<PAGE>
 
================================================================================

                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549

                                 ------------

                                   FORM 10-K

       X   ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
      ---  EXCHANGE ACT OF 1934
          

           FOR THE FISCAL YEAR ENDED DECEMBER 31, 1997

                                      OR

      ___  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
           SECURITIES EXCHANGE ACT OF 1934 [NO FEE REQUIRED]

           FOR THE TRANSITION PERIOD FROM _________ TO ________

                        COMMISSION FILE NUMBER 0-17162

                                 ------------
                         KEY PRODUCTION COMPANY, INC.
       A DELAWARE CORPORATION                  IRS EMPLOYER NO. 84-1089744

                      707 SEVENTEENTH STREET, SUITE 3300
                            DENVER, COLORADO 80202
                        TELEPHONE NUMBER (303) 295-3995

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

                    COMMON STOCK, PAR VALUE $.25 PER SHARE

       SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: NONE

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

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

     Aggregate market value of the voting stock held by non-affiliates of
      Key Production Company, Inc. as of March 11, 1998....... $123,159,256

     Number of shares of Key Production Company, Inc. common stock
      outstanding as of March 11, 1998...........................11,498,345

                     DOCUMENTS INCORPORATED BY REFERENCE:

      Portions of the Registrant's Proxy Statement for its 1998 Annual Meeting
of Stockholders are incorporated by reference into Part III.
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<PAGE>
 
                               TABLE OF CONTENTS

                                  DESCRIPTION

ITEM                                                                   PAGE
----                                                                   ---- 
 
PART I.................................................................. 1
     1.   BUSINESS...................................................... 1
     2.   PROPERTIES.................................................... 4
     3.   LEGAL PROCEEDINGS............................................. 6
     4.   SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS........... 6
          EXECUTIVE OFFICERS OF THE REGISTRANT.......................... 7
 
PART II................................................................. 8
     5.   MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED
          STOCKHOLDER MATTERS........................................... 8
     6.   SELECTED FINANCIAL DATA....................................... 8
     7.   MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
          CONDITION AND RESULTS OF OPERATIONS........................... 9
     8.   FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA...................14
     9.   CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING 
          AND FINANCIAL DISCLOSURE......................................34
 
PART III................................................................34
     10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT*...........34
     11.  EXECUTIVE COMPENSATION*.......................................34
     12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS
          AND MANAGEMENT*...............................................34
     13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS................35
 
PART IV.................................................................35
     14.  EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON
          FORM 8-K......................................................35

     *    This information is incorporated herein by reference from the
          Company's Proxy Statement for its 1998 Annual Meeting of Stockholders.

     ALL DEFINED TERMS UNDER RULE 4-10(A) OF REGULATION S-X SHALL HAVE THEIR
STATUTORILY-PRESCRIBED MEANINGS WHEN USED IN THIS REPORT. QUANTITIES OF NATURAL
GAS ARE EXPRESSED IN THIS REPORT IN TERMS OF THOUSAND CUBIC FEET (MCF), MILLION
CUBIC FEET (MMCF) OR BILLION CUBIC FEET (BCF). OIL IS QUANTIFIED IN TERMS OF
BARRELS (BBLS), THOUSANDS OF BARRELS (MBBLS) AND MILLIONS OF BARRELS (MMBBLS).
OIL IS COMPARED TO NATURAL GAS IN TERMS OF EQUIVALENT THOUSAND CUBIC FEET
(EMCF). ONE BARREL OF OIL IS THE ENERGY EQUIVALENT OF SIX MCF OF NATURAL GAS.
WITH RESPECT TO INFORMATION RELATING TO THE COMPANY'S WORKING INTEREST IN WELLS
OR ACREAGE, "NET" OIL AND GAS WELLS OR ACREAGE IS DETERMINED BY MULTIPLYING
GROSS WELLS OR ACREAGE BY THE COMPANY'S WORKING INTEREST THEREIN. UNLESS
OTHERWISE SPECIFIED, ALL REFERENCES TO WELLS AND ACRES ARE GROSS. PERCENTAGES
ARE CALCULATED ON ACTUAL, UNROUNDED NUMBERS AND MAY NOT AGREE WITH PERCENTAGES
CALCULATED OFF THE ROUNDED NUMBERS PRESENTED IN THIS FORM 10-K.
<PAGE>
 
                                    PART I

ITEM  1.  BUSINESS

GENERAL

     Key Production Company, Inc. (Key or the Company) is an independent oil and
gas company engaged in oil and gas exploration, development and production in
the continental United States.  The Company's exploration interests are spread
over 14 states with primary focus areas in the Anadarko Basin of Oklahoma,
California, the Rocky Mountain region, North Texas, and the Gulf Coast.  The
Company was incorporated in Delaware on June 22, 1988, and maintains its
corporate offices in Denver, Colorado.  Key maintains regional exploration
offices in: Tulsa, Oklahoma; Dallas, Texas; Sacramento, California; and New
Orleans, Louisiana.  The Company's common stock trades on the New York Stock
Exchange under the symbol KP.

BUSINESS DURING 1997

     Key reported 1997 net income of $9.7 million, ($.80 per share) on revenues
of $42.2 million.  Net cash provided by operating activities totaled $34.1
million.  Oil and gas production, on an equivalent unit basis, was up 12 percent
from the prior year level.  Product prices averaged $2.38 per Mcf of gas and
$18.04 per barrel of oil.

     Gas production totaled 10,958 MMcf, a 19 percent increase compared to 1996.
This increase was primarily due to production from wells drilled during the
year.  Despite a property acquisition at the end of the third quarter that added
260 barrels of oil to Key's daily production, oil volumes for the year declined
two percent to 839 MBbls.

     In 1997, the Company spent $36.7 million on exploration and development
activities.  Key participated in drilling 95 gross (25.8 net) wells in 1997.
During 1997, 78 gross (17.0 net) wells were completed as producers and 17 gross
(8.8 net) wells were dry.  Including property acquisitions (net of sales), Key's
1997 capital expenditures totaled $43.9 million.

     In September 1997, Key entered into an exploration joint venture agreement
with EEX Corporation (EEX) covering EEX's leasehold position in the Hardeman
Basin of north-central Texas.  The agreement gives Key the right to drill on
EEX-controlled leasehold as well as access to a 340 square mile 3-D seismic grid
owned by EEX.  Key committed to drill a minimum of 20 wells in the area over a
two-year period.  EEX receives a carried interest in the wells that Key drills.

     Key also purchased 20 percent of EEX's interest in 52 producing properties
in the Hardeman Basin.  As discussed above, this acquisition increased Key's
daily oil production by 260 barrels, or 11 percent, compared to third quarter
levels.  The majority of these properties were operated by EEX at the time of
the acquisition.  Under the terms of the agreement, Key assumed operations of
all properties previously operated by EEX.  Key also operates all properties
drilled under the exploration joint venture with EEX.

     Key has working interests in approximately 1,941 gross (262.1 net) wells
located primarily in the Anadarko Basin of Oklahoma, Wyoming, Texas, Louisiana,
California and offshore Gulf of Mexico.  In addition, Key has royalty or
overriding royalty interests in approximately 79 properties in the 

                                       1
<PAGE>
 
Mid-Continent region, 60 properties in the Gulf Coast region, 9 properties in
the North Texas region and 1,832 properties in the Rocky Mountain region.

     At year-end, Key held approximately 101,000 net acres of developed
leasehold located in California, Oklahoma, Wyoming, Texas, Mississippi and
Louisiana.  Key also held approximately 197,000 net acres of undeveloped
leasehold located in California, Oklahoma, Wyoming, Texas, Mississippi and
Louisiana.  In connection with the EEX joint venture discussed above, the
Company also has exploration rights on approximately 107,000 acres located in
the Hardeman Basin of north-central Texas.

COMPETITION

     The oil and gas industry is highly competitive.  As an independent oil and
gas company, Key must compete against companies with substantially larger
financial and other resources for a variety of opportunities including reserve
and lease acquisitions and marketing agreements.

NATURAL GAS AND OIL PRICES

     Key's gas price averaged $2.38 per Mcf in 1997, $.23 higher than the prior
year average of $2.15 per Mcf.  Key's average realized oil price dropped to
$18.04 per barrel in 1997, down from $20.30 in the prior year.  Key's business
will continue to be affected by future changes in domestic and international oil
and gas prices.  It is impossible to predict, with any substantial degree of
accuracy, the trend in, or level of, future oil and gas prices and their impact
on the Company's reported results in future periods.

RESERVE VALUE CEILING TEST

     Key reviews the carrying value of its oil and gas properties on a quarterly
basis under the full cost accounting rules of the Securities and Exchange
Commission (SEC or the Commission).  Under the full cost accounting rules,
capitalized costs of oil and gas properties may not exceed the present value of
estimated future net revenues from proved reserves, discounted at 10 percent,
plus the lower of cost or fair market value of unproved properties, as adjusted
for related tax effects and deferred tax reserves.  Application of this rule
generally requires pricing future revenues at the unescalated prices in effect
at the end of each fiscal quarter and requires a write-down if the "ceiling" is
exceeded, even if prices declined for only a short period of time.  If a write-
down were required, the charge to earnings would not impact cash flow from
operating activities.  Key has not recorded any such write-downs.

REGULATION OF OIL AND GAS

     Key's exploration, production and marketing are regulated extensively at
the federal, state and local levels.  Oil and gas exploration, development and
production activities are subject to various laws and regulations governing a
wide variety of matters.  For example, the states in which Key produces oil and
gas have statutes or regulations addressing production practices that may affect
Key's operations and limit the quantity of hydrocarbons Key may produce and
sell.  Other regulated matters include the marketing and transportation of oil
and gas and the valuation of royalty payments.

     Among other regulated matters on the federal level, the Federal Energy
Regulatory Commission (FERC) regulates interstate transportation of natural gas
under the Natural Gas Act.  Key's gas sales are affected by regulation of

                                       2
<PAGE>
 
intrastate and interstate gas transportation.  In an attempt to promote
competition, FERC has issued a series of orders which have significantly altered
the marketing and transportation of natural gas.  To date, Key has not
experienced any material adverse effect on gas marketing as a result of these
FERC orders.  However, the Company cannot predict what effect subsequent
regulations may have on its future gas marketing.

ENVIRONMENTAL

     Key, as an owner of interests in oil and gas properties, is subject to
various federal, state, and local laws and regulations relating to discharge of
materials into, and protection of, the environment.  These laws and regulations
may, among other things, impose liability on the lessee under an oil and gas
lease for the cost of pollution clean-up resulting from operations, subject the
lessee to liability for pollution damages, require suspension or cessation of
operations in affected areas and impose restrictions on the injection of liquids
into subsurface aquifers that may contaminate groundwater.

     Key has made and will continue to make expenditures in its efforts to
comply with these requirements, which it believes are necessary business costs
in the oil and gas industry.  These costs are inextricably connected to normal
operating expenses such that the Company is unable to separate the expenses
related to environmental matters.  However, the Company does not believe any
such additional expenses will materially affect its business.  Although
environmental requirements do have a substantial impact upon the energy
industry, generally these requirements do not appear to affect Key any
differently or to any greater or lesser extent than other companies in the
industry.

     The Company is not aware of any environmental claims existing as of
December 31, 1997, which would have a material impact upon the Company's
financial condition or results of operations.  Key does not believe that
compliance with federal, state or local provisions regulating the discharge of
materials into the environment, or otherwise relating to the protection of the
environment, will have such an impact.

EMPLOYEES

     On December 31, 1997, Key had 56 full-time employees.

OFFICES

     Key's principal executive offices are located at 707 Seventeenth Street,
Suite 3300, Denver, Colorado 80202-3404.

                                       3
<PAGE>
 
ITEM 2. PROPERTIES
 
PRODUCTIVE WELLS AND ACREAGE

     The number of productive gas and oil wells in which Key has working
interests as of December 31, 1997, is set forth below.
<TABLE>
<CAPTION>
    
                              Gas                      Oil    
                             -----                    -----   
                        Gross      Net           Gross      Net 
                        -----     -----          -----     ----- 
<S>                     <C>       <C>            <C>       <C>  
Mid-Continent             594     109.1            136      24.6
Gulf Coast                169      21.1            196      25.9
Rocky Mountains           113       5.5            674      54.9
California                 15      14.4              -         -
North Texas                 -         -             44       6.6
                        -----     -----          -----     ----- 
                          891     150.1          1,050     112.0
                        =====     =====          =====     ===== 
</TABLE>

     In addition, Key has royalty or overriding royalty interests in
approximately 79 properties in the Mid-Continent region, 60 properties in the
Gulf Coast region, 9 properties in the North Texas region and 1,832 properties
in the Rocky Mountain region.  As of December 31, 1997, Key held approximately
101,000 net developed acres.

GROSS WELLS DRILLED

     The following table sets forth the number of wells drilled during 1997,
1996 and 1995 in which the Company participated.
<TABLE>
<CAPTION>
 
                             Exploratory                   Developmental
                             -----------                   -------------
                     Productive    Dry     Total   Productive    Dry     Total
                     ----------  -------  -------  ----------  -------  -------
<S>                <C>         <C>      <C>      <C>         <C>      <C>
 
     1997
     ----
Mid-Continent               1        2        3          46        5       51
Gulf Coast                  -        1        1           9        1       10
Rocky Mountains             -        1        1          14        -       14
California                  7        6       13           -        -        -
North Texas                 1        1        2           -        -        -
                     --------   ------   ------      ------    -----   ------ 
                            9       11       20          69        6       75
                     ========   ======   ======      ======    =====   ====== 
 
     1996
     ----
Mid-Continent               6        4       10          34        1       35
Gulf Coast                  1        4        5          12        -       12
Rocky Mountains             2        2        4           8        -        8
California                  6        1        7           -        -        -
                     --------   ------   ------      ------    -----   ------ 
                           15       11       26          54        1       55
                     ========   ======   ======      ======    =====   ======  
 
     1995
     ----
Mid-Continent               9        5       14          19        -       19
Gulf Coast                  -        -        -           1        -        1
Rocky Mountains             1        2        3          17        -       17
California                  1        1        2           -        -        -
                     --------   ------   ------      ------    -----   ------ 
                           11        8       19          37        -       37
                     ========   ======   ======      ======    =====   ======  
</TABLE> 
 
     At December 31, 1997, 17 gross (4.3 net) wells were in the process of being
drilled.

                                       4
<PAGE>
 
UNDEVELOPED ACREAGE

     As of December 31, 1997, Key held an interest in approximately 197,000 net
undeveloped acres.  Nearly 75 percent of this acreage is located in the Rocky
Mountain region with the remainder located in California, Mississippi,
Louisiana, and Oklahoma.

PRODUCTION AND PRICING INFORMATION

     The following table describes, for each of the last three fiscal years, oil
and gas production and pricing data for the Company.
<TABLE>
<CAPTION>
                                            Average  
                                          Production         Average Sales Price
Year Ended December 31,     Oil    Gas       Cost            -------------------
-------------------------  MBbls   MMcf    Per EMcf         Per Bbl        Per Mcf
                           -----  ------  ----------        -------        -------
<S>                        <C>    <C>     <C>              <C>            <C>
1997.....................    839  10,958     $.66           $18.04         $2.38
1996.....................    853   9,198     $.67           $20.30         $2.15
1995.....................    633   5,262     $.70           $15.70         $1.71
</TABLE>
RESERVE VALUE INFORMATION

     The estimated proved oil and gas reserves of Key, as of December 31, 1997,
1996 and 1995, and the standardized measure of discounted future net cash flows
attributable thereto at December 31, 1997, 1996, and 1995, are included in
Supplemental Oil and Gas Disclosures to Financial Statements appearing on pages
31 through 33 of this Form 10-K.  Supplemental Oil and Gas Disclosures also
include Key's net revenues from production (including royalty and working
interest production) of oil and natural gas for the three years ended December
31, 1997.

     Future reserve values are based on year-end prices except in those
instances where the sale of gas is covered by contract terms providing for
determinable escalations. Operating costs, production and ad valorem taxes and
future development costs are based on current costs with no escalations.
<TABLE>
<CAPTION>
 
 
                                                Present Value of Estimated
                                                Future Net Cash Flows Before
                            Estimated Future            Income Tax
                             Net Cash Flows     (Discounted at 10 Percent)
                           -------------------  --------------------------
                                      Proved                     Proved
 Year Ended December 31,    Proved   Developed     Proved      Developed
-------------------------  --------  ---------  ------------  ------------
                                           (In thousands)
<S>                        <C>       <C>        <C>           <C>
1997.....................  $175,001   $171,861      $121,718      $119,620
1996.....................  $265,541   $257,704      $172,583      $167,983
1995.....................  $ 88,016   $ 86,299      $ 61,201      $ 60,296
 
</TABLE>

     The present value of estimated future net cash flows from proved reserves
after income taxes are $99,253,000, $129,220,000, and $50,758,000 for 1997, 1996
and 1995, respectively.

                                       5
<PAGE>
 
     Estimated future net cash flows at December 31, 1997, are expected to be
received as shown in the following years:
<TABLE>
<CAPTION>
                                       Proved   
Year Ended December 31,      Proved   Developed                  
-----------------------     --------  --------- 
                               (In thousands)
<S>                        <C>       <C>
1998.....................    34,203     33,825
1999.....................    28,354     27,787
2000.....................    21,702     21,354
Thereafter...............    90,742     88,895
                           --------   --------
 
Total....................  $175,001   $171,861
                           ========   ========
</TABLE>

     No major discovery or other favorable or adverse event is believed to have
occurred since December 31, 1997, which would cause significant change in the
estimated proved reserves reported herein.  The above estimates are based on
year-end pricing in accordance with Commission guidelines and do not reflect
current prices.  Since January 1, 1997, no oil or gas reserve information has
been filed with, or included in any report to, any federal authority or agency
other than the SEC and/or the Energy Information Administration.

ITEM  3.  LEGAL PROCEEDINGS

     The Company is not subject to any pending litigation that, in the opinion
of the Company's management, will materially affect the financial position or
results of operations of the Company.

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

     On May 8, 1997, the Company held its annual meeting of stockholders.
Francis H. Merelli, Cortlandt S. Dietler and L. Paul Teague were elected as
directors and amendments to the Stock Option Plan for Non-Employee Directors and
the 1992 Stock Option Plan were approved.  Following is a summary of votes cast.
<TABLE>
<CAPTION>
 
Election of Directors                         For     Withhold Authority
---------------------                         ---     ------------------                    
<S>                                        <C>        <C>                                   
                                                                                            
F.H. Merelli                               9,108,650             458,142                    
Cortlandt S. Dietler                       9,107,510             459,282                    
L. Paul Teague                             9,109,536             457,256                     
</TABLE> 
 
Amendments to Stock Option Plan for Non-Employee Directors:
------------------------------------------------------------
 
     For                 Against                   Abstain
     ---                 -------                   ------- 
 
  4,168,165              1,909,125                 127,680
 
Amendment to 1992 Stock Option Plan:
------------------------------------
 
     For                 Against                   Abstain 
     ---                 -------                   -------      
  3,745,855              2,299,014                 160,101
 

                                       6
<PAGE>
 
                      EXECUTIVE OFFICERS OF THE REGISTRANT

     F. H. MERELLI, 61, has been chairman of the board of directors, president
and chief executive officer of the Company since September 9, 1992. From July
1991 to September 1992, Mr. Merelli was engaged as a private consultant in the
oil and gas industry.  Mr. Merelli was president and chief operating officer of
Apache Corporation, and president, chief operating officer and a director of Key
from June 1988 to July 1991, at which time he resigned from those positions in
both companies.  He was president of Terra Resources, Inc. from 1979 to 1988.
Mr. Merelli has been a director of Apache Corporation since July 1997.

     MONROE W. ROBERTSON, 48, has been with the Company since September 10,
1992.  Since February 1994, he has served as senior vice president and corporate
secretary and prior to that time as vice president and corporate secretary.
From August 1988 to July 1992, he was employed by Apache Corporation in various
capacities, the most recent of which was director of operational planning.  From
1986 to 1988, Mr. Robertson was director of corporate planning for Terra
Resources, Inc.  From 1973 to 1986, Mr. Robertson was employed by Gulf Oil
Corporation in various engineering and management positions.

     CATHY L. ANDERSON, 42, has been controller of the Company since January 15,
1993.  From July 1985 to January 1993, Ms. Anderson was employed by Arthur
Andersen LLP, a public accounting firm, in various capacities, the most recent
of which was audit manager.

     STEPHEN P. BELL, 43, has been vice president - land of the Company since
February 2, 1994.  From March 1991 to February 1994, he was president of Concord
Reserve, Inc., a privately-held independent oil and gas company.  He was
employed by Pacific Enterprises Oil Company (formerly Terra Resources, Inc.) as
Mid-Continent regional manager from February 1990 to February 1991 and as land
manager from August 1985 to January 1990.

                                       7
<PAGE>
 
                                    PART II

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

     Key's common stock, par value $.25 per share, trades on the New York Stock
Exchange under the symbol KP.  No dividends were paid in 1997 or in 1996.  The
table below shows the market price of the common stock for 1997 and 1996:
<TABLE>
<CAPTION>
 
                             MARKET PRICE
                             ------------
                        1997              1996
                  ----------------  ----------------
                   High      Low     High      Low
                  -------  -------  -------  -------
<S>               <C>      <C>      <C>      <C>
First Quarter     $13.250   $9.625  $ 5.875   $4.750
Second Quarter    $10.750   $8.000  $ 8.063   $6.875
Third Quarter     $13.250   $9.625  $10.375   $7.375
Fourth Quarter    $13.188   $9.000  $14.625   $9.500
 
</TABLE>

     The closing price of Key's common stock as reported on the New York Stock
Exchange for March 11, 1998, was $11.00.  At December 31, 1997, the Company's
11,498,355 shares of common stock outstanding were held by approximately 6,290
stockholders of record and approximately 8,100 beneficial owners.

ITEM 6.   SELECTED FINANCIAL DATA

     The following table sets forth selected financial data of the Company for
each of the years in the five-year period ended December 31, 1997, which
information has been derived from the Company's audited financial statements.
This information should be read in connection with and is qualified in its
entirety by the more detailed information and financial statements under Item 8
below.
<TABLE>
<CAPTION>
 
                                              For the Year Ended December 31,
                                        --------------------------------------------
                                          1997     1996     1995     1994     1993
                                        --------  -------  -------  -------  -------
                                           (In thousands, except per share data)
<S>                                     <C>       <C>      <C>      <C>      <C>
  Revenues............................  $ 42,151  $37,886  $19,297  $16,637  $11,735
  Net income/(a)/.....................     9,696    7,980    3,054    2,943    3,495
    Basic earnings per share /(a)/....       .84      .73      .34      .30      .34
    Diluted earnings per share /(a)/..       .80      .69      .32      .29      .34
  Oil and gas expenditures............    44,625   43,476   13,591   29,966    1,885
  Total assets........................   130,647   95,940   59,199   52,611   39,805
  Long-term debt......................    35,000   22,500   14,600   10,000        -
  Stockholders' equity................    64,911   55,269   35,699   34,257   35,918
</TABLE>
     /(a)/ Net income for 1993 includes a non-recurring gain of $1,603,000, $.16
           per share, due to a change in the method of accounting for income
           taxes and an extraordinary loss on early extinguishment of debt of
           $122,000, ($.01) per share.

                                       8
<PAGE>
 
ITEM 7.   MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
          RESULTS OF OPERATIONS

FINANCIAL RESULTS

     Key reported 1997 net income of $9.7 million, up from $8.0 million in 1996
and $3.1 million in 1995.  Diluted earnings per share was $.80 in 1997. On a per
share basis, net income rose 16 percent over the $.69 diluted earnings per share
reported in 1996 and is two and one-half times the $.32 diluted earnings per
share reported in 1995.  The increase to per share results occurred despite an
increase in the shares outstanding.  Earnings for 1997, 1996 and 1995 are based
on revenues of $42.2, $37.9 and $19.3 million, respectively.  Higher gas volumes
and prices drove the increase in earnings, but were partially offset by lower
oil prices.  Gas volumes for 1997 reflect significant production increases from
new drilling.

REVENUES

     Oil and gas production revenues increased 12 percent between 1997 and 1996
as a result of increases in gas production and gas prices.  Oil production and
oil prices decreased in 1997, but were more than offset by increases in gas
sales.  Key's oil and gas revenues were $42.0 million in 1997 compared to $37.6
million in 1996.

     Oil and gas revenues nearly doubled between 1996 and 1995 as a result of
increases in production and oil and gas prices.  Key's oil and gas revenues were
$37.6 million in 1996, compared to $19.3 million in 1995.  Results for 1996
reflect the positive impact of the Brock acquisition and the Company's
successful drilling projects.

     Key's gas sales were $26.1 million for 1997, reflecting a 32 percent
increase over 1996 gas sales.  Daily production increased from 25,132 Mcf per
day in 1996 to 30,021 Mcf per day in 1997.  Production increases contributed
approximately $3.8 million to gas sales.  Roughly 80 percent of the 1997 gas
production increase is from new drilling.  The balance of the increase can be
attributed to the Brock acquisition at the end of March 1996.  Key's average
realized price increased from $2.15 per Mcf in 1996 to $2.38 per Mcf in 1997,
for an additional $2.5 million in gas sales.

     Gas sales rose from $9.0 million in 1995 to $19.8 million in 1996, a 119
percent increase.  Most of this increase can be attributed to increased gas
production.  Augmented by the Brock acquisition and production from new
drilling, daily gas volumes advanced from 14,416 Mcf per day in 1995 to 25,132
Mcf per day in 1996, adding approximately $6.7 million in value.  In addition,
Key's average gas price increased by $.44 per Mcf and contributed another $4.1
million to 1996 gas sales.

     Oil sales went from $17.3 million in 1996 to $15.1 million in 1997, lagging
1996 results by 13 percent.  Key's average realized oil price dropped from
$20.30 per barrel in 1996 to $18.04 per barrel in 1997.  Price declines are
responsible for approximately $1.9 million of the $2.2 million oil sales
variance.  Oil production slipped from 2,332 barrels per day in 1996 to 2,298
barrels per day in 1997.  The overall decrease to oil production occurred even
with the acquisition of producing oil properties in the third quarter of 1997.
The production decline was only 2 percent, but had a negative $.3 million impact
on sales.  The third quarter acquisition added almost $.5 million to oil sales.

                                       9
<PAGE>
 
     Oil sales for 1996 increased 74 percent to $17.3 million, $7.4 million over
1995 sales.  The Company's average oil price increased from $15.70 per barrel in
1995 to $20.30 per barrel in 1996, elevating oil sales by $3.9 million.  Average
daily production climbed 35 percent to 2,332 barrels per day in 1996, adding
$3.5 million.

     Product sales from gas processing plants contributed approximately
$748,000, $459,000 and $301,000 to oil and gas production revenues in 1997, 1996
and 1995, respectively.  In 1997, Key's oil and gas revenues were derived from
the following product mix: 36 percent oil, 62 percent gas and 2 percent from
plant product sales.  This compares to the following components for 1996: 46
percent oil, 53 percent gas and the balance from plant product sales.

     Other revenues were approximately $186,000, $333,000 and $42,000 for 1997,
1996 and 1995, respectively.  Key's primary source of other revenue for 1997
($141,000) and 1996 ($178,000) has been income from a pipeline acquired in the
1996 Brock acquisition.  This pipeline was sold in March 1997, resulting in a
decrease to other revenues between 1997 and 1996.  Other revenue for 1996 also
includes a contract settlement for $123,000.  The remaining other revenues for
all periods presented includes proceeds from gas contract settlements and
miscellaneous income items.

COSTS AND EXPENSES

     Depreciation, depletion and amortization (DD&A) expense increased just 4
percent between 1997 and 1996, while oil and gas revenues increased by 12
percent.  A decrease in the depletion rate from 33.3 percent in 1996 to 30.9
percent in 1997 mitigated the effect of higher oil and gas sales in 1997.
Improved gas prices and new reserves from drilling each contributed to the
favorable DD&A rate in 1997.

     DD&A expense increased 70 percent between 1996 and 1995.  The DD&A increase
was a direct result of Key's increased oil and gas sales.  However, due to a
decline in the 1996 DD&A rate, the increase was not as pronounced as the sales
increase.  Key's 1996 depletion rate as a percentage of oil and gas sales
decreased from 38.0 percent in 1995 to 33.3 percent in 1996.  Improved product
prices, particularly for oil, were the catalyst for improved DD&A rates in 1996.
Included in DD&A expense for the three years presented is a small amount of
depreciation on fixed assets and amortization of financing costs associated with
the Company's credit facility.

     Operating expenses for 1997 moved upward in direct correlation with oil and
gas sales.  On a unit of production basis, operating expenses declined from $.67
per EMcf in 1996 to $.66 per EMcf in 1997.  Current year operating expenses
include a $.2 million credit Key received for charges over-billed by an
operator.  Without this credit, 1997 and 1996 expenses on a unit of production
basis would have remained flat at $.67 per EMcf.

     Operating expenses increased 51 percent to $9.6 million between 1996 and
1995.  Expense increases are a result of the Brock acquisition in 1996 and the
resulting larger property base.  In contrast, expenses compared on a unit of
production basis dropped from $.70 per EMcf in 1995 to $.67 per EMcf in 1996.

     General, administrative and other costs (G&A) held steady at $2.0 and $2.1
million for 1997 and 1996, respectively.  Due to an increase in sales volumes,
this translates to a $.01 per EMcf decrease between 1996 and 1997. G&A increased
about 42 percent, or $.6 million, from 1995 to 1996.  In units of production,
this variance equates to a $.02 per EMcf decrease between 1995 and 1996.  Due to
certain economies of scale and full cost accounting rules, 

                                       10
<PAGE>
 
which provide for the capitalization of direct overhead related to acquisition,
exploration and development activities, the Company was able to maintain levels
of administrative expense while managing a growing asset base.

     Interest expense before capitalization was $1,718,000, $1,349,000 and
$828,000 for 1997, 1996 and 1995, respectively.  The long-term debt balance was
$35.0 million at December 31, 1997, compared to $22.5 million at December 31,
1996.  Key capitalized interest of $1,019,000, $682,000, and $574,000 in 1997,
1996 and 1995, respectively.  These amounts are for borrowings associated with
undeveloped leasehold.

     As discussed in more detail in Footnote 3, "Income Taxes", in connection
with the acquisition of Brock, a deferred income tax valuation was established
for NOLs that are subject to annual limitations.  Key is using an effective tax
rate of 38 percent for 1997 and 1996.  The effective tax rate was only 19
percent in 1995 due to the reversal of Key's valuation allowance.

CASH FLOW AND LIQUIDITY

     Key's primary needs for cash are to fund oil and gas exploration,
development and acquisition activities and for payment of existing obligations
and trade commitments related to oil and gas operations.  The Company's primary
sources of liquidity are cash flows from operating activities and proceeds from
financing activities.

     Cash from operating activities climbed from $21.9 million in 1996 to $34.1
million in 1997, a 56 percent increase.  Of this increase, $3.4 million is due
to increases in net income, DD&A expense and deferred taxes.  Other factors
contributing to the variance were changes in the accounts payable and accounts
receivable balances.

     Cash from operating activities reached $21.9 million for 1996, nearly
double the $11.3 million reported for 1995.  The Brock acquisition and resulting
increases to net income, DD&A expense and deferred taxes added $14.5 million.
This increase was partially offset by an increase to oil and gas revenue
receivables, which also stem from the Brock acquisition.

     Expenditures for exploration and development for 1997 totaled $36.3
million, or 106 percent of cash from operating activities.  This is an 81
percent increase over the $20.0 million spent in 1996 and a 169 percent increase
over the $13.5 million spent in 1995.  In 1997, exploration and development
projects were funded with a combination of cash from operations and long-term
debt.  Following a five-year pattern of growth, the Company continues to expand
its exploration program.  Key drilled 95 gross wells (25.8 net) in 1997, 81
gross wells (17.6 net) in 1996 and 56 gross wells (8.35 net) in 1995.

     On March 28, 1996, Key consummated a merger with Brock Exploration
Corporation.  In this non-cash transaction, Brock became a wholly-owned
subsidiary of Key.  Key's consolidated balance sheet includes the assets and
liabilities, as well as the adjustments required to record the acquisition under
purchase accounting rules.

     In 1997, Key made various property acquisitions.  In the second quarter,
Key acquired non-producing acreage over 11 salt domes in west-central
Mississippi.  In the third quarter, Key acquired producing properties in the
Hardeman Basin of North Texas.  Both transactions were funded with a combination
of cash from operating activities and funds obtained from the Company's credit
facility.

                                       11
<PAGE>
 
     Key has a $50 million credit facility with NationsBank of Texas, N.A. In
1997, the Company increased its borrowing base from $36 million to $42 million.
During the year, an additional $12.5 million (net) was borrowed to fund various
acquisition, exploration and development projects.  In 1996, long-term debt
increased from $14.6 million to $22.5 million.  Subsequent to the acquisition of
Brock, Key drew on its own credit facility to retire Brock debt and obtain more
favorable financing terms.  In 1995, the Company borrowed a net of $4.6 million
to finance exploration and drilling activities and stock repurchases.

     The Company continued its policy of repurchasing shares of Key common stock
in 1997.  In the second quarter of 1997, Key purchased 40,000 shares of Key
common stock from Janet Moylan for $.4 million, or $10.00 per share.  In the
fourth quarter of 1996, Key purchased 224,022 shares of Key common stock from
Lawrence Brock for $2.2 million, or $10.00 per share.  In the fourth quarter of
1995, Key purchased 331,000 shares of its own stock from Apache Corporation for
$1.7 million, or $5.00 per share.

     Management believes that cash on hand at year-end, net cash generated from
operations and remaining amounts available under the existing line of credit
will be adequate to meet future liquidity needs, including satisfying the
Company's financial obligations and funding operations, exploration and
development activities.

YEAR 2000 COMPLIANCE

     Many existing computer programs use only two digits to identify a year in
the date field and were designed and developed without considering the impact of
the upcoming change in the century.  If not corrected, many computer
applications could fail or create erroneous results by or at the Year 2000.  The
Company relies on three primary software systems to record, process and track
information in three functional areas: accounting, land and lease records and
reservoir engineering.  During 1997, the Company assessed the impact of this
potential problem on its computer systems.

     The software used in the land and lease records and reservoir engineering
areas is Year 2000 compliant.  This assessment is based on information provided
by the developers of these programs.  Company personnel also independently
verified the ability of these programs to correctly handle dates at and beyond
the Year 2000.  The accounting software used by the Company is not Year 2000
compliant at this time.  The software vendor for this program has developed an
upgrade designed to correct the portions of the program not currently Year 2000
compliant.  This upgrade is available, at no additional charge, as part of the
Company's annual software maintenance agreement with the vendor.  The upgrade
will be installed and tested during 1998.  The cost of installing the upgrade is
not expected to be significant.

     The Company feels that its remediation plan adequately addresses the Year
2000 problem and therefore this issue is not expected to materially impact the
Company's internal operations.  As part of its remediation plan, the Company
also attempted to assess the impact of this issue on the various entities with
which the Company does business.  Although failure of these entities to
adequately address the impact of various Year 2000 issues could indirectly
impact the Company, it is not possible to quantify that impact, if any.  The
Company does not, however, anticipate that the impact would have a material
adverse affect on the Company's business.

                                       12
<PAGE>
 
FUTURE TRENDS

     The Company expects drilling to be the primary focus of its growth strategy
into 1998 and beyond.  Exploration and development will continue in each of the
Company's regional focus areas: Mid-Continent, Gulf Coast, California, north-
central Texas and the Rocky Mountains.  Exploration and development expenditures
for 1998 are expected to exceed 1997 expenditures of $36.7 million.  The Company
expects to fund these expenditures from cash on hand and cash generated by
operating activities combined with amounts available under its credit facility.

     The Company will continue to review merger and acquisition opportunities.
Potential acquisitions or mergers with the economic and strategic attributes
necessary to facilitate the profitable growth of the Company will be actively
pursued.

     Since year-end, the price the Company receives for its oil and gas
production has declined.  Although production from wells drilled during 1997 and
1998 will help to mitigate the effect, lower product prices may have a
significant negative impact on 1998 revenue and net income.  Lower product
prices also impact the calculation of the limitation on capitalized costs under
the full cost accounting rules of the Securities and Exchange Commission.
Application of this rule generally requires pricing future revenues at the
unescalated prices in effect at the end of each fiscal quarter and requires a
write-down if the "ceiling" is exceeded, even if prices decline for only a short
period of time.  If a write-down were required, the charge to earnings would not
impact cash flow from operating activities. It is impossible to predict, with
any substantial degree of accuracy, the trend in, or level of, future oil and
gas prices and their impact on the Company's reported results in future periods.


CAUTIONARY STATEMENT PURSUANT TO SAFE HARBOR PROVISION OF THE PRIVATE SECURITIES
LITIGATION REFORM ACT OF 1995

     This report contains "forward-looking statements" within the meaning of the
federal securities laws.  These forward-looking statements include, among
others, statements concerning the Company's outlook with regard to production
levels, price realizations, expenditures for exploration and development, plans
for funding operations and capital expenditures, and other statements of
expectations, beliefs, future plans and strategies, anticipated events or trends
and similar expressions concerning matters that are not historical facts.  The
forward-looking statements in this report are subject to risks and uncertainties
that could cause actual results to differ materially from those expressed in or
implied by the statements.

     These risks and uncertainties include, but are not limited to, fluctuations
in the price the Company receives for its oil and gas production, reductions in
the quantity of oil and gas sold due to decreased industry-wide demand and/or
curtailments in production from specific properties due to mechanical, marketing
or other problems, operating and capital expenditures that are either
significantly higher or lower than anticipated because the actual cost of
identified projects varied from original estimates and/or from the number of
exploration and development opportunities being greater or fewer than currently
anticipated, and increased financing costs due to a significant increase in
interest rates.  These and other risks and uncertainties affecting the Company
are discussed in greater detail in this report and in other filings by the
Company with the Securities and Exchange Commission.

                                       13
<PAGE>
 
ITEM  8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

     See following Index

                          KEY PRODUCTION COMPANY, INC.

            INDEX TO FINANCIAL STATEMENTS AND SUPPLEMENTAL SCHEDULES
 
                                                                       Page
 
Report of independent public accountants............................... 15
Consolidated statement of income for each of the three years in the
  period ended December 31, 1997....................................... 16
Consolidated statement of cash flows for each of the three years in
  the period ended December 31, 1997................................... 17
Consolidated balance sheet as of December 31, 1997 and 1996............ 18
Consolidated statement of stockholders' equity for each of the three
  years in the period ended December 31, 1997.......................... 19
Summary of significant accounting policies............................. 20
Notes to consolidated financial statements............................. 23
Supplemental oil and gas disclosures................................... 31
Supplemental quarterly financial data.................................. 34

     All other supplemental information and schedules have been omitted because
they are not applicable or the information required is shown in the consolidated
financial statements or related notes thereto.

                                       14
<PAGE>
 
                    REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS


To the Stockholders of
  Key Production Company, Inc.:

     We have audited the accompanying consolidated balance sheets of Key
Production Company, Inc. (a Delaware corporation) and subsidiaries as of
December 31, 1997 and 1996, and the related consolidated statements of income,
stockholders' equity and cash flows for each of the three years in the period
ended December 31, 1997. 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 Key
Production Company, Inc. and subsidiaries as of December 31, 1997 and 1996, and
the results of its operations and its cash flows for each of the three years in
the period ended December 31, 1997, in conformity with generally accepted
accounting principles.
 


                                                            ARTHUR ANDERSEN LLP



Denver, Colorado,
February 25, 1998.

                                       15
<PAGE>
 
                          KEY PRODUCTION COMPANY, INC.

                        CONSOLIDATED STATEMENT OF INCOME

<TABLE>
<CAPTION>
 
 
                                                 For the Year Ended December 31,
                                             ----------------------------------------
                                                 1997          1996          1995
                                             ------------  ------------  ------------
                                              (In thousands, except per share data)
<S>                                          <C>           <C>           <C>
REVENUES:
 Oil and gas production revenues...........      $41,965       $37,553       $19,255
 Other revenues............................          186           333            42
                                                 -------       -------       -------
                                                  42,151        37,886        19,297
                                                 -------       -------       -------
OPERATING EXPENSES:
 Depreciation, depletion and amortization..       13,245        12,688         7,451
 Operating costs...........................       10,627         9,639         6,376
 Administrative, selling and other.........        2,045         2,069         1,461
 Financing costs:
   Interest expense........................          699           667           254
   Interest income.........................         (104)          (48)          (16)
                                                 -------       -------       -------
                                                  26,512        25,015        15,526
                                                 -------       -------       -------
 
INCOME BEFORE INCOME TAXES.................       15,639        12,871         3,771
PROVISION FOR INCOME TAXES.................        5,943         4,891           717
                                                 -------       -------       -------
NET INCOME.................................      $ 9,696       $ 7,980       $ 3,054
                                                 =======       =======       =======
 
BASIC EARNINGS PER SHARE (NOTE 10).........         $.84          $.73       $   .34
                                                 =======       =======       =======
 
DILUTED EARNINGS PER SHARE (NOTE 10).......      $   .80          $.69       $   .32
                                                 =======       =======       =======
</TABLE>
The accompanying Summary of Significant Accounting Policies and Notes to 
Consolidated Financial Statements are integral parts of this statement.

                                       16
<PAGE>
 
                          KEY PRODUCTION COMPANY, INC.

                      CONSOLIDATED STATEMENT OF CASH FLOWS
<TABLE>
<CAPTION>
 
                                             For the Year Ended December 31,
                                            ----------------------------------
                                               1997        1996        1995
                                            ----------  ----------  ----------
                                                      (In thousands)
<S>                                         <C>         <C>         <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
 Net income...............................   $  9,696    $  7,980    $  3,054
 Adjustments to reconcile net income to
   net cash provided by operating
   activities:
   Depreciation, depletion and
     amortization.........................     13,245      12,688       7,451
   Deferred income taxes..................      5,943       4,854         543
 Changes in operating assets and
   liabilities, net of the effect of
   businesses acquired:
   (Increase) decrease in receivables.....     (1,631)     (4,173)         30
   (Increase) decrease in prepaid
     expenses and other...................        494        (114)       (321)
   Increase in accounts payable
     and accrued expenses.................      7,023         582         629
   Increase (decrease) in long-term
     property liabilities and other.......       (664)         81         (88)
                                             --------    --------    --------
   Net cash provided by operating
     activities...........................     34,106      21,898      11,298
                                             --------    --------    --------
 
CASH FLOWS FROM INVESTING ACTIVITIES:
 Oil and gas exploration and
   development expenditures...............    (36,286)    (20,021)    (13,478)
 Acquisition of oil and gas properties....     (7,906)     (1,633)       (597)
 Cash received in connection with
   acquisition, net of purchase
   adjustments............................          -       2,098           -
 Proceeds from sale of oil and gas
   properties.............................        726         878         351
 Other capital expenditures...............     (1,027)       (171)       (198)
                                             --------    --------    --------
   Net cash used by investing activities..    (44,493)    (18,849)    (13,922)
                                             --------    --------    --------
 
CASH FLOWS FROM FINANCING ACTIVITIES:
 Long-term borrowings.....................     17,000      14,704       4,900
 Payments on long-term debt...............     (4,500)    (14,754)       (300)
 Payments to acquire treasury stock.......       (414)     (2,246)     (1,666)
 Proceeds from issuance of common stock...         69         237           -
                                             --------    --------    --------
   Net cash provided (used) by
     financing activities.................     12,155      (2,059)      2,934
                                             --------    --------    --------
 
NET INCREASE IN CASH AND CASH
 EQUIVALENTS..............................      1,768         990         310
CASH AND CASH EQUIVALENTS AT BEGINNING
 OF YEAR..................................      1,581         591         281
                                             --------    --------    --------
CASH AND CASH EQUIVALENTS AT END OF YEAR..   $  3,349    $  1,581    $    591
                                             ========    ========    ========
</TABLE>
The accompanying Summary of Significant Accounting Policies and Notes to 
Consolidated Financial Statements are integral parts of this statement.

                                       17
<PAGE>
 
                          KEY PRODUCTION COMPANY, INC.

                           CONSOLIDATED BALANCE SHEET
<TABLE>
<CAPTION>
 
                                                        December 31,
                                                    --------------------
                      ASSETS                          1997       1996
                                                    ---------  ---------
                                               (In thousands, except share data)
<S>                                                 <C>        <C>
CURRENT ASSETS:
 Cash and cash equivalents........................  $  3,349   $  1,581
 Receivables......................................    10,254      8,623
 Prepaid expenses and other.......................       380        874
                                                    --------   --------
                                                      13,983     11,078
                                                    --------   --------
OIL AND GAS PROPERTIES, ON THE BASIS OF
 FULL COST ACCOUNTING:
 Proved properties................................   138,447    102,487
 Unproved properties and properties
  under development, not being amortized..........    18,624     10,685
                                                    --------   --------
                                                     157,071    113,172
 Less - accumulated depreciation, depletion
  and amortization................................   (41,919)   (28,941)
                                                    --------   --------
                                                     115,152     84,231
                                                    --------   --------
 
OTHER ASSETS, NET.................................     1,512        631
                                                    --------   --------
                                                    $130,647   $ 95,940
                                                    ========   ========
 
    LIABILITIES AND STOCKHOLDERS' EQUITY
 
CURRENT LIABILITIES:
 Accounts payable.................................  $ 11,290   $  4,405
 Accrued exploration and development..............     1,285        852
 Accrued lease operating expense and other........       729        761
                                                    --------   --------
                                                      13,304      6,018
                                                    --------   --------
 
LONG-TERM DEBT....................................    35,000     22,500
                                                    --------   --------
 
NON-CURRENT LIABILITIES:
 Deferred income taxes............................    15,703      9,929
 Long-term property liabilities and other.........     1,729      2,224
                                                    --------   --------
                                                      17,432     12,153
                                                    --------   --------
 
COMMITMENTS AND CONTINGENCIES (NOTES 6 AND 7)
 
STOCKHOLDERS' EQUITY:
 Common stock, $.25 par value, 50,000,000 shares
  authorized, 11,776,190 and 11,713,584 shares
  issued, respectively............................     2,944      2,928
 Paid-in capital..................................    37,380     37,245
 Retained earnings................................    27,165     17,469
 Treasury stock at cost, 277,835 and 259,093
  shares, respectively............................    (2,578)    (2,373)
                                                    --------   --------
                                                      64,911     55,269
                                                    --------   --------
                                                    $130,647   $ 95,940
                                                    ========   ========
</TABLE>
The accompanying Summary of Significant Accounting Policies and Notes to 
Consolidated Financial Statements are integral parts of this statement.

                                       18
<PAGE>
 
                          KEY PRODUCTION COMPANY, INC.

                 CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY

<TABLE>
<CAPTION>
                                                                              Total
                                          Paid-In    Retained    Treasury  Stockholders'
                          Common Stock    Capital    Earnings     Stock       Equity
                          ------------    -------    --------    --------  -------------
                                                (In thousands)
BALANCE, DECEMBER 31,
<S>                        <C>            <C>        <C>          <C>          <C>
 1994...................     $2,914       $34,388    $ 6,435      $ (9,480)    $34,257
 Net income.............          -             -      3,054             -       3,054
 Treasury stock issued..          -            13          -            41          54
 Treasury stock
   purchased............          -             -          -        (1,666)     (1,666)
                             ------       -------    -------      --------     -------
BALANCE, DECEMBER 31,
 1995...................      2,914        34,401      9,489        (11,105)   35,699
 Net income.............          -             -      7,980              -     7,980
 Common stock issued....         14          (120)         -              -      (106)
 Treasury stock issued..          -         2,964          -         10,978    13,942
 Treasury stock                                                             
   purchased............          -             -          -         (2,246)   (2,246)
                             ------       -------    -------      ----------  -------
BALANCE, DECEMBER 31,                                                       
 1996...................      2,928        37,245     17,469         (2,373)   55,269
 Net income.............          -             -      9,696              -     9,696
 Common stock issued....         16           111          -              -       127
 Treasury stock issued..          -            24          -            209       233
 Treasury stock                                                             
   purchased............          -             -          -           (414)     (414)
                             ------       -------    -------       --------   -------
                                                                            
BALANCE, DECEMBER 31,                                                       
 1997...................     $2,944       $37,380    $27,165       $ (2,578)  $64,911
                             ======       =======    =======   ============   =======
</TABLE>
The accompanying Summary of Significant Accounting Policies and Notes to 
Consolidated Financial Statements are integral parts of this statement.

                                       19
<PAGE>
 
                         KEY PRODUCTION COMPANY, INC.
         
                  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

BUSINESS

     Key Production Company, Inc. (Key or the Company) was formed in 1988 to
succeed to a portion of the assets and liabilities of Apache Petroleum Company
L.P. (APC).  Key is an independent oil and gas company engaged in oil and gas
exploration, development and production in the continental United States.  The
Company's exploration interests are spread over 14 states with primary focus
areas in the Anadarko Basin of Oklahoma, California, the Rocky Mountain region,
north-central Texas and the Gulf Coast.
         
BASIS OF PRESENTATION

     Key consummated the acquisition of Brock Exploration Corporation (Brock) on
March 28, 1996 in a tax-free reorganization pursuant to which Brock became a
wholly-owned subsidiary of Key.  To effect the transaction, each Brock
shareholder received one share of Key common stock for each 1.45 Brock shares
held.  The accompanying consolidated financial statements include the accounts
of Key for 1997, 1996 and 1995 and the accounts of Brock for the periods
subsequent to the acquisition.

     The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period.  Actual results could differ from those estimates.

OIL AND GAS PROPERTIES

     The Company follows the full cost method of accounting for its investment
in oil and gas properties and, accordingly, capitalizes all exploration and
development costs incurred for the purposes of finding oil and gas reserves,
including dry hole costs, geological and geophysical costs and direct overhead
related to exploration and development activities.  Payroll and other internal
costs capitalized include salaries and related benefits paid to employees
directly engaged in the acquisition, exploration and development of oil and gas
properties, as well as other specifically identifiable internal costs.  Future
development, site restoration, dismantlement and abandonment costs, net of
salvage values, are estimated on a property-by-property basis using prevailing
prices.  No gains or losses are normally recognized on the sale or disposition
of oil and gas properties under full cost accounting.

     Key computes the provision for depreciation, depletion and amortization
(DD&A) of oil and gas properties on a quarterly basis using the future gross
revenue method.  The quarterly provision is calculated by multiplying the
quarter's oil and gas revenues by an overall rate determined by dividing the
total unamortized cost of oil and gas properties including estimated future
development costs (excluding the cost of investments in unproved and unevaluated
properties) by the total estimated future oil and gas revenues.

                                       20
<PAGE>
 
     Key limits the capitalized costs of oil and gas properties, net of
accumulated DD&A, to the estimated future net cash flows from proved oil and gas
reserves discounted at 10 percent, plus the lower of cost or fair market value
of unproved properties as adjusted for related tax effects.  This limit may be
particularly sensitive to changes in the near term in pricing and production
rates.  If capitalized costs exceed this limit, the excess is charged to DD&A
expense.  The Company has not recorded any such write-downs of capitalized
costs.
 
     The costs of certain unevaluated leasehold acreage and wells in the process
of being drilled are not amortized.  Amortization commences when such costs are
evaluated or upon completion of wells in progress.  Costs not being amortized
are periodically assessed for possible impairments or reductions in value.  If a
reduction in value has occurred, the portion of the carrying cost in excess of
the current value is included in the costs subject to amortization.  Interest
costs related to undeveloped properties are also capitalized.  Financing costs
were reduced by capitalized interest totaling $1,019,000, $682,000 and $574,000
in 1997, 1996 and 1995, respectively.

     Office furniture and equipment are recorded at cost and depreciated on a
straight-line basis over the estimated useful lives of the assets which range
from five to 10 years.

REVENUE RECOGNITION

     Key uses the sales method of accounting for natural gas revenues.  Under
this method, revenues are recognized based on actual volumes of gas sold to
purchasers.  The volumes of gas sold may differ from the volumes to which Key is
entitled based on its interests in the properties.  Differences between volumes
sold and volumes based on entitlements create gas imbalances which are reflected
as adjustments to reported gas reserves and future cash flows. Adjustments for
gas imbalances reduced Key's proved gas reserves by approximately 5 percent at
December 31, 1997.

INCOME TAXES
 
     The Company utilizes an asset and liability approach to account for income
taxes.  A deferred tax liability or asset is determined based upon the temporary
differences between the financial reporting basis and tax basis of assets and
liabilities as measured by the enacted tax rates.  A valuation allowance must be
established for any portion of a deferred tax asset for which it is more likely
than not that a tax benefit will not be realized.

STATEMENT OF CASH FLOWS

     The Company considers all highly liquid debt instruments purchased with an
original maturity of three months or less to be cash equivalents.  These
investments earned 5.9 and 5.5 percent rates of interest at December 31, 1997
and 1996, respectively, with cost approximating market.

FAIR VALUE OF FINANCIAL INSTRUMENTS

     The Company's financial investments consist of cash, trade receivables,
trade payables and long-term debt.  The carrying value of cash and cash
equivalents, trade receivables and trade payables are considered to be
representative of their fair market value, due to the short maturity of these
instruments.  The fair value of long-term debt is estimated based on current

                                       21
<PAGE>
 
rates available for similar debt with similar maturities and securities and
approximates its carrying value.

RECLASSIFICATION

     Certain prior year amounts have been reclassified to conform with the 1997
presentation.

TREASURY STOCK

     Treasury shares were acquired in 1997, 1996 and 1995 under the Company's
policy of purchasing shares when market conditions appear favorable.  Treasury
stock is recorded at cost.

                                       22
<PAGE>
 
                         KEY PRODUCTION COMPANY, INC.       
                                                            
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 


1. ACQUISITIONS

     In 1997, Key made various property acquisitions.  In the second quarter,
Key acquired non-producing acreage over 11 salt domes in west-central
Mississippi.  In the third quarter, Key acquired producing properties in the
Hardeman Basin of North Texas.

     Key consummated the acquisition of Brock Exploration Corporation (Brock) on
March 28, 1996 in a tax-free reorganization pursuant to which Brock became a
wholly-owned subsidiary of Key.  To effect the transaction, each Brock
shareholder received one share of Key common stock for each 1.45 Brock shares
held.  The following unaudited pro forma information was prepared as if the
Brock acquisition occurred at the beginning the period presented.  The
pro forma data presented is based on numerous assumptions and is not necessarily
indicative of future results of operations.

                                       For The Year Ended December 31,
                                       -------------------------------
 
                                                    1996  
                                                   -------
                                     (In thousands, except per share data)
Revenues                                           $40,897
Net income                                         $ 8,601
Basic earnings per share                           $   .74
Diluted earnings per share                         $   .71 
 
2. DEBT

     BANK FINANCING--The bank financing is a $50 million revolving credit
facility with NationsBank of Texas, N.A.  The Company entered into the Credit
Agreement (Agreement) on April 25, 1994, to fund acquisitions and drilling
opportunities. In 1997, the Company elected to increase the borrowing base to
$42 million from $36 million in 1996.

     Interest on amounts borrowed is charged at NationsBank's prime rate or at
London Interbank Offered Rates (LIBOR) plus .5 to 1.125 percent, at the
Company's option.  The factor added to LIBOR is determined by the Company's debt
to capitalization ratio at the time of borrowing.  The average interest rate on
the various maturities of debt outstanding at December 31, 1997, was 6.66
percent.  Key pays a .25 percent fee on the unused portion of the borrowing
base, as well as other fees of approximately $10,000 per year in return for the
bank's commitment to maintain the availability of those funds. On April 1, 2000,
the borrowing converts from a revolving loan to a term note. At that point, if
not renegotiated before then, the Company must commence quarterly principal
payments in addition to paying interest.  The entire facility matures on January
1, 2003.  The conversion and maturity dates are based on the First Amendment to
the Credit Agreement made on January 1, 1997.

     The credit facility requires the Company to comply with certain covenants
contained within the Agreement until full and final payment of the obligation
and termination of the Agreement.  The Company has been in compliance with the
covenants since the inception of the Agreement.

                                       23
<PAGE>
 
                         KEY PRODUCTION COMPANY, INC.             
                                                                  
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED) 

     Aggregate maturities of long-term debt outstanding at December 31, 1997,
are as follows:
 
                                          (In thousands)
     1998                                   $     -
     1999                                         -
     2000                                     8,750
     2001                                    11,667
     2002                                    11,667
     Thereafter                               2,916
                                            -------
                                            $35,000
                                            ======= 


3. INCOME TAXES

     Deferred tax assets and liabilities are comprised of the following
components at December 31, 1997 and 1996:
<TABLE>
<CAPTION>
 
                                                1997       1996
                                             ----------  ---------
                                                (In thousands)
<S>                                          <C>         <C>
Long-term deferred tax assets:
 Operating loss carryforwards                 $  4,104   $  5,459
 Percentage depletion carryforward                 826        446
 Other                                              59        135
                                              --------   --------
                                                 4,989      6,040
Valuation allowance........................     (2,233)    (3,490)
                                              --------   --------
                                                 2,756      2,550
Long-term deferred tax liabilities:
 Depreciation, depletion and amortization..    (18,459)   (12,479)
                                              --------   --------
 
 Net deferred income tax liability.........   $(15,703)  $ (9,929)
                                              ========   ========
</TABLE>

     The Company had net tax operating loss carryforwards of approximately $9.7
million at December 31, 1997, which expire in the years 1998 through 2010.  As
of December 31, 1997, a portion of these net operating losses (NOLs) acquired as
part of the Brock acquisition are subject to annual limitations. The Company has
provided a valuation allowance for the portion of these NOLs which it does not
believe will be available for use prior to expiration.

     In 1995, the Company concluded that all of Key's NOLs could be utilized and
therefore reversed the valuation allowance previously established.  At that
time, the Company determined that it was no longer necessary to provide a
valuation allowance.  This adjustment decreased the combined federal and state
effective tax rate from 38 percent to approximately 19 percent for 1995.

                                       24
<PAGE>
 
                         KEY PRODUCTION COMPANY, INC.             
                                                                  
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)      

     Income tax expense consisted of the following:
<TABLE>
<CAPTION>
 
                                                                                          For the Year Ended December 31,
                                                                                          --------------------------------
                                                                                  1997                  1996              1995
                                                                                  ----                  ----              ----
                                                                                                  (In thousands)
<S>                                                                             <C>              <C>                    <C>
Current Taxes:
 Federal......................................................................   $    -                $   37           $   23
 State........................................................................        -                     -              151
Deferred Taxes................................................................    5,943                 4,854              543
                                                                                 ------                ------           ------
 Total tax provision on income                                                   $5,943                $4,891           $  717
                                                                                 ======                ======           ======
 
     A reconciliation of the statutory income tax rate to the effective rate
     is as follows:
                                                                                   1997                 1996              1995
                                                                                 ------                 ----              ----
Statutory income tax rate.....................................................     34.0%                 34.0%            34.0%
State income tax..............................................................      4.0                   4.0              4.0
Reversal of valuation allowance
 and other....................................................................        -                     -            (19.0)
                                                                                 ------                 ------          ------
                                                                                   38.0%                 38.0%            19.0%
                                                                                 ======                 ======          ======
 
</TABLE>
4. NON-CASH INVESTING AND FINANCING ACTIVITIES

     Supplemental Disclosure of Cash Flow Information
<TABLE>
<CAPTION>
 
                                        For the Year Ended December 31,
                                        -------------------------------
                                          1997       1996       1995
                                        ---------  ---------  ---------
                                                (In thousands)
<S>                                     <C>        <C>        <C>
      Cash paid during the year for:
        Interest (net of amounts
          capitalized)................      $ 987      $ 537      $ 171
        Income taxes (net of
          refunds received)...........      $ 145      $ 245      $ 361
 
</TABLE>
     Supplemental Schedule of Non-Cash-Investing and Financing Activities

     In connection with the Brock acquisition, the Company received cash and
cash equivalents totaling $2,098,000.  In addition to the cash impact, the
acquisition had the following non-cash impact on the Company's December 31, 1996
balance sheet:
<TABLE>
<CAPTION>
 
                                    Amount
                                --------------
                                (In thousands)
<S>                             <C>
 
     Current assets                   $ 1,383
     Oil and gas properties            21,346
                                      -------
                                      $22,729
                                      =======
 
 
     Current liabilities              $ 1,099
     Long-term debt                     7,950
     Non-current liabilities            1,909
     Stockholders' equity              13,869
                                      -------
                                      $24,827
                                      =======
 
</TABLE>

                                       25
<PAGE>
 
                         KEY PRODUCTION COMPANY, INC.             
                                                                  
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED) 

5. STOCK OPTIONS

     The Key Production Company, Inc. 1992 Stock Option Plan reserves 2,000,000
shares of common stock for issuance to the Company's officers and employees.  A
total of 889,500 options were outstanding at year-end.  The options expire at
various dates through 2007 and are at prices ranging from $2.50 to $11.38 per
share with an aggregate exercise price of $6,980,781.

     The Key Production Company, Inc. Stock Option Plan for Non-Employee
Directors reserves 360,000 shares of common stock for issuance to the Company's
non-employee directors.  There were 90,000 options outstanding at year-end at an
aggregate exercise price of $495,000.  These outstanding options were granted at
exercise prices from $2.88 to $8.13 and expire at various dates through 2006.

     The Company's president was granted options for 500,000 shares of the
Company's common stock in 1992 in accordance with the terms of his employment
agreement.  These outstanding options were granted at an exercise price of $3.00
and expire in 2002.

     All options granted had an exercise price equal to or above market price on
the date of grant.  Subject to accelerated vesting under certain circumstances
such as death of the employee or change in control of the Company, one-third of
the options vest in each of the three years following the date of grant.

     The following table summarizes the changes in stock options for the year,
the number of common shares available for grant and the number of outstanding
options vested at year-end.
<TABLE>
<CAPTION>
 
 
                                              1997
                                      --------------------
                                                  Weighted
                                                  Average
                                      Number of   Exercise
                                       Options     Price
                                      ----------  --------
<S>                                   <C>         <C>
 
  Outstanding, Beginning of Year....  1,049,000     $ 3.32
  Granted...........................    500,000     $11.38
  Exercised.........................    (69,500)    $ 2.85
                                      ---------
  Outstanding, End of Year..........  1,479,500     $ 6.07
                                      =========
  Exercisable, End of Year..........    942,833     $ 3.19
                                      =========
  Available for Grant, End of Year..  1,225,000
                                      =========
</TABLE>

                                       26
<PAGE>
 
                         KEY PRODUCTION COMPANY, INC.             
                                                                  
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED) 

<TABLE>
<CAPTION>
 
                                              1996
                                      --------------------
                                                  Weighted
                                                  Average
                                      Number of   Exercise
                                       Options     Price
                                      ----------  --------
<S>                                   <C>         <C>
 
  Outstanding, Beginning of Year....  1,090,000      $3.08
  Granted...........................     45,000      $8.13
  Exercised.........................    (86,000)     $2.75
                                      ---------
  Outstanding, End of Year..........  1,049,000      $3.32
                                      =========
  Exercisable, End of Year..........    925,667      $3.06
                                      =========
  Available for Grant, End of Year..    545,000
                                      =========
 
 
                                              1995
                                      --------------------
                                                  Weighted
                                                  Average
                                      Number of   Exercise
                                       Options     Price
                                      ---------   --------
 
  Outstanding, Beginning of Year....  1,070,000      $3.05
  Granted...........................     20,000      $4.88
                                      ---------
  Outstanding, End of Year..........  1,090,000      $3.08
                                      =========
  Exercisable, End of Year..........    840,000      $3.00
                                      =========
  Available for Grant, End of Year..    590,000
                                      =========
 
</TABLE>

      Statement of Financial Accounting Standards No. 123, "Accounting for
Stock-Based Compensation" (SFAS No. 123) was adopted by the Company as of
December 31, 1996.  This Statement defines a fair value based method of
accounting for employee stock options or similar equity instruments.  However,
SFAS No. 123 allows the continued measurement of compensation cost for such
plans using the intrinsic value based method prescribed by APB Opinion No. 25,
"Accounting for Stock Issued to Employees" (APB No. 25), provided that pro forma
results of operations are disclosed for those options granted beginning January
1, 1995.  The Company has elected to account for stock-based compensation plans
under APB No. 25, under which no compensation expense has been recognized for
stock option grants in 1997, 1996 and 1995.  If the accounting provisions of
SFAS No. 123 had been adopted as of the beginning of 1995, the Company would
report 1997 pro forma net income of $9.1 million, basic earnings of $.80 per
share and diluted earnings of $.75 per share. The effect on 1996 and 1995 net
earnings would have been immaterial.  Thus, no pro forma fair value disclosures
are presented for those years.

     The weighted-average fair value of each option granted is estimated on the
date of grant using the Black Scholes option pricing model with the following
assumptions for 1997: risk-free interest rate of 6.8 percent, expected weighted-
average lives of five years, expected volatility of 38 percent and expected
dividends of zero percent.

                                       27
<PAGE>
 
                         KEY PRODUCTION COMPANY, INC.             
                                                                  
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED) 

The following table summarizes information about the stock options outstanding
at December 31, 1997:
<TABLE>
<CAPTION>
 
                                               Options Outstanding         Options Exercisable
                                               -------------------         -------------------
                                            Weighted
                                            Average         Weighted                     Weighted
                 Range of                  Remaining        Average                      Average
     Year        Exercise      Number     Contractual       Exercise          Number     Exercise
   Granted        Prices     Outstanding     Life             Price         Exercisable   Price
--------------  -----------  -----------  -----------  -------------------  -----------  --------
<S>             <C>          <C>          <C>          <C>                  <C>          <C>
 
  1992-1993     $2.50-$3.75      724,000   4.87 years      $   3.01           724,000       $3.01
  1994-1995     $3.00-$4.88      210,500   6.30 years      $   3.54           203,833       $3.50
  1996-1997    $8.13-$11.38      545,000   9.04 years      $  11.11            15,000       $8.13
                               ---------  -----------      --------          --------    --------
                               1,479,500   6.61 years      $   6.07           942,833       $3.19
                               =========  ===========      ========          ========     ========
</TABLE>
6. EMPLOYEE BENEFIT PLANS

     RETIREMENT PLAN--The Company provides a 401(k) retirement/savings plan for
all employees.  This plan allows participants to contribute up to 10 percent of
their compensation, with Key matching contributions up to a maximum of 4 percent
of their compensation.  The Company's contribution is made in the form of Key
common stock. Employees vest in the Company's contribution at the rate of 25
percent per year. Total expenses for the Company's matching contribution were
$114,109, $78,877 and $55,362 in 1997, 1996 and 1995, respectively.  In
connection with the annual testing required on all 401(k) plans, Key made a
qualified non-elective contribution in 1995 totaling $23,056 for the benefit of
all non-highly compensated employees.   This contribution was required to keep
the plan qualified due to the top heavy status of the plan.  No such
contribution was required for 1996 or 1997.

     DEFERRED COMPENSATION PLAN--Effective December 1, 1993, the Company
established the Key Production Company, Inc. Deferred Compensation Plan.  This
plan is intended to provide a mechanism whereby certain management employees of
the Company may defer compensation.  The Company intends for this plan to
provide the eligible employees with the opportunity to defer compensation in
cases where deferrals under the 401(k) plan may be limited by applicable
provisions of the Internal Revenue Code of 1986.

     INCOME CONTINUANCE PLAN--Effective June 1, 1994, the Company established
the Key Production Company, Inc. Income Continuance Plan.  This plan provides
for the continuation of salary and benefits for certain employees in the event
of a change in control of the Company.

     The administrative, compliance and legal costs associated with
administering these plans are paid by Key.  Such expenses were not significant
in 1997, 1996 or 1995.

                                       28
<PAGE>
 
                         KEY PRODUCTION COMPANY, INC.             
                                                                  
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED) 

7. COMMITMENTS AND CONTINGENCIES

     LEASE COMMITMENTS-The Company has leases for office space with varying
expiration dates through 2002.  Rental expense was $262,648, $138,858 and
$96,997 for 1997, 1996 and 1995, respectively.

     As of December 31, 1997, minimum rental commitments under these leases are
payable in the following years:


          1998     $  340,154
          1999        335,935
          2000        286,250
          2001        277,211
          2002         39,674
                   ----------
                   $1,279,224
                   ==========

     LITIGATION--The Company is involved in litigation claims and is subject to
governmental and regulatory controls arising in the ordinary course of business.
It is the opinion of the Company's management that all claims and litigation
involving the Company are not likely to have a material adverse effect on its
financial position, results of operations or cash flows.

     ENVIRONMENTAL--The Company is not aware of any environmental claims
existing as of December 31, 1997, which would have a material impact upon the
Company's financial condition, results of operations or cash flows.  Key does
not believe that compliance with federal, state or local provisions regulating
the discharge of materials into the environment, or otherwise relating to the
protection of the environment, will have such an impact in the future.

8. TRANSACTIONS WITH RELATED PARTIES

     In October 1995, Key purchased 331,000 shares of its own stock from Apache
at the market price of $5.00 per share.

     In October 1996, the Company purchased 224,022 shares of Key common stock
from Lawrence Brock for $10.00 per share, the then current market price.  Mr.
Brock was the chairman and chief executive officer of Brock at the time Brock
was acquired by the Company.  The purchase was funded using the Company's
existing credit facility. Prospectively, the resulting reduction in the number
of shares outstanding will proportionately increase the per share amounts Key
reports.

     In May of 1997, the Company purchased 40,000 shares of Key common stock
from Janet Moylan, widow of Tim Moylan.  Mr. Moylan was a director of Key from
1993 to 1996.  The shares were purchased at $10.00 per share, which was the
market price at that time.

                                       29
<PAGE>
 
                         KEY PRODUCTION COMPANY, INC.             
                                                                  
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED) 

9. CONCENTRATION OF CREDIT RISK

     Substantially all of the Company's accounts receivable at December 31, 1997
and 1996, result from oil and gas sales to other companies in the oil and gas
industry.  This concentration of customers may impact the Company's overall
credit risk, either positively or negatively, in that these entities may be
similarly affected by industry-wide changes in economic or other conditions.
Such receivables are generally not collateralized.

     The following parties purchased 10 percent or more of Key's oil and gas
production:
<TABLE>
<CAPTION>
 
                                       For the Year Ended December 31,
                                       ---------------------------------
          Purchaser                     1997          1996         1995
          ---------                     ----          ----         ----
<S>                                     <C>           <C>          <C>
     Natural Gas Clearinghouse........     -           4%           37%
     Eighty-Eight Oil Company.........    12%         16%           29%
     ProEnergy........................    14%         16%            -
     Transok, Inc. ...................    14%          -             -
</TABLE>

     Effective January 1, 1993, Key entered into an agreement with Apache
Corporation (Apache) under which Key paid Apache a fee to market the majority of
its gas production that was not subject to traditional gas contract
arrangements.  From 1993 to March 1996, the majority of Key's gas production
marketed by Apache was sold to Natural Gas Clearinghouse.  Effective April 1996,
a portion of Key's gas production previously marketed by Apache was sold to
ProEnergy.  Beginning January 1997, Key signed a five-year agreement with
Transok, Inc.  Under this arrangement, Transok will gather and purchase the
majority of Key's Mid-Continent gas production.

10. EARNINGS PER SHARE

     In February 1997, the Financial Accounting Standards Board issued SFAS No.
128, "Earnings Per Share."  This new statement became effective December 15,
1997, and provides computation, presentation and disclosure requirements for
earnings per share.  Basic earnings per share is computed based on the monthly
weighted-average number of shares outstanding during the periods.  The weighted-
average number of common shares used in computing basic earnings per share was
11,480,071, 10,924,845 and 9,112,489 for 1997, 1996 and 1995, respectively.
Diluted earnings per share is computed based on the monthly weighted-average
number of common shares outstanding during the periods and the assumed exercise
of dilutive common stock equivalents (stock options) using the treasury stock
method.  Dilutive common stock equivalents assumed to have been exercised
totaled 688,818, 621,355 and 434,949 for 1997, 1996 and 1995, respectively.

     The Company's reported earnings per share for 1996 and 1995 have been
restated.  In 1996 and 1995, only one per share figure was presented because the
fully diluted and primary earnings per share were the same.  The effect of this
accounting change on previously reported earnings per share (EPS) data was as
follows:
<TABLE>
<CAPTION>
 
     Per Share Amounts                1996             1995 
                                      -----            -----
<S>                                   <C>              <C>  
     Primary EPS as reported          $ .69            $ .32
     Effect of SFAS No. 128             .04              .02
                                      -----            -----
     Basic EPS as restated            $ .73            $ .34
                                      =====            =====
                                                            
     Fully diluted EPS as reported    $ .69            $ .32
     Effect of SFAS No. 128               -                -
                                      -----            -----
     Diluted EPS as restated          $ .69            $ .32
                                      =====            ===== 
</TABLE>

                                       30
<PAGE>
 
                          KEY PRODUCTION COMPANY, INC.

                      SUPPLEMENTAL OIL AND GAS DISCLOSURES

     OIL AND GAS OPERATIONS--The following tables contain revenues and direct
cost information relating to the Company's oil and gas exploration and
production activities for the periods indicated.  Key has no long-term supply or
purchase agreements with governments or authorities in which it acts as
producer.
<TABLE>
<CAPTION>
 
                                                For the Year Ended December 31,
                                             -------------------------------------
                                                1997         1996         1995
                                             -----------  -----------  -----------
                                              (In thousands, except percentages)
<S>                                          <C>          <C>          <C>
Oil and gas revenues from production.......     $41,965      $37,553      $19,255
                                                -------      -------      -------
Operating costs:
 Depreciation, depletion and amortization..      12,978       12,521        7,315
 Lease operating...........................       7,913        7,325        4,916
 Production taxes..........................       2,714        2,314        1,460
 Income tax................................       6,977        5,849        1,057
                                                -------      -------      -------
                                                 30,582       28,009       14,748
                                                -------      -------      -------
Results of operations from oil and gas
 producing activities......................     $11,383      $ 9,544      $ 4,507
                                                =======      =======      =======
 
Amortization rate as a percentage
 of revenues...............................        30.9%        33.3%        38.0%
                                                =======      =======      =======
</TABLE>

     CAPITALIZED COSTS--The following table sets forth the capitalized costs and
related accumulated depreciation, depletion and amortization relating to the
Company's oil and gas production, exploration and development activities.
<TABLE>
<CAPTION>
 
                                           For the Year Ended December 31,
                                          ----------------------------------
                                             1997        1996        1995
                                          ----------  ----------  ----------
                                                    (In thousands)
<S>                                       <C>         <C>         <C>
Balance, beginning of year..............   $113,172    $ 70,574    $ 57,334
Costs incurred during the year:
 Exploration
   Evaluated............................      6,444       6,613       3,534
   Unevaluated..........................      4,160       1,056       1,502
 Development............................     26,115      12,834       7,958
 Acquisition of properties
   Proved...............................      3,763      22,283         597
   Unproved.............................      4,143         690           -
 Property sales
   Proved...............................       (361)       (713)          -
   Unproved.............................       (365)       (165)       (351)
                                           --------    --------    --------
Balance, end of year....................    157,071     113,172      70,574
Less - costs not being amortized........    (18,624)    (10,685)     (9,104)
                                           --------    --------    --------
Costs being amortized...................    138,447     102,487      61,470
Less - accumulated depreciation,
 depletion and amortization.............    (41,919)    (28,941)    (16,420)
                                           --------    --------    --------
Capitalized costs being amortized, net..   $ 96,528    $ 73,546    $ 45,050
                                           ========    ========    ========
</TABLE>

     COSTS NOT BEING AMORTIZED--Oil and gas property costs not being amortized
at December 31, 1997, totaled $18,624,000.  Of the total, $12,216,000,
$1,442,000, $901,000 and $4,065,000 was incurred in 1997, 1996, 1995 and 1994,
respectively. The Company expects a majority of these costs to be evaluated and
to become subject to amortization within the next three years.

                                       31
<PAGE>
 
     OIL AND GAS RESERVE INFORMATION (UNAUDITED)--Proved oil and gas reserve
quantities are based on estimates prepared by the Company's engineers, and were
audited by Ryder Scott Company Petroleum Engineers, independent petroleum
engineers, in accordance with guidelines established by the Securities and
Exchange Commission (SEC).  Reserve estimates are based on economic and
operating conditions existing at December 31 of each year presented.

     There are numerous uncertainties inherent in estimating quantities of
proved reserves and projecting future rates of production and timing of
development expenditures.  The following reserve data represents estimates only
and should not be construed as being exact.  All of the Company's reserves are
located in the continental or offshore United States.
<TABLE>
<CAPTION>
 
                             Gas in Million Cubic Feet     Oil in Thousands of Barrels
                            ----------------------------  ------------------------------
                              1997       1996     1995      1997       1996       1995
                            ---------  --------  -------  ---------  ---------  --------
<S>                         <C>        <C>       <C>      <C>        <C>        <C>
 
Total proved reserves-
 Developed and
   undeveloped
   Beginning of year......    64,094    37,478   33,597      6,207      3,792     3,623
   Revisions of previous
     estimates............    (1,206)    1,289    1,083       (306)       410       241
   Improved recovery......         -        27      205          5        165       255
   Extensions and
     discoveries..........    17,401    13,675    7,459        845        242       301
   Purchases of
     reserves.............       374    21,107      396        301      2,457         5
   Production.............   (10,958)   (9,198)  (5,262)      (839)      (853)     (633)
   Sales of
     properties...........      (162)     (284)       -          -         (6)        -
                             -------    ------   ------      -----      -----     -----
   End of year............    69,543    64,094   37,478      6,213      6,207     3,792
                             =======    ======   ======      =====      =====     =====
Proved developed
 reserves-
   Beginning of year......    62,806    36,986   31,967      6,006      3,685     3,099
   End of year............    67,771    62,806   36,986      6,197      6,006     3,685
</TABLE>

     FUTURE NET CASH FLOWS (UNAUDITED)--Future revenues are based on year-end
prices except in those instances where the sale of gas is covered by contract
terms providing for determinable escalations.  Operating costs, production and
ad valorem taxes and future development costs are based on current costs with no
escalation.

     The following table presents information concerning future net cash flows
from the production of oil and gas reserves, net of income tax expense. Income
tax expense has been computed using expected future tax rates and giving effect
to permanent differences and credits which, under current laws, relate to oil
and gas producing activities.  This information does not purport to present the
fair market value of Key's oil and gas assets, but does present a standardized
disclosure concerning possible future net cash flows that will result under the
assumptions used.

                  DISCOUNTED FUTURE NET CASH FLOWS AND CHANGES
                  RELATING TO PROVED RESERVES AT DECEMBER 31,
<TABLE>
<CAPTION>
 
                                                                                          1997        1996       1995
                                                                                       ----------  ----------  ---------
                                                                                                (In thousands)
<S>                                                                                    <C>         <C>         <C>
   Cash inflows......................................................................   $266,095   $ 380,765   $141,429
   Production and development costs..................................................    (91,094)   (115,224)   (53,413)
   Income tax expense................................................................    (34,171)    (70,692)   (15,822)
                                                                                        --------   ---------   --------
   Net cash flows....................................................................    140,830     194,849     72,194
   10% annual discount rate..........................................................    (41,577)    (65,629)   (21,436)
                                                                                        --------   ---------   --------
   Discounted future net cash flows..................................................   $ 99,253   $ 129,220   $ 50,758
                                                                                        ========   =========   ========
</TABLE> 
 

                                       32
<PAGE>
 
The following are the principal sources of change in the discounted future net
 cash flows:
<TABLE> 
<CAPTION> 
 
                                                                                         For the Year Ended December 31,
                                                                                         -------------------------------
                                                                                          1997        1996        1995
                                                                                          ----        ----        ----
                                                                                                 (In thousands)
<S>                                                                                     <C>        <C>         <C> 
Sales, net of production costs.......................................................   $(31,338)  $ (27,915)  $(12,879)
Net change in prices and production costs............................................    (69,612)     42,155      1,512
Extensions, discoveries and improved
  recovery, net of related costs.....................................................     36,531      33,267     10,544
Change in future development costs...................................................        660       1,112      1,026
Revision of quantities...............................................................     (2,432)      6,205      2,969
Accretion of discount................................................................     17,259       6,120      5,133
Change in income taxes...............................................................     20,902     (32,920)    (1,837)
Purchases of reserves in place.......................................................      4,592      57,672        409
Sales of properties..................................................................       (254)       (238)         -
Change in production rates and other.................................................     (6,275)     (6,996)     1,159
                                                                                        --------   ---------   --------
                                                                                        $(29,967)  $  78,462   $  8,036
                                                                                        ========   =========   ========
</TABLE>

     IMPACT OF PRICING (UNAUDITED)--The estimates of cash flows and reserve
quantities shown above are based on year-end oil and gas prices, except in those
cases where future gas sales are covered by contracts at specified prices.
Fluctuations are largely due to the seasonal pricing nature of natural gas,
supply perceptions for natural gas and significant worldwide volatility in oil
prices.

     Under SEC rules, companies that follow full cost accounting methods are
required to make quarterly "ceiling test" calculations.  Under this test,
capitalized costs of oil and gas properties may not exceed the present value of
estimated future net revenues from proved reserves, discounted at 10 percent,
plus the lower of cost or fair market value of unproved properties, as adjusted
for related tax effects and deferred tax reserves.  Application of these rules
during periods of relatively low oil and gas prices, even if of short-term
duration, may result in write-downs.

                                       33
<PAGE>
 
                          KEY PRODUCTION COMPANY, INC.

                UNAUDITED SUPPLEMENTAL QUARTERLY FINANCIAL DATA
<TABLE>
<CAPTION>
 
                         First   Second    Third   Fourth    Total
                        -------  -------  -------  -------  -------
                           (In thousands, except per share data)
<S>                     <C>      <C>      <C>      <C>      <C>
1997
----
Revenues..............  $11,110  $ 9,516   $9,613  $11,912  $42,151
Expenses, net.........    8,240    7,473    7,613    9,129   32,455
                        -------  -------   ------  -------  -------
Net income............  $ 2,870  $ 2,043   $2,000  $ 2,783  $ 9,696
                        =======  =======   ======  =======  =======
Basic earnings per
 common share.........  $   .25  $   .18   $  .17  $   .24  $   .84
                        =======  =======   ======  =======  =======
Diluted earnings per
 common share.........  $   .24  $   .17   $  .16  $   .23  $   .80
                        =======  =======   ======  =======  =======
 
 
1996
----
Revenues..............  $ 5,881  $10,209   $9,788  $12,008  $37,886
Expenses, net.........    4,967    8,303    7,617    9,019   29,906
                        -------  -------   ------  -------  -------
Net income............  $   914  $ 1,906   $2,171  $ 2,989  $ 7,980
                        =======  =======   ======  =======  =======
Basic earnings per
 common share *.......  $   .10  $   .16   $  .19  $   .26  $   .73
                        =======  =======   ======  =======  =======
Diluted earnings per
 common share *.......  $   .10  $   .16   $  .18  $   .24  $   .69
                        =======  =======   ======  =======  =======
</TABLE>

* The sum of the individual quarters' net income per share may not agree with
year-to-date net income as each period's computation is based on the weighted
average number of shares outstanding during that period.

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

          None.

                                   PART III

ITEM  10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

     The information set forth under the caption "Information About Nominees for
Election as Directors" in the Company's proxy statement relating to the
Company's 1998 annual meeting of stockholders (Proxy Statement) is incorporated
herein by reference.  Certain information with regard to the executive officers
of the Company is set forth under the caption "Executive Officers of the
Registrant" in Part I of this report.

ITEM  11. EXECUTIVE COMPENSATION

     The information set forth under the captions "Summary Compensation Table,"
"Aggregated Option Exercises In The Last Fiscal Year and Fiscal Year-End Option
Values," "Director Compensation," and "Employment Agreements" in the Proxy
Statement is incorporated herein by reference.


ITEM  12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

     The information set forth under the captions "Security Ownership of Certain
Beneficial Owners" and "Security Ownership of Management" in the Proxy Statement
is incorporated herein by reference.

                                       34
<PAGE>
 
ITEM  13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

     None.

                                    PART IV

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

(a)  1.  The following financial statements are included in Item 8 to this
         10-K.

          Statement of income for each of the three years in the period ended
          December 31, 1997.

          Statement of cash flows for each of the three years in the period
          ended December 31, 1997.

          Balance sheet as of December 31, 1997 and 1996.

          Statement of changes in stockholders' equity for each of the three
          years in the period ended December 31, 1997.

          Summary of significant accounting policies.

          Notes to financial statements.

          Report of independent public accountants.

          Supplemental oil and gas disclosures.

          Supplemental quarterly financial data.

     2.  Schedules: None.

     3.  Exhibits:

          Exhibits not incorporated by reference to a prior filing are
          designated by an asterisk (*) and are filed herewith; all exhibits not
          so designated are incorporated by reference to a prior SEC filing as
          indicated.

          Exhibits designated by a plus sign (+) are management contracts or
          compensatory plans or arrangements required to be filed herewith
          pursuant to Item 14.


       Exhibit No.             Description
       -----------             -----------

           2.1 --   Dissolution Agreement and Quitclaim Assignment between APC
                    Operating Partnership L.P., Apache Corporation and the
                    Registrant, dated as of January 1, 1993 (incorporated by
                    reference to Exhibit 2.1 to the Registrant's Form 10-Q for
                    the period ended March 31, 1993, file no. 0-17162).

           2.2 --   Agreement and Plan of Merger dated as of December 21, 1995
                    among Key Production Company, Inc., Key Acquisition One,
                    Inc. and Brock Exploration Corporation (incorporated by
                    reference to Exhibit 2.2 to the Registrant's Statement on

                                       35
<PAGE>
 
                    Form S-4, registration no. 333-00889 filed with the SEC on
                    February 15, 1996).

           3.1  --  Certificate of Incorporation of the Registrant (incorporated
                    by reference to Exhibit 3.1 to the Registrant's Registration
                    Statement on Form S-4, registration no. 33-23533 filed with
                    the SEC on August 5, 1988).

           3.2  --  Amendment to Certificate of Incorporation of the Registrant
                    (incorporated by reference to Exhibit 3.2 to the
                    Registrant's Registration Statement on Form S-4,
                    registration no. 33-23533 filed with the SEC on August 5,
                    1988).

           3.3  --  Bylaws of the Registrant, as amended and restated on June 8,
                    1995 (incorporated by reference to Exhibit 3.3 to the
                    Registrant's Form 10Q for the quarter ended June 30, 1995,
                    file no. 0-17162).

           4.1  --  Form of Common Stock Certificate (incorporated by reference
                    to Exhibit 4.12 to the Registrant's Amendment No. 1 to
                    Registration Statement on Form S-4, registration no. 33-
                    23533 filed with the SEC on August 15, 1988).

         +10.7  --  Key Production Company, Inc. 1992 Stock Option Plan
                    (incorporated by reference to Exhibit 10.7 to the
                    Registrant's Form 10-K for the fiscal year ended December
                    31, 1992, file no. 0-17162).
  
         +10.8  --  Key Production Company, Inc. Stock Option Plan for Non-
                    Employee Directors, (incorporated by reference to Exhibit to
                    the Registrant's Form 10-K for the fiscal year ended
                    December 31, 1992, file no. 0-17162). 
 
 
         +10.9  --  Stock Option Agreement between the Registrant and Francis H.
                    Merelli, dated September 1, 1992 (incorporated by reference
                    to Exhibit 10.9 to the Registrant's Form 10-K for the fiscal
                    year ended December 31, 1992, file no. 0-17162). 
 
 
 
         +10.10 --  Key Production Company, Inc. 401(k) Plan (incorporated by
                    reference to Exhibit 10.10 to the Registrant's Form 10-K for
                    the fiscal year ended December 31, 1992, file no. 0-17162).
                     
 
         +10.11 --  Employment Agreement between the Registrant and Francis H.
                    Merelli, dated as of September 1, 1992 (incorporated by
                    reference to Exhibit 10.11 to the Registrant's Form 10-K for
                    the fiscal year ended December 31, 1992, file no. 0-17162).
                     
 
 
         +10.12 --  Employment Agreement between the Registrant and Monroe W.
                    Robertson, dated as of September 1, 1992 (incorporated by
                    reference to Exhibit 10.12 to the Registrant's Form 10-K for
                    the fiscal year ended December 31, 1992, file no. 0-17162).
                     
 
          10.16 --  Credit Agreement between Key Production Company, Inc. and
                    NationsBank of Texas, N.A., dated April 25, 1994
                    (incorporated by reference to Exhibit 10.16 to the
                    Registrant's Form 8-K dated April 29, 1994, file no. 0-
                    17162).

                                       36
<PAGE>
 
       +  10.18  -- Key Production Company, Inc. Income Continuance Plan, dated
                    effective June 1, 1994 (incorporated by reference to Exhibit
                    10.18 to the Registrant's Form 10-K for the fiscal year
                    ended December 31, 1994, file no. 0-17162).
          10.19  -- First Amendment to Credit Agreement between Key Production
                    Company, Inc. and NationsBank of Texas, N.A., dated January
                    1, 1997 (incorporated by reference to Exhibit 10.19 to the
                    Registrant's Form 10-K for the fiscal year ended December
                    31, 1996, file no. 0-17162).
 
         * 23.1  -- Consent of Arthur Andersen LLP dated March 23, 1998.

         * 27.1  -- Financial Data Schedule for Commercial and Industrial
                    Companies per Article 5 of Regulation S-X for the year ended
                    December 31, 1997.

(b)  Reports on Form 8-K:

     No reports on Form 8-K were filed during the quarter ended December 31,
     1997.

                                       37
<PAGE>
 
                                  SIGNATURES



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

                              KEY PRODUCTION COMPANY, INC.

                              By: /s/ F. H. Merelli
                                 _______________________________________
                                 F. H. Merelli
Date: 3/23/98                    Chairman, President and Chief
                                 Executive Officer


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

            Signature             Title                Date
            ---------             -----                ----


/s/ F. H. Merelli
________________________      Director, Chairman,
   F. H. Merelli              President and Chief
                              Executive Officer
                              (Principal Executive
                              Officer)                 3/23/98

/s/ Monroe W. Robertson
________________________      Senior Vice President
   Monroe W. Robertson        and Secretary
                              (Principal Financial
                              Officer)                 3/23/98

/s/ Cathy L. Anderson
________________________      Controller
   Cathy L. Anderson          (Principal Accounting
                              Officer)                 3/23/98

/s/ Cortlandt S. Dietler
________________________      Director                 3/23/98
   Cortlandt S. Dietler                                


/s/ L. Paul Teague
________________________      Director                 3/23/98
   L. Paul Teague

                                       38