<PAGE>
 
                                 UNITED STATES
                      SECURITIES AND EXCHANGE COMMISSION
                            WASHINGTON, D.C.  20549

                                   FORM 10-K
(Mark One)
(X)              ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
                    OF THE SECURITIES EXCHANGE ACT OF 1934
                  For the fiscal year ended December 31, 1998

                                      OR

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


                         Commission File Number 0-9498

                        BELLWETHER EXPLORATION COMPANY
            (Exact name of registrant as specified in its charter)

               Delaware                                76-0437769
   (State or other jurisdiction of          (I.R.S. Employer Identification No.)
   incorporation or organization)

1331 Lamar, Suite 1455, Houston, Texas                      77010
(Address of principal executive offices)                 (Zip Code)

      Registrant's telephone number, including area code: (713) 650-1025

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


          SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:
                                        
     Common Stock, $0.01 par value                            NASDAQ/NMS
     Preferred Stock purchase rights

     Indicate by check mark whether the registrant (1) has filed all reports
required 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
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 10-K or any amendment
to this Form 10-K. [X]

     The aggregate market value of the voting stock held by non-affiliates of
the registrant at March 8, 1999 was approximately $42,494,406.

     As of March 8, 1999, the number of outstanding shares of the registrant's
common stock was 14,164,802.

     Documents Incorporated by Reference:  Portions of the registrant's annual
proxy statement, to be filed within 120 days after December 31, 1998, are
incorporated by reference into Part III.
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------


                          ANNUAL REPORT ON FORM 10-K
                  For the Fiscal Year Ended December 31, 1998

                               TABLE OF CONTENTS
<TABLE>
<CAPTION>
 
                                                                        Page
                                                                       Number
                                                                     ----------
PART I
<S>            <C>                                                      <C> 
 Item 1.       Business..............................................    3
 Item 2.       Properties............................................   11
 Item 3.       Legal Proceedings.....................................   22
 Item 4.       Submission of Matters to a Vote of Security Holders...   23
 
PART II
 
 Item 5.       Market for the Registrant's Common Equity and
               Related Stockholder Matters...........................   23
 Item 6.       Selected Financial Data...............................   24
 Item 7.       Management's Discussion and Analysis of Financial
               Condition and Results of Operations...................   25
 Item 7a.      Quantitative and Qualitative Disclosures
               About Market Risk.....................................   41
 Item 8.       Financial Statements and Supplementary Data...........   42
 Item 9.       Changes in and Disagreements with Accountants on
               Accounting and Financial Disclosure...................   72
 
PART III
 
 Item 10.      Directors and Executive Officers of the Registrant....   72
 Item 11.      Executive Compensation................................   72
 Item 12.      Security Ownership of Certain Beneficial Owners and
               Management............................................   72
 Item 13.      Certain Relationships and Related Transactions........   72
 
PART IV
 
 Item 14.      Exhibits, Financial Statement Schedules and Reports
               on Form 8-K...........................................   73
</TABLE>
  --   Signatures
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------

                                    PART I
                                    ------
Item 1.  Business
-----------------

     This annual report on Form 10-K includes "forward-looking statements"
within the meaning of Section 27A of the Securities Act of 1933, as amended (the
"Securities Act"), and Section 21E of the Securities Exchange Act of 1934
("Exchange Act"). All statements other than statements of historical fact
included herein regarding the Company's financial position, estimated quantities
and net present values of reserves, business strategy, plans and objectives for
future operations and covenant compliance, are forward-looking statements. The
Company can give no assurances that the assumptions upon which these statements
are based will prove to have been correct. Important factors that could cause
actual results to differ materially from the Company's expectations ("cautionary
statements") are disclosed under Risk Factors and elsewhere herein. All
subsequent written and oral forward-looking statements attributable to the
Company or persons acting on its behalf are expressly qualified by the
cautionary statements.

General
-------

     Bellwether Exploration Company ("Bellwether" or the "Company") is an
independent energy company engaged in the acquisition, exploitation,
development, and production of and exploration for oil and gas properties and
the gathering and processing of natural gas.  The Company's core area of
activity is the Texas and Louisiana Gulf Coast, both on and offshore.
Additionally, the Company has material properties in Alabama and offshore
California.  At December 31, 1998, the Company's estimated net proved reserves,
using constant prices which were in effect at such date, totaled 8.5 MMBbl of
oil, 1.6 MMBbl of natural gas liquids ("NGL"), and 111.6 MMcf of natural gas for
a total of 172.0 billion cubic feet of gas equivalent ("BCFE").  On an
equivalency basis, approximately 65% of the Company's estimated net proved
reserves were natural gas and 95% were developed at such date.  In addition, the
Company has interests in natural gas processing plants in California and West
Texas.

     The Company was formed as a Delaware corporation in 1994 to succeed to the
business and properties of its predecessor company pursuant to a merger, the
primary purpose of which was to change the predecessor company's state of
incorporation from Colorado to Delaware.  The predecessor company was formed in
1980 from the consolidation of the business and properties of related oil and
gas limited partnerships.  References to Bellwether or the Company include the
predecessor company, unless the context requires otherwise.

     In order to facilitate greater comparability with its peer group by the
financial community, the Company changed its fiscal year to the calendar year,
beginning January 1, 1998. This resulted in a six-month transition period of
July 1, 1997 through December 31, 1997 ("transition period").

Oil and Gas Activities
----------------------

     In 1987 and 1988, the Company merged with two independent oil and gas
companies owned by institutional investors and managed by Torch Energy

                                       3
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------

Advisors Incorporated ("Torch"). Since those mergers, the Company has operated
under agreements, pursuant to which the Company outsources certain
administrative functions to Torch.

     In August 1994, Bellwether acquired, by merger, certain of the assets,
liabilities and properties of Odyssey Partners, Ltd. ("Odyssey"), an exploration
company specializing in 3 dimensional ("3-D") seismic and computer-aided
exploration ("CAEX") technology, in exchange for 0.9 million shares of Common
Stock and $5.6 million in cash. The Odyssey merger provided the Company with
significant expertise in 3-D seismic and CAEX technology.

     On February 28, 1995, Bellwether acquired Hampton Resources Corporation
("Hampton") by merger for $17.0 million in cash and approximately 1.0 million
shares of Common Stock.  Hampton was a publicly held oil and gas company based
in Houston, Texas.

     In April 1997, the Company acquired oil and gas properties and $13.9
million of working capital from affiliates of Torch ("Partnership
Transactions"), for $141.1 million after purchase price adjustments.  The
Company financed the Partnership Transactions and related fees, with $34.1
million net proceeds of a Common Stock offering, $97.0 million net proceeds of
$100.0 million offering of 10 7/8% Senior Subordinated Notes due 2007 (the
"Offerings")and advances under a new credit facility ("New Credit Facility" or
"Senior Credit Facility").  In addition, as consideration for advisory services,
Torch was issued 150,000 shares of the Company's common stock and a warrant,
expiring in April 2002,to purchase 100,000 shares of common stock at $9.90 per
share.  The warrant and shares were valued at $1.5 million and recorded as a
cost of the Partnership Transactions.

     Subsequent to the Partnership Transactions, the Company identified for
divestiture non-core properties including approximately 10% of the estimated net
proved reserves attributable to the Partnership Transactions.  These properties
were primarily small working interests in geographically diverse locations, with
generally lower operating margins and limited development potential.  Such
properties were sold in a series of transactions from May 1997 to December 1997
for aggregate consideration of $24 million.  The net proceeds from these
divestitures were used to repay indebtedness.

Business Strategy
-----------------

     Since the completion of the Partnership Transactions, the Company has
employed a balanced growth strategy which emphasizes growth in reserves,
production, cash flows and net asset values through a combination of strategic
producing property acquisitions and technology-driven exploratory and
development drilling focused within core operating areas.  The key elements of
this strategy are as follows:

     Core Areas. The Company will enhance its competitive position by focusing
its activities within core geographic areas where it has significant existing
assets and infrastructure, superior technical expertise and experience, a
technical/operational database and demonstrated business know-how. The Company
considers the Texas-Louisiana Gulf Coast, both on and

                                       4
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------

offshore, to be its core area. The Company may seek to establish additional core
areas in the future which are complementary to its strategy.

     High value operated properties.  The Company will increase efficiency,
establish greater control and enhance economic impact with respect to its
activities through concentrating its holdings in a fewer number of higher value
properties, a majority of which it will seek to operate.  Achievement of this
objective will be a principal targeting criteria in the execution of its
acquisition and divestiture strategies.  Toward this end the Company's
exploration program will emphasize internal prospect generation as well as
strategic relationships with prospect generators having demonstrated expertise
within a particular play type or area of interest.

     Technology Driven. The Company will seek to improve its success rates and
drive down its finding and operating costs by employing the latest state of the
art technology in its exploration, development and operating activities. Its
exploration and development program will utilize 3-D seismic evaluation,
sophisticated seismic processing and modeling tools and computer aided
exploration and development systems. Operationally the Company will employ
horizontal drilling, enhanced recovery methods and advanced completion and
production techniques.

     Interdisciplinary Approach. The Company will utilize interdisciplinary
teams comprised of geologists, geophysicists and engineers in the generation and
evaluation of acquisition, exploration and exploitation investment
opportunities. Through this approach the Company will maximize the
identification and quantification of opportunities and reduce risk through the
application of complementary experience, know-how and technology. The Company
will target opportunities which offer multiple application of successful
concepts and are on trend with and extensions of existing applications of such
concepts.

     Contain and Reduce Cost. In order to maintain a competitive cost structure
and to increase efficiency, the Company will continuously seek to reduce cost,
whether operating, capital or overhead. In this regard the Company expects to
continue to outsource certain non-strategic functions. Additionally, the Company
will regularly review its property base aggressively exploiting identified
opportunities and divesting non-core or lower margin assets and redeploying
capital to a higher use.

Markets
-------

     Bellwether's ability to market oil and gas from the Company's wells depends
upon numerous factors beyond the Company's control, including: 1) the extent of
domestic production and imports of oil and gas, 2) the proximity of gas
production to gas pipelines, 3) the availability of capacity in such pipelines,
4) the demand for oil and gas by utilities and other end users, 5) the
availability of alternate fuel sources, 6) the effects of inclement weather, 7)
state and federal regulation of oil and gas production and 8) federal regulation
of gas sold or transported in interstate commerce. No

                                       5
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------

assurances can be given that Bellwether will be able to market all of the oil or
gas produced by the Company or that favorable prices can be obtained for the oil
and gas Bellwether produces.

     In view of the many uncertainties affecting the supply of and demand for
oil, gas and refined petroleum products, the Company is unable to predict future
oil and gas prices and demand or the overall effect such prices and demand will
have on the Company. The marketing of oil and gas by Bellwether can be affected
by a number of factors which are beyond the Company's control, the exact effects
of which cannot be accurately predicted.

     Sales to Torch Co-Energy LLC accounted for approximately 28% and 22% of
fiscal year 1998 and transition period 1997 revenues, respectively.  Sales to
Valero Industrial Gas, L.P. accounted for 18.0% of fiscal 1997 revenues.  Sales
to Texas Gas Transmission Corporation, Warren Petroleum Corporation and Koch
Industries Inc. accounted for 32.9% of fiscal 1996 revenues.  Management of the
Company does not believe that the loss of any single customer or contract would
materially affect the Company's business.  There are no other significant
delivery commitments and substantially all of the Company's oil and gas
production is sold at market responsive pricing through a marketing affiliate of
Torch.  The Company from time to time may enter into crude oil and natural gas
price swaps or other similar hedge transactions to reduce its exposure to price
fluctuations.

Regulation
----------

     Federal Regulations
     -------------------

     Transportation of Gas.  The Company's sales of natural gas are affected by
the availability, terms and cost of transportation.  The rates, terms and
conditions applicable to the interstate transportation of gas by pipelines are
regulated by the Federal Energy Regulatory Commission ("FERC") under the Natural
Gas Act ("NGA"), as well as under section 311 of the Natural Gas Policy Act
("NGPA").  Since 1985, the FERC has implemented regulations intended to increase
competition within the gas industry by making gas transportation more accessible
to gas buyers and sellers on an open-access, non-discriminatory basis.

          The FERC has announced several important transportation-related policy
statements and proposed rule changes, including a statement of policy and
request for comments concerning alternatives to its traditional cost-of-service
ratemaking methodology to establish the rates interstate pipelines may charge
for their services.  A number of pipelines have obtained FERC authorization to
charge negotiated rates as one such alternative.  While the changes being
considered would affect the Company only indirectly, they are intended to
further enhance competition in natural gas markets.  The Company cannot predict
what further action the FERC will take on these matters; however, the Company
does not believe that it will be affected by any action taken materially
differently than other natural gas producers.

                                       6
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------

     Sales and Transportation of Oil.  Sales of oil and condensate can be made
by the Company at market prices not subject at this time to price controls.  The
price that the Company receives from the sale of these products will be affected
by the cost of transporting the products to market.  As required by the Energy
Policy Act of 1992, the FERC has revised its regulations governing the rates
that may be charged by oil pipelines.  The new rules, which were effective
January 1, 1995, provide a simplified, generally applicable method of regulating
such rates by use of an indexing system for setting transportation rate
ceilings.  In certain circumstances, the new rules permit oil pipelines to
establish rates using traditional cost of service and other methods of rate
making.

     Legislative Proposals.  In the past, Congress has been very active in the
area of gas regulation.  There are legislative proposals pending in the state
legislatures of various states, which, if enacted, could significantly affect
the petroleum industry.  At the present time it is impossible to predict what
proposals, if any, might actually be enacted by Congress or the various state
legislatures and what effect, if any, such proposals might have on the Company's
operations.

     Federal, State or Indian Leases.  In the event the Company conducts
operations on federal, state or Indian oil and gas leases, such operations must
comply with numerous regulatory restrictions, including various
nondiscrimination statutes, and certain of such operations must be conducted
pursuant to certain on-site security regulations and other appropriate permits
issued by the Bureau of Land Management ("BLM") or, in the case of the Company's
Outer Continental Shelf ("OCS") leases in federal waters, Minerals Management
Service ("MMS") or other appropriate federal or state agencies.  The Company's
OCS leases in federal waters are administered by the MMS and require compliance
with detailed MMS regulations and orders.  The MMS has promulgated regulations
implementing restrictions on various production-related activities, including
restricting the flaring or venting of natural gas.  In addition, the MMS has
proposed to amend its regulations to prohibit the flaring of liquid hydrocarbons
and oil without prior authorization.  Under certain circumstances, the MMS may
require any Company operations on federal leases to be suspended or terminated.
Any such suspension or termination could materially and adversely affect the
Company's financial condition and operations.  The MMS has issued a notice of
proposed rule making in which it proposes to amend its regulations governing the
calculation of royalties and the valuation of crude oil produced from federal
leases.  Among other matters, this proposed rule would amend the valuation
procedure for the sale of federal royalty oil.  The Company cannot predict what
action the MMS will take on this matter, nor can it predict at this stage of the
proceeding how the Company might be affected by this proposed amendment to the
MMS' royalty regulations.

     The Mineral Leasing Act of 1920 (the "Mineral Act") prohibits direct or
indirect ownership of any interest in federal onshore oil and gas leases by a
foreign citizen of a country that denies "similar or like privileges" to
citizens of the United States.  Such restrictions on citizens of a "non-

                                       7
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------

reciprocal" country include ownership or holding or controlling stock in a
corporation that holds a federal onshore oil and gas lease.  If this restriction
is violated, the corporation's lease can be canceled in a proceeding instituted
by the United States Attorney General.  Although the regulations of the BLM
(which administers the Mineral Act) provide for agency designations of non-
reciprocal countries, there are presently no such designations in effect.  The
Company owns interests in numerous federal onshore oil and gas leases.  It is
possible that the Common Stock will be acquired by citizens of foreign
countries, which at some time in the future might be determined to be non-
reciprocal under the Mineral Act.

     State Regulations.  Most states regulate the production and sale of oil and
gas, including: 1) requirements for obtaining drilling permits, 2)the method of
developing new fields, 3) the spacing and operation of wells and 4) the
prevention of waste of oil and gas resources.  The rate of production may be
regulated and the maximum daily production allowable from both oil and gas wells
may be established on a market demand or conservation basis or both.

     The Company owns certain natural gas pipeline facilities that it believes
meet the traditional tests the FERC has used to establish a pipeline's status as
a gatherer not subject to FERC jurisdiction under the NGA.  State regulation of
gathering facilities generally includes various safety, environmental, and in
some circumstances, nondiscriminatory take requirements, but does not generally
entail rate regulation.

     The Company may enter into agreements relating to the construction or
operation of a pipeline system for the transportation of gas.  To the extent
that such gas is produced, transported and consumed wholly within one state,
such operations may, in certain instances, be subject to the jurisdiction of
such state's administrative authority charged with the responsibility of
regulating intrastate pipelines.  In such event, the rates which the Company
could charge for gas, the transportation of gas, and the construction and
operation of such pipeline would be subject to the rules and regulations
governing such matters, if any, of such administrative authority.

     Environmental Regulations
     -------------------------

     General.  The Company's activities are subject to existing federal, state
and local laws and regulations governing environmental quality and pollution
control. Activities of the Company with respect to gas facilities, including the
operation and construction of pipelines, plants and other facilities for
transporting, processing, treating or storing gas and other products, are also
subject to stringent environmental regulation by state and federal authorities
including the Environmental Protection Agency ("EPA").  Risks are inherent in
oil and gas exploration and production operations, and no assurance can be given
that significant costs and liabilities will not be incurred in connection with
environmental compliance issues.  The Company cannot predict what effect future
regulation or legislation, enforcement policies issued thereunder, and claims
for damages to property, employees,

                                       8
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------

other persons and the environment resulting from the Company's operations could
have on its activities.

     Solid and Hazardous Waste.  The Company currently owns or leases, and has
in the past owned or leased, numerous properties that for many years have been
used for the exploration and production of oil and gas. Although the Company
believes it has utilized operating and waste disposal practices that were
standard in the industry at the time, hydrocarbons or other solid wastes may
have been disposed or released on or under the properties owned or leased by the
Company or on or under locations where such wastes have been taken for disposal.
In addition, many of these properties have been owned or operated by third
parties.  The Company had no control over such parties' treatment of
hydrocarbons or other solid wastes and the manner in which such substances may
have been disposed or released.  State and federal laws applicable to oil and
gas wastes and properties have gradually become stricter over time.  Under these
new laws, the Company could be required to remove or remediate previously
disposed wastes (including wastes disposed or released by prior owners or
operators) or property contamination (including groundwater contamination by
prior owners or operators) or to perform remedial plugging operations to prevent
future contamination.

     The Company generates wastes, including hazardous wastes, that are subject
to the federal Resource Conservation and Recovery Act ("RCRA") and comparable
state statutes.  The EPA and various state agencies have limited the approved
methods of disposal for certain hazardous and non-hazardous wastes. Furthermore,
it is possible that certain wastes generated by the Company's oil and gas
operations that are currently exempt from treatment as "hazardous wastes" may in
the future be designated as "hazardous wastes" under RCRA or other applicable
statutes, and therefore be subject to more rigorous and costly operating and
disposal requirements.

     Superfund.  The Comprehensive Environmental Response, Compensation and
Liability Act ("CERCLA"), also known as the "Superfund" law, imposes liability,
without regard to fault or the legality of the original conduct, on certain
classes of persons with respect to the release of a "hazardous substance" into
the environment.  These persons include the owner and operator of a disposal
site where a release occurred and any company that disposed or arranged for the
disposal of the hazardous substance released at the site.  CERCLA also
authorizes the EPA and, in some cases, third parties, to take actions in
response to threats to the public health or the environment and to seek to
recover from the responsible classes of persons the costs of such action.  In
the course of its operations, the Company has generated and will generate wastes
that may fall within CERCLA's definition of "hazardous substances." The Company
may also be an owner of sites on which "hazardous substances" have been
released.  The Company may be responsible under CERCLA for all or part of the
costs to clean up sites at which such wastes have been disposed.

     Oil Pollution Act.  The Oil Pollution Act of 1990 (the "OPA") and
regulations thereunder impose certain duties and liabilities on "responsible

                                       9
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------

parties" related to the prevention of oil spills and damages resulting from such
spills in United States waters.  A "responsible party" includes the owner or
operator of an onshore facility, vessel or pipeline, or the lessee or permittee
of the area in which an offshore facility is located.  The OPA assigns liability
to each responsible party for oil removal costs and a variety of public and
private damages.  While liability limits apply in some circumstances, a party
cannot take advantage of liability limits if the spill was caused by gross
negligence or willful misconduct or resulted from violation of a federal safety,
construction or operating regulation.  If the party fails to report a spill or
to cooperate fully in the cleanup, liability limits also do not apply.  Few
defenses exist to the liability imposed by the OPA.  The failure to comply with
OPA requirements may subject a responsible party to civil or even criminal
liability.

     The OPA also imposes ongoing requirements on a responsible party, including
proof of financial responsibility to cover at least some costs in a potential
spill.  Certain amendments to the OPA that were enacted in 1996 require owners
and operators of offshore facilities that have a worst case oil spill potential
of more than 1,000 barrels to demonstrate financial responsibility in amounts
ranging from $10 million in specified state waters to $35 million in federal OCS
waters, with higher amounts, up to $150 million in certain limited
circumstances, where the MMS believes such a level is justified by the risks
posed by the quantity or quality of oil that is handled by the facility.  On
March 25, 1997, the MMS promulgated a proposed rule implementing these OPA
financial responsibility requirements.  The Company believes that it currently
has established adequate proof of financial responsibility for its offshore
facilities.  However, the Company cannot predict whether the financial
responsibility requirements under the OPA amendments or the proposed rule will
result in the imposition of substantial additional annual costs to the Company
in the future or otherwise materially adversely affect the Company.  The impact
of the financial responsibility requirements is not expected to be any more
burdensome to the Company than it will be to other similarly or less capitalized
owners or operators in the Gulf of Mexico and offshore California.

     Air Emissions.  The operations of the Company are subject to local, state
and federal laws and regulations for the control of emissions from sources of
air pollution.  Administrative enforcement actions for failure to comply
strictly with air regulations or permits may result in the payment of civil
penalties and, in extreme cases, the shutdown of air emission sources.  The
Company believes it is in compliance with all air emission regulations.

     OSHA and other Regulations.  The Company is subject to the requirements of
the federal Occupational Safety and Health Act ("OSHA") and comparable state
statutes.  The OSHA hazard communication standard, the EPA community right-to-
know regulations under Title III of CERCLA and similar state statutes require
the Company to organize and/or disclose information about hazardous materials
used or produced in the Company's operations.  The Company believes that it is
in substantial compliance with these applicable requirements.

                                       10
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------


Competition
-----------

     The oil and gas industry is highly competitive in all of its phases.
Bellwether encounters competition from other oil and gas companies in all areas
of the Company's operations, including the acquisition of reserves and producing
properties and the marketing of oil and gas. Many of these companies possess
greater financial and other resources than Bellwether. Competition for producing
properties is affected by the amount of funds available to the Company,
information about a producing property available to the Company and any
standards established by the Company for the minimum projected return on
investment. Competition may also be presented by alternate fuel sources.

ITEM 2.  PROPERTIES
-------------------

Reserves
--------

     The Company holds interests in oil and gas properties, all of which are
located in the United States.  The Company's principal developed properties are
located in Texas, Louisiana, Alabama, offshore California and the Gulf of
Mexico.  Estimated net proved oil and gas reserves at December 31, 1998
decreased approximately 20% from December 31, 1997.  This decrease was primarily
caused by lower oil prices which resulted in decreases in the economic life of
properties, most notably Waddell Ranch and Point Pedernales.  The Company has
not filed oil or gas reserve information with any foreign government or Federal
authority or agency.

     The following table sets forth certain information, as of December 31,
1998, which relates to fields which hold approximately 79% of the Company's
proved oil and gas reserves:

                                       11
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------
<TABLE>
<CAPTION>
 
                                                                 Net Proved Reserves                    1998 Net Production
                                                    ------------------------------------------  ----------------------------------
                                                           OIL &                                   OIL &
                                                            NGL          GAS                        NGL          GAS
FIELD                                                     (MBBLS)       (MMCF)        MMCFE       (MBBLS)      (MMCF)       MMCFE
-------------------------------------------------   --------------  -----------  -------------  ------------  ----------  --------
<S>                                                       <C>          <C>           <C>          <C>          <C>          <C>
Waddell Ranch field, TX                                    3,735         6,874        29,284         523          760        3,898
Point Pedernales field,
  offshore CA                                              2,463         1,382        16,160         585          257        3,767
Ship Shoal Complex,
  Gulf of Mexico                                           1,067         5,942        12,344         385        2,949        5,259
High Island Block A-334
  field, Gulf of Mexico                                      269         7,664         9,278          53        1,798        2,116
Blue Creek field, AL                                         ---         8,930         8,930         ---          911          911
Cove field, offshore TX                                       13         6,202         6,280           9        2,596        2,650
La Rica field, TX                                              4         6,195         6,219         ---          591          591
Porters Creek field, TX                                       54         4,807         5,131           9          547          601
Robinson's Bend field, AL                                    ---         4,704         4,704         ---          337          337
Reddell field, LA                                             86         3,834         4,350          10          467          527
Giddings field, TX                                           162         3,266         4,238          87          951        1,473
Gomez field, TX                                              ---         4,144         4,144         ---          318          318
Fort Trinidad field, TX                                      561           705         4,071          68          186          594
Mist field, OR                                               ---         3,790         3,790         ---           33           33
South Marsh Island Block
  269 field, Gulf of
  Mexico                                                     177         2,286         3,348          36          364          580
Morganza field, LA                                            26         3,077         3,233           6          569          605
West Chalkley field, LA                                       16         3,033         3,129           4          479          503
Rocky Creek field, TX                                          4         2,906         2,930           1          574          580
East Cameron Block 17,
  offshore LA                                                  9         2,148         2,202           8          779          827
Happy field, TX                                              293            57         1,815          95            6          576
Others                                                     1,122        29,639        36,371         419        5,830        8,344
                                                    ------------------------------------------  ----------------------------------
                                                          10,061       111,585       171,951       2,298       21,302       35,090
                                                    ==========================================  ==================================
</TABLE>

     In general, estimates of economically recoverable oil and natural gas
reserves and of the future net cash flows therefrom are based upon a number of
variable factors and assumptions, such as historical production from the
properties, assumptions concerning future oil and natural gas prices and future
operating costs and the assumed effects of regulation by governmental agencies,
all of which may vary considerably from actual results. All such estimates are
to some degree speculative, and classifications of reserves are only attempts to
define the degree of speculation involved. Estimates of the economically
recoverable oil and natural gas reserves attributable to any particular group of
properties, classifications of such reserves based on risk of recovery and
estimates of future net cash flows expected therefrom, prepared by different
engineers or by the same engineers at different times, may vary substantially.
The Company's actual production, revenues, severance and excise taxes and
development and operating expenditures with respect to its reserves will vary
from such estimates, and such variances could be material.

                                       12
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------

     Estimates with respect to proved reserves that may be developed and
produced in the future are often based upon volumetric calculations and upon
analogy to similar types of reserves rather than actual production history.

     Estimates based on these methods are generally less reliable than those
based on actual production history. Subsequent evaluation of the same reserves
based upon production history will result in variations, which may be
substantial, in the estimated reserves.

     In accordance with applicable requirements of the Securities and Exchange
Commission ("SEC"), the estimated discounted future net cash flows from
estimated proved reserves are based on prices and costs as of the date of the
estimate unless such prices or costs are contractually determined at such date.
Actual future prices and costs may be materially higher or lower. Actual future
net cash flows also will be affected by factors such as actual production,
supply and demand for oil and natural gas, curtailments or increases in
consumption by natural gas purchasers, changes in governmental regulations or
taxation and the impact of inflation on costs.

Acreage
-------

     The following table sets forth the acres of developed and undeveloped oil
and gas properties in which the Company held an interest as of December 31,
1998.  Undeveloped acreage is considered to be those leased acres on which wells
have not been drilled or completed to a point that would permit the production
of commercial quantities of oil and gas, regardless of whether or not such
acreage contains proved reserves.  A gross acre in the following table refers to
the number of acres in which a working interest is owned directly by the
Company.  The number of net acres is the sum of the fractional ownership of
working interests owned directly by the Company in the gross acres expressed as
a whole number and percentages thereof.  A net acre is deemed to exist when the
sum of fractional ownership of working interests in gross acres equals one.
<TABLE>
<CAPTION>
 
                                              Gross      Net   
                                             -------   ------- 
<S>                                          <C>       <C>     
                                                               
      Developed Acreage...................   476,883   109,933 
      Undeveloped Acreage.................   159,501    74,207 
                                             -------   ------- 
          Total...........................   636,384   184,140  
                                             =======   =======
</TABLE>

     Bellwether believes that the title to its oil and gas properties is good
and defensible in accordance with standards generally accepted in the oil and
gas industry, subject to such exceptions which, in the opinion of the Company,
are not so material as to detract substantially from the use or value of such
properties. The Company's properties are typically subject, in one degree or
another, to one or more of the following: 1) royalties and other burdens and
obligations, express or implied, under oil and gas leases; 2) overriding
royalties and other burdens created by the Company or its predecessors in title;
3) a variety of contractual obligations (including, in some cases, development
obligations) arising under operating agreements,

                                       13
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------

farmout agreements, production sales contracts and other agreements that may
affect the properties or their titles; 4) back-ins and reversionary interests
arising under purchase agreements and leasehold assignments; 5) liens that arise
in the normal course of operations, such as those for unpaid taxes, statutory
liens securing obligations to unpaid suppliers and contractors and contractual
liens under operating agreements; 6) pooling, unitization and communitization
agreements, declarations and orders; and 7) easements, restrictions, rights-of-
way and other matters that commonly affect oil and gas producing property. To
the extent that such burdens and obligations affect the Company's rights to
production revenues, they have been taken into account in calculating the
Company's net revenue interests and in estimating the size and value of the
Company's reserves. Bellwether believes that the burdens and obligations
affecting the Company's properties are conventional in the industry for
properties of the kind owned by the Company.

Productive Wells
----------------

     The following table sets forth Bellwether's gross and net interests in
productive oil and gas wells as of December 31, 1998.  Productive wells are
defined as producing wells and wells capable of production.
<TABLE>
<CAPTION>
 
                                       Gross   Net
                                       -----   ---
      <S>                              <C>     <C>
 
      Oil Wells.....................   1,303   212
      Gas Wells.....................     703   164
                                       -----   ---
          Total.....................   2,006   376
                                       =====   ===
</TABLE>

Production
----------

     The Company's principal production volumes during the fiscal year ended
December 31, 1998 were from the states of Louisiana, Texas and Alabama, from
federal waters in offshore California and from the Gulf of Mexico in federal and
state waters.

     Data relating to production volumes, average sales prices, average unit
production costs and oil and gas reserve information appear in Note 11 of the
Notes to Consolidated Financial Statements  Supplemental Information.

Drilling Activity and Present Activities
----------------------------------------

     During the last three fiscal years and the transition period ended
December 31, 1997, the Company's principal drilling activities occurred in the
continental United States and offshore Texas, Louisiana and California in
federal and state waters.

     The following table sets forth the results of drilling activity for the
last three fiscal years and the transition period.  Gross wells, as it applies
to wells in the following tables, refers to the number of wells in which a
working interest is owned directly by the Company.  A "net well" is deemed to
exist when the sum of fractional ownership working interests in gross wells
equals one.  The number of net wells is the sum of the fractional

                                       14
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------

ownership of working interests owned directly by the Company in gross wells
expressed as whole numbers and percentages thereof.

<TABLE>
<CAPTION>
                                                         Exploratory Wells
                                                         -----------------
                                               Gross                                                      Net
                      -----------------------------------------------------      --------------------------------------------------
                                                     Dry                                                       Dry
                             Productive             Holes          Total                 Productive           Holes        Total
                      -----------------------------------------------------      --------------------------------------------------
 
<S>                              <C>                <C>             <C>                      <C>               <C>           <C>
Fiscal 1996                       1                  3               4                        .06               .24          .30
Fiscal 1997                       3                  4               7                        .75               .74         1.49
Six Month 
 Transition 1977                  2                  2               4                        .28               .78         1.06
Fiscal 1998                      14                  5              19                       4.10              1.52         5.62
</TABLE>

<TABLE>
<CAPTION>
                                                         Development Wells
                                                         -----------------
                                              Gross                                                       Net
                       ------------------------------------------------          --------------------------------------------------
                                                  Dry                                                        Dry
                             Productive          Holes         Total                    Productive          Holes          Total
                       ------------------------------------------------          --------------------------------------------------
<S>                              <C>              <C>            <C>                        <C>               <C>          <C>
Fiscal 1996                      21                1             22                         1.66               .90          2.56
Fiscal 1997                      52                2             54                         5.34               .63          5.97
Six Month Transition
 Transition 1997                 30                5             35                         2.40              1.19          3.59
Fiscal 1998                      69                4             73                         7.53               .52          8.05
</TABLE>

The Company had 5 wells in process as of December 31, 1998.

Gas Plant and Gas Gathering Facilities
--------------------------------------

     As of December 31, 1998 the Company owned iterests in the following gas 
plants:

<TABLE>
<CAPTION>
                                                                         Fiscal Year 1998
                                                            --------------------------------------
                                                               Capacity    Throughput    Ownership
Facility                State         Operator                   MMCFD        MMCFD       Interest
--------                -----         --------              --------------------------------------
 
<S>                     <C>     <C>                            <C>         <C>           <C>
Point 
Pedernales
Gas Plant                CA     Nuevo Energy Company               13           4.8        19.70%

Snyder Gas                      Torch Energy
Plant                    TX     Marketing Inc.                     60            14        13.91%
 
Diamond M-
Sharon Ridge                    Exxon Company,
Gas Plant (1)            TX     U.S.A.                             (1)           (1)          (1)
</TABLE>

(1) The Company has a 36.72% interest in the operations of the former Diamond M-
Sharon Ridge Gas Plant.  This plant was dismantled in December 1993, and the gas
is being processed by Snyder Gas Plant pursuant to a processing agreement.

                                       15
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------

Risk Factors
------------

     Historically Low Oil Prices
     ---------------------------

     Oil prices were lower in 1998 than in previous years, and hit historic lows
during the first quarter of 1999. Continued low oil prices will continue to
affect the Company adversely.

     Volatility of Oil and Gas Prices and Markets
     --------------------------------------------

     Prices for oil and gas are subject to large fluctuations in response to
relatively minor changes in the supply of and demand for oil and gas, market
uncertainty and a variety of additional factors beyond the control of the
Company. These factors include: 1) weather conditions in the United States, 2)
the condition of the United States economy, 3) the actions of the Organization
of Petroleum Exporting Countries, 4) governmental regulation, 5) political
stability in the Middle East and elsewhere, 6) the foreign supply of oil and
gas, 7) the price of foreign imports and 8) the availability of alternate fuel
sources. Any substantial and extended decline in the price of oil or gas would
have an adverse effect on the Company's carrying value of its proved reserves,
its borrowing capacity, its ability to obtain additional capital, and its
revenues, profitability and cash flows.

     Volatile oil and gas prices make it difficult to estimate the value of
producing properties in connection with acquisitions and often cause disruption
in the market for oil and gas producing properties, as buyers and sellers have
difficulty agreeing on such value. Price volatility also makes it difficult to
budget for and project the return on acquisitions and exploitation, development
and exploration projects.

     The availability of a ready market for the Company's oil and natural gas
production also depends on a number of factors, including the demand for and
supply of oil and natural gas and the proximity of reserves to, and the capacity
of, oil and natural gas gathering systems, pipelines or trucking and terminal
facilities. Wells may temporarily be shut-in for lack of a market or due to
inadequacy or unavailability of pipeline or gathering system capacity.

     Ability to Replace Reserves
     ---------------------------

     The Company's future performance depends upon its ability to find, develop
and acquire additional oil and gas reserves that are economically recoverable.
The proved reserves of Bellwether will generally decline as reserves are
depleted. The Company therefore must locate and develop or acquire new oil and
gas reserves to replace those being depleted by production. Because the
Company's reserves are characterized by relatively rapid decline rates, without
successful exploration, development or acquisition activities, the Company's
revenues will decline rapidly. No assurances can be given that the Company will
be able to find and develop or acquire additional reserves at an acceptable
cost.

                                       16
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------


     Acquisition Risks
     -----------------

     The Company's rapid growth in recent years has been attributable in
significant part to acquisitions of oil and gas properties. The Company expects
to continue to evaluate and, where appropriate, pursue acquisition opportunities
on terms management considers favorable to the Company. There can be no
assurance that suitable acquisition candidates will be identified in the future,
or that the Company will be able to finance such acquisitions on favorable
terms. In addition, the Company competes against other companies for
acquisitions, and there can be no assurances that the Company will be successful
in the acquisition of any material property interests. Further, there can be no
assurances that any future acquisitions made by the Company will be integrated
successfully into the Company's operations or will achieve desired profitability
objectives.

     The successful acquisition of producing properties requires an assessment
of: 1) recoverable reserves, 2) exploration and exploitation potential, 3)
future oil and natural gas prices, 4) operating costs, 5) potential
environmental and other liabilities and 6) other factors beyond the Company's
control. In connection with such an assessment, the Company performs a review of
the properties that it believes to be generally consistent with industry
practices. Nonetheless, the resulting assessments are inexact and their accuracy
is inherently uncertain, and such a review may not reveal all existing or
potential problems, nor will it necessarily permit the Company to become
sufficiently familiar with the properties to fully assess their merits and
deficiencies. Inspections may not always be performed on every well, and
structural and environmental problems are not necessarily observable even when
an inspection is undertaken. In addition, sellers of properties may be unwilling
or financially unable to indemnify the Company for known or unknown liabilities
at the time of an acquisition.

     Additionally, significant acquisitions can change the nature of the
operations and business of the Company depending upon the character of the
acquired properties, which may be substantially different in operating and
geologic characteristics or geographic location than existing properties. While
the Company's operations are focused in Texas, Louisiana, Alabama, offshore
California and the Gulf of Mexico, there is no assurance that the Company will
not pursue acquisitions or properties located in other geographic areas.

     In connection with the Partnership Transactions, Bellwether assumed or
otherwise became liable for all obligations with respect to operations of the
properties acquired in such transactions, including environmental and
operational liabilities, unknown liabilities, and liabilities arising prior to
the closing date.

                                       17
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------


     Drilling Risks
     --------------

     Drilling activities are subject to many risks, including the risk that no
commercially productive reservoirs will be encountered. There can be no
assurance that new wells drilled by the Company will be productive or that the
Company will recover all or any portion of its investment. Drilling for oil and
natural gas may involve unprofitable efforts, not only from dry wells, but from
wells that are productive but do not produce sufficient net revenues to return a
profit after drilling, operating and other costs. The cost of drilling,
completing and operating wells is often uncertain and cost overruns are common.
The Company's drilling operations may be curtailed, delayed or canceled as a
result of numerous factors, many of which are beyond the Company's control,
including: 1) title problems, 2) weather conditions, 3) compliance with
governmental requirements and 4) shortages or delays in the delivery of
equipment and services.


     Substantial Capital Requirements
     --------------------------------

     The Company makes, and will continue to make, substantial capital
expenditures for the exploitation, exploration, acquisition and production of
oil and gas reserves. Historically, the Company has financed these expenditures
primarily with  sale of senior subordinated notes, proceeds from bank
borrowings, sales of its Common Stock and cash flow from operations. The
Company believes that it will have sufficient cash flows provided by operating
activities, the proceeds of equity offerings and borrowings under the Senior
Credit Facility to fund planned capital expenditures. If revenues or the
Company's borrowing base decrease as a result of lower oil and gas prices,
operating difficulties or declines in reserves, the Company may have limited
ability to expend the capital necessary to undertake or complete future drilling
programs. There can be no assurance that additional debt or equity financing or
cash generated by operations will be available to meet these requirements.

     Significant Leverage and Debt Service
     -------------------------------------

     The Company's level of indebtedness has several important effects on its
future operations, including: 1) a substantial portion of the Company's cash
flow from operations must be dedicated to the payment of interest on its
indebtedness and will not be available for other purposes, 2) covenants
contained in the Company's debt obligations require the Company to meet certain
financial tests, and other restrictions limit its ability to borrow additional
funds or to dispose of assets and may affect the Company's flexibility in
planning for, and reacting to, changes in its business, including possible
acquisition activities and 3) the Company's ability to obtain financing in the
future for working capital, capital expenditures, acquisitions, general
corporate purposes or other purposes may be impaired. The Company's ability to
meet its debt service obligations and to reduce its total indebtedness will be
dependent upon the Company's future performance, which will be subject to
general economic conditions and to financial,

                                       18
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------

business and other factors affecting the operations of the Company, many of
which are beyond its control. There can be no assurance that the Company's
future performance will not be adversely affected by such economic conditions
and financial, business and other factors.

     Administrative Services Agreement; Reliance on Torch
     ----------------------------------------------------

     The Company currently has seventeen employees. The Company is party to an
administrative services agreement ("Administrative Services Agreement") with
Torch, pursuant to which Torch performs certain administrative functions for the
Company, including financial, accounting, legal and technical support. The
Company believes that its relationship with Torch provides the Company with
access to professional, technical and administrative personnel not otherwise
available to a company of its size. Bellwether believes that if the
Administrative Services Agreement were terminated Bellwether could, over time,
hire experienced personnel and acquire the accounting and reporting systems and
other assets necessary to replace Torch. However, the unanticipated termination
of the Administrative Services Agreement could have a material adverse effect
upon the Company. The Administrative Services Agreement may be terminated by
Bellwether upon one year's prior notice and may not be terminated by Torch prior
to December 31, 1999.  The Company intends to terminate the current
Administrative Services Agreement on December 31, 1999, and is currently in
negotiations with Torch  to finalize agreements which would take the place of
the existing Administrative Services Agreement.

     Conflicts of Interest
     ---------------------

     Torch also renders administrative services to other independent oil and gas
companies and may manage or render management or administrative services for
other energy companies in the future. These services may include the review and
recommendation of potential acquisitions. It is possible that conflicts may
occur between Bellwether and these other companies in connection with possible
acquisitions or otherwise in connection with the services rendered by Torch.
Although the Administrative Services Agreement provides for procedures to
reconcile conflicts of interest between these other companies and the Company,
no assurances can be made that such procedures will fully protect the Company
from losses which may occur if a conflict between the Company and these other
companies arises.

     Estimates of Oil and Gas Reserves
     ---------------------------------

     This document contains estimates of oil and gas reserves owned by the
Company, and the future net cash flows attributable to those reserves. There are
numerous uncertainties inherent in estimating quantities of proved reserves and
cash flows attributable to such reserves, including factors beyond the control
of the Company and the reserve engineers. Reserve engineering is a subjective
process of estimating underground accumulations of oil and gas that cannot be
measured in an exact manner. The accuracy of an estimate of quantities of
reserves, or of cash flows attributable to such

                                       19
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------

reserves, is a function of: 1) the available data, 2) assumptions regarding
future oil and gas prices and expenditures for future development and
exploitation activities, and 3) of engineering and geological interpretation and
judgment. Additionally, reserves and future cash flows may be subject to
material downward or upward revisions based upon production history, development
and exploitation activities and prices of oil and gas. Actual future production,
revenue, taxes, development expenditures, operating expenses, quantities of
recoverable reserves and the value of cash flows from such reserves may vary
significantly from the assumptions and estimates set forth herein. In addition,
reserve engineers may make different estimates of reserves and cash flows based
on the same available data. In calculating reserves on a gas equivalent basis,
oil was converted to gas equivalent at the ratio of one Bbl of oil to six Mcf of
gas. While this ratio approximates the energy equivalency of oil to gas on a Btu
basis, it may not represent the relative prices received by the Company on the
sale of its oil and gas production.

     The estimated quantities of proved reserves and the discounted present
value of future net cash flows attributable to estimated proved reserves set
forth herein were prepared in accordance with the rules of the SEC, and are not
intended to represent the fair market value of such reserves.

     Hedging of Production
     ---------------------

     The Company may, from time to time, reduce its exposure to the volatility
of oil and gas prices by hedging a portion of its production. In a typical hedge
transaction, the Company will have the right to receive from the counterparty to
the hedge, the excess of the fixed price specified in the hedge over a floating
price based on a market index, multiplied by the quantity hedged. If the
floating price exceeds the fixed price, the Company is required to pay the
counterparty this difference multiplied by the quantity hedged. In such case,
the Company is required to pay the difference regardless of whether the Company
has sufficient production to cover the quantities specified in the hedge.
Significant reductions in production at times when the floating price exceeds
the fixed price could require the Company to make payments under the hedge
agreements even though such payments are not offset by sales of production.
Hedging will also prevent the Company from receiving the full advantage of
increases in oil or gas prices above the fixed amount specified in the hedge.

                                       20
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------

     Operating Hazards, Offshore Operations and Uninsured Risks
     ----------------------------------------------------------

     Bellwether's operations are subject to risks inherent in the oil and gas
industry, such as: 1) blowouts, 2) cratering, 3) explosions, 4) uncontrollable
flows of oil, gas or well fluids, 5) fires, 6) pollution, 7) earthquakes and 8)
environmental risks. These risks could result in substantial losses to the
Company due to injury and loss of life, severe damage to and destruction of
property and equipment, pollution and other environmental damage and suspension
of operations. Moreover, a portion of the Company's operations are offshore and
therefore are subject to a variety of operating risks peculiar to the marine
environment, such as hurricanes or other adverse weather conditions, to more
extensive governmental regulation, including regulations that may, in certain
circumstances, impose strict liability for pollution damage, and to interruption
or termination of operations by governmental authorities based on environmental
or other considerations.

     The Company's operations could result in liability for: 1) personal
injuries, 2) property damage, 3) oil spills, 4) discharge of hazardous
materials, 5) remediation and clean-up costs and other environmental damages.
The Company could be liable for environmental damages caused by previous
property owners. As a result, substantial liabilities to third parties or
governmental entities may be incurred, the payment of which could have a
material adverse effect on the Company's financial condition and results of
operations. The Company maintains insurance coverage for its operations,
including limited coverage for sudden environmental damages, but does not
believe that insurance coverage for all environmental damages that occur over
time is available at a reasonable cost. Moreover, the Company does not believe
that insurance coverage for the full potential liability that could be caused by
sudden environmental damages is available at a reasonable cost. Accordingly, the
Company may be subject to liability or may lose substantial portions of its
properties in the event of certain environmental damages.

     Environmental and Other Regulation
     ----------------------------------

     The Company's operations are subject to numerous laws and regulations
governing the discharge of materials into the environment or otherwise relating
to environmental protection. These laws and regulations require: 1) the
acquisition of a permit before drilling commences, 2) restrict the types,
quantities and concentration of various substances that can be released into the
environment in connection with drilling and production activities, 3) limit or
prohibit drilling activities on certain lands lying within wilderness, wetlands
and other protected areas, and 4) impose substantial liabilities for pollution
resulting from the Company's operations. Moreover, the recent trend toward
stricter standards in environmental legislation and regulation is likely to
continue. For instance, legislation has been proposed in Congress from time to
time that would reclassify certain oil and gas exploration and production wastes
as "hazardous wastes" which would make the reclassified wastes subject to much
more stringent handling, disposal and clean-up requirements. If such legislation
were to be enacted, it could have

                                       21
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------

a significant impact on the operating costs of the Company, as well as the oil
and gas industry in general. Initiatives to further regulate the disposal of oil
and gas wastes are also pending in certain states, and these various initiatives
could have a similar impact on the Company. Management believes that the Company
is in substantial compliance with current applicable environmental laws and
regulations.

     The Oil Pollution Act of 1990 imposes a variety of regulations on
"responsible parties" related to the prevention of oil spills. The
implementation of new, or the modification of existing, environmental laws or
regulations, including regulations promulgated pursuant to the Oil Pollution Act
of 1990, could have a material adverse impact on the Company.


     Competition
     -----------

     The Company operates in the highly competitive areas of oil and gas
exploration, development and production. The Company's competitors include major
integrated oil and gas companies and substantial independent energy companies,
many of which possess greater financial and other resources than the Company.

ITEM 3.  LEGAL PROCEEDINGS
--------------------------

     Cause No. C-4417-96-G; A.R. Guerra, et al. V. Eastern Exploration, Inc., et
al.; In the 370th Judicial District Court of Hidalgo County, Texas

     On October 11, 1996, Plaintiffs filed suit in Hidalgo County, Texas, naming
Eastern Exploration, Inc., ("Eastern"), Rebel Drilling, L.P., Southwest Gas
Supply, Inc., and Bellwether Exploration Company as Defendants.  Plaintiffs seek
recovery of compensatory royalties in the amount of $3.3 million under the
offset and compensatory royalty provisions of a 648-Acre Lease entered into
between Plaintiffs, as Lessors, and Eastern, as Lessee, a lease in which the
Company's predecessor, Hampton Resources Corporation, acquired a partial
interest by assignment.  Plaintiffs also included a separate claim for damages
from an alleged breach of the bonus provisions of an entirely distinct and
unrelated Top Lease Agreement.  The Company believes that Plaintiffs claims for
recovery of damages for alleged breach of the bonus provisions of the Top Lease
Agreement, are without merit, and the Company has filed a Motion for Summary
Judgement with the Court seeking dismissal of the claims.  Plaintiffs have also
filed a Motion for Summary Judgement as to their claims.  Rulings on both
Plaintiffs' and Company's Motions for Summary Judgement are pending.  While the
Company believes the Plaintiff's allegations are groundless and the Company will
vigorously defend such position.  The Company is unable to provide any
assessment of possible outcomes in the case due to the uncertainty of the law
surrounding the issues raised in the summary judgement motions, the vagaries of
the trial process, and the need for additional discovery.  Cross motions for
summary judgement have been filed by the Plaintiffs.  Hearings on both
Plaintiffs and Defendants Motions for Summary Judgement were heard in the middle
of November

                                       22
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------

1998. No ruling on the Motions has been issued as of the date of this document.

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

     None.


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

     The Company's common stock is traded on the NASDAQ National Market (Symbol:
BELW).  There were approximately 1,009 stockholders of record as of March 8,
1999.  The Company has not paid dividends on its common stock and does not
anticipate the payment of cash dividends in the immediate future as it
contemplates that cash flows will be used for continued growth in Company
operations.  In addition, certain covenants contained in the Company's financing
arrangements restrict the payment of dividends (See Management's Discussion and
Analysis of Financial Condition and Results of Operations - Financing Activities
and Note 7 of the Notes to Consolidated Financial Statements).  The following
table sets forth the range of the high and low sales prices, as reported by the
NASDAQ for Bellwether common stock for the periods indicated.
<TABLE>
<CAPTION>
 
                                              Sales Price     
                                          --------------------
                                           High        Low    
                                          ------   -----------
<S>                                       <C>      <C>        
  Quarter Ended:
   September 30, 1996.................... $ 6.88         $4.38
   December 31, 1996..................... $ 9.00         $5.63
   March 31, 1997........................ $11.50         $7.88
   June 30, 1997......................... $10.25         $7.25

   September 30, 1997.................... $15.38         $9.08
   December 31, 1997..................... $14.88         $9.75

   March 31,1998......................... $11.13         $7.88
   June 30, 1998......................... $ 9.88         $7.81
   September 30, 1998.................... $ 8.88         $3.81
   December 31, 1998..................... $ 7.69         $4.13
</TABLE>

Treasury Stock Repurchases
--------------------------

     In September 1998, the Board of Directors of the Company authorized the
open market repurchase of up to $5 million of the Company's Common Stock during
1998, at times and prices deemed attractive by management. During September and
October 1998, the Company repurchased 310,800 shares of Common Stock in open
market transactions, at an average purchase price of $6.13 per share.

                                       23
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------

ITEM 6.  SELECTED FINANCIAL DATA
--------------------------------

     The following selected financial data with respect to the Company should be
read in conjunction with the Consolidated Financial Statements and supplementary
information included in Item 8 (amounts in thousands, except per share data).
<TABLE>
<CAPTION>
                                            Six Month                                     
                          Fiscal Year      Transition
                            Ended         Period Ended                   
                           Dec. 31,         Dec. 31,                          Fiscal Years Ended June 30,
                          ----------      ------------      -----------------------------------------------------------------
                             1998             1997             1997(1)           1996            1995(2)           1994(3)
                          ----------      ----------        ------------      ----------      ------------      -------------

 
<S>                       <C>             <C>                <C>              <C>              <C>                 <C>
Gas revenues............. $ 46,461        $ 26,755            $ 24,202         $ 9,856          $ 4,864             $ 2,620
Oil revenues.............   26,756          17,408              14,865           5,810            3,643               1,086
Gas plant revenues
  net....................    1,203             804               3,330           3,534            4,627               2,917
Interest and other
  income.................    1,347             609                 363             116               97                  63
                          ----------      ----------        ------------      ----------      ------------      -------------
Total revenues...........   75,767          45,576              42,760          19,316           13,231               6,686

Production expenses......   25,381          13,836              11,437           5,317            2,856               1,294
General and
  administrative
  expenses...............    8,459           3,748               4,042           3,013            2,739               1,234
Depreciation, depletion 
  and amortization.......   39,688          16,352              15,574           8,148            5,269               2,489
Impairment expense.......   73,899             ---                 ---             ---              ---                 ---
Interest expense.........   11,660           5,978               4,477           1,657            1,245                 721
Provision (benefit)
  for income taxes.......   (6,069)          2,114               2,585              46                9                 ---
Other expenses...........      ---             ---                 ---             153              172                 134
                          ----------      ----------        ------------      ----------      ------------      -------------
Total expenses...........  153,018          42,028              38,115          18,334           12,290               5,872
                          ----------      ----------        ------------      ----------      ------------      -------------

Net income (loss)........ $(77,251)       $  3,548            $  4,645         $   982          $   941             $   814
                          ==========      ==========        ============      ==========      ============      =============
Earnings (loss) per
  common share........... $  (5.50)       $   0.26            $   0.46         $  0.11          $  0.12             $  0.35
Earnings (loss) per
  common share-diluted....$  (5.50)       $   0.25            $   0.45         $  0.11          $  0.12             $  0.33

Working capital...........$  6,077        $ 13,964            $ 22,783         $ 5,168          $(1,246)            $  (249)
Long-term debt, net
  of current maturities...$104,400        $100,000            $115,300         $13,048          $18,525             $12,797
Stockholders' equity......$ 14,489        $ 91,669            $ 87,924         $46,597          $45,447             $18,372
Total assets..............$131,196        $214,757            $222,648         $67,225          $74,650             $35,870
</TABLE>

______________
(1)  Includes operations from the Partnership Transactions beginning April 1,
     1997.
(2)  Reflects operations from Odyssey and Hampton mergers beginning August 1994
     and February 1995, respectively.
(3)  Includes operations of the gas plant and Associated Gas Resources Inc. from
     dates of acquisition in July and December 1993, respectively.

                                       24
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------


ITEM 7.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
--------------------------------------------------------------------------------
OF OPERATIONS
-------------

     Bellwether is an independent energy company primarily engaged in the
acquisition, exploitation and development of and exploration for oil and gas
properties. Prior to April 1997, the Company had grown and diversified its
operations primarily through acquisitions and subsequent development of the
acquired properties. Subsequent to April 1997 the Company has employed a more
balanced growth strategy combining strategic acquisitions of producing
properties with technology driven exploration and development drilling. As a
result, the Company's results of operations have been significantly affected by
its success in acquiring oil and gas properties and its ability to maintain or
increase production through its exploitation activities.

     In April 1997, the Company purchased oil and gas properties and $13.9
million of working capital from affiliates of Torch for an adjusted purchase
price of $141.1 million ("Partnership Transactions"). The acquisition was
recorded effective April 1, 1997 and the operations of the Company include the
Partnership Transactions from that date. The Partnership Transactions were
financed with $34.1 million of net proceeds of a Common Stock offering, $97.0
million net proceeds of 10 7/8% Senior Subordinated Notes due 2007 (the
"Offerings") and borrowings under a new credit facility ("New Credit Facility").
In addition as consideration for advisory services Torch was issued 150,000
shares of the Company's common stock and a warrant, expiring in April 2002, to
purchase 100,000 shares at $9.90 per share for advisory services rendered in
connection with the Partnership Transactions. The warrant and shares were valued
at $1.5 million and recorded as a cost of the Partnership Transactions.

     In order to facilitate greater comparability with its peer group by the
financial community, the Company changed its fiscal year to the calendar year,
beginning January 1, 1998. This resulted in a six-month transition period of
July 1, 1997 through December 31, 1997 ("transition period").

     The Company uses the full cost method of accounting for its investment in
oil and gas properties. Under the full cost method of accounting, all costs of
acquisition, exploration and development of oil and gas reserves are capitalized
in a "full cost pool" as incurred. Oil and gas properties in the pool, plus
estimated future expenditures to develop proved reserves and future abandonment,
site reclamation and dismantlement costs, are depleted and charged to operations
using the unit of production method based on the ratio of current production to
total proved recoverable oil and gas reserves. To the extent that such
capitalized costs (net of depreciation, depletion and amortization) exceed the
discounted future net revenues on an after-tax basis of estimated proved oil and
gas reserves, such excess costs are charged to operations. Once incurred, the
writedown of oil and gas properties is not reversible at a later date even if
oil and gas prices increase. Sharp declines in oil and gas prices, including
further gas price decline subsequent to year end, and to a lesser extent,
downward revision in estimated proved reserves resulted in a $73.9 million

                                       25
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------

pretax impairment charge ($71.6 after tax), in the fiscal year ended
December 31, 1998. February 23, 1999 prices used in computing the impairment
were based on a NYMEX oil price of $12.48 per barrel and a NYMEX gas price of
$1.71 per MMBTU, adjusted to the wellhead.

     The Company periodically uses derivative financial instruments to manage
oil and gas price risk. Settlements of gains and losses on price swap contracts
are generally based upon the difference between the contract price and the
average closing NYMEX or other floating index price and are reported as a
component of oil and gas revenue during the period in which the underlying
commodity is produced. Gains or losses attributable to the termination of swap
contracts are deferred and recognized in revenue when the hedged oil and gas is
sold.

Financing Activities
--------------------

     The Company's outstanding indebtedness totals $104.4 million at
December 31, 1998; $100 million is attributable to 10 7/8% Senior Subordinated
Notes due in 2007 while $4.4 million is outstanding under a senior revolving
unsecured credit facility with an ultimate maturity date of November 2003.

     In April 1997, the Company entered into a senior revolving unsecured credit
facility("Senior Credit Facility") in an amount up to $90.0 million, with a
current borrowing base of $60.0 million, and a maturity date of November 5,
2003. Bellwether may elect an interest rate based either on a margin plus London
Interbank Offered Rate ("LIBOR") or the higher of the prime rate or the sum of
1/2 of 1% plus the Federal Funds Rate. For LIBOR borrowings, the interest rate
will vary from LIBOR plus 0.875% to LIBOR plus 1.25% based upon the borrowing
base usage. In connection with the acquisition of oil and gas properties, $33.3
million was drawn under this facility, including $22.0 million to retire
indebtedness previously outstanding. As of December 31, 1998, $4.4 million was
outstanding under the Senior Credit Facility. The Senior Credit Facility
contains various covenants including certain required financial measurements for
current ratio, consolidated tangible net worth and interest coverage ratio. In
addition, the Senior Credit Facility includes certain limitations on restricted
payments, dividends, incurrence of additional funded indebtedness and asset
sales.

     In October 1996, the Company entered into a syndicated credit facility in
an amount up to $50.0 million with an initial borrowing base of $27.0 million,
to be re-determined semi-annually. This credit facility was unsecured and was
retired in April 1997. In February 1995, the Company entered into a credit
facility with a commercial bank providing an initial borrowing base of $29.8
million. The borrowings under the credit facility were secured by the Company's
interest in oil and gas properties, a gathering system and two gas plants. The
Credit Facility was retired in October 1996.

     In April 1997, the Company issued $100.0 million of 10 7/8% senior
subordinated notes ("Notes") that mature April 1, 2007 for net proceed of $97.0
million. Interest on the Notes is payable semi-annually on April 1 and October 1
commencing on October 1, 1997. The Notes contain certain covenants, including
limitations on: 1) the incurrence of debt, 2) on other senior subordinated

                                       26
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------

indebtedness, 3) on restricted payments and 4) on liens as well as restrictions
5) on the disposition of proceeds of asset sales and 6) on mergers, and 7)
consolidations or sales of assets. Additionally, the notes require the Company
to offer to purchase the notes in the event of a change of control.

     In order to reduce interest costs, effective September 22, 1998, the
Company entered into an eight and one half year interest rate swap agreement
with a notional value of $80 million. Under the agreement, the Company receives
a fixed interest rate and pays a floating interest rate based on the simple
average of three foreign LIBOR rates. Floating rates are redetermined for a six
month period each April 1 and October 1. The floating rate for the period from
inception to April 1, 1999 is 9.73%. Through April 1, 2002, the floating rate is
capped at 10.875% and capped at 12.375% thereafter. This interest swap is
accounted for as a hedge.

     In April 1997, the Company issued 4.4 million common shares in a public
offering. The net proceeds of the offering were $34.1 million.

Liquidity and Capital Resources
--------------------------------

     The Company's principal sources of capital for the last three years and for
the six month transition period have been the sale of Notes, borrowings under
bank credit facilities, the public sale of common stock and cash flow from
operations. The Company sold $100 million in Notes in fiscal 1997. Borrowings
from banks were $4.9 million, $1.5 million and $57.3 million for the fiscal year
1998, the transition period 1997 and fiscal year ended June 30, 1997
respectively. The Company issued 4.4 million shares of common stock in a public
offering in April 1997 for net proceeds of $34.1 million. Cash flow from
operations before change in assets and liabilities totaled $30.4 million, $21.8
million, $23.3 million and $9.1 million for the fiscal year 1998, the transition
period 1997 and fiscal years 1997 and 1996, respectively. The increase in cash
flow from operations before changes in assets and liabilities resulted primarily
from the Partnership Acquisitions in early 1997. However, cash flow from
operations before changes in working capital for the fiscal year 1998 was
adversely impacted by a 22% reduction in the average price received for the
Company's oil and gas production as compared to the average price received
during the twelve months ended December 31, 1997. In addition, during March
1996, the Company agreed to assume the purchase obligation under a gas contract
in the West Monroe field in Louisiana in exchange for a cash payment of $9.9
million. In a series of transactions from May through December 1997, the Company
divested non-core assets representing approximately 10% of its estimated net
proved reserves for $24.3 million.

     The Company's primary uses of capital have been to fund acquisitions and to
fund its exploration and development projects. Acquisitions, net of working
capital acquired, totaled $10.3 million, $5.5 million and $140 million for the
fiscal year 1998, the transition period 1997 and fiscal 1997, respectively. The
Company's expenditures for exploration and development of its oil and gas
properties totaled $30.6 million, $13.7 million, $15.6 million and $6.4 million
for the fiscal year 1998, the transition period ended December 31, 1997 and the
fiscal years ended June 30, 1997 and 1996, respectively.

                                       27
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------


Outlook
-------

     The Company has adopted a $26.8 million capital budget for the year ending
December 31, 1999 primarily for development and exploratory drilling activities.
The Company believes its working capital and net cash flows provided by
operating activities are sufficient to meet these capital commitments.
Additionally, the Company currently has a $60.0 million borrowing base under its
Senior Credit Facility with $4.4 million outstanding borrowings at December 31,
1998. Further, the Company expects its borrowing base may be reduced to an
undetermined amount at the next redetermination in April or May of 1999 as a
result of the recent price declines as well as downward reserve revisions. The
Company is continuously reviewing acquisition opportunities and expects to
conclude one or more acquisitions during 1999. Acquisitions are not included in
the capital budget and will be funded through additional borrowings and/or the
issuance of securities.

     The Company's results of operations and cash flow are affected by changing
oil and gas prices. Changes in oil and gas prices often result in changes in the
level of drilling activity, which in turn adjusts the demand for and cost of
exploration and development. Thus, increased prices may generate increased
revenue without necessarily a corresponding increase in profitability while
declining prices almost always have a negative impact on profitability. These
industry market conditions have been far more significant determinants of
Company earnings than have macroeconomic factors such as general inflation,
which has had only minimal impact of Company activities in recent years. It is
impossible to predict the precise effect of changing prices and inflation on
future Company operations, and no assurance can be given as to the Company's
future success at reducing the impact of price changes in the Company's
operating results.

     World crude prices have continued to decline throughout 1998 and into 1999.
The primary reasons for this continued decline are believed to be 1) a
significant increase in worldwide production, 2) high worldwide inventories, 3)
decreased demand due to the Southeast Asian economic collapse and 4) decreased
demand resulting from mild Northern Hemisphere winters.  Worldwide production
capacity exceeds demand so macro management of worldwide production is a key
factor to crude oil prices.  Existing production cutbacks established in 1998
by, the Organization of Petroleum Exporting Countries ("OPEC") and other
producers are expected to be extended to December 31, 1999 and additional
cutbacks beginning in April 1999 have been announced.  However, there can be no
assurance that such agreed cutbacks will actually occur.

     In addition to continued oil price softening, gas prices have declined an
average of 17% in 1998 as compared to 1997. This softening due to weather
related decreased demand and high storage inventories has continued into 1999 as
compared to the same period of 1998.

     The weak oil and gas prices reduce the value of oil and gas in the ground
(primary assets), reduce cash flows attributable to such assets and consequently
can affect future borrowing base capacity and future exploration and development
activity.  This slow down in activity has already been

                                       28
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------

reflected in record low rig counts. The domestic oil and gas rig counts have
declined 69% and 20%, respectively, from a year ago. This has resulted in
reduced rig prices and availability which can benefit the Company's exploration
and development activities.

Year 2000 Issues
----------------

     The Year 2000 problem ("Y2k")refers to the inability of computer and other
information technology systems to properly process date and time information.
The problem was caused, in part, by the outdated programming practice of using
two digits rather than four to represent the year in a date.  The consequence of
the Y2k problem is that information technology and embedded processing systems
are at risk of malfunction, particularly during the transition between 1999 to
2000.

     The effects of the Y2k are exacerbated by the interdependence of computer
and telecommunication systems throughout the world. This interdependence also
exists among the Company and its vendors, customers and business partners, as
well as with government agencies.

     The risks of Y2k fall into three general areas: 1) Corporate Systems,
2) Field Systems and 3) Third Party Exposure. The Company intends to address
each of these areas through a readiness process that follow the steps below:

   a)  Planning and Awareness
   b)  Inventory and Assessment
   c)  Identify Potential Problems and their Business Impact
   d)  Identify/Approve Solutions
   e)  Test and Implement Solutions
   f)  Contingency Planning

     The Company has formed a Y2k Team comprised of representatives from senior
management, exploration, exploitation, accounting, legal and internal audit. The
continuing progress of this Y2k Team is reported regularly to the Company's
Board of Directors.

     The Company outsources a substantial portion of its information technology
and field operations to Torch. The Company and Torch have jointly developed a
plan to address the Company's Year 2000 issues. (As used in the remainder of
this discussion, references to the Company include the Torch employees assisting
the Company in its Year 2000 compliance program.)

     The estimated total costs for Y2k readiness has been nominal. It is
anticipated that such costs for complete Y2k readiness will continue to be
nominal as much of these costs are borne by Torch under the terms of the
existing outsourcing agreement. In addition, there have been no material capital
expenditures for Y2k and there is not anticipated to be material capital
expenditures as most major critical field operations do not have date sensitive
equipment. Remediation and testing is scheduled to be completed by June 30,
1999.

                                       29
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------


Corporate Systems
-----------------

1.   Planning and Awareness. All employees have attended Y2k informational
     programs including a general discussion of what Y2k is and how it could
     affect the business. Employees of all levels of the organization have been
     asked to participate in the identification of potential Y2k risks including
     routine Excel and Word documents. Awareness of the issue is extremely high.
     Overall planning of the Y2k function has been delegated to the Y2k Team
     mentioned above.

2.   Inventory and Assessment. The Company has completed an inventory of the
     traditional computing platforms including client/server systems, LAN
     systems and PC systems, as well as an inventory of all systems software and
     operating systems for each computing system. In addition, third party
     service interfaces, banking/treasury interfaces and telecommunications have
     been cataloged.

     Assessment of component compliance (compliant, not-compliant, expected date
     of compliance, etc.) has been completed and included research of product
     information on the Internet, contacting peer group companies and accessing
     information that peer group companies have already found.

3.   Identification.  The failure to identify and correct a material Y2k problem
     in the Corporate Systems could result in inaccurate or untimely financial
     information for management decision-making or financial reporting purposes.
     The severity of such problems may impact the duration during which quality
     information is available to management.  At this time, management believes
     that any Y2k disruptions associated with its financial and administration
     systems will not have a material effect on the Company.

4.   Identify/Approve Solutions.  Based upon the assessments of components'
     compliance, solutions are determined.  These solutions include:  1) fix or
     replace the non-compliant component, 2) buy patches or replacement items,
     3) develop workarounds, 4) identify alternate automated processes, 5)
     design manual procedures and 6) develop business continuity plans for
     specific items or systems.

5.   Test and Implement Solutions.  Since April 1998 Torch has been working on a
     upgrade to its accounting software and is expected to achieve full Y2k
     compliance in the first half of 1999.  In addition, all network and desktop
     applications used by the Company have been inventoried and are generally
     Y2k compliant.  The costs of all such risk assessments and remediation are
     borne by Torch under the terms of Bellwether's outsourcing agreements.  No
     software or hardware can be purchased and placed into service after
     June 30, 1999 without express Y2k compliance assurance.

6.   Contingency Planning.  Notwithstanding the foregoing, should there be
     significant unanticipated disruptions in the Company's financial and
     administrative systems, a number of accounting processes that are currently
     automated will need to be performed manually.  The Company is currently

                                       30
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------

     considering its options with respect to contingency arrangements for
     temporary staffing to accommodate such situations.

Field Systems
-------------

1.   Planning and Awareness. The Company's Y2k program has involved all levels
     of management of field and facility assets from production foremen and
     higher. Employees at all levels of the organization have been asked to
     participate in the identification of potential Y2k risk, which might
     otherwise go unnoticed by higher level employees and officers of
     Bellwether, and as a result, awareness of the issue is high.

2.   Inventory and Assessment. This step entailed locating all embedded chip
     technology used in the field operations including safety systems,
     measurement devices, overflow valves, SCADA systems and other field
     processes that are date-or-time-sensitive. It is estimated that there are
     less than a hundred embedded components residing in the computer systems
     within Bellwether's numerous operated oil and natural gas fields and
     processing plants. During the assessment stage a list of assets to be
     tested was assembled. Consideration was given to 1) issues of health and
     safety, 2) environmental concerns, 3) economic factors and 4) other
     business risks as appropriate. Vendors and manufacturers have been
     contacted as well as product research through the Internet and the use of
     peer group company shared information. To date, the majority of embedded
     components researched have been deemed either date-insensitive or Y2k
     compliant. However, the complexity of embedded systems is such that a small
     minority of non-compliant components, even a single non-compliant
     component, can corrupt an entire system. Now that the component level
     evaluation is substantially complete, a broader evaluation at the system
     level has commenced. Bellwether anticipates that the system level
     evaluation will be completed by the end of the second quarter 1999.

3.   Identification. The failure to identify and correct a material Y2k problem
     could result in outcomes ranging from errors in data reporting to
     curtailments or shutdowns in production. The Company is actively engaged in
     a program to prioritize the remediation of embedded components and systems
     which are either known to be Y2k non-compliant or which have higher risk of
     Y2k failures, and to further prioritize remediation targets by the
     anticipated financial impact of any such failures on the Company. To assist
     in this effort, Bellwether and Torch have retained consultants who are
     knowledgeable and experienced in the assessment of Y2k issues impacting
     field operations. Bellwether intends to give extremely high priority to the
     remediation of any situation that impacts employee health and safety or
     environmental security. The cost of the assessment is not expected to be
     material to Bellwether's financial results. At this time management is
     unable to express any degree of confidence that there will not be material
     production disruptions associated with Y2k non-compliance. Depending on the
     magnitude of any such disruptions and the time required to correct them,
     such failures could materially and adversely impact the Company's results
     of operations, liquidity and financial condition.

                                       31
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------

4.   Identify/Approve Solutions. Based upon the assessment of field systems,
     regarding compliance or non-compliance, solutions are determined. These
     potential solutions include 1) fix or replace non-compliant items, 2) buy
     patches or replacement items, 3) develop workarounds, 4) identify
     alternative automated processes, 5) design manual procedures and 6) develop
     business continuity plans for specific items or systems.

5.   Test and Implement Solutions. Once identified, assessed and prioritized,
     Bellwether intends to test, upgrade and certify those embedded components
     and systems in field process control units deemed to pose the greatest risk
     of significant non-compliance. It is important to note that in some
     circumstances, the procedures used to test embedded components for Y2k
     compliance themselves pose a risk of damaging the component or corrupting
     the system. Accordingly, there may be situations in which a decision not to
     test may be deemed the most prudent.

     The Company does not expect the cost of testing and upgrading its embedded
     chips to be material due to the number of components and the low cost of
     such components. If this assumption is incorrect, the Company may incur
     material costs in connection with testing and remedying Year 2000 problems.
     In addition, if the Company is not successful and ultimately experiences
     Y2k related failures, the costs attributable to lost production, damages to
     facilities and environmental damages may be material. The effort to address
     the Y2k situation is dynamic and may likely not be fully completed by
     December 31, 1999.


6.   Contingency Planning.  Should material production disruptions occur as a
     result of Y2k failures in the field operations, Bellwether's operating cash
     flow will be impacted.  This contingency is being factored into
     deliberations on capital budgeting, liquidity and capital adequacy.  It is
     management's intention to maintain adequate financial flexibility to
     sustain the Company during any such period of cash flow disruption.

Third Party Exposures
---------------------

1.   Planning and Awareness. The Company has been involved in informational
     programs with its employees and the employees of Torch who have significant
     interaction with outside vendors, customers and business partners of the
     Company. All levels of employees in the organization have been asked to
     participate in the identification of potential third party Y2k risk, which
     might otherwise go unnoticed by higher level employees and officers of
     Bellwether, and as a result, awareness of the issue is considered high.

2.   Inventory and Assessment. Surveys of general Y2k readiness have been sent
     to all vendors, customers and business partners of the Company. An
     assessment is made regarding the priority of risk associated with each
     third party, and how the third party's level of compliance directly affects
     day-to-day business. The Company's most critical customers are outside
     operators of wells, gas plants, refineries, natural gas marketers and
     pipelines.

                                       32
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------


3.   Identification. Refineries are extremely complex operations containing
     hundreds or thousands of computerized processes. The failure on the part of
     a Bellwether refinery customer to identify and correct a material Y2k
     problem could result in material disruptions in the sale of Bellwether's
     production to that refinery. In many cases, affected Bellwether production
     may not be easily shifted to other markets, and the result can range from
     reduced realizations on crude oil produced, curtailed production or even
     shut-in production. Failures of natural gas marketers and the pipelines
     that connect Bellwether's production to markets may have similar effects.
     Although the Company has made inquiries to key third parties on the subject
     of Y2k readiness and will continue to do so, it has no ability to require
     responses to such inquiries or to independently verify their accuracy.
     Accordingly, management is unable to express any degree of confidence that
     there will not be material production disruptions associated with third
     party Y2k non-compliance. Depending on the magnitude of any such
     disruptions and the time required to correct them, such failures could
     materially and adversely impact the Company's results of operations,
     liquidity and financial condition.

     Other significant concerns include the integrity of global
     telecommunication systems, the readiness of commercial banks to execute
     electronic fund transfers and of the ability of the financial community to
     maintain an orderly market in Bellwether's securities.

4.   Identify/Approve Solutions.  By prioritizing the various third party risks
     mentioned above, a list of most critical third party vendor, customer and
     business partners has been determined.  By cross-referencing the results of
     the Y2k readiness survey with the Company's priority list of third parties
     solutions can be determined.  These may involve field and/or office visits
     and more detailed meetings to access the third party's Y2k compliance.

5.   Test and Implement Solutions.  Where the Company perceives significant risk
     of Y2k non-compliance that may have a material impact on the Company, and
     where the relationship between the Company and a vendor, customer or
     business partner permits, joint testing may be undertaken during 1999.
     Joint testing would occur following upgrades and other remediation to
     hardware, software and communications links, as applicable, with the intent
     of determining that the remediated system being tested will perform as
     expected after December 31, 1999.

6.   Contingency Planning.  Should material production disruptions occur as a
     result of Y2k failures of third parties, Bellwether's operating cash flow
     will be impacted.  This contingency is being factored into deliberations on
     capital budgeting, liquidity and capital adequacy.  It is management's
     intention to maintain adequate financial flexibility to sustain the Company
     during any such period of cash flow disruption.

                                       33
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------

RESULTS OF OPERATIONS
---------------------

     For comparability with annual periods, amounts discussed in this section
regarding the six month transition period 1997 have been annualized.  These
amounts  may not be indicative of twelve month's operating results.  The table
below recaps the major components of financial and operating performance to be
discussed (amounts in thousands):

<TABLE>
<CAPTION>
                                                        Annualized (1)
                                                          Transition               Fiscal             Fiscal
                                  Fiscal 1998            Period 1997                1997               1996
                                ---------------       ------------------        -----------        ------------
 
<S>                                <C>                    <C>                     <C>                 <C>
Oil and gas revenues               $ 73,217               $88,326                 $39,067             $15,666
Gas plant revenues,net                1,203                 1,608                   3,330               2,577
Gas gathering revenue, net              ---                   ---                     ---                 957
Interest and other                    1,347                 1,218                     363                 116
                                ---------------       ------------------        -----------        ------------
 
Total revenue                        75,767                91,152                  42,760              19,316
 
Production expenses                  25,381                27,672                  11,437               5,317
Depreciation,depletion and
  amortization                       39,688                32,704                  15,574               8,148
Impairment expense                   73,899                   ---                     ---                 ---
General and administrative
  expenses                            8,459                 7,496                   4,042               3,013
Income tax (benefit)
 and other                           (6,069)                4,228                   2,585                 199
Interest expense                     11,660                11,956                   4,477               1,657
                                ---------------       ------------------        -----------        ------------
Net income (loss)                  $(77,251)              $ 7,096                 $ 4,645             $   982
                                ===============       ==================        ===========        ============
 
Production
  Oil and condensate (MBBLS)          2,298                 2,108                     854                 334
  Natural gas (MMCF)                 21,302                22,386                  10,552               5,099
  Gas equivalent (MMCFE)             35,090                35,034                  15,676               7,103
          
 
Average sales price (2)
  Oil and condensate (per
  barrel)                          $  11.34               $ 16.34                 $ 17.41             $ 17.81
  Natural gas (per MCF)            $   2.05               $  2.55                 $  2.29             $  2.02
</TABLE>

                                       34
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------


Average unit production
  costs per equivalent
  MCF (1 barrel equals 6
  MCF)                         $   .72      $   .79       $   .73       $   .75
 
Average unit general and
  administrative expense
  per equivalent MCF (3)       $   .24      $   .21       $   .23       $   .34


Average unit depletion rate
  per equivalent MCF(4)        $  1.10      $   .90       $   .94       $   .98
 
_______
(1)  Annualized amounts were computed by multiplying Transition Period 1997
     components by 2
(2)  Average sales price is exclusive of the effect of natural gas and crude oil
     price hedges
(3)  Exclusive of general and administrative expenses allocated to gas plants
     and gas gathering facilities
(4)  Exclusive of depreciation on gas plants

     Operations of the gas plant and the gathering system are summarized as
follows:
<TABLE>
<CAPTION>
 
                                                             Annualized
                                                             Transition
                                                 Fiscal        Period        Fiscal      Fiscal
                                                  1998          1997          1997        1996
                                                 ------      ----------      ------      ------
<S>                                              <C>            <C>          <C>         <C>
Plant product sales volume (MBBLS).............     254           218           319          321
Average product sales price per barrel.........  $10.19        $14.45        $16.77       $13.01
Gathering system throughput (MMCF per day).....     ---           ---           ---          4.0(1)
</TABLE>
___________
(1)  Represents operations from July 1995 through February 1996. Subsequent to
     February 1996, the Company ceased recognition of such operations following
     the Company's assumption of a gas purchase contract and receipt of $9.9
     million. (See Note 2 of Notes to Consolidated Financial Statements).


     Fiscal 1998 Compared with Annualized Transition Period 1997:
     ------------------------------------------------------------

     Fiscal 1998 reflects a loss of $77.3 million as compared to net income of
$7.1 million for the annualized transition period 1997.  The loss in 1998 is
directly attributable to oil and gas price declines of 31% and 20%,
respectively, and the full cost ceiling impairment of $73.9 million.  Such
impairment resulted from the price declines as well as the downward revision in
proved reserves.

     Oil and gas revenues were $73.2 million for the year ended December 31,
1998, a decrease of 17% over the annualized transition period 1997.  This
decrease is primarily due to the decline in oil and gas prices mentioned above.
Oil prices decreased from $16.34 per barrel in the annualized

                                       35
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------

transition period 1997 to $11.34 in the fiscal year ended December 31, 1998. Gas
prices decreased from $2.55 per Mcf in the annualized transition period 1997 to
$2.05 per Mcf in the fiscal year ended December 31, 1998. The Company utilized
various hedging transactions to manage a portion of the risks associated with
natural gas and crude oil price volatility. As a result of these hedges, oil and
gas revenues were increased by $3.6 million in the year ended December 31, 1998
and reduced by $1.6 million in the transition period 1997.

     Gas plant revenues were $3.2 million in the year ended December 31, 1998, a
decrease of 22% from the transition period 1997 gas plant revenues of $4.1
million.  The decrease in average liquid prices of 30% is the primary reason gas
plant revenues have declined.  The average liquid price in fiscal 1998 was
$10.19 per barrel while the annualized transition period 1997 average liquid
price was $14.45 per barrel.  Throughput volumes have remained steady at 14.3
MMcf per day in fiscal 1998 as compared to 14.9 MMcf per day in annualized
transition period 1997.  Plant shut-in days were less in fiscal 1998 with 8 days
downtime in 1998 resulting from an accident in an adjacent plant and the tie-in
of new equipment.  Downtime in 1997 totaled 24 days (48 days annualized) for
installation of an amine unit in September 1997 and repairs to the insulation in
the incinerator.  Gas plant expenses were $2.0 million in fiscal 1998 and $2.5
million in annualized transition period 1997.

     Interest and other income increased to $1.3 million in fiscal 1998 from
$1.2 million in annualized transition period 1997.

     Production expenses for the year ended December 31, 1998 were $25.4
million, a decrease of 8% from the transition period amount.  On an MCF
equivalency basis, production expenses for the year decreased to $.72 per
equivalent MCF versus $.79 per equivalent MCF in the transition period 1997.

     Depreciation, depletion and amortization for the year ended December 31,
1998 increased 21% to $39.7 million.  The increase is due to the increase in the
depreciation, depletion and amortization rate per MCF to $1.10 per MCF.  This
represents a 21% increase over the annualized transition period 1997 rate of
$.90 per MCF.  The rate increase is primarily due to a downward revision to
proved reserves of 26 BCFE or 12% of the reserve quantities at the beginning of
the year.  Weak oil and gas prices  were the most significant contributor to the
reserve revision.  Production performance also contributed to the revision, but
to a lesser extent as the weak prices resulted in a shortened economic life for
certain of the Company's properties.

     An impairment expense of $73.9 million was required in fiscal 1998 because
the Company's capitalized costs (net of depreciation, depletion and
amortization) exceeded the discounted future net reserves on a after-tax basis
of estimated proved oil and gas reserves.  The decline in oil and gas reserves
and discounted future net revenues is due largely to depressed oil and gas
prices.

     General and administrative expenses increased from $7.5 million in
annualized transition period 1997 to $8.5 million in the year ended December

                                       36
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------

31, 1998. The closing of the Company's Dallas exploration office in March 1998
resulted in $.3 million of increased general and administrative expenses and
certain transition costs related to the change of the Company's fiscal year also
increased such expenses by approximately $.4 million. On an MCF basis, general
and administrative cost increased to $.24 per MCF in fiscal 1998 as compared to
$.21 per MCF in the transition period 1997.

     Annualized interest expense decreased 2% to $11.7 million from $12.0
million in fiscal 1997.

     Annualized Transition Period 1997 Compared with Fiscal 1997:
     ------------------------------------------------------------

     Net income for the annualized transition period 1997 was $7.1 million as
compared to net income of $4.6 million in the fiscal year 1997.  The primary
reason for the increase is the full year's production attributable to the
Partnership Transactions in the annualized transition period 1997.  The fiscal
1997 period reflects only 3 months of such activity.

     Oil and gas revenues were $88.3 million for the annualized transition
period 1997, an increase of 126% over the fiscal year ended June 30, 1997.  This
increase is due to a full year of production from the properties acquired in the
Partnership Transactions which closed in the fourth quarter of fiscal 1997.
Annualized production on a MCFE basis increased 124% to 35,034 equivalent MCF in
the transition period compared to 15,676 equivalent MCF of production in fiscal
1997.

     During the period, the volatility of oil and gas prices also directly
impacted revenues.  Most significantly, natural gas prices increased in the
transition period 1997 to $2.55 per Mcf from $2.29 per Mcf in fiscal 1997.
During the transition period 1997 and fiscal 1997, the Company utilized various
hedging transactions to manage a portion of the risks associated with natural
gas and crude oil price volatility.  As a result of these hedges, oil and gas
revenues were reduced by $1.6 million in the transition period 1997 and by
$18,000 in fiscal 1997.

     Gas plant revenues were $4.1 million in the annualized transition period
1997, a decrease of 39% from fiscal 1997 gas plant revenues.  The decrease,
prior to annualization, was due to a 10 day shut-down of the plant in September
to install an amine unit and a two week shut-down in December to repair the
insulation in the incinerator (a total of 48 days on a annualized basis). Also,
contributing to the decline in the annualized transition period 1997 gas plant
revenues was a 14% decline from fiscal 1997 in plant liquids prices. Annualized
gas plant expenses were $2.5 million in the transition period 1997 as compared
to $3.3 million during fiscal 1997.  The decrease in expenses is attributable to
the plant shut-downs.

     Production expenses for the annualized transition period 1997 were $27.7
million, an increase of 142% over the fiscal 1997 amount.  The increase is
primarily due to inclusion of the Partnership Transactions for all of transition
1997, while fiscal 1997 amounts reflect only one quarter for the Partnership
Transactions.  On an MCF equivalency basis, production expenses for the
annualized transition period increased to $.79 per equivalent MCF

                                       37
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------

versus $.73 per equivalent MCF in fiscal 1997. The increase in the per unit rate
results from the suspension of production, but not production expenses, at the
Point Pedernales field for most of the last quarter of the transition period and
from out of period expenses recorded within the annualized 1997 transition
period.

     Depreciation, depletion and amortization for the annualized transition
period 1997 increased 110% to $32.7 million.  The impact of increased production
in the transition period due to the Partnership Transactions was partially
offset by a $.04 per MCF decrease in the depletion rate.  Depreciation,
depletion and amortization was $.90 per MCF in the annualized transition period
1997 as compared to $.94 per MCF in fiscal 1997.
 
     General and administrative expenses increased from $4.0 million in fiscal
1997 to $7.5 million in annualized transition period 1997.  The increase is
primarily due to increased management fees resulting from the Partnership
Transactions.  Management fees are based on the Company's net assets and
operating cash flows.  On an MCF basis, general and administrative expenses
decreased to $.21 per MCF in transition 1997 from $.23 per MCF in fiscal 1997.

     Annualized interest expense increased 167% to $12 million from $4.5 million
in fiscal 1997.  The increase is primarily due to interest attributable to the
$100 million of 10 7/8% Senior Subordinated Notes issued April 1997 to finance
the Partnership Transactions.

     Fiscal 1997 Compared to Fiscal 1996:
     ------------------------------------

     Net income for the fiscal years ending June 30, 1997 and 1996 were $4.6
million or $.45 per share and $1 million or $.11 per share, respectively.  This
increase results primarily from the increased production and revenue generated
by the Partnership Transactions.

     Oil and gas revenues were $39.1 million in fiscal 1997, an increase of 149%
over the fiscal year ended June 30, 1996.  This increase is largely attributable
to a 120.6% increase in equivalent production in 1997 resulting primarily from
the Partnership Transactions.

     In addition, natural gas prices increased 13% to $2.29 per Mcf in fiscal
1997 as compared to $2.02 per Mcf in fiscal 1996.  As a result of natural gas
and crude oil hedging activities, oil and gas revenues were reduced by $18,000
in fiscal 1997 and by $560,000 in fiscal 1996.

     Gas plant revenues were $6.7 million in fiscal 1997, an increase of 26%
over prior year revenues of $5.3 million.  Contributing to this increase were
increases in plant liquid prices of 29% over the prior year.

     There were no gas gathering revenues in fiscal 1997 due to the Company's
agreement in February 1996 to assume payment obligations under a gas purchase
contract and its decision to cease recognition of income from gas gathering
operations.

                                       38
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------

     Production expenses for fiscal 1997 totaled $11.4 million, as compared to
$5.3 million in fiscal 1996.  The 115% increase in production expenses in fiscal
1997 was attributable to increased production from the Partnership Transactions.
On a MCF basis, production expenses were $.73 per MCF in fiscal 1997 as compared
to $.75 in fiscal 1996.

     Depreciation, depletion and amortization increased 93% to $15.6 million in
fiscal 1997 versus $8.1 million in fiscal 1996.  Such increase was attributable
to higher production from the Partnership Transactions, offset by a 4% decrease
in the depletion rate of $.94 per MCF as a result of the Partnership
Transactions.

     General and administrative expenses increased in 1997 to $4.0 million from
$3.0 million in fiscal 1996.  The increase is attributable to the increased
management fee resulting from the April 1997 Partnership Transactions.  General
and administrative expenses on an equivalent MCF basis actually decreased from
$.34 per equivalent MCF in fiscal 1996 to $.23 per equivalent MCF in fiscal
1997.

     Interest expense increased 170% to $4.5 million in fiscal 1997 from $1.7
million in fiscal 1996.  The increase is due to the Company issuing $100 million
of 10 7/8% Senior Subordinated Notes in April 1997 to finance the Partnership
Transactions.

Other Matters
-------------

     Dividends
     ---------

     At present, there is no plan to pay dividends on the Common Stock.  Certain
restrictions contained in the Company's outstanding Notes and Senior Credit
Facility limit the amount of dividends which may be declared.  The Company
maintains a policy, which is subject to review from time to time by the Board of
Directors, of reinvesting its discretionary cash flows for the continued growth
of the Company.

     Gas Balancing Positions
     -----------------------

     It is customary in the industry for various working interest partners to
sell more or less than their entitled share of natural gas production.  The
Company uses the sales method of accounting for gas imbalances.  Under this
method, gas sales are recorded when revenue checks are received or are
receivable on the accrual basis.  The settlement or disposition of gas balancing
positions as of December 31, 1998 is not anticipated to adversely impact the
financial condition of the Company.

     Derivative Financial Instruments
     --------------------------------

     The Company periodically uses derivative financial instruments to manage
oil and gas price risk and interest rate risk. For purposes of its hedging
activities, the Company divides product price risks into two categories,
fluctuations in the price of oil and gas on the NYMEX and

                                       39
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------

fluctuations in the difference between NYMEX prices and the price actually
received by the Company for its production (referred to as "basis
differential"). From time to time the Company enters into swap transactions in
which the Company agrees to pay a fixed price and the counter party to the swap
agrees to pay a NYMEX based price. At December 31, 1998, the Company was not a
party to any swap transactions. From time to time the Company also enters into
contracts which fix the basis differential between the NYMEX price and the price
received at a sales location. At December 31, 1998, the Company has entered into
basis swap contracts to hedge the basis differential on 10,000 million cubic
feet per day (mcfpd) at a differential of gas for delivery at Houston Ship
Channel for the period from January to October 1999 for $.02 under the NYMEX 3
day average. Also, the differential on an additional 9,000 mcfpd of gas for
delivery at Transco Zone 3 and at ANR Louisiana sales from April through October
1999 is hedged at a differential of zero and $.09 below the NYMEX 3 day average,
respectively. These basis differential hedges are not expected to be material to
the Company.

     Effective September 22, 1998, the Company entered into an eight and a half
year interest rate swap agreement with a notational value of $80 million.  Under
the agreement, the Company receives a fixed interest rate and pays a floating
interest rate based on the simple average of three foreign LIBOR rates.
Floating rates are redetermined for a six month period each April 1 and
October 1. The floating rate for the period from inception to April 1, 1999 is
9.73%. Through April 2002 the floating rate is capped at 10.875% and capped at
12.375% thereafter. A 10% increase in these floating rates would have the effect
of increasing interest costs to the Company by $800,000 per year.

     New Accounting Pronouncements
     -----------------------------

     In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities."  This statement establishes standards of
accounting for and disclosures of derivative instruments and hedging activities.
This statement is effective for fiscal years beginning after June 15, 1999.  The
Company has not yet determined the impact of this statement on the Company's
financial condition or results of operations.

     Subsequent Events
     -----------------

     During 1998, in connection with a possible transaction with Carpatsky
Petroleum Company ("Carpatsky"), the Company agreed to guarantee $500,000 of
indebtedness of Carpatsky to Torch.  The transaction ultimately was not pursued.
The Carpatsky note to Torch went into default in June 1998.  The Company has
agreed to pay Torch $565,700 under the guaranty which will subrogate the Company
to Torch's rights under the note.  The Company has further agreed with Carpatsky
to convert the note into 4.5 million shares of Carpatsky, with a current market
value of $450,000 and a warrant to acquire an additional number of common shares
to be determined.  Carpatsky is currently traded on the Alberta Stock Exchange
and is subject to normal market fluctuations.  Consummation of these
transactions are subject to agreement on documentation and final approval of
terms by the respective parties.

                                       40
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------


ITEM 7A.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
--------------------------------------------------------------------

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

     Commodity Price Risk - The Company produces and sells crude oil, natural
gas and natural gas liquids.  As a result, the Company's operating results can
be significantly affected by fluctuations in commodity prices caused by changing
market forces.  The Company periodically seeks to reduce its exposure to price
volatility by hedging its productions through swaps, options and other commodity
derivative instruments.  The Company uses hedge accounting for these
instruments, and settlements of gains or losses on these contracts are reported
as a component of oil and gas revenues and operating cash flows in the period
realized.  These agreements expose the Company to counterparty credit risk to
the extent that the counterparty is unable to meet its settlement commitments to
the Company.

     Interest Rate Risk - The Company may enter into financial instruments such
as interest rate swaps to manage the impact of changes in interest rates.
Effective September 22, 1998, the Company entered into an eight and a half year
interest rate swap agreement with a notional value of $80 million.  Under the
agreement, the Company receives a fixed interest rate and pays a floating
interest rate, subject to a cap, based on the simple average of three foreign
LIBOR rates.  Floating rates are redetermined for a six month period each
April 1 and October 1. This agreement is not held for trading purposes. As the
swap provider is a major financial institution, the Company does not anticipate
non-performance by the provider.

     The Company's exposure to changes in interest rates primarily results from
short term changes in the LIBOR rates.  A 10% increase in the floating LIBOR
rates would have the effect of increasing interest costs to the Company by
$800,000 per year.

                                       41
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------


ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
----------------------------------------------------

                  INDEX TO FINANCIAL STATEMENTS AND SCHEDULES
                  -------------------------------------------
                                                                       PAGE
                                                                      NUMBER
                                                                      ------
 

Independent Auditors' Report..........................................   43
 
Financial Statements:
 
  Consolidated Balance Sheets as of December 31, 1998 and 1997, and
    June 30, 1997.....................................................   44
 
  Consolidated Statements of Operations for the Periods Ended
    December 31, 1998 and 1997, and June 30, 1997 and 1996............   46
 
  Consolidated Statements of Changes in Stockholders' Equity for the
    Periods Ended December 31, 1998 and 1997, June 30, 1997 and 1996..   47
 
  Consolidated Statements of Cash Flows for the Periods Ended
    December 31, 1998 and 1997, June 30, 1997 and 1996................   48
 
  Notes to Consolidated Financial Statements..........................   50

                                       42
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------


                         INDEPENDENT AUDITORS' REPORT
                         ----------------------------



The Board of Directors and Stockholders of
Bellwether Exploration Company and Subsidiaries:



We have audited the accompanying consolidated balance sheets of Bellwether
Exploration Company and subsidiaries as of December 31, 1998, 1997 and June 30,
1997 and the related consolidated statements of operations, changes in
stockholders' equity and cash flows for the year ended December 31, 1998, the
six month period ended December 31, 1997 and for the years ended June 30, 1997
and 1996.  These financial statements are the responsibility of the Company's
management.  Our responsibility is to express an opinion on these consolidated
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, such consolidated financial statements present fairly, in all
material respects, the financial position of Bellwether Exploration Company and
subsidiaries as of December 31, 1998, 1997 and June 30, 1997 and the results of
their operations and their cash flows for the year ended December 31, 1998, the
six month period ended December 31, 1997, and the years ended June 30, 1997 and
1996, in conformity with generally accepted accounting principles.



KPMG LLP
Houston, Texas
March 2, 1999

                                       43
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------


                          CONSOLIDATED BALANCE SHEETS
                          ---------------------------
                                    ASSETS
                                    ------
                            (Amounts in thousands)



<TABLE>
<CAPTION>
 
 
                                                      DECEMBER 31,     DECEMBER 31,       JUNE 30,
                                                         1998             1997              1997
                                                      ------------     ------------       --------
<S>                                                   <C>                <C>               <C>
CURRENT ASSETS:
 
Cash and cash equivalents.......................      $      10          $  2,699         $ 15,341
Accounts receivable and accrued
  revenues......................................         15,602            18,293           16,795
Accounts receivable - related parties...........            853             4,645            1,836
Prepaid expenses................................          1,719             3,240            1,759
                                                      -----------      ------------       ---------
  Total current assets..........................         18,184            28,877           35,731
                                                      -----------      ------------       ---------
 
PROPERTY, PLANT AND EQUIPMENT, AT
  COST:
 
Oil and gas properties (full cost)
  Unproved properties of $8,945,
  $6,469 and $4,500 excluded from
  amortization as of December 31,
  1998, 1997 and June 30, 1997,
  respectively..................................        289,231           250,227          233,175

Gas plant facilities............................         17,406            16,717           12,924
                                                      ----------       ------------       ---------
                                                        306,637           266,944          246,099
Less accumulated depreciation,
  depletion and amortization....................       (198,421)          (86,811)         (65,097)
                                                      ----------       ------------       ---------
                                                        108,216           180,133          181,002
                                                      ----------       ------------       ---------
 
OTHER ASSETS....................................          4,796             5,747            5,915
                                                      ----------       ------------       ---------
 
                                                      $ 131,196          $214,757         $222,648
                                                      ==========      =============       =========
</TABLE>


                See Notes to Consolidated Financial Statements.

                                       44
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------


                          CONSOLIDATED BALANCE SHEETS
                          ---------------------------
                     LIABILITIES AND STOCKHOLDERS' EQUITY
                     ------------------------------------
               (Amounts in thousands, except share information)
<TABLE>
<CAPTION>
 
                                                  DECEMBER 31,      DECEMBER 31,        June 30,
                                                      1998              1997             1997
                                                  ------------      ------------      ------------
<S>                                               <C>               <C>               <C>
CURRENT LIABILITIES:
 
Accounts payable and accrued  
  liabilities....................................  $ 11,982           $ 14,241          $ 12,739
Accounts payable - related parties...............       125                672               209
                                                  ------------      ------------      ------------
  Total current liabilities......................    12,107             14,913            12,948
                                                  ------------      ------------      ------------

LONG-TERM DEBT...................................   104,400            100,000           115,300

DEFERRED INCOME TAXES............................       ---              7,106             5,521

OTHER LIABILITIES................................       200              1,069               955

CONTINGENCIES....................................       ---                ---               ---

STOCKHOLDERS' EQUITY:

Preferred stock, $0.01 par value,
  1,000,000 shares authorized, none
  issued or outstanding..........................       ---                ---               ---

Common stock, $0.01 par value,
  30,000,000 shares authorized,
  14,164,791, 13,891,465 and
  13,844,965 shares issued and
  outstanding at December 31, 1998
  and 1997 and at June 30, 1997,.................       142                139               139
Additional paid-in capital.......................    80,442             78,470            78,273
Retained earnings (deficit)......................   (64,191)            13,060             9,512
Treasury stock, at cost, 310,800
   shares........................................    (1,904)               ---               ---

Total stockholders' equity.......................    14,489             91,669            87,924
                                                  ------------      ------------      ------------
                                                   $131,196           $214,757          $222,648
                                                  ============      ============      ============
</TABLE>



                See Notes to Consolidated Financial Statements.

                                       45
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------


                     CONSOLIDATED STATEMENTS OF OPERATIONS
                     -------------------------------------
                 (Amounts in thousands, except per share data)

<TABLE>
<CAPTION>
                                                        Six Month
                                                       Transition
                                    Year Ended        Period Ended    
                                   December 31,       December 31,         Fiscal Year Ended June 30,
                                   ------------       ------------       ------------------------------
                                      1998                1997               1997              1996
                                   ------------       ------------       -----------        -----------
<S>                                <C>                <C>                <C>                <C>
REVENUES:
  Gas revenues....................   $ 46,461           $26,755            $24,202            $ 9,856
  Oil revenues....................     26,756            17,408             14,865              5,810
  Gas plant revenues, net.........      1,203               804              3,330              2,577
  Gas gathering revenues, net.....        ---               ---                ---                957
  Interest and other income.......      1,347               609                363                116
                                   ------------       ------------       -----------        -----------
                                       75,767            45,576             42,760             19,316
                                   ------------       ------------       -----------        -----------

COSTS AND EXPENSES:

  Production expenses.............     25,381            13,836             11,437              5,317
  General and administrative
    expenses......................      8,459             3,748              4,042              3,013
  Depreciation, depletion and
    amortization..................     39,688            16,352             15,574              8,148
  Impairment expense..............     73,899               ---                ---                ---
  Interest expense................     11,660             5,978              4,477              1,657
  Other expenses..................        ---               ---                ---                153
                                   ------------       ------------       -----------        -----------
                                      159,087            39,914             35,530             18,288
                                   ------------       ------------       -----------        -----------

Income (loss) before income tax
  (benefit).......................    (83,320)            5,662              7,230              1,028

Provision for income tax
  (benefit).......................     (6,069)            2,114              2,585                 46

Net income (loss).................   $(77,251)          $ 3,548            $ 4,645            $   982
                                   ============       ============       ===========        ===========

Net income (loss) per share.......   $  (5.50)          $  0.26            $  0.46            $  0.11
                                   ============       ============       ===========        ===========

Net income (loss) per share
  - diluted.......................   $  (5.50)          $  0.25            $  0.45            $  0.11
                                   ============       ============       ===========        ===========

Weighted average common shares
  outstanding.....................     14,039            13,876             10,201              9,052
                                   ============       ============       ===========        ===========

Weighted average common shares
  outstanding - diluted...........     14,039            14,446             10,261              9,114
                                   ============       ============       ===========        ===========
</TABLE>


                See Notes to Consolidated Financial Statements.

                                       46
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------



                      CONSOLIDATED STATEMENTS OF CHANGES
                      ----------------------------------
                            IN STOCKHOLDERS' EQUITY
                            -----------------------
                            (Amounts in thousands)

<TABLE>
<CAPTION>
                              COMMON STOCK     PREFERRED STOCK   ADDITIONAL    RETAINED      TREASURY STOCK
                             ---------------   ---------------     PAID-IN     EARNINGS    ------------------
                             SHARES   AMOUNT   SHARES   AMOUNT     CAPITAL     (DEFICIT)   SHARES     AMOUNT      TOTAL
                             ------   ------   ------   ------   -----------   ---------   -------   --------   ---------
<S>                          <C>      <C>      <C>      <C>      <C>           <C>         <C>       <C>        <C>
 
Balance June 30, 1995.....    9,045       90      ---      ---       41,472       3,885       ---        ---      45,447
Stock options exercised...       30        1      ---      ---          167         ---       ---        ---         168
Net income................      ---      ---      ---      ---          ---         982       ---        ---         982
                             ------     ----   ------   ------      -------    --------    ------    -------    --------
 
Balance June 30, 1996.....    9,075       91      ---      ---       41,639       4,867       ---        ---      46,597
Shares issued in public
 stock offering, net of
 offering costs...........    4,687       47      ---      ---       36,169         ---       ---        ---      36,216
Stock options exercised 
 and related tax effect...       83        1      ---      ---          465         ---       ---        ---         466
Net income................      ---      ---      ---      ---          ---       4,645       ---        ---       4,645
                             ------     ----   ------   ------      -------    --------    ------    -------    --------
 
Balance June 30, 1997.....   13,845      139      ---      ---       78,273       9,512       ---        ---      87,924
 
Offering costs............      ---      ---      ---      ---          (96)        ---       ---        ---         (96)
Stock options exercised 
 and related tax effects..       47      ---      ---      ---          293         ---       ---        ---         293
Net income................      ---      ---      ---      ---          ---       3,548       ---        ---       3,548
                             ------     ----   ------   ------      -------    --------    ------    -------    --------
 
Balance
 December 31, 1997........   13,892     $139      ---   $  ---      $78,470    $ 13,060       ---    $   ---    $ 91,669
                             ======     ====   ======   ======      =======    ========    ======    =======    ========
 
Stock options exercised 
 and related tax effects..      273        3      ---      ---        1,972         ---       ---        ---       1,975
Treasury shares
 purchased................      ---      ---      ---      ---          ---         ---      (311)    (1,904)     (1,904)
Net loss..................      ---      ---      ---      ---          ---     (77,251)      ---        ---     (77,251)
                             ------     ----   ------   ------      -------    --------    ------    -------    --------
 
Balance
  December 31, 1998.......   14,165     $142      ---   $  ---      $80,442    $(64,191)     (311)   $(1,904)   $ 14,489
                             ======     ====   ======   ======      =======    ========    ======    =======    ========
 
</TABLE>

                See Notes to Consolidated Financial Statements.

                                       47
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------



                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                     -------------------------------------
                            (Amounts in Thousands)

<TABLE>
<CAPTION>
                                                                           Six Month   
                                                                          Transition  
                                                       Year Ended        Period Ended 
                                                      December 31,        December 31,      Fiscal Years Ended June 30,
                                                    ---------------      -------------      ---------------------------        
                                                         1998                1997              1997             1996
                                                    ---------------      -------------      ----------       ----------
CASH FLOWS FROM OPERATING ACTIVITIES:
<S>                                                   <C>                  <C>              <C>              <C>
Net income (loss)...............................       $(77,251)            $  3,548         $   4,645        $   982
Adjustments to reconcile net income
  (loss) to net cash provided by
  operating activities:
  Depreciation, depletion and
  amortization..................................         40,544               16,708            16,044          8,273  
  Impairment expense............................         73,899                  ---               ---            ---
  Deferred taxes................................         (6,820)               1,585             2,562           (183)
                                                    ---------------      -------------      ----------       ----------
                                                         30,372               21,841            23,251          9,072

Change in assets and liabilities,
  net of acquisition effects:
  Accounts receivable and accrued
    revenues....................................          2,691               (1,498)            2,941           (668)
  Prepaid expenses..............................          1,521               (1,481)             (638)            25
  Accounts payable and accrued expenses.........         (2,220)               1,502             4,438             84
  Due (to) from affiliates......................          3,245               (2,346)            5,738           (791)
  Other.........................................         (1,908)                 (57)           (6,447)          (237)
                                                    ---------------      -------------      ----------       ----------
NET CASH FLOWS PROVIDED BY OPERATING
  ACTIVITIES....................................         33,701               17,961            29,283          7,485
                                                    ---------------      -------------      ----------       ----------
CASH FLOWS FROM INVESTING ACTIVITIES:
Acquisitions of oil and gas properties,
  including working capital of $13,914
  in fiscal year ended June 30, 1997
  -  Partnership Transactions...................            ---                  ---          (147,909)           ---
  -  Other acquisitions.........................         (9,596)              (5,486)           (2,005)           ---
Additions to oil and gas properties.............        (30,583)             (13,727)          (20,811)        (6,934)
Proceeds from sales of properties...............            421                5,362            18,775            644
Additions to gas plant facilities...............           (689)              (1,632)              (84)           (44)
Proceeds from gas contract assignment...........            ---                  ---               ---          9,875
Other...........................................            (88)                 (17)              (88)             1
                                                    ---------------      -------------      ----------       ----------

NET CASH FLOWS PROVIDED BY (USED IN)
  INVESTING ACTIVITIES..........................        (40,535)             (15,500)         (152,122)         3,542
                                                    ===============      =============      ==========       ==========
</TABLE>


                See Notes to Consolidated Financial Statements.

                                       48
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------


               CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)
               -------------------------------------------------
                            (Amounts in Thousands)
                                        
<TABLE>
<CAPTION>
                                                                  Six Month               
                                                                 Transition 
                                               Year Ended       Period Ended              Fiscal Year Ended 
                                              December 31,       December 31,                  June 30,
                                              ------------      -------------     --------------------------------
                                                 1998               1997               1997               1996
                                              ------------      -------------      ------------       ------------
CASH FLOWS FROM FINANCING ACTIVITIES:
<S>                                              <C>               <C>              <C>                <C>
Proceeds from borrowings......................    $ 4,900           $  1,500         $157,300           $    ---
Net proceeds from issuance of
  common stock................................      1,649                197           35,145                168
Payments of long-term debt....................       (500)           (16,800)         (55,048)           (11,500)
Purchase of treasury shares...................     (1,904)               ---              ---                ---
                                              ------------      -------------      ------------       ------------

NET CASH FLOWS PROVIDED BY
  (USED IN) FINANCING ACTIVITIES..............      4,145            (15,103)         137,397            (11,332)
                                              ------------      -------------      ------------       ------------

Net increase (decrease) in cash and
  cash equivalents............................     (2,689)           (12,642)          14,558               (305)
Cash and cash equivalents at
  beginning of period.........................      2,699             15,341              783              1,088
                                              ------------      -------------      ------------       ------------

CASH AND CASH EQUIVALENTS AT END
  OF PERIOD...................................    $    10           $  2,699         $ 15,341           $    783
                                              ============      =============      ============       ============
</TABLE>


                See Notes to Consolidated Financial Statements.

                                       49
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------

1.   ORGANIZATION
     ------------

          Bellwether Exploration Company ("the Company") was formed as a
     Delaware corporation in 1994 to succeed to the business and properties of
     its predecessor company pursuant to a merger, the primary purpose of which
     was to change the predecessor company's state of incorporation from
     Colorado to Delaware.  The predecessor company was formed in 1980 from the
     consolidation of the business and properties of related oil and gas limited
     partnerships.  References to Bellwether or the Company include the
     predecessor company, unless the context requires otherwise.

2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
     ------------------------------------------

     Principles of Consolidation
     ---------------------------

          The consolidated financial statements include the accounts of
     Bellwether Exploration Company and its wholly-owned subsidiaries.  Snyder
     Gas Plant Venture and NGL/Torch Gas Plant Venture and their 13.91% and
     36.72% investments in the Snyder and Diamond M-Sharon Ridge Gas Plants have
     been pro rata consolidated.  All significant intercompany accounts and
     transactions have been eliminated in consolidation.

     Fiscal Year Change
     ------------------

          In order to facilitate greater comparability with its peer group by
     the financial community, the Company changed its fiscal year to the
     calendar year, beginning January 1, 1998.  This resulted in a six-month
     transition period of July 1, 1997 through December 31, 1997 ("transition
     period").

     Oil and Gas Properties
     ----------------------

          The Company utilizes the full cost method to account for its
     investment in oil and gas properties.  Under this method, all costs of
     acquisition, exploration and development of oil and gas reserves (including
     such costs as leasehold acquisition costs, geological expenditures, dry
     hole costs and tangible and intangible development costs and direct
     internal costs) are capitalized as incurred.  The cost of oil and gas
     properties, the estimated  future expenditures to develop proved reserves,
     and estimated future abandonment, site remediation and dismantlement costs
     are depleted and charged to operations using the unit-of-production method
     based on the ratio of current production to proved oil and gas reserves as
     estimated by independent engineering consultants.  Costs directly
     associated with the acquisition and evaluation of unproved properties are
     excluded from the amortization computation until it is determined whether
     or not proved reserves can be assigned to the properties or whether
     impairment has occurred.  Depletion expense per equivalent MCF of

                                       50
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                  ------------------------------------------

     production was approximately $1.10 in 1998, $.90 in transition period 1997,
     $.94 in fiscal 1997 and $.98 in fiscal 1996.

          The following table shows, by category of cost and date incurred, the
     unproved property costs excluded from amortization (amounts in thousands):

<TABLE>
<CAPTION>
                                                                                           Total at 
                                      Leasehold                 Exploration              December 31,
                                        Costs                      Costs                     1998    
                                 -------------------       -------------------       --------------------
Costs Incurred During
Periods Ended:
<S>                                 <C>                         <C>                      <C>                 
December 31, 1998                     $4,957                      $1,067                    $6,024           
December 31, 1997                      1,918                       - 0 -                     1,918           
June 30, 1997                          1,003                       - 0 -                     1,003           
June 30, 1996                          - 0 -                       - 0 -                     - 0 -           
  Prior                                - 0 -                       - 0 -                     - 0 -           
                                 -------------------       -------------------       --------------------
                                      $7,878                      $1,067                    $8,945           
                                 ===================       ===================       ====================
</TABLE>


          Dispositions of oil and gas properties are recorded as adjustments to
     capitalized costs, with no gain or loss recognized unless such adjustments
     would significantly alter the relationship between capitalized costs and
     proved reserves of oil and gas.  To the extent that capitalized costs of
     oil and gas properties, net of accumulated depreciation, depletion and
     amortization, exceed the discounted future net revenues of proved oil and
     gas reserves net of deferred taxes, such excess capitalized costs would be
     charged to operations.  Oil and gas prices declined in 1998, with continued
     declines in 1999.  As a result of such declines, the Company's capitalized
     costs were in excess of future net revenues calculated using prices in
     effect in late February 1999.  The Company recorded an oil and gas property
     impairment of $73.9 million in 1998.  No such impairment in book value was
     required at December 1997, June 1997 or 1996.

          Any reference to oil and gas reserve information in the Notes to
     Consolidated Financial Statements is unaudited.

     Gas Plants and Gas Gathering System
     -----------------------------------

          Gas plant facilities include the costs to acquire certain gas plants
     and to secure rights-of-way.  Capitalized costs associated with gas plants
     facilities are amortized primarily over the estimated useful lives of the
     various components of the facilities utilizing the straight-line method.
     The estimated useful lives of such assets range from four to fifteen years.

          The Company's gas gathering subsidiary and certain third parties were
     the beneficiaries of an agreement whereby another party had an obligation
     to purchase, until May 31, 1999, the gas produced by the Company and such
     third parties from the West Monroe field in Union Parish, Louisiana at a

                                       51
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                  ------------------------------------------

     price of $4.50 per MMBTU.  Bellwether owned a large majority of the gas
     produced and sold pursuant to the Purchase Agreement.  In March 1996, in
     exchange for Bellwether's agreement to assume the purchase obligations
     under the gas purchase contract, Bellwether was paid $9.9 million.  As a
     result of this transaction, the Company has written off the remaining book
     value of the gas gathering system and has recorded a liability to cover the
     estimated future losses under the contract.  Gas gathering operations of
     the subsidiary and payments to third parties are charged to the liability
     as incurred.  From the proceeds, $9.5 million was paid on the Company's
     credit facility.

     Gas Imbalances
     --------------

          The Company uses the sales method of accounting for gas imbalances.
     Under this method, gas sales are recorded when revenue checks are received
     or are receivable on the accrual basis.  The Company had a net imbalance
     liability, at fair value of $.5 million, $1.7 million and $1.6 million at
     December 31, 1998 and 1997 and June 30, 1997, respectively.  The Company's
     net imbalance was immaterial at June 30, 1996.

     Natural Gas and Crude Oil Hedging
     ---------------------------------

          Commodity derivatives utilized as hedges include swap contracts.  In
     order to qualify as a hedge, price movements in the underlying commodity
     derivative must be sufficiently correlated with the hedged commodity.  When
     a commodity derivative ceases to qualify as a hedge, the change in its fair
     value is recognized in income currently.  Settlement of gains and losses on
     price swap contracts are realized monthly, generally based upon the
     difference between the contract price and the average closing New York
     Mercantile Exchange ("NYMEX") price and are reported as a component of oil
     and gas revenues and operating cash flows in the period realized.  Gains
     and losses attributable to the termination of a swap contract are deferred
     on the balance sheet and recognized in revenue when the hedged crude oil
     and natural gas is sold.  There were no such deferred gains or losses at
     December 31, 1998 and 1997 or at June 30, 1997 and 1996.

          Oil and gas revenues were increased by $3.6 million in the year ended
     December 31, 1998 and decreased by $1.6 million in the six month transition
     period ended December 1997, and by $18,000 and $0.6 million in the fiscal
     years ended June 1997 and 1996, as a result of such hedging activity.

     Income Taxes
     ------------

          Deferred taxes are accounted for under the asset and liability method
     of accounting for income taxes.  Under this method, deferred income taxes
     are recognized for the tax consequences of "temporary differences" by
     applying enacted statutory tax rates applicable to future years to
     differences between the financial statement carrying amounts and the tax

                                       52
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                  ------------------------------------------

     basis of existing assets and liabilities.  The effect on deferred taxes of
     a change in tax rates is recognized in income in the period the change
     occurs.

     Statements of Cash Flows
     ------------------------

          For cash flow presentation purposes, the Company considers all highly
     liquid debt instruments purchased with an original maturity of three months
     or less to be cash equivalents.  Interest paid in cash for the year ended
     December 31, 1998, the six month transition period ended December 31, 1997,
     and the fiscal years ended June 30, 1997 and 1996, was $11.1 million, $5.4
     million, $1.5 million and $1.6 million, respectively.  Income taxes paid in
     cash for the  year ended December 31, 1998, the transition period ended
     December 31, 1997 and the fiscal years ended June 30, 1997 and 1996, were
     $1,408,000, $41,000, $198,000 and $126,000, respectively.  A portion of the
     purchase price of the Partnership Transactions included the issuance to
     Torch, as consideration for advisory services, 150,000 shares of the
     Company's common stock valued at $1.2 million and a warrant to purchase
     100,000 shares of common stock at $9.90 per share valued at $300,000.

     New Accounting Pronouncements
     -----------------------------

          In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative
     Instruments and Hedging Activities."  This statement establishes standards
     of accounting for and disclosures of derivative instruments and hedging
     activities.  This statement is effective for fiscal years beginning after
     June 15, 1999.  The Company has not yet determined the impact of this
     statement on the Company's financial condition or results of operations.

     Use of Estimates
     ----------------

          Management of the Company has made a number of estimates and
     assumptions relating to the reporting of assets and liabilities and the
     disclosure of contingent assets and liabilities as well as reserve
     information which affects the depletion calculation and the computation of
     the full cost ceiling limitation to prepare these financial statements in
     conformity with generally accepted accounting principles. Actual results
     could differ from these estimates.

     Reclassifications
     -----------------

          Certain reclassifications of prior period statements have been made to
     conform with current reporting practices.

                                       53
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                  ------------------------------------------


3.   ACQUISITIONS AND MERGERS
     ------------------------

          During the last three fiscal years, the Company has completed the
     following mergers and acquisitions, all of which were recorded using the
     purchase method of accounting:

          In April 1997, the Company closed acquisitions of oil and gas
     properties, totaling $141.1 million, after purchase price adjustments,
     including working capital of $13.9 million, from certain partnerships and
     other entities managed or sponsored by Torch Energy Advisors Incorporated
     ("Torch").  The acquisitions were financed by the sale of 4.4 million
     shares of common stock, the sale of $100.0 million of 10-7/8% senior
     subordinated notes due in 2007 and the use of $33.3 million of a new
     $90.0 million senior unsecured credit facility (including the repayment
     of $22.0 million on a then existing credit facility).

          On February 28, 1995 the Company acquired Hampton in exchange for
     $17.0 million in cash and 1,006,458 shares of the Company's common stock.
     The Company had paid previous to the merger $2.7 million to acquire common
     and preferred stock of Hampton and incurred $1.4 million in expenses in
     arranging the merger.  The total cost of the Hampton acquisition was $25.9
     million, consisting of $21.1 million in cash and $4.8 million in common
     stock.  Hampton was an energy company engaged in the exploration,
     acquisition and production of oil and natural gas, primarily in the onshore
     Gulf Coast region and offshore in Texas state waters.

4.   RELATED PARTY TRANSACTIONS
     --------------------------

          The Company is a party to an administrative services agreement which
     requires Torch to administer certain business activities of the Company for
     a monthly fee equal to the sum of one-twelfth of 2% of the average of the
     book value of the Company's total assets, excluding cash, plus 2% of annual
     operating cash flows (as defined) during the period in which the services
     are rendered plus reimbursement of certain costs incurred on behalf of the
     Company.  The administrative services agreement terminates December 31,
     1999, and the Company is actively negotiating a series of replacement
     agreements.  For the periods ended December 31, 1998 and 1997, and June 30,
     1997 and 1996, related fees paid to Torch amounted to $4.0 million, $2.4
     million, $2.3 million and $1.5 million, respectively.  Additionally, in the
     ordinary course of business, the Company incurs intercompany balances
     resulting from the payment of costs and expenses by affiliated entities on
     behalf of the Company.  Torch may charge interest on any unpaid balances
     not paid within 30 days, however, no such interest has been charged by
     Torch since the inception of the agreement.

         In April, 1997, Torch was issued 150,000 shares of the Company's common
     stock and a warrant, expiring in April 2002, to purchase 100,000

                                       54
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                  ------------------------------------------

     shares at $9.90 per share for advisory services rendered in connection with
     the Partnership Transactions. The Company's stock was valued at $1.2
     million, and the warrant was valued at $300,000. In December 1993, Torch
     was issued a warrant to purchase 187,500 shares of the Company's common
     stock at a price of $6.40 per share for its advisory services in
     identifying and negotiating a merger; such warrants were exercised in
     connection with the Partnership Transactions with total proceeds to the
     Company of $684,000.

          Torch was also a selling partner in the Partnership Transactions
     through its ownership of general partnership and working interests in the
     partnerships programs.  As a result, Torch was paid $18.4 million for such
     interests.  A director of the Company holds significant options to purchase
     stock in Torch, which if exercised would constitute a substantial equity
     interest in Torch.

          A subsidiary of Torch markets oil and natural gas production from
     certain oil and gas properties in which the Company owns an interest. The
     Company generally pays fees of 2% of revenues for such marketing services.
     Such charges were $1,143,000, $757,000, $646,000 and $114,000 in periods
     ended December 1998 and 1997, June 1997 and 1996, respectively.

          Costs of the evaluation of potential property acquisitions and due
     diligence conducted in conjunction with acquisitions closed are incurred by
     Torch at the Company's request.  The Company was charged $379,000,
     $217,000, $650,000 and $74,000, for these costs in periods ended December
     1998 and 1997, June 1997 and 1996, respectively.

          Torch operates certain oil and gas interests owned by the Company. The
     Company is charged, on the same basis as other third parties, for all
     customary expenses and cost reimbursements associated with these
     activities. Operator's overhead charged for these activities for the
     periods ended December 31, 1998 and 1997, June 30, 1997 and 1996 was
     $1,349,000, $698,000, $729,000 and $367,000, respectively.

          Torch became the operator of the Snyder Gas Plant on December 1, 1993.
     In periods ended December 1998 and 1997, June 1997 and 1996, the fees paid
     by the Company to Torch were $72,000, $42,000, $49,000 and $83,000,
     respectively.

5.   STOCKHOLDERS' EQUITY
     --------------------

     Common and Preferred Stock
     --------------------------

          The Certificate of Incorporation of the Company authorizes the
     issuance of up to 15,000,000 shares of common stock and 1,000,000 shares of
     preferred stock, the terms, preferences, rights and restrictions of which
     are established by the Board of Directors of the Company. Certain

                                       55
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                  ------------------------------------------

     restrictions contained in the Company's loan agreements limit the amount of
     dividends which may be declared. There is no present plan to pay cash
     dividends on common stock as the Company intends to reinvest its cash flows
     for continued growth of the Company.

          In April 1997, the Company issued 4.4 million shares of common stock
     for net proceeds to the Company of $34.1 million.  Such proceeds were used
     in financing the Partnership Transactions.  Also included in the April
     Offering were 719,264 shares sold by certain shareholders.  Additional
     shares issued during fiscal 1997 included 125,000 shares issued upon
     exercise of a warrant and 150,000 shares issued to Torch for advisory
     services rendered in connection with the Partnership Transactions.

          In July, 1997 in a special meeting of Stockholders of the Company, the
     Company's Certificate of Incorporation was amended to increase the number
     of authorized shares of Common Stock from 15,000,000 to 30,000,000.

          On September 12, 1997, the Company authorized and declared a dividend
     of one preferred stock purchase right for each share of common stock, par
     value $.01 per share, of the Company.  The dividend was payable on
     September 26, 1997 to the holders of record of Common Shares as of the
     close of business on such date.

          In addition to stock options outstanding, the Company has 160,000
     warrants outstanding at exercise prices ranging from $6.90 per share to
     $9.90 per share.  The expiration date for 100,000 warrants is April 2002,
     while the expiration date for the remaining 60,000 warrants is August 1999.

          A tax benefit related to the exercise at employee stock options of
     approximately $324,000 was allocated directly to additional paid in capital
     in 1998.  Such benefit was not material in prior periods.

     Earnings Per Share
     ------------------

          SFAS No. 128 requires the reconciliation of the numerator (income) and
     denominator (shares) of the earnings per share computation to the numerator
     and denominator of the diluted earnings per share computation.  The
     Company's reconciliation is as follows (amounts in thousands):

                                       56
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                  ------------------------------------------

<TABLE>
<CAPTION>
 
 
 
                                                      Year Ended                              Six Month Transition Period Ended
                                                  December 31, 1998                                   December 31, 1997
                              -------------------------------------------------   ------------------------------------------------
                                  Income           Shares          Per Share          Income          Shares          Per Share
                              --------------   -------------   ----------------   -------------   --------------   ---------------
<S>    <C>                       <C>               <C>              <C>              <C>             <C>               <C>

Net income (loss)                $(77,251)                                            $3,548
                              --------------   -------------   ----------------   -------------   --------------   ---------------
Earnings (loss) per                                                                                                             
  common share                   $(77,251)           14,039          $(5.50)          $3,548            13,876            $0.26 
                              
Effect of Dilutive            
Securities: Options &         
Warrants                              ---               ---             ---              ---               570
                              --------------   -------------   ----------------   -------------   --------------   ---------------
Earnings (loss) per           
  common share - diluted         $(77,251)           14,039          $(5.50)          $3,548            14,446            $0.25
                              ==============   =============   ================   =============   ==============   =============== 
</TABLE>


<TABLE>
<CAPTION>
                                                                   Fiscal Year Ended June 30,
                            -----------------------------------------------------------------------------------------------------
                                                    1997                                               1996
                            ------------------------------------------------   --------------------------------------------------
                                 Income           Shares        Per Share         Income           Shares          Per Share
                            ---------------   ------------   ---------------   ------------    --------------   -----------------
<S>                              <C>              <C>             <C>             <C>              <C>               <C>
Net Income                       $4,645                                             $982                                         
                            ---------------   ------------   ---------------   ------------    --------------   -----------------

Earnings per                                                                                                                     
 common share                    $4,645          10,201           $0.46             $982             9,052            $0.11      

Effect of Dilutive                                                                                                               
 securities: Options &                                                                                                           
 Warrants                           ---              60                              ---                62                       
                            ---------------   ------------   ---------------   ------------    --------------   -----------------
Earnings per common                                                                                                              
 share - diluted                 $4,645          10,261           $0.45             $982             9,114            $0.11      
                            ===============   ============   ===============   ============    ==============   =================
</TABLE>

          Securities that could potentially dilute basic earnings per share in
     the future, that were not included in the computation of diluted earnings
     per share because to do so would have been antidilutive are as follows:

                                         For the Year Ended
                                         December 31 ,1998(Shares)
                                         -------------------------

                    Options and Warrants.................  203,000
                                                           =======

                                       57
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                  ------------------------------------------

     Treasury Stock
     --------------

          In September 1998, the Company's Board of Directors authorized the
     repurchase of up to $5 million of the Company's common stock. As of
     September 30, 1998, 310,810 shares had been acquired at an aggregate price
     of $1,904,000.  These treasury shares are reported at cost as a reduction
     to Stockholders' Equity.


     Stock Incentive Plans
     ---------------------

          The Company has stock option plans that provide for granting of
     options for the purchase of common stock to directors, officers and key
     employees of the Company and Torch. These stock options may be granted
     subject to terms ranging from 6 to 10 years at a price equal to the fair
     market value of the stock at the date of grant. At December 31, 1998,
     options under the plans available for future grants were 267,500.

          A summary of activity in the stock option plans is set forth below:

<TABLE>
<CAPTION>
                                                                      Number                            Option
                                                                    Of shares                       Price Range
                                                              -------------------------      -------------------------------
<S>                                                                 <C>                            <C>
Balance at June 30, 1995.................................            921,325                      $3.00  -  $7.00             
  Granted................................................             27,000                      $4.38  -  $6.38             
  Surrendered............................................            (10,000)                     $5.75             
  Exercised..............................................            (30,000)                     $5.63             
                                                              -------------------------      -------------------------------
Balance at June 30, 1996.................................            908,325                      $3.00  -  $7.00             
  Granted................................................            378,500                      $6.25  - $10.19             
  Surrendered............................................            (12,000)                     $7.63             
  Exercised..............................................            (82,500)                     $5.63     $5.75             
                                                              -------------------------      -------------------------------
Balance at June 30, 1997.................................          1,192,325                      $3.00  - $10.19             
  Granted................................................            242,000                      $10.31 - $12.38             
  Exercised..............................................            (46,500)                     $3.00  - $10.00             
                                                              -------------------------      -------------------------------
Balance at December 31, 1997.............................          1,387,825                      $3.00  - $12.38             
  Granted................................................            288,000                      $6.25  - $10.94             
  Surrendered............................................           (146,000)                     $5.62  - $12.38             
  Exercised..............................................           (273,325)                     $3.00  - $ 7.75             
                                                              -------------------------      -------------------------------
Balance at December 31, 1998.............................          1,256,500                      $4.38  - $12.38             
                                                              =========================      ================================

Exercisable at December 31, 1998.........................            910,167                      $4.38  - $12.38
                                                              =========================      ================================
</TABLE>

                                       58
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                  ------------------------------------------

     Detail of stock options outstanding and options exercisable at December 31,
1998 follows:

<TABLE>
<CAPTION>
                                                            Outstanding                                       Exercisable
                                     -----------------------------------------------------      ------------------------------------
                                                              Weighted    
                                                              Average          Weighted                                  Weighted 
                                                             Remaining          Average                                   Average 
                                                                Life           Exercise                                  Exercise   
      Range of Exercise Prices              Number            (Years)            Price                 Number              Price    
------------------------------------------------------------------------------------------------------------------------------------
<S>                                     <C>               <C>                <C>                   <C>               <C>
1994 Plan $4.38 to $ 7.63                       549,000              5.76        5.70                      549,000          5.70
1996 Plan $6.25 to $12.38                       707,500              8.84        8.98                      361,167          9.26
                                     ------------------                                         ------------------
Total                                         1,256,500                                                    910,167
                                     ==================                                         ==================
</TABLE>

     The estimated weighted average fair value per share of options granted
during 1998, transition period 1997 and fiscal 1997 and fiscal 1996 was $2.34,
$1.78, $2.34 and $3.22, respectively.  The fair value of each option grant is
estimated on the date of grant using the Black-Scholes option-pricing model with
the following weighted-average assumptions:  For 1998, transition period 1997,
fiscal 1997 and fiscal 1996 expected stock price volatility of 40%; and risk
free interest rate of 5 1/2% and an average expected option life of 5 years.
Had compensation expense for stock-based compensation been determined based on
the fair value at the date of grant, the Company's net income and earnings per
share would have been reduced to the pro forma amounts indicated below (in
thousands except share information):


<TABLE>
<CAPTION>
                                                                   Six Month
                                                                   Transition
                                                Year Ended        Period Ended             Fiscal Years
                                               December 31,        December 31,            Ended June 30,
                                         ------------------     -----------------     -------------------------
                                                  1998                1997               1997         1996
                                         ------------------     -----------------     -----------   -----------
<S>                                            <C>                 <C>                      <C>          <C>
Net income (loss)
     As Reported.........................       $(77,251)            $3,548               $4,645       $ 982
     Pro forma...........................       $(78,321)            $2,524               $3,853       $ 921
Earnings (loss) per share                                                              
     As reported.........................       $  (5.50)            $ 0.26               $ 0.46       $0.11
     Pro forma...........................       $  (5.58)              0.18                 0.38        0.10
Diluted earnings (loss) per share                                                                             
     As reported.........................       $  (5.42)            $ 0.25               $ 0.45       $0.11
     Pro forma...........................       $  (5.50)              0.17                 0.38        0.10
</TABLE>

6.   DERIVATIVE FINANCIAL INSTRUMENTS
     --------------------------------

     The Company periodically uses derivative financial instruments to manage
oil and gas price risk; generally commodity price swap agreements which provide
for the Company to receive or make counterparty payments on the differential
between a fixed price and a variable indexed price for natural gas or crude oil.
Gains and losses from these hedging activities are included in oil and gas sales
at the time

                                       59
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                  ------------------------------------------

the related production is delivered. During fiscal 1998 the Company hedged an
aggregate of 9,979 MMBTU of natural gas at an average NYMEX quoted price of
$2.34 per MMBTU, before transaction and transporting costs. In addition, the
company sold call options on 1,000 barrels of oil per day for the months of
October through December 1998 at a strike price of $18.50 for a premium of $1.00
per barrel. Such call options do not qualify as hedges for accounting purposes
and, therefore, were marked to market. At December 31, 1998 the Company was a
party to three gas price basis hedges: 1) 10,000 Mcf per day(Mcfpd) for delivery
at Houston Ship Channel for the period January through October 1999 at
approximately $.02 under the NYMEX 3 day average, 2) 5,000 Mcfpd for delivery at
Transco Zone 3 for the period April through October 1999 at a zero price
adjustment to the NYMEX 3 day average and 3) 4,000 Mcfpd for delivery at ANR-
Louisiana for the period April through October 1999 for $.09 under the NYMEX 3
day average. Hedging activities increased returns by $3.6 million for the year
1998 and reduced revenues by $1.6 million, $18,000 and $.6 million for the
transition period 1997 and for the fiscal years ended June 30, 1997 and 1996,
respectively. There was no hedging in 1995. At December 31, 1998 the Company had
no unrealized hedging gains or losses.

     These energy swap agreements expose the Company to counterparty credit risk
to the extent the counterparty is unable to meet its monthly settlement
commitment to the Company.

     In order to reduce interest costs, effective September 22,  1998, the
Company entered into an eight and a half year interest rate swap agreement with
a notional value of $80 million.  Under the agreement, the Company receives a
fixed interest rate and pays a floating interest rate based on the simple
average of three foreign LIBOR rates.  Floating rates are redetermined for a six
month period each April 1 and October 1.  The floating rate for the period from
inception to April 1, 1999 is 9.73%.  Through April 1, 2002 the floating rate is
capped at 10.875% and capped at 12.375% thereafter.  This interest swap is
accounted for as a hedge.

                                       60
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                  ------------------------------------------

DETERMINATION OF FAIR VALUES OF FINANCIAL INSTRUMENTS
-----------------------------------------------------

     Fair value for cash, short-term investments, receivables and payables
approximates carrying value.  The following table details the carrying values
and approximate fair values of the Company's other investments, derivative
financial instruments and long-term debt at December 31, 1998, 1997 and June 30,
1997(in thousands).

<TABLE>
<CAPTION>
 
                              December 31, 1998                   December 31, 1997                     June 30, 1997
                      ------------------------------     -------------------------------     ---------------------------------
                         Carrying        Approximate        Carrying         Approximate          Carrying         Approximate 
                           Value          Fair Value          Value           Fair Value           Value            Fair Value
                      ------------    --------------     ------------     --------------     ---------------    --------------
Liabilities/
 (Assets):
<S>                      <C>             <C>                <C>              <C>                <C>                <C>
Derivative
 instruments
 other than
 trading:
  Interest swap          $  ---             $ (1,392)         $  ---           $  ---             $  ---             $  ---
  agreements
  Production
  swap agreements        $  ---             $  ---            $  ---           $   (505)          $  ---             $    994
 
Long-term debt           $104,400           $107,001          $100,000         $107,420           $115,300           $120,580
(See Note 7)
</TABLE>


7.   LONG-TERM DEBT
     --------------

     Long-term debt is comprised of the following at December 31, 1998 and 
1997, June 30, 1997 (in thousands):

<TABLE>
<CAPTION>
                                                                   December 31,              December 31,            June 30,
                                                             ---------------------     ---------------------    --------------------
                                                                      1998                       1997                  1997
                                                             ---------------------     ---------------------    --------------------
<S>                                                             <C>                       <C>                     <C>
Bank credit facility....................................               $  4,400                 $   ---                $ 15,300
 
10-7/8% Senior Subordinated Notes.......................               $100,000                 $100,000               $100,000
                                                             ---------------------     ---------------------    --------------------
Long-term debt..........................................               $104,400                 $100,000               $115,300
                                                             =====================     ====================     ====================
</TABLE>

                                       61
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                  ------------------------------------------


     Debt maturities by fiscal year are as follows (amounts in thousands):

<TABLE>
<CAPTION>
<S>                        <C>
1998                       $    ---
1999                            ---
2000                            ---
2001                            ---
2002                          4,400
Thereafter                  100,000
                           --------
                           $104,400
                           ========
</TABLE>

     In October 1996, the Company entered into a syndicated credit facility
("Syndicated Credit Facility") in an amount up to $50.0 million with an initial
borrowing base of $27.0 million, to be re-determined semi-annually.  At
Bellwether's option, the interest rate varied, based upon borrowing base usage,
from London Interbank Offered Rate ("LIBOR") plus 7/8% to LIBOR plus 1-1/4%, or
the greater of the prime rate or Federal Funds rate plus  1/2%.  The Syndicated
Credit Facility was unsecured and was retired in April 1997.

     In April 1997, the Company entered into a senior revolving unsecured credit
facility ("Senior Credit Facility") in an amount up to $90.0 million, with a
borrowing base to be re-determined semi-annually, and a maturity date of
March 31, 2002. On October 1, 1998 the borrowing base was re-determined to be
$60.0 million. Bellwether may elect an interest rate based either on a margin
plus LIBOR or the higher of the prime rate or the sum of 1/2 of 1% plus the
Federal Funds Rate. For LIBOR borrowings, the interest rate will vary from LIBOR
plus 0.875% to LIBOR plus 1.25% based upon borrowing base usage. In connection
with the acquisition of oil and gas properties, $33.3 million was drawn under
this facility, including $22 million used to retire outstandings under the
Syndicated Credit facility. At December 31, 1998, there were $4.4 million
borrowings outstanding.

     The Senior Credit Facility contains various covenants including certain
required financial measurements for a current ratio, consolidated tangible net
worth and interest coverage ratio.  In addition, the Senior Credit Facility
includes certain limitations on restricted payments, dividends, incurrence of
additional funded indebtedness and asset sales.

     In April 1997, the Company issued $100.0 million of 10-7/8% senior
subordinated notes ("Notes") that mature April 1, 2007.  Interest on the Notes
is payable semi-annually on April 1 and October 1.  The Notes will be
redeemable, in whole or in part, at the option of the Company at any time on or
after April 1, 2002 at 105.44% which decreases annually to 100.00% on April 1,
2005 and thereafter, plus accrued and unpaid interest.  In the event of Change
of Control of the Company, each holder of the Notes will have the right to
require the Company to repurchase all or part of such holder's Notes at an offer
price in cash equal to 101.0% of the aggregate principal amount thereof, plus
accrued and unpaid interest to the date of purchase.  The Notes contain certain
covenants, including 

                                       62
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                  ------------------------------------------

limitations on indebtedness, restricted payments, transactions with affiliates,
liens, guarantees of indebtedness by subsidiaries, dividends and other payment
restrictions affecting restricted subsidiaries, issuance and sales of restricted
subsidiary stock, disposition of proceeds of asset sales, and restrictions on
mergers, and consolidations or sales of assets.

8.   INCOME TAXES (IN THOUSANDS)
     ---------------------------

          Income tax expense (benefit) is summarized as follows:

<TABLE>
<CAPTION>
                                                            Six Month  
                                                            Transition    
                                         Year Ended        Period Ended               Fiscal Year Ended June 
                                        December 31,        December 31,                        30,
                                       --------------      --------------        ---------------------------------
                                            1998               1997                   1997                1996 
                                       --------------      --------------        --------------      -------------
Current
<S>                                       <C>                  <C>                  <C>                 <C>
  Federal...........................      $   658                $  400               $  (12)             $ 126
  State.............................           93                   129                   35                103
Deferred - Federal
  and State.........................       (6,820)                1,585                2,562               (183)
                                       --------------      --------------        --------------      -------------
Total income tax
  expense (benefit).................      $(6,069)               $2,114               $2,585              $  46
                                       ==============      ==============        ==============      =============
</TABLE>

                                       63
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                  ------------------------------------------

          The tax effect of temporary differences that give rise to significant
portions of the deferred tax assets and liabilities at December 31, 1998 and 
1997, June 30, 1997 and 1996 is as follows:

<TABLE>
<CAPTION>

                                                      December 31,        December 31,                          June 30,
                                                 -------------------------------------------     -----------------------------------
                                                         1998                  1997                    1997                  1996
                                                 -------------------------------------------     -----------------     -------------
<S>                                                    <C>                   <C>                    <C>                    <C>
Net operating loss
  carryforwards..................................      $ 6,044               $  7,858               $  8,668               $ 8,922
Percentage depletion
  carryforwards..................................          271                    271                    271                   271
Alternative minimum
  tax credit carryforwards.......................        1,150                    513                    114                   126
Plant, property and                                     18,325                    ---                    ---                   ---
  equipment......................................
State income taxes...............................        1,901                    ---                    ---                   ---
                                                 -------------------------------------------     -----------------     -------------
  Total deferred income tax
   assets........................................       27,691                  8,642                  9,053                 9,319
                                                 -------------------------------------------     -----------------     -------------
Plant, property and                                        ---                (12,106)               (11,019)               (8,840)
  equipment......................................
State income taxes...............................          ---                   (748)                  (661)                 (446)
                                                 -------------------------------------------     -----------------     -------------
Total deferred income tax
  liabilities....................................          ---                (12,854)               (11,680)               (9,286)
                                                 -------------------------------------------     -----------------     -------------
Valuation allowances.............................      (27,691)                (2,894)                (2,894)               (2,894)
                                                 -------------------------------------------     -----------------     -------------
Net deferred income tax
  liability......................................     $      0               $ (7,106)              $ (5,521)              $(2,861)
                                                 ===========================================     =================     =============

</TABLE>

          At December 31, 1998, the Company determined that it is more likely
     than not that the deferred tax assets will not be realized and the
     valuation allowance was increased by $24.8 million to a total valuation
     allowance of $27.7 million.

          A tax benefit related to the exercise of employee stock options of
     approximately $323,000 was allocated directly to additional paid-in capital
     in 1998. Such benefit was not material in prior periods.

                                       64
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                  ------------------------------------------


          Total income tax differs from the amount computed by applying the
     Federal income tax rate to income before income taxes and minority
     interest.  The reasons for the differences are as follows:

<TABLE>
<CAPTION>
                                                                         Six Month
                                                        Year            Transition                                             
                                                        Ended          Period Ended                Fiscal Year Ended           
                                                     December 31,       December 31,                     June 30,      
                                                    --------------     -------------       --------------------------------
                                                        1998                1997                1997               1996
                                                    --------------     -------------       --------------      ------------
<S>                                                    <C>                   <C>                <C>     <C>     <C>
Statutory Federal income tax
  rate...........................................      (34.0%)             34.0%                34.0%             34.0%         
Increase (Decrease) in tax rate                                                                                                 
  resulting from:                                                                                                               
  State income taxes, net of                                                                                                    
    federal benefit..............................       (3.1%)              3.2%                 1.3%              7.0%         

  Non-deductible travel and                                                                                                     
    entertainment................................        0.1%               0.1%                 0.5%              0.3%         
                                                                                                                                
  Change in valuation allowance..................       29.7%               ---                  ---             (36.8%)        
                                                    --------------     -------------       --------------      ------------
                                                        (7.3%)             37.3%                35.8%              4.5%         
                                                    ==============     =============       ==============      ============
</TABLE>

          The Company issued 3,400,000 shares of its common stock on July 20,
     1994.  As a result of the common stock issuance, the Company has undergone
     an ownership change.  Therefore, the Company's ability to use its net
     operating loss ("NOL") carryforwards for federal income tax purposes is
     subject to significant restrictions.

          Section 382 of the Internal Revenue Code significantly limits the
     amount of NOL and investment tax credit carryforwards that are available to
     offset future taxable income and related tax liability when a change in
     ownership occurs.

          At December 31, 1998, the Company had net operating loss carryforwards
     of approximately $17.8 million which will expire in future years beginning
     in 1999.  Due to provisions of Section 382, the Company is limited to
     approximately $2.9 million utilization of NOL per year.

9.   CONTINGENCIES
     -------------

          The Company has been named as a defendant in certain lawsuits
     incidental to its business.  Management does not believe that the outcome
     of such litigation will have a material adverse impact on the Company.

                                       65
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                  ------------------------------------------


10.  SELECT QUARTERLY FINANCIAL DATA (AMOUNTS IN THOUSANDS, EXCEPT PER SHARE
     ------------------------------------------------------------------------
     DATA)  (Unaudited):
     -----              

<TABLE>
<CAPTION>
                                                                            Quarter Ended
                                   ---------------------------------------------------------------------------------------------
<S>                                   <C>                <C>                <C>                 <C>                 <C>
                                       December          September            June               March              December
                                       31, 1998          30, 1998           30, 1998            31, 1998            31, 1997
                                   ---------------------------------------------------------------------------------------------
Revenues                               $  15,943         $  19,034          $  20,953           $  19,837           $  24,399
Operating income (loss)                $ (82,812)        $    (283)         $     399           $    (624)          $   4,287
Net income (loss)                      $ (76,919)        $    (187)         $     247           $    (392)          $   2,691
Earnings (loss) per
  common share                         $   (5.55)        $   (0.01)         $    0.02           $   (0.03)          $    0.19
Earnings (loss) per
  common shares -
  diluted                              $   (5.55)        $   (0.01)         $    0.02           $   (0.03)          $    0.19

                                   ---------------------------------------------------------------------------------------------
                                       September           June              March              December            September
                                       30, 1997          30, 1997           31, 1997            31, 1996            30, 1996 
                                   ---------------------------------------------------------------------------------------------
Revenues                               $  21,177         $  23,514          $   7,294           $   6,633           $   5,319
Operating income                       $   1,375         $   2,175          $   2,303           $   1,771           $     981
Net income                             $     857         $   1,449          $   1,462           $   1,116           $     618
Earnings per 
  common share                         $    0.06         $    0.11          $    0.16           $    0.12           $    0.07
Earnings per common share
  common share -
  diluted                              $    0.06         $    0.11          $    0.16           $    0.12           $    0.06

</TABLE>


     The quarter ended December 31, 1998 reflects a $73.9 million full cost
ceiling impairment which resulted from recent material oil and gas price
declines.

                                       66
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                  ------------------------------------------

11.  SUPPLEMENTAL INFORMATION - (Unaudited)
     ------------------------              

     OIL AND GAS PRODUCING ACTIVITIES:
     ---------------------------------

          Included herein is information with respect to oil and gas
     acquisition, exploration, development and production activities, which is
     based on estimates of year-end oil and gas reserve quantities and estimates
     of future development costs and production schedules.  Reserve quantities
     and future production are based primarily upon reserve reports prepared by
     the independent petroleum engineering firms of Williamson Petroleum
     Consultants, Inc. for fiscal 1996 and Ryder Scott Company for fiscal 1997,
     1998 and the transition period 1997.  These estimates are inherently
     imprecise and subject to substantial revision.

          Estimates of future net cash flows from proved reserves of gas, oil,
     condensate and natural gas liquids were made in accordance with Statement
     of Financial Accounting Standards No. 69, "Disclosures about Oil and Gas
     Producing Activities."  The estimates are based on prices at year-end.
     Estimated future cash inflows are reduced by estimated future development
     and production costs based on year-end cost levels, assuming continuation
     of existing economic conditions, and by estimated future income tax
     expense.  Tax expense is calculated by applying the existing statutory tax
     rates, including any known future changes, to the pre-tax net cash flows,
     less depreciation of the tax basis of the properties and depletion
     allowances applicable to the gas, oil, condensate and NGL production.  The
     impact of the net operating loss is considered in calculation of tax
     expense.  The results of these disclosures should not be construed to
     represent the fair market value of the Company's oil and gas properties.  A
     market value determination would include many additional factors including:
     1)  anticipated future increases or decreases in oil and gas prices and
     production and development costs;  2)  an allowance for return on
     investment;  3)  the value of additional reserves, not considered proved at
     the present, which may be recovered as a result of further exploration and
     development activities; and 4) other business risks.

                                       67
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                  ------------------------------------------

     Costs incurred (in thousands)
     --------------               

          The following table sets forth the costs incurred in property
     acquisition and development activities:

<TABLE>
<CAPTION>
 
                                                                           Six Month
                                                                          Transition    
                                               Year Ended                Period Ended                   Fiscal Year Ended
                                              December 31,               December 31,                         June 30,
                                        ----------------------     ----------------------    ---------------------------------------
                                                  1998                       1997                    1997                 1996
                                        ----------------------     ----------------------    --------------------    ---------------
Property acquisition:
<S>                                        <C>                        <C>                       <C>                  <C>
  Proved properties.....................               $   617                    $ 3,281               $138,984             $  128
  Unproved properties...................                 8,979                      2,205                  1,002                424
Exploration.............................                16,186                      3,274                  1,576                824
Development.............................                14,397                     10,453                 14,032              5,558
                                        ----------------------     ----------------------    -------------------    ---------------
                                                       $40,179                    $19,213               $155,594             $6,934
                                        ======================     ======================    ===================    ===============

</TABLE>

Capitalized costs (in thousands)
-----------------               

          The following table sets forth the capitalized costs relating to oil
     and gas activities and the associated accumulated depreciation, depletion
     and amortization:
<TABLE>
<CAPTION>
 
                                                                          Six Month
                                                                          Transition    
                                                Year Ended               Period Ended                    Fiscal Year Ended
                                               December 31,              December 31,                        June 30,
                                         ---------------------     ---------------------     --------------------------------------
                                                  1998                      1997                     1997                  1996
                                         ---------------------     ---------------------     -------------------    -------------
<S>                                         <C>                       <C>                       <C>                    <C>
Proved properties........................       $ 280,286                  $243,758                $228,675            $ 62,590
Unproved properties......................           8,945                     6,469                   4,500              13,453
                                         ---------------------     ---------------------     -------------------    -------------
Total capitalized costs..................         289,231                   250,227                 233,175              76,043

Accumulated depreciation,                                                                                         
  depletion, amortization and                                                                                     
  impairment.............................        (193,445)                  (82,975)                (61,783)            (28,316)
                                         ---------------------     ---------------------     -------------------    -------------
Net capitalized costs....................       $  95,786                  $167,252                $171,392            $ 47,727
                                         =====================     =====================     ===================    =============
</TABLE>

                                       68
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                  ------------------------------------------

Results of operations for producing activities (in thousands):
----------------------------------------------                

<TABLE>
<CAPTION>
 
                                                                      Six Month
                                                                     Transition
                                              Year Ended            Period Ended              Fiscal Year Ended
                                             December 31,           December 31,                  June 30,
                                            -------------          -------------         ---------------------------
                                                 1998                   1997                 1997           1996 (1)
                                            ------------           -------------         ------------    -----------
<S>                                           <C>                     <C>                  <C>             <C>
 
Revenues from oil and gas
 producing activities.....................    $ 73,217                $44,163              $39,067         $15,666
Production costs..........................      25,381                 13,836               11,437           5,317
Income tax................................         ---                  5,379                4,529             ---
Impairment expense........................      73,899                    ---                  ---             ---
Depreciation, depletion and
 amortization.............................      38,548                 15,831               14,691           6,933
                                            ------------           -------------         ------------    -----------
 Results of operations from
 producing activities
 (excluding corporate
 overhead and interest costs).............    $(64,611)               $ 9,117              $ 8,410         $ 3,416
                                            ============           =============         ============    ===========
</TABLE>

     (1)  Net operating loss carryfowards were sufficient to offset income.

     Per unit sales prices and costs:
     ------------------------------- 
<TABLE>
<CAPTION>
 
                                                                       Six Month
                                                                      Transition 
                                                Year Ended           Period Ended                Fiscal Year Ended  
                                               December 31,          December 31,                    June 30,
                                              --------------        --------------       -------------------------------
                                                  1998                  1997                 1997               1996
                                              --------------        --------------       ------------       ------------
Average sales price: (1)
<S>                                             <C>                  <C>                   <C>                <C>
  Oil (per barrel)........................       $11.34               $16.34                $17.41             $17.81
  Gas (per MCF)...........................       $ 2.05               $ 2.55                $ 2.29             $ 2.02

Average production cost per
  equivalent MCF..........................       $  .72               $  .79                $  .73             $  .75

Average unit depletion rate
  per equivalent MCF......................       $ 1.10               $  .90                $  .94             $  .98
</TABLE>

  1) Average sales price is exclusive of the effect of natural gas and crude oil
  price swaps, which increased revenues $3.6 million in 1998 and decreased
  revenues $1.6 million in transition period 1997 and $18,000 and $.6 million in
  fiscal years ended June 30, 1997 and 1996, respectively.

                                       69
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                  ------------------------------------------

Reserves
--------

          The Company's estimated total proved and proved developed reserves of
     oil and gas are as follows:


<TABLE>
<CAPTION>
                                                                                                 Six Month Transition
                                              Year Ended                                             Period Ended
   Description                              December 31, 1998                                      December 31, 1997
------------------         --------------------------------------------------     ----------------------------------------------
                                Oil                 NGL              Gas              Oil              NGL              Gas
                               (MBBL)              (MBBL)           (MMCF)           (MBBL)           (MBBL)           (MMCF)
                           --------------     --------------     ------------     ------------     ------------     ------------
<S>                            <C>               <C>                <C>              <C>              <C>             <C>
Proved reserves at                                                                                   
   beginning of period          12,238             2,571            125,960           12,007           4,023          127,940
Revisions of previous           (2,473)           (1,032)            (5,944)           1,246          (1,417)           1,599
   estimates                                                                                         
Extensions and discoveries         813               225              9,416              641              52            4,869
Production                      (2,106)             (191)           (21,302)            (967)            (87)         (11,193)
Sales of reserves in-place          (4)              ---               (167)            (694)            ---             (642)
Purchase of reserves in-                                                                             
   place                            21               ---              3,622                5             ---            3,387
                           --------------     --------------     ------------     ------------     ------------     ------------
Proved reserves at end of                                                                            
   period                        8,489             1,573            111,585           12,238           2,571          125,960
                           ==============     ==============     ============     ============     ============     ============
Proved developed reserves                                                                            
   Beginning of period          11,153             2,460            119,270           10,162           3,705          117,914
                           ==============     ==============     ============     ============     ============     ============
   End of period                 8,021             1,554            106,253           11,153           2,460          119,270
                           ==============     ==============     ============     ============     ============     ============
</TABLE>


<TABLE>
<CAPTION>
 
 
 
                                                          Fiscal Years Ended June 30,
                                    --------------------------------------------------------------------------
          Description                              1997                                  1996
--------------------------------    -------------------------------------     --------------------------------
                                         Oil         NGL          Gas               Oil                Gas
                                       (MBBL)       (MBBL)       (MMCF)            (MBBL)            (MMCF)
                                    -------------------------------------     --------------------------------
<S>                                   <C>          <C>         <C>                <C>               <C>
Proved reserves at beginning
   of period                           1,808         ---        33,194            2,597             30,159
Revisions of previous
   estimates                          (1,187)      2,435        (2,773)            (534)             2,853
Extensions and discoveries               658          52         4,202               89              7,128
Production                              (854)        ---       (10,552)            (334)            (5,099)
Sales of reserves in-place            (1,260)        ---       (16,194)             (14)            (2,023)
Purchase of reserves
   in-place                           12,842       1,536       120,063                4                176
                                    -------------------------------------     --------------------------------
Proved reserves at end of
   year                               12,007       4,023       127,940            1,808             33,194
                                    =====================================     ================================
Proved developed reserves-
   Beginning of year                   1,494         ---        22,696            1,891             23,795
                                    =====================================     ================================
   End of year                        10,162       3,705       117,914            1,494             22,696
                                    =====================================     ================================ 
</TABLE>

                                       70
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------


     Discounted future net cash flows (in thousands)
     ---------------------------------------------- 

          The standardized measure of discounted future net cash flows and
     changes therein related to proved oil and gas reserves are shown below:

<TABLE>
<CAPTION>

                                                      December 31,       December 31,              June 30,
                                                         1998               1997              1997           1996       
                                                    ----------------   ----------------   ------------   ------------
<S>                                                   <C>                <C>                <C>             <C>        
Future cash inflows.............................       $ 328,285          $ 517,323        $ 529,928        $113,550    
Future production costs.........................        (132,108)          (191,988)        (183,479)        (33,117)   
Future income taxes.............................             ---            (48,594)         (59,419)        (11,095)   
Future development costs........................         (29,609)           (33,197)         (32,237)         (8,959)
                                                    ----------------   ----------------   ------------   ------------
Future net cash flows...........................         166,568            243,544          254,793          60,379    
10% discount factor.............................         (50,588)           (57,829)         (67,300)        (15,191)   
                                                    ----------------   ----------------   ------------   ------------
Standardized measure of discounted future net
  cash flows....................................       $ 115,980          $ 185,715        $ 187,493        $ 45,188
                                                    ================   ================   ============   ============
</TABLE>

          The following are the principal sources of change in the standardized
     measure of discounted future net cash flows:

<TABLE>
<CAPTION>
 
                                                                                  Six Month
                                                                                 Transition
                                                        Year Ended               Period Ended                Fiscal Year
                                                        December 31              December 31                Ended June 30
                                                 -----------------------  -----------------------  ------------  ---------------
                                                          1998                     1997                 1997           1996
                                                 -----------------------  -----------------------  ------------  ---------------
<S>                                                    <C>                      <C>                  <C>             <C>
Standardized measure - beginning of year.........       $185,715                 $187,493            $ 45,188         $ 37,291 
Sales, net of production costs...................        (44,264)                 (30,327)            (27,630)         (10,349)
Purchases of reserves in-place...................          3,379                    4,117             151,836              246 
Net change in prices and production costs........        (55,408)                  (3,922)             22,599           11,458 
Net change in income taxes.......................         14,517                    8,706             (20,265)          (2,958)
Extensions, discoveries and improved                                                                                           
  recovery, net of future production and                                                                                       
  development costs..............................          8,255                   10,769              12,555            7,709 
Changes in estimated future development                                                                                        
  costs..........................................          4,542                   (3,588)             (3,034)             497 
Development costs incurred during the                                                                                          
  period.........................................         11,244                    6,662               9,124              883 
Revisions of quantity estimates..................        (20,520)                     569              27,102             (438)
Accretion of discount............................         18,572                   18,749               4,518            3,729 
Sales of reserves in-place.......................           (260)                  (4,602)            (16,140)          (1,614)
Changes in production rates and other............         (9,792)                  (8,911)            (18,360)          (1,266)
                                                 -----------------------  -----------------------  ------------  ---------------
Standardized measure - end of year...............       $115,980                 $185,715            $187,493         $ 45,188  
                                                 =======================  =======================  ============  ===============
</TABLE>

          The discounted future cash flows above were calculated using NYMEX
     equivalent prices of $12.05, $18.32 and $19.80 per barrel and $2.15, $2.58
     and $2.35 per MMBTU, for December 31, 1998 and 1997 and June 30, 1997,
     respectively, adjusted to the wellhead to reflect adjustments for
     transportation, quality and heating content.

                                       71
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------


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

     On or about June 18, 1997 the Company replaced the firm of Deloitte and
Touche LLP as its principal independent accountant and auditors to audit all the
Company's financial statements with the firm of KPMG LLP.  The decision to make
this change was influenced by the acquisition of Partnership properties and
interests, which were previously audited by KPMG LLP.  The Company does not and
has not during the past three years had disagreements with Deloitte and Touche
LLP or KPMG LLP concerning their audit or application of accounting principles
according to GAAP.

                                   PART III
                                   --------

ITEM 10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
------------------------------------------------------------

     The information required by this item will be included in a definitive
proxy statement, pursuant to Regulation 14A, to be filed not later than 120 days
after December 31, 1998. Such information is incorporated herein by reference.

ITEM 11.  EXECUTIVE COMPENSATION
--------------------------------

     The information required by this item will be included in a definitive
proxy statement, pursuant to Regulation 14A, to be filed not later than 120 days
after December 31, 1998. Such information is incorporated herein by reference.


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

     The information required by this item will be included in a definitive
proxy statement, pursuant to Regulation 14A, to be filed not later than 120 days
after December 31, 1998. Such information is incorporated herein by reference.


ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
--------------------------------------------------------

     The information required by this item will be included in a definitive
proxy statement, pursuant to Regulation 14A, to be filed not later than 120 days
after December 31, 1998. Such information is incorporated herein by reference.

                                       72
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------


                                    PART IV
                                    -------

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

(a)  1. and 2. Financial Statements.  See index to Consolidated Financial
               Statements and Supplemental Information in Item 8, which
               information is incorporated herein by reference.

     3. Exhibits

     3.1  Certificate of Incorporation of Bellwether Exploration Company
          (incorporated by reference to Exhibit 3.1 to the Company's
          Registration Statement No. 33-76570)

     3.2  Certificate of Amendment to Certificate of Incorporation (incorporated
          by reference to Exhibit 3.2 to the Company's Annual Report on
          Form 10-K for the fiscal year ended June 30, 1997)

     3.3  Certificate of Designation, Preferences and Rights of Series A
          Preferred Stock (incorporated by reference to Exhibit 1 to the
          Company's  Registration Statement on Form 8-A dated September 19,
          1997.)

     3.4  By-laws of Bellwether Exploration Company (incorporated by reference
          to Exhibit 3.2 to the Company's Registration Statement No. 33-76570)

     3.5  Amendment to Article II, Section 2.2 of Bellwether Exploration
          Company's Bylaws (incorporated by reference to Exhibit 3.5 to the
          Company's Annual Report on Form 10-K for the transition period ended
          December 31, 1997).

     3.6  Amendment to Bellwether Exploration Company's bylaws adopted on
          March 27, 1998 (incorporated by reference to Exhibit 3.6 to the
          Company's Annual Report on Form 10-K for the transition period ended
          December 31, 1997).

     4.1  Specimen Stock Certificate (incorporated by reference to Exhibit 4.1
          to the Company's Registration Statement on Form S-1, File
          No. 33-76570)

     4.2  The Company's 1996 Stock Incentive Plan (incorporated by reference to
          Exhibit 10.20 to the Company's Registration Statement on Form S-1,
          File No. 33-21813)

     4.3  Indenture dated April 9, 1997 among the Company, a Subsidiary
          Guarantor and Bank of Montreal Trust Company (incorporated herein by
          reference to Exhibit 4.2 to the Company's Registration Statement on
          Form S-1, Registration No. 33-21813)

                                       73
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------

     4.4  First Supplemental Indenture dated April 21, 1997 among the Company,
          Odyssey Petroleum Company, Black Hawk Oil Company, 1989-I TEAI Limited
          Partnership and Bank of Montreal Trust Company, as Trustee
          (incorporated by reference to Exhibit 99.2 on the Company's Form 8-K
          Current Report filed on April 23, 1997)

     4.5  Shareholders Rights Agreement between the Company and American Stock
          Transfer & Trust Company (incorporated herein by reference to the
          Company's Registration Statement on Form 8-A as filed with the
          Securities and Exchange Commission on September 19, 1997)

     4.6  Warrant to Torch Energy Dated April 9, 1997 (incorporated by reference
          to Exhibit 4.6 to the Company's Annual Report on Form 10-K for the
          fiscal year ended June 30, 1997)

     10.1 Administrative Services Agreement with Torch Energy Advisors
          Incorporated commencing January 1, 1994 (incorporated by reference to
          Exhibit 94-10-3 to the Company's Report on Form 10-Q for the quarter
          ended March 31, 1994)

     10.2 Amended Joint Venture Agreement dated July 29, 1993 between the
          Company and NGL Associates (incorporated by reference to Exhibit
          10.93.5 to the Company's Report on Form 10-K dated July 29, 1993)

     10.3 Amended Joint Venture dated July 15, 1993 between Torch Energy
          Marketing, Inc. and NGL Associates (incorporated by reference to
          Exhibit 10.93.8 to the Company's report on Form 8-K dated December 31,
          1993)

     10.4 Registration Rights Agreement dated December 31, 1993 among the
          Company and the Stockholders of Associated Gas Resources, Inc.
          (incorporated by reference to Exhibit 10.1 to the Company's
          Registration Statement No. 33-76570)

     10.5 1994 Stock Incentive Plan (incorporated by reference to Exhibit 10.9
          to the Company's Registration Statement No. 33-76570)

     10.6 Amendment dated March 14, 1994 to the Amended Joint Venture Agreement
          dated as of July 29, 1993 between the Company and NGL Associates
          (incorporated by reference to Exhibit 10.11 to the Company's
          Registration Statement No. 33-76570)

     10.7 Amendment dated March 14, 1994 to the Amended Joint Venture Agreement
          dated as of July 15, 1993 between Torch Energy Marketing, Inc. and NGL
          Associates (incorporated by reference to Exhibit 10.12 to the
          Company's Registration Statement No. 33-76570)

                                       74
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------


     10.8  Registration Rights Agreement among the Company, Allstate Insurance
           Company and the former owners of Odyssey Partners, Ltd. (incorporated
           by reference to Exhibit 10.4 to the Company's Registration Statement
           No. 33-76570)

     10.9  Assignment of gas purchase contract from Texas Gas Transmission
           Corporation to Bellwether (incorporated by reference to
           Exhibit 96-10-4 to the Company's Report on Form 10-Q for the quarter
           ended March 31, 1997)

     10.10 Acquisition Agreement dated March 31, 1997 among Bellwether
           Exploration Company, Program Acquisition Company and the other
           parties thereto. (incorporated by reference to Exhibit 2.2 of the
           Company's Registration Statement on Form S-1 (Registration
           No. 333-21813) filed on April 3, 1997)

     10.11 Credit Agreement dated April 21, 1997 among the Company, Odyssey
           Petroleum Company, Black Hawk Oil Company, 1989-I TEAI Limited
           Partnership, Morgan Guarantee Trust Company of New York, as
           administrative Agent, and certain banking institutions (incorporated
           by reference to the Company's Form 8-K Current Report as filed with
           the Commission on April 23, 1997)

     10.12 Purchase and Sale Agreement dated June 9, 1997 among Bellwether
           Exploration Company, Black Hawk Oil Company, 1988-II TEAI Limited
           Partnership, 1989-I TEAI Limited Partnership, TEAI Oil and Gas
           Company, and the other parties thereto as Sellers, and Jay Resources
           Corporation as Buyer (incorporated by reference to Exhibit 10.18 to
           the Company's Annual Report on Form 10-K for the fiscal year ended
           June 30, 1997).

     10.13 Employment contract dated June 1, 1998 between the Company and J.
           Darby Sere' (incorporated by reference to Exhibit 10.1 to the
           Company's 10-Q for the quarter ended June 30, 1998).

     10.14 Employment contract dated June 1, 1998 between the Company and
           William C. Rankin (incorporated by reference to Exhibit 10.2 to the
           Company's Report on Form 10-Q for the quarter ended June 30, 1998).

     16.1  Letter from predecessor auditors regarding change in certifying
           accountant (incorporated by reference to Exhibit 16-1 to the
           Company's Form 8K/A-1 dated July 8, 1997)

     21.1  Subsidiaries of Bellwether Exploration Company - Included herewith.

                                       75
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------

     23    Consents of experts:

     23.1  Consent of Williamson Petroleum Consultants, Inc. -- Included 
           herewith.

     23.2  Consent of Ryder Scott Company -- Included herewith.

     23.3  Consent of KPMG LLP -- Included herewith.

     27    Financial Data Schedule -- Included herewith.

                                       76
<PAGE>
 
                BELLWETHER EXPLORATION COMPANY AND SUBSIDIARIES
                -----------------------------------------------

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

                                            BELLWETHER EXPLORATION COMPANY

                                            /s/ J. Darby Sere'
                                            ------------------
                                            J. Darby Sere'
                                            Chairman of Board of
                                            Directors and Chief
                                            Executive Officer


Dated March 19, 1999

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

       SIGNATURES                TITLE                        DATE

 
 
/s/ J. Darby Sere'           Chairman of Board of          March 19, 1999
----------------------       Directors and Chief           --------------
J. Darby Sere'               Executive Officer    


 
/s/ William C. Rankin        Senior Vice President
----------------------       and Chief Financial 
William C. Rankin            Officer                       March 19, 1999
                                                           --------------
 

/s/ Dr. Jack Birks           Director                      March 19, 1999
----------------------                                     --------------
Dr. Jack Birks
 


/s/ J.P. Bryan               Director                      March 19, 1999
----------------------                                     --------------
J.P. Bryan
 


/s/ Vincent H. Buckley       Director                      March 19, 1999
----------------------                                     --------------
Vincent H. Buckley
 


/s/ Habib Kairouz            Director                      March 19, 1999
----------------------                                     --------------
Habib Kairouz
 


/s/ A. K. McLanahan          Director                      March 19, 1999
----------------------                                     --------------
A. K. McLanahan
 


/s/ Townes G. Pressler       Director                      March 19, 1999
----------------------                                     --------------
Townes G. Pressler


                                       77