productive or nonproductive.
Geological  and  geophysical  costs  and the  costs of  carrying  and  retaining
undeveloped  properties are expensed as incurred.  Management estimates that the
salvage value of lease and well equipment will  approximately  offset the future
liability for plugging and  abandonment  of the related wells.  Accordingly,  no
accrual for such costs has been recorded.

Depletion  and  depreciation  of  capitalized  costs for  producing  oil and gas
properties is provided  using the  units-of-production  method based upon proved
reserves.  Depletion  and  depreciation  expense for the  Company's  oil and gas
properties  amounted to $589,853 and  $741,924 for the years ended  December 31,
1996 and 1995, respectively.

Impairment  of  Long-Lived  Assets - The  Company  performs  an  assessment  for
impairment  whenever  events  or  changes  in  circumstances  indicate  that the
carrying amount of a long-lived asset may not be recoverable. When an assessment
for impairment of oil and gas properties is performed,  the Company compares the
net carrying  value of proved oil and gas properties on a  lease-by-lease  basis
(the lowest level at which cash flows can be determined  on a consistent  basis)
to the  related  estimates  of  undiscounted  future  net  cash  flows  for such
properties.  If the  net  carrying  value  exceeds  the  net  cash  flows,  then
impairment  is recognized  to reduce the carrying  value to the  estimated  fair
value. The allowance for impairment is included in accumulated  depreciation and
depletion in the accompanying balance sheets.


                                       F-7

<PAGE>



                   PEASE OIL AND GAS COMPANY AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Property,  Plant and  Equipment - Property,  plant,  and  equipment is stated at
cost.  Depreciation  of property,  plant and equipment is  calculated  using the
straight-line method over the estimated useful lives of the assets, as follows:

                                                                     YEARS

   Gas plant                                                          17
   Service equipment and vehicles                                    4-7
   Buildings and office equipment                                   7-15

Depreciation  expense  related to  property,  plant and  equipment  amounted  to
$419,792  and  $458,563  for  the  years  ended  December  31,  1996  and  1995,
respectively.

The cost of normal  maintenance and repairs is charged to operating  expenses as
incurred.  Material  expenditures  which  increase  the  life  of an  asset  are
capitalized  and  depreciated  over the estimated  remaining  useful life of the
asset.  The cost of properties  sold, or otherwise  disposed of, and the related
accumulated  depreciation or amortization are removed from the accounts, and any
gains or losses are reflected in current operations.

Non-compete  Agreements - The costs of non-compete  agreements  were incurred in
connection  with the 1993  acquisition  of  substantially  all of the  Company's
assets.  These costs are being  amortized  over the terms of the two to ten-year
agreements  on a  straight-line  basis.  Amortization  expense  related  to  the
non-compete  agreements was $45,994 and $91,827 for the years ended December 31,
1996 and 1995, respectively.

Debt  Issuance  Costs - Debt  issuance  costs  relate to the $5 million  private
placement of convertible  debentures  discussed in Note 3. These costs are being
amortized  using the  straight-line  method  (which  approximates  the  interest
method) over the 5-year term of the debentures.

Inventory - Inventory consists primarily of oil and gas production equipment and
oil field supplies.  These items are generally held for resale.  At December 31,
1996 and 1995,  inventory  also  includes  approximately  $72,000 and  $100,000,
respectively, of crude oil, fuel, and propane. Inventory is carried at the lower
of cost or market, cost being determined generally under the first-in, first-out
(FIFO) method of accounting,  or where possible, by specific identification.  At
December  31, 1996 and 1995,  the Company  has  classified  $200,000 of used oil
field equipment inventory as long-term (included in other assets) because, based
on current inventory usage, it is not expected to be sold within the next year.

Accounting  Estimates - The  preparation  of financial  statements in conformity
with  generally  accepted  accounting  principles  requires  management  to make
estimates  and  assumptions  that affect the amounts  reported in the  financial
statements  and the  accompanying  notes.  The actual  results could differ from
those estimates.


                                       F-8

<PAGE>



                   PEASE OIL AND GAS COMPANY AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

The  Company's  financial  statements  are  based  on a  number  of  significant
estimates  including  the allowance for doubtful  accounts,  accrued  production
taxes,  realizability of intangible assets, assumptions affecting the fair value
of stock options and warrants, selection of the useful lives for property, plant
and equipment,  and oil and gas reserve  quantities  which are the basis for the
calculation  of  depreciation,   depletion,   and  impairment  of  oil  and  gas
properties.   Management   emphasizes  that  reserve  estimates  are  inherently
imprecise and that estimates of more recent  discoveries are more imprecise than
those for  properties  with long  production  histories.  At December  31, 1996,
approximately  35% of the  Company's  oil and gas reserves are  attributable  to
non-producing properties.  Accordingly,  the Company's estimates are expected to
change as future information becomes available.

The Company is required  under  certain  circumstances  to evaluate the possible
impairment of the carrying  value of its long-lived  assets.  For proved oil and
gas properties,  this involves a comparison to the estimated future undiscounted
cash flows,  which is the primary basis for  determining the related fair values
for such properties.  In addition to the  uncertainties  inherent in the reserve
estimation  process,  these  amounts are affected by  historical  and  projected
prices  for oil and  natural  gas which  have  typically  been  volatile.  It is
reasonably  possible  that the  Company's  oil and gas  reserve  estimates  will
materially change in the forthcoming year.

At December  31,  1996,  the  Company's  gas plant had a net  carrying  value of
approximately  $3,340,000.  The determination of impairment of the gas plant may
change in the future based on the  Company's  ability to continue to develop its
properties  whereby  sufficient  quantities  of  natural  gas  and  liquids  are
available to operate the plant profitably.

Income Taxes - Income taxes are provided  for in  accordance  with  Statement of
Financial  Accounting Standards No. 109, "Accounting for Income Taxes." SFAS No.
109 requires an asset and liability  approach in the recognition of deferred tax
liabilities  and assets for the expected  future tax  consequences  of temporary
differences  between the  carrying  amounts  and the tax bases of the  Company's
assets and liabilities.

Revenue  Recognition - The Company recognizes gas plant revenues and oil and gas
sales upon  delivery to the  purchaser.  Revenues  from oil field  services  are
recognized as the services are performed.  Oil field supply and equipment  sales
are recognized when the goods are shipped to the customer.

Net Loss Per Common  Share - Net loss per common  share is  computed by dividing
the net loss  applicable  to common  stockholders  (which  includes  accrued but
unpaid  preferred  dividends)  by the weighted  average  number of common shares
outstanding  during the year.  All common stock  equivalents  have been excluded
from the computations because their effect would be anti-dilutive.

In  connection  with the 1995  conversion  of  preferred  stock to common  stock
discussed in Note 6, the Company experienced a significant change in its capital
structure. The pro forma effect of these changes, as if the conversions occurred
on  January  1,  1995,  would  have  resulted  in a  reduction  in the 1995 loss
applicable to common stockholders before non-cash inducement from $.18 per share
to $.14 per share.  The pro forma  loss per share  calculations  give  effect to
4,257,455 common shares which

                                       F-9

<PAGE>



                   PEASE OIL AND GAS COMPANY AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

were issued in the  conversion and the  elimination of dividends  related to the
converted preferred shares of approximately  $117,000 for 1995. However, the pro
forma  information  does not give  effect  to the  inducement  discussed  in the
following paragraph.

The Company completed a tender offer to the Company's preferred  stockholders in
February  1995.  In  connection  therewith,  the Company  offered the  preferred
holders  4.5  common  shares  for each  preferred  share  owned.  The 4.5 shares
represented  an increase from the original  terms of the  preferred  stock which
provided  for 2.625 common  shares for each  preferred  share.  Under a recently
issued  accounting  pronouncement,  the Company was required to reduce  earnings
available  to common  stockholders  by the fair value of the  additional  shares
which were issued to induce the preferred  stockholders to convert their shares.
Since the Company  issued an  additional  1,750,000  common shares in the tender
offer  compared  to the shares that would have been  issued  under the  original
terms of the preferred  stock, the Company was required to deduct the fair value
of these  additional  shares of  $1,523,906  from  earnings  available to common
stockholders.  This  non-cash  charge  resulted in the reduction of earnings per
share by $.24 for the year ended December 31, 1995.

While this charge is intended to show the cost of the  inducement  to the owners
of the Company's common shares immediately  before the tender offer,  management
does not believe that it  accurately  reflects the impact of the tender offer on
the Company's common stockholders. As disclosed to the preferred stockholders in
connection  with the  tender  offer,  the book  value per share of common  stock
increased from a negative amount to approximately $1.00 per share as a result of
the tender offer.  Therefore,  management believes that, even though the current
accounting  rules  require  the $.24  charge per common  share,  there are other
significant  offsetting factors by which the common shareholders  benefited from
this  conversion  which  are  not  reflected  in the  1995  earnings  per  share
presentation.

Stock-Based  Compensation - The Company  accounts for  stock-based  compensation
using the  intrinsic  value method  prescribed in  Accounting  Principles  Board
Opinion  No.  25,  "Accounting  for Stock  Issued  to  Employees,"  and  related
interpretations.  Accordingly,  compensation  cost for stock options  granted to
employees is measured as the excess,  if any, of the quoted  market price of the
Company's common stock at the measurement  date  (generally,  the date of grant)
over the amount an employee must pay to acquire the stock.  In October 1995, the
Financial  Accounting  Standards Board issued a new statement titled "Accounting
for  Stock-Based  Compensation"  (FAS  123).  FAS  123  requires  that  options,
warrants,  and similar  instruments which are granted to non-employees for goods
and  services  be  recorded  at fair  value on the  grant  date.  Fair  value is
generally  determined under an option pricing model using the criteria set forth
in FAS 123.

Reclassifications  -  Certain  reclassifications  have  been  made  to the  1995
financial   statements   to   conform   to  the   presentation   in  1996.   The
reclassifications had no effect on the 1995 net loss.

2.       RESTRUCTURING:

During 1995,  in light of declining  natural gas prices,  declining  rig counts,
lackluster margins and the competitive  environment  inherent in the oil and gas
industry, the Company undertook steps to reduce

                                      F-10

                                     <PAGE>



                   PEASE OIL AND GAS COMPANY AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

operating  costs,  increase  efficiencies,  reduce  operating risks and generate
additional  working  capital.  During the second  quarter of 1995,  the  Company
announced a  restructuring  program that included  substantially  downsizing its
service and supply businesses and closing its  administrative  office in Denver,
Colorado.  As a result of this  restructuring,  35 of the Company's 70 employees
were terminated, and service equipment, land and buildings were sold.

As of December 31, 1995,  the Company  recognized  $226,986 of costs incurred in
connection with both the tender offer discussed in Note 6, and the restructuring
discussed above. The costs recognized in the restructuring  consist primarily of
severance pay, a loss on the abandonment of the office lease, and a $90,000 loss
from the liquidation of inventory at an auction.

For the year ended December 31, 1995,  the operating  revenues and net operating
loss of the service and supply  businesses,  exclusive of restructuring  charges
and gains on sales of assets, were as follows:


   Revenues                                           $1,302,741
   Operating costs                                    (1,391,588)
   Depreciation                                         (157,380)
                                                 ---------------------

                     Net operating loss                $(246,227)


Substantially,  all of the 1995 net  operating  loss from these  operations  was
incurred prior to completion of the restructuring discussed above.


3.       DEBT FINANCING ARRANGEMENTS:

Long-Term Debt - Long-term  debt at December 31, 1996 and 1995,  consists of the
following:

                                                         1996            1995
                                                    --------------  ------------
 Unaffiliated Parties:

 Collateralized convertible 10% debentures due
 April 2001.  See discussion below under the
 caption "Convertible Debt and Consulting Agreement: $3,267,830      $     -
 Other installment notes.  Interest at 6.9% to 9.75%,
 monthly principal and interest payments of
 approximately $3,440 through 1998.  All of the
 notes are  collateralized by vehicles.                  52,555          85,423

 Contract payable, $4,444 credited monthly against gas
 purchases, due July 1997, collateralized by
 certificate of deposit.                                 13,334          66,667


                                      F-11

<PAGE>



                   PEASE OIL AND GAS COMPANY AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

                                                         1996              1995
                                                    ---------------   ---------


Note payable to a bank, interest at prime plus 3%.         -          1,762,802


Convertible 12% debentures, due May 1996, convertible
into 82,353 share of common stock.                         -             70,000
                                                    ---------------   ---------

         Total unaffiliated parties                     5,065,889     1,984,892
                                                    ---------------   ----------

Related Parties:

Note payable to the Company's president and CEO.
Interest at 6% annual principal payments of
$65,000 due January 1997 and 1998.  The note is
convertible into common stock at $5.00 per share
and is collateralized by equipment.                       130,000       130,000

Unsecured notes payable to the Company's president
and CEO and various entities controlled by him.
Interest at 8% to 10% with principal and interest
due January 1, 1997.                                      116,719       176,717

Accrued interest                                           39,177        32,024
                                                        ----------     ---------

         Total related parties                            285,896       338,741
                                                        ----------     ---------

Total long-term debt                                    5,351,785     2,323,633

Less current maturities:
    Related parties                                      (285,896)         -
    Other                                                 (45,944)   (1,100,474)
                                                        ----------    ----------

         Total long-term debt, less current maturities $5,019,945    $1,223,159
                                                       ==========    ==========



In March  1996,  the  Company's  president  agreed to  extend  the due date of a
delinquent $60,000 note payable to him. As consideration for the extension,  the
Company's  Board  of  Directors  approved  amending  the  note  to  provide  for
conversion to common stock at $1.00 per share.  In December  1996, the president
exercised the conversion feature.  The Company's Board of Directors has resolved
to repay all outstanding  loans from related  parties during 1997.  Accordingly,
all such amounts are included in current liabilities in the 1996 balance sheet.


                                      F-12

<PAGE>



                   PEASE OIL AND GAS COMPANY AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Aggregate  Debt  Maturities  -  The  aggregate  maturities  of  long-term  debt,
including  the  discount  associated  with  the  convertible  debenture,  are as
follows:


  Year Ending      Related
  December 31,     Parties            Others              Total

    1997           $285,896           $45,944           $331,840
    1998              -                19,945             19,945
    2001              -             5,000,000          5,000,000
                -------------      -----------        -----------
                   $285,896        $5,065,889         $5,351,785
                =============      ===========        ===========

Convertible  Debt and Consulting  Agreement - In March 1996, the Company entered
into a consulting  agreement with a company (the  "Consultant") that specializes
in developing and implementing  capitalization plans,  including the utilization
of debt capital in business operations. The initial term of the agreement is for
two years and  provides  for minimum  monthly  cash  payments  of  $17,500.  The
Consultant  can elect to extend the agreement  for an  additional  period of one
year. In addition to cash compensation,  the Company agreed to grant warrants to
purchase  1,000,000  shares of the Company's common stock. The exercise price of
the warrants is $.75 per share and they expire in March 2001.

In April 1996, the Company,  with the assistance of the Consultant,  initiated a
private  placement  to  sell  up to  $5,000,000  of  collateralized  convertible
debentures in the form of "Units".  Each Unit consists of one $50,000  five-year
10%  collateralized  convertible  debenture and detachable  warrants to purchase
25,000 shares of the  Company's  common stock at $1.25 per share (see Note 7 for
additional  information with respect to the warrants).  Between May and November
1996, the offering was sold to various  investors and the Company was successful
in selling the entire $5,000,000 generating net cash proceeds of $4,300,000. The
estimated  fair value of the  detachable  warrants of $1,829,000 is treated as a
discount  and is being  amortized  using the  interest  method,  resulting  in a
balance of  $1,732,170  at December 31, 1996.  Accordingly,  the  collateralized
convertible 10% debentures consisted of the following at December 31, 1996:

   Convertible debentures, interest at 10%
     collateralized by certain oil and gas properties,
     due April 2001                                          $   5,000,000
   Less unamortized discount                                    (1,732,170)
                                                             $   3,267,830

The debentures are  collateralized  by a first priority  interest in certain oil
and gas properties owned and operated by the Company.


                                      F-13

<PAGE>



                   PEASE OIL AND GAS COMPANY AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

The debentures are convertible, at the holders option, into the Company's common
stock for $3.00 per share and may be  redeemed  by the  Company,  in whole or in
part,  beginning at a premium of 110% of the original  principal  amount and are
subject to adjustment beginning on April 25, 1999. Interest on the debentures is
payable  quarterly  commencing  on September  30, 1996 and the entire  principal
balance is due on April 15, 2001.

The  Company  also  agreed  to pay the  Consultant  a fee equal to 2% of the net
proceeds from the private  placement and up to 7% from the net proceeds from any
warrants  which are  exercised  during  the term of the  agreement  or up to six
months after termination in certain circumstances.  All of the compensation paid
to the  Consultant is limited to 15% of the gross  proceeds  generated  from the
private placement, exercise of warrants, or other debt or equity financings that
may be  consummated  during the term of the  agreement.  In August 1996, a major
shareholder of the Consultant was elected to the Company's Board of Directors.

4.       INCOME TAXES:

The Company's  income tax benefit for the years ended December 31, 1996 and 1995
consists of the following:


                                                  1996              1995
                                              ------------       ----------

  Current benefit (provision)                    $41,409           $(21,000)
  Deferred benefit                                  -               400,000
                                              ------------       -----------

                     Total                       $41,409           $379,000
                                              ============       ===========



A  reconciliation  of the income tax benefit at the statutory rate to the income
tax benefit reported in the accompanying financial statements is as follows:


                                                         1996           1995
                                                     ------------    ----------

Computed tax benefit at the expected statutory rate    $494,000       $389,100
State income taxes and other                             39,000         10,900
Federal income taxes assessed in audit                     -           (21,000)
Increase in valuation allowance                        (533,000)          -
Federal income tax refund                                41,409           -
                                                     -------------   ----------

                          Total                         $41,409       $379,000
                                                     =============   ==========


                                      F-14

<PAGE>



                   PEASE OIL AND GAS COMPANY AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Deferred tax assets (liabilities) as of December 31, 1996 and 1995 are comprised
of the following:


                                                       1996             1995
                                                  ---------------   ----------
 Long-term Assets:
         Net operating loss carryforwards          $3,616,000        $3,050,000
         Tax credit carryforwards                     294,000           294,000
         Percentage depletion carryforwards            58,000            58,000
         Other                                         25,000            45,000
                                                  --------------    -----------
              Total                                 3,993,000         3,447,000

         Less valuation allowance                  (1,770,000)       (1,237,000)
                                                  --------------    ------------
                                                    2,223,000         2,210,000
Long-term liability for property and equipment     (2,223,000)       (2,210,000)
                                                  --------------    ------------
              Net long-term liability               $   -             $   -
                                                  ==============    ============

The Company has provided a valuation  allowance for the net  operating  loss and
credit carryforwards based upon the various expiration dates and the limitations
which exist under IRS Sections 382 and 384.

During the year ended  December 31, 1996,  the Company  increased  the valuation
allowance by $533,000  primarily  due to an increase in the net  operating  loss
carryforwards which are not considered to be realizable.

At December 31,  1996,  the Company has net  operating  loss  carryforwards  for
income tax purposes of approximately $9,600,000,  which expire primarily in 2008
through 2011. Approximately $2,880,000 of these net operating losses are subject
to  limitations  under IRS  Sections  382 and 384.  These losses may only offset
future  taxable  income to the  extent of  approximately  $335,000  per year and
generally  may not  offset  any  gain  on the  sale of  assets  acquired  in the
acquisition of Skaer Enterprises, Inc. Additionally,  the Company has tax credit
carryforwards  at December 31, 1996, of  approximately  $294,000 and  percentage
depletion carryforwards of approximately $150,000.


5.       COMMITMENTS AND CONTINGENCIES:

Gas Contracts - The Company  operates a natural gas  processing  plant (the "Gas
Plant").  The Company had a contract  with a major  utility which called for the
major  utility to purchase a minimum of 2.92  billion  cubic feet  ("BCF") and a
maximum of 3.65 BCF of natural gas annually. The price paid by the major utility
was on an MMBTU basis  above the  Colorado  Interstate  Gas  Company's  Northern
Pipeline "spot" price. The contract expired on June 30, 1996.

Historically,  the price  paid under this  contract  was at a premium  above the
market  which   allowed  the  Company  to  conduct  its  marketing  and  trading
activities.  The expiration of this contract and the  corresponding  loss of the
market premium resulted in the elimination of the Company's marketing and

                                      F-15

<PAGE>



                   PEASE OIL AND GAS COMPANY AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

trading activities  beginning in July 1996.  Management is continuing to explore
alternatives with the major utility and other purchasers of natural gas in order
to maximize the Company's natural gas revenue.

The Company  also had a contract  with an  independent  producer  that  required
purchases  of gas  quantities  at a fixed  margin  per MMBTU for any  difference
between  plant sales and the contract  volumes with the utility.  This  contract
also expired in June 1996. The revenue and corresponding costs incurred pursuant
to these  contracts  have been  reflected  as Gas  Marketing  and Trading in the
consolidated statements of operations.

Leases - The Company leases its office facilities under noncancellable operating
leases.   The  total  minimum   commitments   under  these  leases  amounted  to
approximately  $100,000 as of December  31, 1996.  Total rent expense  under all
operating leases for the years ended December 31, 1996 and 1995, was $26,807 and
$90,569, respectively.

Employment  Agreements - During 1994, the Board of Directors approved employment
agreements  with  the  Company's  executive  officers.  The  agreements  may  be
terminated by the officers  upon 90 days notice or by the Company  without cause
upon 30 days notice. In the event of a termination by the Company without cause,
the Company would be required to pay the officers their respective  salaries for
one to three years. If the termination occurs following a change in control, the
Company  would be required to make lump sum payments  equivalent to two to three
years salary for each of the officers.

Profit  Sharing Plan - The Company has  established a 401(k) profit sharing plan
that covers all employees  with one month of service who elect to participate in
the Plan. The Plan provides that the employees may elect to contribute up to 15%
of  their  salary  to  the  Plan.  All  of  the  Company's   contributions   are
discretionary and amounted to $8,926 and $2,996 for the years ended December 31,
1996 and 1995, respectively.

Contingencies - The Company may from time to time be involved in various claims,
lawsuits,   disputes  with  third  parties,  actions  involving  allegations  of
discrimination,  or breach  of  contract  incidental  to the  operations  of its
business.  The  Company  is  not  currently  involved  in  any  such  incidental
litigation  which it  believes  could have a  materially  adverse  effect on its
financial condition or results of operations.


6.       PREFERRED STOCK:

The Company  has the  authority  to issue up to  2,000,000  shares of  Preferred
Stock,  which  may be  issued  in such  series  and  with  such  preferences  as
determined by the Board of Directors.  During 1993, the Company issued 1,170,000
shares  of Series A  Cumulative  Convertible  Preferred  Stock  (the  "Preferred
Stock").

At December 31, 1996, the Preferred Stock had a liquidation preference of $12.25
per share ($10 liquidation  value plus $2.25 of dividends in arrears),  and each
share of Preferred Stock was

                                      F-16

<PAGE>



                   PEASE OIL AND GAS COMPANY AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

convertible  into 3.0625 shares of common stock and warrants to purchase  3.0625
common shares.  Each warrant entitles the holder to purchase one share of common
stock at $6.00 per share through August 13, 1998, when the warrants expire.  The
Preferred  Stock will  automatically  convert  into common stock if the reported
sale of Preferred  Stock equals or exceeds $13.00 per share for ten  consecutive
days.  The Company may redeem the  Preferred  Stock at $10.00 per share plus any
dividends  in  arrears.  Each share of  Preferred  Stock is  entitled to receive
dividends at 10% per annum when,  as and if declared by the  Company's  Board of
Directors. Unpaid dividends accrue and are cumulative.

In  February  1995,  the  Company  completed  a tender  offer  to the  preferred
stockholders  whereby  the  holders  of  the  Preferred  Stock  were  given  the
opportunity  to  convert  each  share of  Preferred  Stock and all  accrued  and
undeclared  dividends  (including  the  full  dividend  for the  quarters  ended
December  31, 1994 and March 31, 1995) into 4.5 shares of the  Company's  common
stock.  As a result of this tender offer,  933,492 shares of the preferred stock
converted into  4,200,716  shares of the Company's  common stock.  In connection
with the tender offer and other  conversions of preferred stock through December
31, 1996, warrants for an aggregate of 2,605,900 shares are outstanding.

Through  December  31, 1996,  the Board of  Directors  has elected to forego the
declaration  of the regular  quarterly  dividend for five  consecutive  quarters
resulting in dividends in arrears of  approximately  $405,000  ($2.25 per share)
related  to  179,938  outstanding  shares of  Preferred  Stock.  The  Company is
precluded from paying  dividends on its common stock so long as any dividends on
the Preferred Stock are in arrears.  The terms of the Preferred Stock prohibited
the Company from entering into certain  transactions without an affirmative vote
of the preferred  stockholders.  Otherwise,  the preferred  stockholders have no
voting rights.

In connection  with the Company's 1993  preferred  stock  offering,  the Company
issued  warrants to the underwriter to purchase 90,000 shares of preferred stock
at $12.00 per share. If not previously exercised,  these warrants will expire in
August 1998. In 1993, the Company also granted  warrants to a consultant for the
purchase of 60,000  shares of common  stock.  The warrants are  exercisable  for
$6.00 per share and expired in November 1996.

7.       STOCK BASED COMPENSATION:

Stock Option Plans - The Company's  shareholders have approved four stock option
plans that  authorize an aggregate of 900,000  shares for stock options that may
be granted to officers,  directors,  employees,  and consultants.  The dates the
plans, along with the corresponding number of options,  that were adopted by the
Company's  stockholders are as follows:  June 14, 1991, 100,000 shares; June 25,
1993, 300,000 shares;  June 3, 1994, 150,000 shares and August 10, 1996, 350,000
shares. The plans permit the issuance of incentive and non-statutory options and
provide for a minimum  exercise  price equal to 100% of the fair market value of
the  Company's  common  stock on the date of grant.  The maximum term of options
granted  under the plans is 10 years and  options  granted to  employees  expire
three months after the  termination  of  employment.  None of the options may be
exercised during the first six months of the option term.


                                      F-17

<PAGE>



                   PEASE OIL AND GAS COMPANY AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

No options may be granted  after 10 years from the  adoption  date of each plan.
The  following  is a summary of activity  under these stock option plans for the
years ended December 31, 1996 and 1995:


                                          1996                    1995
                                       ------------          ----------------
                                               Weighted                Weighted
                                                Average                 Average
                                    Number     Exercise     Number     Exercise
                                  of Shares     Price     of Shares      Price

Outstanding, beginning of year    459,600        $.94      347,000      $ 3.53

   Canceled                         -              -      (224,000)       3.43
   Expired                         (4,000)       7.19      (99,000)       3.70
   Granted                        165,700        1.39      435,600         .79
                                ----------      -----       ------     ---------

Outstanding, end of year          621,300        1.02      459,600         .94
                                ==========      =====     =========    =========


For all options granted during 1996 and 1995, the weighted  average market price
of the Company's common stock on the grant date was  approximately  equal to the
weighted  average  exercise  price.  At December 31,  1996,  options for 542,000
shares were  exercisable  and options for the  remaining  79,300  shares  became
exercisable in February 1997. If not previously  exercised,  options outstanding
at December 31, 1996, will expire as follows:

                                                                  Weighted
                                                                   Average
                                                  Number          Exercise
  Year Ending December 31,                      of Shares          Price

        1997                                      5,000             $3.44
        1998                                     15,000              2.94
        2000                                    295,600               .83
        2000                                    140,000               .70
        2001                                     86,400              1.00
        2001                                     79,300              1.81
                                             ------------
                                                621,300

Warrants and Non-Qualified Stock Options - The Company has also granted warrants
and  non-qualified  options which are  summarized as follows for the years ended
December 31, 1996 and 1995:



                                      F-18

<PAGE>



                   PEASE OIL AND GAS COMPANY AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

<TABLE>
<CAPTION>

                                                       1996                            1995
                                              ------------------------       -------------------------
                                                              Weighted                        Weighted
                                                               Average                         Average
                                               Number         Exercise         Number         Exercise
                                              of Shares         Price         of Shares         Price

<S>                                            <C>            <C>              <C>            <C>
  Outstanding, beginning of year ..........    3,359,418      $   5.00         232,302        $  4.05
     Granted to:
          Officer and director ............      101,500          1.00            --              --
          Consultants .....................    1,090,000(a)        .75         358,000            .97
          Former officer and director .....        --               --          77,000           3.61
             Investors in private placements of:
                  Common stock ...............     --               -- 1.25    250,000           1.25
                  Convertible debentures ..... 2,500,000           1.25           --              --
             Brokers in private placement of
              convertible debentures             223,500(b)        2.00           --              --
     Issued to former holders of preferred
             stock upon conversion                69,670           6.00      2,507,116           6.00
     Repriced .............................         --              --         (15,000)          6.00
     Expired ..............................      (60,000)          6.00        (50,000)           .85
     Exercised ............................      (67,500)           .95           --              --
                                                ----------    ----------     -----------       --------
Outstanding, end of year ................      7,216,588           2.94      3,359,418           5.00
                                                ==========    ==========     ===========       ========
</TABLE>

(a) Of such amount,  warrants to purchase up to 1,000,000 shares were granted to
Beta Capital Group, Inc. in connection with a two-year consulting agreement. See
Note 3, "Convertible Debt and Consulting Agreement."

(b) Of such  amount,  warrants  entitling  the holder to  purchase  up to 11,137
shares were issued to Steve Antry, the President of Beta Capital Group, Inc. for
his  services  as a broker  in  connection  with  placement  of the  convertible
debentures.

                                      F-19

<PAGE>



                   PEASE OIL AND GAS COMPANY AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

All outstanding warrants and non-qualified  options were exercisable at December
31,  1996.  If not  previously  exercised,  warrants and  non-qualified  options
outstanding at December 31, 1996, will expire as follows:

                                                                Weighted
                                                                Average
                                               Number          Exercise
   Year Ending December 31,                   of Shares          Price
   ------------------------                 ---------------    -----------
          1997                                400,000             $1.25
          1998                              2,605,900              6.00
          1998                                118,188              1.51
          1999                                223,500              2.00
          1999                                 50,000              3.34
          2000                                118,000               .76
          2000                                 77,000              3.61
          2001                              1,040,000               .75
          2001                                101,500              1.00
          2001                              2,482,500              1.25
                                           ----------------

          Total                             7,216,588

Presented  below is a comparison  of the  weighted  average  exercise  price and
market  price of the  Company's  common  stock on the  measurement  date for all
warrants and stock options granted to non-employees during 1996 and 1995:

<TABLE>
<CAPTION>
                                           1996                                   1995
                             --------------------------------        -------------------------------
                              Number of    Exercise     Market       Number of   Exercise    Market
                               Shares        Price       Price        Shares       Price      Price

 Market price equal to
<S>                             <C>        <C>        <C>             <C>        <C>          <C>
       exercise price           101,500    $  1.00    $  1.00         118,000    $  .76       $  .76

 Market price greater than
       exercise price            50,000        .85       1.00            -           -             -

 Exercise price greater than  3,763,500       1.16        .69         567,000      1.50          .79
       market price
</TABLE>



Fair value of all warrants and stock options granted to non-employees during the
year ended  December 31, 1996,  was determined  using the  Black-Scholes  option
pricing model.  Significant  assumptions  included a risk-free  interest rate of
6.5%, expected volatility of 63%, and that no dividends would be declared during
the expected term of the options.  The weighted average  contractual term of the
options was approximately 4.8 years compared to a weighted average expected term
of 1.9 years.

                                      F-20

<PAGE>



                   PEASE OIL AND GAS COMPANY AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

The estimated fair value of warrants  granted to  non-employees in 1996 amounted
to  $600,000,  which is recorded  as a debt  issuance  cost in the 1996  balance
sheet.

In connection with private placements of debt and equity securities, the Company
granted common stock purchase  warrants that are redeemable at the option of the
Company. Presented below is a summary of these warrants:


                                                               Redemption
    Year          Expiration     Exercise    Number of          Price Per
   Granted          Date          Price        Shares              Share

   1994           August 1998     $1.92        83,188               $.25
   1995           April 1997       1.25       250,000                .25
   1996           July 2001        1.25     2,500,000                .10

In December  1996, the Company  provided  notice of redemption to the holders of
the  warrants  granted in 1995.  Accordingly,  the holders must  exercise  their
warrants by January 31, 1997 or accept the redemption price (see Note 11).

Pro Forma Stock-Based Compensation Disclosures - The Company applies APB Opinion
25 and related  interpretations  in  accounting  for stock  options and warrants
which are  granted to  employees.  Accordingly,  no  compensation  cost has been
recognized  for grants of options and warrants to  employees  since the exercise
prices were not less than the fair value of the  Company's  common  stock on the
grant dates.  Had  compensation  cost been determined based on the fair value at
the grant dates for awards under those plans  consistent  with the method of FAS
123,  the  Company's  net loss and loss per share would have been changed to the
pro forma amounts indicated below.


                                                        Year Ended December 31,
                                                        1996              1995
   Net loss applicable to common stockholders:
        As reported                                 $(1,614,270)  $ (2,609,030)
        Pro forma                                    (1,764,270)    (2,772,030)
   Net loss per common share:
        As reported                                 $      (.22)  $       (.42)

        Pro forma                                          (.24)          (.45)




                                      F-21

<PAGE>



                   PEASE OIL AND GAS COMPANY AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

The fair value of each employee  option and warrant granted in 1996 and 1995 was
estimated on the date of grant using the Black-Scholes option-pricing model with
the following weighted average assumptions:


                                               Year Ended December 31,
                                               1996              1995

  Expected volatility                            64%              61%
  Risk-free interest rate                         6.5%             6.5%
  Expected dividends                              -                -
  Expected terms (in years)                       3.4              3.3


8.       FINANCIAL INSTRUMENTS:

Statement of  Financial  Accounting  Standards  No. 107 requires all entities to
disclose  the fair value of certain  financial  instruments  in their  financial
statements.  Accordingly,  at December 31, 1996,  management's  best estimate is
that the carrying  amount of cash,  receivables,  notes payable to  unaffiliated
parties,  accounts payable, and accrued expenses  approximates fair value due to
the short maturity of these instruments. Management estimates that fair value is
approximately equal to carrying value of the convertible debentures since market
interest  rates have not changed  significantly  since the  offering  commenced.
Management  estimates  that  fair  value  differs  from  carrying  value for the
following instruments as of December 31, 1996 and 1995:


<TABLE>
<CAPTION>
                                               1996                          1995
                                    ------------------------      -----------------------
                                     Carrying         Fair        Carrying         Fair
                                       Value          Value         Value          Value

<S>                                  <C>             <C>           <C>            <C>
  Long-term portion of accrued       $256,088        $225,000      $379,652       $335,000
    production taxes

  Notes payable to related parties    285,896         271,000       338,741        300,000
</TABLE>


Fair value of the above debt  instruments  was estimated  using market  interest
rates at December 31, 1996 for debt with comparable terms.









                                      F-22

<PAGE>



                   PEASE OIL AND GAS COMPANY AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

9.       SIGNIFICANT CONCENTRATIONS:

Substantially all of the Company's accounts  receivable at December 31, 1996 and
1995,  result from crude oil, natural gas sales, and joint interest  billings to
companies in the oil and gas industry. This concentration of customers and joint
interest owners may impact the Company's  overall credit risk, either positively
or  negatively,  since these  entities may be  similarly  affected by changes in
economic  or  other  conditions.  In  determining  whether  or  not  to  require
collateral  from a customer or joint interest  owner,  the Company  analyzes the
entity's net worth, cash flows, earnings, and/or credit ratings. Receivables are
generally not  collateralized;  however,  receivables from joint interest owners
are subject to collection  under operating  agreements  which generally  provide
lien rights.  Historical  credit  losses  incurred on trade  receivables  by the
Company have been insignificant.

The Company's oil and gas properties are predominantly located in a single basin
in which the gas  marketing  arrangements  are  influenced  by local  supply and
demand. Accordingly, in comparison to the net price received by gas producers in
many other areas of the United  States,  the Company often  realizes a lower net
sales  price.  Additionally,  since the  Company's  gas plant is located in this
basin and its oil field  service and supply  operations  are  conducted  in this
basin, the Company is vulnerable to a curtailment in drilling  activity in order
to realize the value of oil field inventories and related operating assets.

At December 31, 1996,  the Company had a receivable  from a single  customer for
$67,718,  which was collected in January 1997.  For the years ended December 31,
1996 and 1995, the Company had natural gas sales to the major utility  discussed
in Note 5 which accounted for 34% and 46% of total revenues,  respectively.  For
the year ended  December  31,  1996,  the Company also had oil sales to a single
customer which accounted for 11% of total revenues.

At December 31, 1996, the Company has temporary  cash  investments of $1,941,550
with a single financial institution.  The Company does not maintain insurance to
cover the risk that cash and temporary cash  investments with a single financial
institution may be in excess of amounts insured by federal deposit insurance.


10.      FOURTH QUARTER ADJUSTMENTS:

During the fourth quarter of 1996,  the Company  recognized a charge of $450,000
for drilling costs related to an  unsuccessful  well. This charge is included in
dry holes, plugging and abandonments in the 1996 statement of operations.







                                      F-23

<PAGE>



                   PEASE OIL AND GAS COMPANY AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

11.      SUBSEQUENT EVENTS (UNAUDITED):

Property  Acquisitions - In January 1997, the Company  completed the acquisition
of a 7.8125% after prospect  payout working  interest in a producing oil and gas
prospect in Louisiana.  The prospect is operated by Natural  Energy Group,  Inc.
(NEGX),  an independent oil and gas producer.  The purchase price was $1,750,000
which  consisted of $875,000 in cash and the  issuance of 315,000  shares of the
Company's  common stock with a fair value of  $875,000.  In February  1997,  the
Company entered into agreements with unaffiliated  parties for the purchase of a
10% working  interest in this  prospect.  The purchase price totals $2.5 million
and the agreements  provide for an effective  date of October 16, 1996.  NEGX is
the operator of these properties.

In February 1997, the Company  entered into an agreement with NEGX that provides
the Company with the right and the  obligation to participate as a 12.5% working
interest owner in NEGX's defined drilling program.  The agreement  provides that
the  Company  will be  required  to pay  16.7% of the  costs  to earn its  12.5%
interest,  under  certain  circumstances.  The  Company  is  also  committed  to
participate in other prospects  operated by NEGX through  February 1999 when the
initial term of the agreement expires.  Management  estimates that the Company's
capital  requirements  under this  agreement  will be between $5 million and $20
million for the year ending December 31, 1997.

Financing  Arrangements  - In January  1997,  the  Company  commenced  a private
placement  of up to  1,500,000  shares of common  stock for $2.50 per share.  In
connection  with the  private  placement,  the  Company  agreed  to use its best
efforts to  register  the  shares for sale by  including  such  securities  in a
registration  statement.  As  of  March  10,  1997,  the  Company  had  received
subscriptions  for the entire  1,500,000  shares  resulting in total proceeds of
$3,750,000.  Commissions  and other costs of the  offering  are  estimated to be
approximately 10% of the gross proceeds.

Through March 25, 1997,  options and warrants were exercised for an aggregate of
1.65 million shares, resulting in net proceeds of $1.9 million.

In  February  1997,  the  Company  entered  into a  letter  of  intent  with  an
underwriter for a proposed private  placement of the Company's common stock. The
aggregate  gross  proceeds of the  offering  will be at least $6 million  unless
otherwise agreed by the parties. The underwriter would receive commissions equal
to 10% of the gross  proceeds  and  warrants to purchase  the  Company's  common
stock.

In January 1997,  options for 190,000 shares of the Company's  common stock were
granted to officers  and  directors.  The options are  exercisable  at $2.97 per
share and expire in January 2002.



                                      F-24

<PAGE>



                   PEASE OIL AND GAS COMPANY AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

12.      SUPPLEMENTAL OIL AND GAS DISCLOSURES:

Costs Incurred in Oil and Gas Producing  Activities - The following is a summary
of costs  incurred  in oil and gas  producing  activities  for the  years  ended
December 31, 1996 and 1995:


                                            1996                1995
                                         -----------        ----------

   Property acquisition costs              $16,022             $60,000
   Development costs                       806,564             161,000
   Exploration costs                       555,685                -
                                         -----------        ----------

       Total                            $1,378,271            $221,000
                                        ==========          ========


Results  of  Operations  from Oil and Gas  Producing  Activities  -  Results  of
operations  from  oil  and  gas  producing  activities  (excluding  natural  gas
marketing and trading,  well  administration  fees,  general and  administrative
expenses,  and interest  expense) for the years ended December 31, 1996 and 1995
are presented below.


                                                  1996                1995
                                              -------------       -------------
     Oil and gas sales:
          LGPCo                                 $340,000             $373,000
          Unaffiliated entities                2,207,000            2,251,000
                                             --------------       -------------
               Total oil and gas sales         2,547,000            2,624,000
     Exploration and abandonment expenses       (556,000)             (19,000)
     Production costs                         (1,427,000)          (1,617,000)
     Depletion, depreciation and impairment     (590,000)            (742,000)
     Imputed income tax benefit (provision)       10,000              (91,000)
                                             --------------       -------------

     Results of operations from oil and gas
         producing activities                   $(16,000)            $155,000
                                                  ========          ========

Oil and Gas Reserve Quantities (Unaudited) - Proved oil and gas reserves are the
estimated  quantities  of crude oil,  natural gas, and natural gas liquids which
geological and engineering  data  demonstrate  with  reasonable  certainty to be
recoverable in future years from known  reservoirs  under existing  economic and
operating  conditions.  Proved developed oil and gas reserves are those reserves
expected to be recovered  through  existing  wells with  existing  equipment and
operating  methods.  The  reserve  data is  based  on  studies  prepared  by the
Company's consulting petroleum engineers.  Reserve estimates require substantial
judgment  on  the  part  of   petroleum   engineers   resulting   in   imprecise
determinations, particularly with respect to new discoveries. Accordingly, it is
expected  that the estimates of reserves  will change as future  production  and
development  information  becomes available.  Approximately 25% of the Company's
proved developed  reserves are currently  non-producing as certain wells require
workovers,  recompletions,  or construction of a gathering system to an existing
gas pipeline at an

                                      F-25

<PAGE>



                   PEASE OIL AND GAS COMPANY AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

estimated  total  cost of $1.4  million.  All proved  oil and gas  reserves  are
located in the United  States.  The following  table  presents  estimates of the
Company's  net proved oil and gas  reserves,  and changes  therein for the years
ended December 31, 1996 and 1995.

Changes in Net Quantities of Proved Reserves (Unaudited)


<TABLE>
<CAPTION>
                                                     1996                     1995
                                             -----------------------   ---------------------
                                              Oil .        Gas           Oil           Gas
                                             (Bbls)       (Mcf)         (Bbls)         (Mcf)

<S>                                        <C>           <C>           <C>           <C>
Proved reserves, beginning of year .....   1,294,000     5,851,000     1,352,000     5,724,000
        Purchase of minerals in place ..       7,000          --          38,000       447,000
        Sale of minerals in place ......     (27,000)      (26,000)      (14,000)     (107,000)
        Extensions, discoveries, and....
             other additions ...........      72,000       455,000        82,000       382,000
        Revisions of previous estimates      (71,000)   (1,035,000)      (43,000)      (98,000)
        Production .....................    (100,000)     (412,000)     (121,000)     (497,000)
                                          ----------    ----------    ----------    ----------

Proved reserves, end of year               1,175,000     4,833,000     1,294,000     5,851,000
                                           ==========   ==========    ==========    ==========
Proved developed reserves, beginning
of year                                     1,014,000     4,302,000      794,000     4,206,000
                                           ==========    ==========    ==========   ==========

Proved developed reserves, end of year      1,034,000     4,078,000     1,014,000    4,302,000
                                          ===========   ===========    ===========  ===========
</TABLE>



The significant revision in the Company's estimated 1996 proved gas reserves was
related to a reduction in the proved undeveloped reserves in the Loveland Field.
The reduction was necessary due to the limited  success of a well drilled during
1996.

Standardized Measure of Discounted Future Net Cash Flows (Unaudited) - Statement
of Financial Accounting  Standards No. 69 prescribes  guidelines for computing a
standardized  measure of future net cash flows and changes  therein  relating to
estimated proved  reserves.  The Company has followed these guidelines which are
briefly discussed below.

Future cash inflows and future  production and development  costs are determined
by applying year-end prices and costs to the estimated quantities of oil and gas
to be  produced.  Estimated  future  income  taxes are  computed  using  current
statutory  income  tax  rates  including   consideration  for  estimated  future
statutory  depletion and tax credits.  The  resulting  future net cash flows are
reduced to present value amounts by applying a 10% annual discount factor.


                                      F-26

<PAGE>



                   PEASE OIL AND GAS COMPANY AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

The assumptions used to compute the standardized measure are those prescribed by
the  Financial  Accounting  Standards  Board and,  as such,  do not  necessarily
reflect the Company's  expectations for actual revenues to be derived from those
reserves  nor their  present  worth.  The  limitations  inherent  in the reserve
quantity estimation process, as discussed previously,  are equally applicable to
the standardized  measure  computations  since these estimates are the basis for
the valuation process.

The following summary sets forth the Company's future net cash flows relating to
proved  oil and gas  reserves  as of  December  31,  1996 and 1995  based on the
standardized  measure prescribed in Statement of Financial  Accounting Standards
No. 69.


                                            1996                    1995

Future cash inflows                     $46,727,000              $32,620,000
Future production costs                 (17,220,000)             (13,871,000)
Future development costs                 (3,001,000)              (3,269,000)
Future income tax expense                (6,200,000)              (1,800,000)
                                    ---------------           -----------------
     Future net cash flows               20,306,000               13,680,000
10% annual discount for estimated        (8,326,000)              (5,200,000)
     timing of cash flow            ---------------           -----------------
Standardized Measure of Discounted      $11,980,000               $8,480,000
   Future Net Cash Flows            ===============           =================

Changes in  Standardized  Measure  (Unaudited) - The following are the principal
sources  of change in the  standardized  measure of  discounted  future net cash
flows for the years ended December 31, 1996 and 1995:


                                                         1996            1995
                                                    -------------    -----------

 Standardized measure, beginning of year              $8,480,000     $6,500,000
 Sale of oil and gas produced, net of
      production costs                                (1,120,000)    (1,006,000)
 Purchase of minerals in place                            45,000        228,000
 Sale of minerals in place                               (45,000)       (80,000)
 Net changes in prices and production costs            8,815,000        617,000
 Net changes in estimated development costs              233,000        785,000
 Revisions of previous quantity estimates             (3,769,000)      (803,000)
 Discoveries, extensions, and other additions          1,089,000        620,000
 Accretion of discount                                   848,000        650,000
 Changes in income taxes, net                         (2,596,000)       969,000
                                                    --------------   -----------
 Standardized Measure, end of year                   $11,980,000     $8,480,000
                                                      ===========    ==========

Gas Plant  (Unaudited) - The Company  processes most of the natural gas from its
properties  in a gas plant owned by the  Company.  Since the  revenues  from the
Company's  properties are subject to agreements with royalty owners and, in some
cases,  other working  interest  owners,  gas  processing  agreements  have been
entered into to set forth the contractual  arrangements for processing  charges.
Generally, the Company's processing fee consists of ownership of the natural gas
liquids and a portion of the  residue  gas that  results  from  processing.  The
Standardized  Measure of Discounted  Future Net Cash Flows shown above  excludes
the  Company's  share of the  natural gas liquids and residue gas related to the
Company's  gas  processing   activities,   as  well  as  marketing  and  trading
activities.

The  Company's  reserve  engineer has prepared the  following  estimates for the
reserves related to these activities as of December 31, 1996.


     Future net revenues, discounted at 10%                       $537,000
                                                                  ========

     Net quantities:
             Natural gas (mcf)                                   1,514,000
             Liquids (bbls)                                        237,000

13.     PRIOR PERIOD ADJUSTMENT:

In March 1998, the Company determined that the value originally  assigned to 2.5
million detachable warrants issued in connection with the 1996 private placement
of convertible debentures should be increased by $1,720,000. This amount, plus a
portion of the previously reported debt issuance costs, has been reclassified as
a discount to the convertible debentures.  The impact of this adjustment did not
have a  material  impact  on the  previously  reported  results  of  operations.
However, the carrying amount of the convertible debentures,  debt issuance costs
and  additional  paid-in  capital  has been  restated  to change  the  valuation
assigned to these  warrants.  The effect of the  adjustment  to the December 31,
1996 financial statements is summarized as follows:


<TABLE>
<CAPTION>
                                Convertible                                       Additional
                                Debentures            Debt Issuance Costs       Paid-In Capital
<S>                            <C>                      <C>                      <C>
  As previously reported       $ 5,000,000              $   1,105,874            $  17,392,329
  Prior period adjustments      (1,732,170)                   (12,395)               1,719,775
                               -------------         -------------------         ---------------
  As restated                  $ 3,267,830              $   1,093,479            $  19,112,104
                               ===========           ================            ==============
</TABLE>

See  Note 4 for  additional  information  regarding  the  convertible  debt  and
detachable warrants.

                                      F-27