** **

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

 

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**WASHINGTON,D.C.  20549**

 

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**FORM 10-Q**

 
| **ý** | ** ** | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE**** ****SECURITIES EXCHANGE  ACT OF 1934**                                                                                                               |
|------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       |       |                                                                                                                                                                                                                          |
| ** ** | ** ** | **For the Quarter Ended September 30,  2004**                                                                                                                                                                            |
| ** ** | ** ** | ** **                                                                                                                                                                                                                    |
|       |       | **or**                                                                                                                                                                                                                        |
|       |       |                                                                                                                                                                                                                          |
| **o**      | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(D)**** ****OF THE SECURITIES  EXCHANGE ACT OF 1934**                                                                                                              |
|       |       |                                                                                                                                                                                                                          |
|       |       | **For  the Transition Period From                  to                ** |

 

**Commission File Number: 000-25717**

 

 

**PETROHAWK ENERGY CORPORATION**

(Exact name of registrant as specified in its charter)

 
| **Delaware**                                | ** ** | **86-0876964**                       |
|---------------------------------------------|------------|--------------------------------------|
| (State of Incorporation)                    |       | (I.R.S. Employer Identification No.) |
|                                        |       |                                 |
| **1100 Louisiana, Suite 4400, Houston, TX** | ** ** | **77002**                            |
| (Address of principal executive offices)    |       | (Zip Code)                           |

 

**(832) 204-2700**

(Registrant’s telephone number, including area code)

 

Indicate by check markwhether the Registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months(or for such shorter period that the Registrant was required to file suchreports), and (2) has been subject to such filing requirements for the past 90days.

 

Yes ý  No o

 

Indicate by check markwhether the Registrant is an accelerated filer (as defined in Rule 12b-2 of theExchange Act).

 

Yes o  Noý

 

As of November 1,2004, the Registrant had 13,892,167 shares of Common Stock, $.001 par value,outstanding.

 

 

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**INDEX**

 
| **PART I -  FINANCIAL INFORMATION**                                                                                 |                                                                                                                                                               |
|---------------------------------------------------------------------------------------------------------------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                                                                                |                                                                                                                                                               |
| **ITEM 1.  Financial Statements**                                                                         |                                                                                                                                                               |
|                                                                                                                | Condensed  Consolidated Balance Sheets as of September 30, 2004 and December 31,  2003 (unaudited)                                                       |   |
|                                                                                                                | Condensed  Consolidated Statements of Operations and Comprehensive Income (Loss) for the  three and nine months ended September 30, 2004 and 2003 (unaudited) |   |
|                                                                                                                | Condensed  Consolidated Statements of Cash Flows for the nine months ended September 30,  2004 and 2003 (unaudited)                                           |   |
|                                                                                                                | Notes  to Condensed Consolidated Financial Statements (unaudited)                                                                                                  |   |
| **ITEM  2.  Management’s Discussion and  Analysis of Financial Condition and Results of Operations** |                                                                                                                                                               |
|                                                                                                                | Disclosure  Regarding Forward-Looking Statements                                                                                                                   |   |
|                                                                                                                | PHAWK, LLC Transaction                                                                                                                                             |   |
|                                                                                                                | Related Party Transaction                                                                                                                                          |   |
|                                                                                                                | Overview                                                                                                                                                           |   |
|                                                                                                                | Liquidity and Capital  Resources                                                                                                                                   |   |
|                                                                                                                | Capital  Expenditures                                                                                                                                              |   |
|                                                                                                                | Significant Accounting  Policies                                                                                                                                   |   |
|                                                                                                                | Comparison  of Results of Operations for the three and nine months ended September 30,  2004 and 2003                                                         |   |
|                                                                                                                |                                                                                                                                                               |   |
| **ITEM  3.  Quantitative and Qualitative  Disclosures About Market Risk**                                 |                                                                                                                                                               |
|                                                                                                                |                                                                                                                                                               |   |
| **ITEM 4.  Controls and Procedures.**                                                                     |                                                                                                                                                               |
|                                                                                                                |                                                                                                                                                               |   |
| **PART II. - OTHER  INFORMATION**                                                                                   |                                                                                                                                                               |
|                                                                                                                |                                                                                                                                                               |   |
| **ITEM 2.  Changes in Securities, Use of Proceeds and Issuer  Purchases of Equity Securities**            |                                                                                                                                                               |
|                                                                                                                |                                                                                                                                                               |   |
| **ITEM 4.  Submission of Matters to a Vote of Security  Holders**                                         |                                                                                                                                                               |
|                                                                                                                |                                                                                                                                                               |   |
| **ITEM 6.  Exhibits**                                                                                     |                                                                                                                                                               |
|                                                                                                                |                                                                                                                                                               |
| Signatures                                                                                                          |                                                                                                                                                               |   |

 

2

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**PART I**

**ITEM 1.  FINANCIAL STATEMENTS**

**PETROHAWKENERGY CORPORATION**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

(unaudited)

 
| ** **                                                                                                                                                                                                                                                                                | ** ** | **SEPTEMBER 30,  2004** | ** ** | **DECEMBER 31,  2003** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| **CURRENT ASSETS**                                                                                                                                                                                                                                                                        |       |                         |       |                        |       |
| Cash                                                                                                                                                                                                                                                                                      |       | $                            | 35,096,236 |                        | $          | 2,109,681 |   |
| Accounts  receivable                                                                                                                                                                                                                                                                      |       |                         |       |                        |       |
| Oil  and gas sales                                                                                                                                                                                                                                                                        |       | 4,168,686                    |       | 1,898,746                   |       |
| Other                                                                                                                                                                                                                                                                                     |       | 598,260                      |       | 113,529                     |       |
| Prepaid  expenses and other                                                                                                                                                                                                                                                               |       | 1,112,885                    |       | 564,980                     |       |
| Total  current assets                                                                                                                                                                                                                                                                     |       | 40,976,067                   |       | 4,686,936                   |       |
|                                                                                                                                                                                                                                                                                      |       |                         |       |                        |       |
| **OIL AND GAS PROPERTY,** at cost  (full cost method)                                                                                                                                                                                                                                     |       |                         |       |                        |       |
| Evaluated  properties                                                                                                                                                                                                                                                                     |       | 87,782,235                   |       | 78,717,380                  |       |
| Unevaluated  properties                                                                                                                                                                                                                                                                   |       | 740,519                      |       | 1,294,212                   |       |
| Less  – accumulated amortization of full cost pool                                                                                                                                                                                                                                   |       | (43,121,687                  | )          | (39,740,116                 | )          |
| Net  oil and gas properties                                                                                                                                                                                                                                                               |       | 45,401,067                   |       | 40,271,476                  |       |
|                                                                                                                                                                                                                                                                                      |       |                         |       |                        |       |
| **OTHER OPERATING PROPERTY AND EQUIPMENT**,  at cost                                                                                                                                                                                                                                      |       |                         |       |                        |       |
| Gas  gathering system and equipment                                                                                                                                                                                                                                                       |       | 1,502,692                    |       | 1,496,404                   |       |
| Support  equipment                                                                                                                                                                                                                                                                        |       | 220,482                      |       | 197,379                     |       |
| Other                                                                                                                                                                                                                                                                                     |       | 760,990                      |       | 276,498                     |       |
| Less  – accumulated depreciation                                                                                                                                                                                                                                                     |       | (855,894                     | )          | (813,450                    | )          |
| Net  other operating property and equipment                                                                                                                                                                                                                                               |       | 1,628,270                    |       | 1,156,831                   |       |
|                                                                                                                                                                                                                                                                                      |       |                         |       |                        |       |
| **DEBT ISSUE COSTS**, net of  amortization of $90,287                                                                                                                                                                                                                                     |       | 1,335,299                    |       | —                      |       |
| **OTHER ASSETS**                                                                                                                                                                                                                                                                          |       | 377,232                      |       | —                      |       |
| ** **                                                                                                                                                                                                                                                                                |       |                         |       |                        |       |
| **TOTAL ASSETS**                                                                                                                                                                                                                                                                          |       | $                            | 89,717,935 |                        | $          | 46,115,243 |   |
| ** **                                                                                                                                                                                                                                                                                |       |                         |       |                        |       |
| **CURRENT LIABILITIES**                                                                                                                                                                                                                                                                   |       |                         |       |                        |       |
| Accounts  payable, trade                                                                                                                                                                                                                                                                  |       | $                            | 593,308    |                        | $          | 1,646,559 |   |
| Dividends  payable                                                                                                                                                                                                                                                                        |       | —                       |       | 112,707                     |       |
| Asset  retirement obligations – current portion                                                                                                                                                                                                                                      |       | 220,386                      |       | 171,860                     |       |
| Liabilities  from price risk management activities                                                                                                                                                                                                                                        |       | 592,500                      |       | —                      |       |
| Other  accrued liabilities                                                                                                                                                                                                                                                                |       | 1,976,408                    |       | 566,990                     |       |
| Total  current liabilities                                                                                                                                                                                                                                                                |       | 3,382,602                    |       | 2,498,116                   |       |
|                                                                                                                                                                                                                                                                                      |       |                         |       |                        |       |
| **LONG-TERM DEBT**                                                                                                                                                                                                                                                                        |       | —                       |       | 13,284,652                  |       |
| **SUBORDINATED CONVERTIBLE NOTE PAYABLE**                                                                                                                                                                                                                                                 |       | 35,000,000                   |       | —                      |       |
| **ASSET RETIREMENT OBLIGATIONS**,  less current portion                                                                                                                                                                                                                                   |       | 1,524,886                    |       | 1,062,860                   |       |
|                                                                                                                                                                                                                                                                                      |       |                         |       |                        |       |
| **STOCKHOLDERS’ EQUITY**                                                                                                                                                                                                                                                             |       |                         |       |                        |       |
| Preferred  stock, $.001 par value, 5,000,000 shares authorized:  598,271 and 604,271shares issued and outstanding at September 30, 2004  and December 31, 2003, respectively. Liquidation value at September 30,  2004 of $5,533,890.                                      |       | 598                          |       | 604                         |       |
| Common  stock, $.001 par value: 50,000,000 shares authorized;  13,870,549 and 6,223,036 shares issued at September 30, 2004 and December 31,  2003, respectively; 13,862,167 and 6,214,654 shares outstanding at September 30,  2004 December 31, 2003, respectively. |       | 13,871                       |       | 6,223                       |       |
| Additional  paid-in capital                                                                                                                                                                                                                                                               |       | 73,778,685                   |       | 51,930,449                  |       |
| Treasury  stock, at cost; 8,382 shares at September 30, 2004 and December 31,  2003.                                                                                                                                                                                            |       | (36,428                      | )          | (36,428                     | )          |
| Accumulated  deficit                                                                                                                                                                                                                                                                      |       | (23,946,279                  | )          | (22,631,233                 | )          |
|                                                                                                                                                                                                                                                                                      |       |                         |       |                        |       |
| Total  stockholders’ equity                                                                                                                                                                                                                                                          |       | 49,810,447                   |       | 29,269,615                  |       |
|                                                                                                                                                                                                                                                                                      |       |                         |       |                        |       |
| **TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                                                                       |       | $                            | 89,717,935 |                        | $          | 46,115,243 |   |

 

**Theaccompanying notes are an integral part of these condensed consolidatedfinancial statements**

 

3

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**PETROHAWKENERGY CORPORATION**

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS**

**ANDCOMPREHENSIVE INCOME (LOSS)**

**(unaudited)**

 
| ** **                                                                                                                              | ** ** | **FOR THE THREE MONTHS ENDED  SEPTEMBER 30,** | ** ** | **FOR THE NINE MONTHS ENDED  SEPTEMBER 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                                                                              | ** ** | **2004**                                           | ** ** | **2003**                                          | ** ** | **2004** | ** ** | **2003** | ** ** |
| **REVENUES:**                                                                                                                           |       |                                               |       |                                              |       |   |   |   |   |
| Oil  and gas                                                                                                                            |       | $                                                  | 5,531,893  |                                              | $          | 3,215,201 |   | $ | 14,378,746 |   | $ | 9,169,983 |   |
| Field  services                                                                                                                         |       | 57,306                                             |       | 61,263                                            |       | 250,664 |   | 250,411 |   |
| Total  revenues                                                                                                                         |       | 5,589,199                                          |       | 3,276,464                                         |       | 14,629,410 |   | 9,420,394 |   |
|                                                                                                                                    |       |                                               |       |                                              |       |   |   |   |   |
| **COSTS AND EXPENSES:**                                                                                                                 |       |                                               |       |                                              |       |   |   |   |   |
| Production:                                                                                                                             |       |                                               |       |                                              |       |   |   |   |   |
| Lease  operations                                                                                                                       |       | 879,964                                            |       | 569,193                                           |       | 2,457,445 |   | 1,703,313 |   |
| Production,  severance and ad valorem taxes                                                                                             |       | 290,717                                            |       | 205,820                                           |       | 780,374 |   | 654,296 |   |
| Field  services                                                                                                                         |       | 42,826                                             |       | 50,621                                            |       | 131,099 |   | 143,889 |   |
| General  and administrative                                                                                                             |       | 1,597,039                                          |       | 658,390                                           |       | 4,017,117 |   | 1,907,505 |   |
| Stock-based  compensation                                                                                                               |       | 898,000                                            |       | 45,657                                            |       | 2,925,216 |   | 211,636 |   |
| Depreciation,  depletion and amortization                                                                                               |       | 1,271,221                                          |       | 1,197,554                                         |       | 3,531,587 |   | 3,812,592 |   |
| Accretion  of asset retirement obligations                                                                                              |       | 23,026                                             |       | 13,704                                            |       | 69,078 |   | 41,110 |   |
| Total  costs and expenses                                                                                                               |       | 5,002,793                                          |       | 2,740,939                                         |       | 13,911,916 |   | 8,474,341 |   |
|                                                                                                                                    |       |                                               |       |                                              |       |   |   |   |   |
| **INCOME FROM OPERATIONS**                                                                                                              |       | 586,406                                            |       | 535,525                                           |       | 717,494 |   | 946,053 |   |
|                                                                                                                                    |       |                                               |       |                                              |       |   |   |   |   |
| **OTHER INCOME (EXPENSE):**                                                                                                             |       |                                               |       |                                              |       |   |   |   |   |
| Unrealized  losses on mark-to-market commodity derivative contracts                                                                     |       | (592,500                                           | )          | —                                            |       | (592,500 | ) | — |   |
| Interest  expense                                                                                                                       |       | (784,923                                           | )          | (123,065                                          | )          | (1,278,862 | ) | (367,400 | ) |
| Interest  income and other                                                                                                              |       | 129,365                                            |       | 1,352                                             |       | 148,265 |   | 3,708 |   |
| Total  other income (expense)                                                                                                           |       | (1,248,058                                         | )          | (121,713                                          | )          | (1,723,097 | ) | (363,692 | ) |
|                                                                                                                                    |       |                                               |       |                                              |       |   |   |   |   |
| **INCOME (LOSS) BEFORE INCOME TAX BENEFIT**                                                                                             |       | (661,652                                           | )          | 413,812                                           |       | (1,005,603 | ) | 582,361 |   |
|                                                                                                                                    |       |                                               |       |                                              |       |   |   |   |   |
| **INCOME TAX BENEFIT**                                                                                                                  |       | 61,185                                             |       | —                                            |       | 24,000 |   | — |   |
|                                                                                                                                    |       |                                               |       |                                              |       |   |   |   |   |
| **INCOME (LOSS) BEFORE CUMULATIVE EFFECT OF A  CHANGE IN ACCOUNTING PRINCIPLE**                                                         |       | (600,467                                           | )          | 413,812                                           |       | (981,603 | ) | 582,361 |   |
|                                                                                                                                    |       |                                               |       |                                              |       |   |   |   |   |
| **CUMULATIVE EFFECT ON PRIOR YEARS FROM ADOPTION  OF FASB STATEMENT NO. 143,***ACCOUNTING  FOR ASSET RETIREMENT OBLIGATION, NET OF TAX* | * *   | *—*                                           |       | —                                            |       | — |   | 1,640 |   |
|                                                                                                                                    |       |                                               |       |                                              |       |   |   |   |   |
| **NET INCOME (LOSS)**                                                                                                                   |       | (600,467                                           | )          | 413,812                                           |       | (981,603 | ) | 584,001 |   |
|                                                                                                                                    |       |                                               |       |                                              |       |   |   |   |   |
| **PREFERRED DIVIDENDS**                                                                                                                 |       | 111,586                                            |       | 112,707                                           |       | 333,443 |   | 334,445 |   |
|                                                                                                                                    |       |                                               |       |                                              |       |   |   |   |   |
| **NET INCOME (LOSS) APPLICABLE TO COMMON  STOCKHOLDERS**                                                                                |       | $                                                  | (712,053   | )                                                 | $          | 301,105 |   | $ | (1,315,046 | ) | $ | 249,556 |   |
|                                                                                                                                    |       |                                               |       |                                              |       |   |   |   |   |
| **NET INCOME (LOSS) PER SHARE:**                                                                                                        |       |                                               |       |                                              |       |   |   |   |   |
| Basic                                                                                                                                   |       | $                                                  | (0.05      | )                                                 | $          | 0.05 |   | $ | (0.13 | ) | $ | 0.04 |   |
|                                                                                                                                    |       |                                               |       |                                              |       |   |   |   |   |   |   |   |   |
| Fully  Diluted                                                                                                                          |       | $                                                  | (0.05      | )                                                 | $          | 0.05 |   | $ | (0.13 | ) | $ | 0.04 |   |
|                                                                                                                                    |       |                                               |       |                                              |       |   |   |   |   |
| **WEIGHTED AVERAGE SHARES OUTSTANDING:**                                                                                                |       |                                               |       |                                              |       |   |   |   |   |
| Basic                                                                                                                                   |       | 13,817,614                                         |       | 6,214,654                                         |       | 9,762,828 |   | 6,216,141 |   |
|                                                                                                                                    |       |                                               |       |                                              |       |   |   |   |   |
| Fully  Diluted                                                                                                                          |       | 13,817,614                                         |       | 6,258,165                                         |       | 9,762,828 |   | 6,239,901 |   |
|                                                                                                                                    |       |                                               |       |                                              |       |   |   |   |   |
| **COMPREHENSIVE INCOME (LOSS):**                                                                                                        |       |                                               |       |                                              |       |   |   |   |   |
| **NET INCOME (LOSS)**                                                                                                                   |       | $                                                  | (600,467   | )                                                 | $          | 413,812 |   | $ | (981,603 | ) | $ | 584,001 |   |
| **OTHER COMPREHENSIVE INCOME (LOSS):**                                                                                                  |       |                                               |       |                                              |       |   |   |   |   |
| Realized  loss on qualifying cash flow hedges                                                                                           |       | —                                             |       | 100,789                                           |       | — |   | 1,336,844 |   |
| Unrealized  loss on qualifying cash flow hedges                                                                                         |       | —                                             |       | (5,172                                            | )          | — |   | (634,427 | ) |
|                                                                                                                                    |       |                                               |       |                                              |       |   |   |   |   |
| **TOTAL COMPREHENSIVE INCOME (LOSS)**                                                                                                   |       | $                                                  | (600,467   | )                                                 | $          | 509,429 |   | $ | (981,603 | ) | $ | 1,286,418 |   |

 

**The accompanying notes are an integral part of thesecondensed consolidated financial statements**

 

4

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**PETROHAWK ENERGY CORPORATION**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

**(unaudited)**

 
| ** **                                                                                | ** ** | **FOR THE NINE MONTHS ENDED  SEPTEMBER 30,** | ** ** |
|-------------------------------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                                | ** ** | **2004**                                          | ** ** | **2003** | ** ** |
|                                                                                      |       |                                              |       |   |   |
| **CASH FLOWS FROM OPERATING ACTIVITIES:**                                                 |       |                                              |       |   |   |
| Net  income (loss) before cumulative effect of change in accounting principle             |       | $                                                 | (981,603   | ) | $ | 582,361 |   |
| Adjustments  to reconcile net income (loss) to net cash provided by operating activities: |       |                                              |       |   |   |
| Depreciation,  depletion and amortization                                                 |       | 3,531,587                                         |       | 3,812,592 |   |
| Amortization  of debt issue costs                                                         |       | 90,287                                            |       | — |   |
| Accretion  of asset retirement obligations                                                |       | 69,078                                            |       | 41,110 |   |
| Stock-based  compensation                                                                 |       | 2,925,216                                         |       | 211,636 |   |
| Unrealized  losses on mark-to-market commodity derivative contracts                       |       | 592,500                                           |       | — |   |
| Common  stock issued in lieu of directors’ fees                                      |       | 34,980                                            |       | — |   |
| Changes  in operating assets and liabilities:                                             |       |                                              |       |   |   |
| Accounts  receivable                                                                      |       | (2,754,671                                        | )          | (78,143 | ) |
| Prepaid  expenses and other                                                               |       | (547,905                                          | )          | (264,169 | ) |
| Accounts  payable, trade                                                                  |       | (1,053,251                                        | )          | (1,168,467 | ) |
| Other  accrued liabilities                                                                |       | 1,409,418                                         |       | 31,771 |   |
| Asset  retirement obligations incurred                                                    |       | (2,526                                            | )          | (76,591 | ) |
| Net  cash provided by operating activities                                                |       | 3,313,110                                         |       | 3,092,100 |   |
|                                                                                      |       |                                              |       |   |   |
| **CASH FLOWS FROM INVESTING ACTIVITIES:**                                                 |       |                                              |       |   |   |
| Oil and  gas property expenditures                                                        |       | (6,253,068                                        | )          | (1,953,914 | ) |
| Acquisition  of oil and gas properties from PHAWK, LLC                                    |       | (2,636,003                                        | )          | — |   |
| Proceeds  from sale of oil and gas properties                                             |       | 832,245                                           |       | 533,142 |   |
| Gas  gathering and other equipment expenditures                                           |       | (631,790                                          | )          | (28,005 | ) |
| Change  in other assets                                                                   |       | (377,232                                          | )          | — |   |
| Net  cash used in investing activities                                                    |       | (9,065,848                                        | )          | (1,448,777 | ) |
|                                                                                      |       |                                              |       |   |   |
| **CASH FLOWS FROM FINANCING ACTIVITIES:**                                                 |       |                                              |       |   |   |
| Repayment  of notes payable                                                               |       | (13,284,652                                       | )          | (360,439 | ) |
| Proceeds  from issuance of common stock and warrants                                      |       | 25,249,120                                        |       | — |   |
| Proceeds  from issuance of subordinated convertible note payable                          |       | 35,000,000                                        |       | — |   |
| Debt  issue costs related to PHAWK, LLC Transaction                                       |       | (1,425,586                                        | )          | — |   |
| Equity  offering costs related to PHAWK, LLC Transaction                                  |       | (722,315                                          | )          | — |   |
| Return  of capital to PHAWK, LLC                                                          |       | (5,575,626                                        | )          | — |   |
| Preferred  stock dividends paid                                                           |       | (446,148                                          | )          | (334,445 | ) |
| Acquisition  of preferred and treasury stock                                              |       | (55,500                                           | )          | (8,255 | ) |
| Net  cash provided by (used in) financing activities                                      |       | 38,739,293                                        |       | (703,139 | ) |
|                                                                                      |       |                                              |       |   |   |
| **NET INCREASE IN CASH AND CASH EQUIVALENTS**                                             |       | 32,986,555                                        |       | 940,184 |   |
|                                                                                      |       |                                              |       |   |   |
| **CASH AND CASH EQUIVALENTS:**                                                            |       |                                              |       |   |   |
| Beginning  of period                                                                      |       | 2,109,681                                         |       | 927,313 |   |
|                                                                                      |       |                                              |       |   |   |
| End  of period                                                                            |       | $                                                 | 35,096,236 |   | $ | 1,867,497 |   |
|                                                                                      |       |                                              |       |   |   |
| **SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION**                                      |       |                                              |       |   |   |
| Cash  paid for:                                                                           |       |                                              |       |   |   |
| Interest                                                                                  |       | $                                                 | 1,257,214  |   | $ | 444,745 |   |
|                                                                                      |       |                                              |       |   |   |   |   |
| Income  taxes                                                                             |       | $                                                 | —     |   | $ | 14,500 |   |

 

**Theaccompanying notes are an integral part to these condensed consolidatedfinancial statements**

 

5

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**CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS**

**PETROHAWKENERGY CORPORATION AND SUBSIDIARIES**

** **

**NOTESTO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)**

 

1.                                       **BASIS OF PRESENTATION**

 

The accompanying condensed consolidated financialstatements of Petrohawk Energy Corporation (formerly known as Beta Oil &Gas, Inc.) and subsidiaries (“Petrohawk” or “the Company”) have been preparedin accordance with accounting principles generally accepted in the UnitedStates for interim financial information and with the instructions of Form 10-Qand Rule 10-01 of Regulation S-X.  In theopinion of management, the accompanying unaudited financial statements containall adjustments necessary to present fairly the Company’s financial position asof September 30, 2004 and the results of its operations for the three and ninemonths ended September 30, 2004 and 2003 and cash flows for the nine monthsended September 30, 2004 and 2003. Management believes all such adjustments are of a normal recurring nature.  The results of operations for interim periodsare not necessarily indicative of results to be expected for a full year.  Although we believe that the disclosures inthese financial statements are adequate to make the information presented notmisleading, certain information normally included in financial statements andrelated footnotes prepared in accordance with accounting principles generallyaccepted in the United States have been condensed or omitted pursuant to therules and regulations of the Securities and Exchange Commission (the “SEC”).  The December 31, 2003 consolidatedbalance sheet was derived from audited financial statements, but does notinclude all disclosures required by accounting principles generally accepted inthe United States.  The accompanyingfinancial statements should be read in conjunction with the audited financialstatements as contained in our Annual Report on Form 10-K/A for the fiscal yearended December 31, 2003 that was filed April 20, 2004.

 

*PHAWK, LLC Transaction*

 

OnDecember 12, 2003, the Company entered into a securities purchaseagreement with PHAWK, LLC, formerly known as Petrohawk Energy, LLC (“PHAWK, LLC”),a privately-held independent exploration and production company headquarteredin Houston, Texas, pursuant to which PHAWK, LLC agreed to a cash investment of$60,000,000 in the Company’s common stock, warrants and a convertiblenote.  On May 25, 2004, the Company’sstockholders approved the transaction with PHAWK, LLC (the “PHAWK, LLCTransaction”), whereby the Company received $25,000,000 for the issuance of7,575,757 shares of its common stock and 5,000,000 five-year common stockpurchase warrants exercisable at a price of $3.30 per share.  Additionally, the Company issued a$35,000,000 convertible note that is an unsecured five-year obligation thatafter two years will be convertible by the holder into the Company’s commonstock at a conversion price of $4.00 per share. Interest only will be payable under the note in quarterly installmentsat the rate of 8% per annum.  The fullamount of the principal and accrued and unpaid interest will be payable on thefifth anniversary of the date of the note.

 

TheCompany incurred approximately $2.3 million in offering costs related to thePHAWK, LLC Transaction.  Approximately$1.4 million of the costs were allocated to debt issue costs based upon theface value of the subordinated note payable to the total proceeds received bythe Company.  The debt issue costs arebeing amortized over a five-year period. The remaining $0.9 million of costs, including $0.2 million incurred in2003, are included as equity offering costs and are reflected as a reduction toStockholders’ Equity.

 

Futureuse of these proceeds will include acquisitions of oil and gas properties,future development and exploitation of existing and acquired oil and gasproperties and exploration activity.  Approximately $13.3million of these proceeds were used to repay all of the Company’s existinglong-term bank debt.

 

6

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*Reclassifications*

 

Certain reclassifications of prior period amounts havebeen made to conform to current period presentation.

 

*Oil and Gas Properties*

* *

The Company accounts forits oil and gas producing activities using the full cost method of accountingas prescribed by the SEC. Accordingly, all costs incurred in the acquisition,exploration, and development of proved oil and gas properties, including thecosts of abandoned properties, dry holes, geophysical costs, and annual leaserentals are capitalized.  All generalcorporate costs are expensed as incurred. In general, sales or other dispositions of oil and gas properties areaccounted for as adjustments to capitalized costs, with no gain or lossrecorded; unless the adjustments would significantly alter the relationshipbetween capitalized costs and proved reserves. Amortization of evaluated oil and gas properties is computed on theunits of production method based on all proved reserves on a country-by-countrybasis.  Unevaluated oil and gasproperties are assessed at least annually for impairment either individually oron an aggregate basis, if the properties have similar characteristics.  The net capitalized costs of evaluated oiland gas properties are subject to a full cost ceiling limitation in which thecosts are not allowed to exceed their related estimated future net revenuesdiscounted at 10%, net of tax considerations. Any impairments to unevaluatedproperties are recorded as transfers to the full cost pool.

 

With the volatility ofcommodity prices and the possibility of exploration expenditures resulting inno significant proved reserve additions, it is possible that future impairmentsof oil and gas properties could occur. The price measurement date is on the last day of the quarter or year-endas required by SEC rules.

 

2.                                       **ASSET RETIREMENT OBLIGATIONS**

 

TheCompany adopted SFAS No. 143 effective January 1, 2003.  SFAS No. 143 requires that the fair value ofan asset retirement cost, and corresponding liability, should be recorded aspart of the cost of the related long-lived asset and subsequently allocated toexpense using a systematic and rational method. Upon adoption, the Companyrecorded an asset retirement obligation of $913,560 to reflect the Company’slegal obligations related to future plugging and abandonment of its wells.  The Company estimated the expected cash flowassociated with the obligation and discounted the amount using acredit-adjusted, risk-free interest rate of 8%. The transition adjustment resulting from the adoption of SFAS No. 143,and reported as a cumulative effect of a change in accounting principle, was anincrease to income of $1,640 in 2003. There was no comparable adjustment in2004.

 

TheCompany recorded the following activity related to the liability for the nine monthsended September 30, 2004 and 2003:

 
| ** **                                                                     | ** ** | **FOR THE NINE MONTHS ENDED  SEPTEMBER 30** | ** ** |
|--------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
|                                                                           |       | **2004**                                         | ** ** | **2003** | ** ** |
|                                                                           |       |                                             |       |   |   |
| Beginning  balance – liability for asset retirement obligations           |       | $                                                | 1,234,720  |   | $ | — |   |
| Initial  liability for asset retirement obligations as of January 1, 2003 |       | —                                           |       | 913,560 |   |
| Obligations  fulfilled during the period                                       |       | (2,526                                           | )          | (76,591 | ) |
| Additions                                                                      |       | 444,000                                          |       | — |   |
| Accretion  expense                                                             |       | 69,078                                           |       | 41,110 |   |
|                                                                           |       |                                             |       |   |   |
| Ending  balance – liability for asset retirement obligations              |       | $                                                | 1.745,272  |   | $ | 878,079 |   |
|                                                                                |            |                                                  |            |  |  |  |  |  |  |

 

AtSeptember 30, 2004, $220,386 of the liability for asset retirementobligations balance is classified as current and presented as a separate lineitem on the consolidated balance sheet.

 

7

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3.                                       **STOCKHOLDERS’ EQUITY**

 

***Stock Split***

On May 18, 2004, the Company’s Board of Directorsapproved a one-for-two reverse stock split that was effective May 26, 2004. Thereverse split was implemented to effect the conditional approval by The NASDAQNational Market of the Company’s listing application, which was later formallyapproved.

 

Share and per share data (except par value) forperiods presented have been restated to reflect the reverse stock split.

 

***Stock -Based Compensation***

On January 1, 2003,the Company adopted Statement of Financial Accounting Standards No. 123, *Accounting for Stock-Based Compensation* (“SFASNo. 123”), as amended by Statement of Financial Accounting Standards No. 148 *Accounting for Stock-Based Compensation – Transitionand Disclosure*(“SFAS No. 148”), in accounting for its employee anddirector stock options and applies the fair value based method of accounting tosuch options using the “prospective method” as defined by SFAS No. 148.  Under SFAS No. 123, the fair value of eachoption granted is estimated on the date of grant using the Black-Scholesoption-pricing model.  Previous to theadoption, the Company elected to follow Accounting Principles Board Opinion No.25, *Accounting for Stock Issued to Employees*(“APB No. 25”) and related interpretations in accounting for its employee stockoptions.  However, as required by SFASNo. 123, the Company disclosed on a pro forma basis the impact of the fairvalue accounting for employee stock options. Transactions in equity instruments with non-employees for goods orservices have been accounted for using the fair value method as prescribed bySFAS No. 123.

 

Sincethe Company adopted the fair value recognition provisions of SFAS No. 123prospectively for all employee awards granted, modified or settled after January 1,2003, the cost related to stock-based compensation included in thedetermination of income for the three and nine month periods ended  September 30, 2004 and 2003 is less thanthat which would have been recognized if the fair value method had been appliedto all awards since the original effective date of SFAS No. 123.  Awards vest over periods ranging from one tothree years.  The following tableillustrates the effect on net income and earnings per share as if the fairvalue based method had been applied to all outstanding and unvested awards ineach period.

 
| ** **                                                                                         | ** ** | **FOR THE THREE MONTHS ENDED  SEPTEMBER 30,** | ** ** | **FOR THE NINE MONTHS ENDED  SEPTEMBER 30,** | ** ** |
|----------------------------------------------------------------------------------------------------|------------|----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                                         | ** ** | **2004**                                           | ** ** | **2003**                                          | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                                               |       |                                               |       |                                              |       |   |   |   |   |
| Net  income (loss) applicable to common stockholders as reported                                   |       | $                                                  | (712,053   | )                                                 | $          | 301,105 |   | $ | (1,315,046 | ) | $ | 249,556 |   |
| Add:  Stock-based compensation expense included in reported net income (loss)                      |       | 898,000                                            |       | 45,657                                            |       | 2,925,216 |   | 211,636 |   |
| Deduct:  Total stock-based compensation expense determined under fair value method for  all awards |       | (898,000                                           | )          | (65,511                                           | )          | (3,132,637 | ) | (313,333 | ) |
| Pro  forma net income (loss) applicable to common stockholders                                     |       | $                                                  | (712,053   | )                                                 | $          | 281,251 |   | $ | (1,522,467 | ) | $ | 147,859 |   |
|                                                                                               |       |                                               |       |                                              |       |   |   |   |   |
| Income  (loss) per share:                                                                          |       |                                               |       |                                              |       |   |   |   |   |
| Basic  – as reported                                                                          |       | $                                                  | (0.05      | )                                                 | $          | 0.05 |   | $ | (0.13 | ) | $ | 0.04 |   |
| Basic  – pro forma                                                                            |       | $                                                  | (0.05      | )                                                 | $          | 0.05 |   | $ | (0.16 | ) | $ | 0.02 |   |
|                                                                                               |       |                                               |       |                                              |       |   |   |   |   |
| Diluted  – as reported                                                                        |       | $                                                  | (0.05      | )                                                 | $          | 0.05 |   | $ | (0.13 | ) | $ | 0.04 |   |
| Diluted  – pro forma                                                                          |       | $                                                  | (0.05      | )                                                 | $          | 0.04 |   | $ | (0.16 | ) | $ | 0.02 |   |
|                                                                                                    |            |                                                    |            |                                                   |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

8

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The fair value of eachgrant is estimated on the date of grant using the Black-Scholes option-pricingmodel. The weighted average assumptions used for options granted in 2004include expected volatility of approximately 73.9%, risk-free interest ratesranging from 2.84% to 2.96% and expected lives of three years.  The weighted average assumptions used foroptions granted in 2003 include expected volatility of approximately 61.3%, arisk-free interest rate of 3.15% and expected lives of 5.2 years.

 

During the third quarterof 2004, the Company recognized $898,000 of non-cash stock-based compensationexpense related to stock options, as described below, that were granted toemployees of the Company.

 

During the second quarterof 2004, and in connection with the PHAWK, LLC Transaction, the Companyrecorded $1,979,712 of non-cash stock-based compensation expense related toemployee stock options as follows:

 

•                  $182,516of stock-based compensation expense as a result of the accelerated vesting ofcertain stock options of employees who were employed on May 25, 2004 (closingof the PHAWK, LLC Transaction).

 

•                  $1,797,196of stock-based compensation expense as a result of the modification of certainstock options of employees whereby the period for which the employee has toexercise was extended to the earlier of the option expiration date or fiveyears from the date of the closing of PHAWK, LLC Transaction.

 

Additionally, $47,504 ofstock-based compensation was recorded during the six month period ended June 30,2004 under the amortization of the certain employee stock options granted afterthe Company’s adoption of FAS 123 effective January 1, 2003.

 

***StockOptions Grants***

On July 12, 2004,the Company granted stock options covering 687,500 shares of common stock toemployees of the Company.  The optionswill vest over a two-year period with one-third vesting on the date of grant,one-third in one year from the date of the grant and the remaining one-third intwo years from the date of the grant. The options have an exercise price of $7.50 per share and will expire onJuly 12, 2014.

 

On September 27,2004, the Company granted stock options covering 15,000 shares of common stockto an employee of the Company.  Theoptions will vest over a two-year period with one–third vesting on the date ofgrant, one-third in one year from the date of the grant and the remainingone-third in two years from the date of the grant.  The options have an exercise price of $7.99per share and will expire on September 27, 2014.

 

***CommonStock Warrants***

During the second quarterof 2004, and in connection with the PHAWK, LLC Transaction, the Company issued PHAWK,LLC 5,000,000 five-year common stock purchase warrants at a price of $3.30 pershare. The warrants are exercisable at any time and expire on May 25, 2009.

 

***Treasury Stock***

EffectiveJanuary 14, 2003, the Company’s Board of Directorsauthorized a stock repurchase program for up to an aggregate of 50,000 sharesof the Company’s common stock.  Purchasesmay be made in the open market, at prevailing market prices, or in privatelynegotiated transactions from time to time, and will depend on marketconditions, business opportunities and other factors. Any purchases areexpected to be made in compliance with the safe harbor provisions of Rule10b-18 promulgated by the SEC under the Securities and Exchange Act of 1934.

 

The Company did not purchaseany shares of common stock during the nine months ended September 30,2004.  In August 2004, the Company’sBoard of Directors terminated the stock repurchase program.  During the nine-month period ended September 30,2003, the Company purchased 5,375 shares for $8,255, or $1.54 per share.  At September 30, 2004, the Company held 8,382treasury shares.

 

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4.                                       **NET INCOME (LOSS) PER COMMON SHARE**

 
| ** **                                                                                                     | ** ** | **FOR THE THREE MONTHS ENDED  SEPTEMBER 30,** | ** ** | **FOR THE NINE MONTHS ENDED  SEPTEMBER 30,** | ** ** |
|----------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                                                     | ** ** | **2004**                                           | ** ** | **2003**                                          | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                                                           |       |                                               |       |                                              |       |   |   |   |   |
| Basic:                                                                                                         |       |                                               |       |                                              |       |   |   |   |   |
| Net  income (loss)                                                                                             |       | $                                                  | (600,467   | )                                                 | $          | 413,812 |   | $ | (981,603 | ) | $ | 584,001 |   |
| Less:  Preferred dividends                                                                                     |       | (111,586                                           | )          | (112,707                                          | )          | (333,443 | ) | (334,445 | ) |
| Net  income (loss) applicable to common stockholders                                                           |       | $                                                  | (712,053   | )                                                 | $          | 301,105 |   | $ | (1,315,046 | ) | $ | 249,556 |   |
|                                                                                                           |       |                                               |       |                                              |       |   |   |   |   |
| Weighted  average number of common shares                                                                      |       | 13,817,614                                         |       | 6,214,654                                         |       | 9,762,828 |   | 6,216,141 |   |
| Basic  earnings (loss) per share                                                                               |       | $                                                  | (0.05      | )                                                 | $          | 0.05 |   | $ | (0.13 | ) | $ | 0.04 |   |
|                                                                                                           |       |                                               |       |                                              |       |   |   |   |   |
| Diluted:                                                                                                       |       |                                               |       |                                              |       |   |   |   |   |
| Net  income (loss) applicable to common stockholders                                                           |       | $                                                  | (712,053   | )                                                 | $          | 301,105 |   | $ | (1,315,046 | ) | $ | 249,556 |   |
| Add:  Preferred dividends                                                                                      |       | —                                             |       | —                                            |       | — |   | — |   |
| Net  income (loss) for diluted Earnings (loss) per share                                                       |       | $                                                  | (712,053   | )                                                 | $          | 301,105 |   | $ | (1,315,046 | ) | $ | 249,556 |   |
|                                                                                                           |       |                                               |       |                                              |       |   |   |   |   |
| Weighted  average number of common shares                                                                      |       | 13,817,614                                         |       | 6,214,654                                         |       | 9,762,828 |   | 6,216,141 |   |
| Common  stock equivalent shares representing shares issuable upon exercise of stock  options                   |       | Antidilutive                                       |       | 43,511                                            |       | Antidilutive |   | 23,760 |   |
| Common  stock equivalent shares representing shares issuable upon exercise of warrants                         |       | Antidilutive                                       |       | Antidilutive                                      |       | Antidilutive |   | Antidilutive |   |
| Common  stock equivalent shares representing shares “as-if” conversion of  subordinated note payable |       | Antidilutive                                       |       | —                                            |       | Antidilutive |   | — |   |
| Common  stock equivalent shares representing shares “as-if” conversion of preferred  shares          |       | Antidilutive                                       |       | Antidilutive                                      |       | Antidilutive |   | Antidilutive |   |
| Weighted  average number of shares used in calculation of diluted income (loss) per  share                     |       | 13,817,614                                         |       | 6,258,165                                         |       | 9,762,828 |   | 6,239,901 |   |
| Diluted  earnings (loss) per share                                                                             |       | $                                                  | (0.05      | )                                                 | $          | 0.05 |   | $ | (0.13 | ) | $ | 0.04 |   |
|                                                                                                                |            |                                                    |            |                                                   |            |  |  |  |  |  |  |  |  |  |  |  |

 

10

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The following commonstock equivalents were not included in the computation for diluted earnings (loss)per share because their effects were antidilutive.

 
| **COMMON  STOCK EQUIVALENTS**                               | ** ** | **2004**   | ** ** | **2003**  | ** ** |
|-------------------------------------------------------------|------------|------------|------------|-----------|------------|
|                                                        |       |       |       |      |       |
| Incentive  stock options                                    |       | 339,000    |       | 237,750   |       |
| Non-qualified  options                                      |       | 342,500    |       | 352,500   |       |
| Warrants                                                    |       | 5,832,046  |       | 919,500   |       |
| “As-if”  conversion of subordinated notes payable |       | 8,750,000  |       | —    |       |
| “As-if”  conversion of preferred stock            |       | 598,271    |       | 604,271   |       |
|                                                        |       | 15,861,817 |       | 2,114,021 |       |

 

5.               **RELATED PARTY TRANSACTION**

 

OnAugust 11, 2004, the Company purchased working interests in certain oiland gas properties and various other assets from PHAWK, LLC for $8.5 million.  The effective date of the acquisition is June 1,2004.  Since the Company and PHAWK, LLCare under common control, the assets were recorded by the Company at the netbook value of PHAWK, LLC at the time of the sale.  The purchase price exceeded the net bookvalue by approximately $5.6 million.  Theexcess is reflected as a return of capital to PHAWK, LLC in the financialstatements.

 

ASpecial Committee of one disinterested director was formed by the Company’sboard of directors to evaluate, negotiate and complete the purchase.  The Special Committee hired an independentreservoir engineering firm to provide a reserve evaluation and engaged anindependent financial advisor to evaluate the fairness, from a financial pointof view, to the Company.  The independentfinancial advisor has rendered a fairness opinion to the Special Committee.

 

6.               **LONG-TERM DEBT**

 

On May 25, 2004, and inconnection with the PHAWK, LLC Transaction, the Company issued a $35,000,000,five-year unsecured subordinated note payable to PHAWK, LLC. The note payablebears interest at 8%, is payable quarterly until maturity and is convertibleafter two years to common stock of the Company at a conversion price of$4.00.  The full amount of the principaland accrued and unpaid interest will be payable on May 25, 2009.

 

During 2003, the Company’srevolving credit agreement with a commercial bank was re-determined and itsmaturity extended to April 1, 2005. At September 30, 2004, the $25,000,000 credit facility had aborrowing base of $13,180,000, which is subject to an automatic monthlyreduction of $88,000 that commenced July 31, 2003 and is collateralized bythe Company’s oil and gas properties and gas gathering system and relatedassets.  At September 30, 2004, therewere no outstanding borrowings under the credit agreement. The Company pays acommitment fee equal to 0.25% (1/4 of a percentage point) on the unused portionof the borrowing base, which was approximately $223,000 at September 30,2004, due quarterly in arrears.  The nextre-determination for the borrowing base will occur in November 2004.

 

At September 30,2004, the Company had various outstanding letters of credit of $201,000, whichreduces the amount available under the borrowing base.  The Company pays an annual renewal of 2.25%of the face amount of the letters of credit.

 

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7.               **DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES**

 

***Natural Gas*** - From time to time, the Company may hedge a portion of its natural gasproduction and use costless collars, swaps or a combination of thosederivatives when hedging.  During thethird quarter of 2004, the Company entered into natural gas derivativecontracts to hedge a portion of Petrohawk’s natural gas production for calendaryear 2005.  The derivative contracts arecomprised of costless collars covering volumes of approximately 135,000 MMBTUper month in 2005.  The Company electednot to designate these derivative contracts as cash flow hedges for accountingpurposes, and accordingly, records the changes in mark-to-market of thesederivative contracts as gains or losses in the income statement.  During third quarter of 2004, the Companyrecognized an unrealized loss on mark-to-market of the natural gas derivativecontracts of $0.6 million.

 

Forthe contracts settled during the three and nine months ended September 30,2003, the Company had realized losses of $71,137 and $1,105,469, respectively.  The impact of the natural gas hedges reducedthe Company’s average natural gas price received for the three and nine monthsended September 30, 2003 by $0.16 per Mcf and $0.81 per Mcf,respectively.  Based on the actualaverage daily natural gas production for the nine months ended September 30,2003, approximately 41% of the Company’s natural gas production was hedged forthis period.  At September 30, 2003,there were no outstanding hedge contracts.

 

***Crude Oil*** - During the nine months ended September 30, 2004, the Company hadno outstanding commodity price hedging contracts related to crude oil production.  From time to time, the Company may hedge aportion of its crude oil production and use costless collars, swaps or acombination of those derivatives when hedging.

 

Forthe contracts settled during the three and nine months ended September 30,2003, the Company had realized losses of $29,652 and $231,375, respectively.  The impact of the crude oil hedges reducedthe Company’s average crude price received for the three and nine months ended September 30,2003 by $0.82 per Bbl and $2.47 per Bbl, respectively.  Based on the actual average daily crude oilproduction for the nine months ended September 30, 2003, approximately 32%of the Company’s crude oil production was hedged for this period.  At September 30, 2003, there were nooutstanding hedge contracts.

 

8.               **COMMITMENTS AND CONTINGENCIES**

 

Fromtime to time, the Company is a party to ordinary routine litigation incidentalto our business.  We are not currently aparty to any pending litigation, and we are not aware of any threatenedlitigation that would in the opinion of our legal counsel, have a significantimpact on the financial statements.  Wehave not been a party to any bankruptcy, receivership, reorganization,adjustment or similar proceeding.

 

9.               **SUBSEQUENT EVENT**

 

On October 13, 2004,the Company entered into an Agreement and Plan of Merger with privately-heldWynn-Crosby Energy, Inc. (“Wynn-Crosby”), and an Agreement and Plan of Mergerswith various partnerships managed by Wynn-Crosby.  Pursuant to such agreements, the Company willacquire Wynn-Crosby and the partnerships for $425 million, subject to certainadjustments.  The transaction has beenapproved by the Company’s Board of Directors and is expected to close on orbefore November 30, 2004.  Inaccordance with the agreement, the Company paid $4.25 million to Wynn-Crosby onOctober 13, 2004 as a non-refundable deposit on the purchase price.  The agreements contain customaryrepresentations and warranties and closing conditions.  The Company intends to finance theacquisition using a combination of cash, bank debt and equity.

 

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## **Item2.**                     Management’s Discussion andAnalysis of Financial Condition and Results of Operations

## ** **

The following discussionis to inform you about our financial position, liquidity and capital resourcesas of September 30, 2004 and December 31, 2003 and the results ofoperations for the three and nine month periods ended September 30, 2004and 2003.

 

**Disclosure Regarding Forward-LookingStatements**

Included in this report areforward-looking statements within the meaning of Section 27A of theSecurities Act of 1933, as amended, and Section 21E of the SecuritiesExchange Act of 1934, as amended.  Allstatements, other than statements of historical facts, included in or incorporatedby reference into this Form 10-Q that address activities, events ordevelopments that the Company expects or anticipates will or may occur in thefuture are forward-looking statements.  Thewords “should,” “believe,” “intend,” “expect,” “anticipate,” “project,” “estimate,”“predict,” “plan” and similar expressions are also intended to identifyforward-looking statements.

 

These forward-lookingstatements include, but are not limited to, statements regarding:

 

•                  estimatesof proved reserve quantities and net present values of those reserves;

•                  estimatesof probable and possible reserve quantities;

•                  reservepotential;

•                  businessstrategy;

•                  estimatesof future commodity prices;

•                  amountsand types of capital expenditures and operating expenses;

•                  expansionand growth of our business and operations;

•                  expansionand development trends of the oil and natural gas industry;

•                  productionof oil and natural gas reserves;

•                  explorationprospects;

•                  wellsto be drilled, and drilling results;

•                  operatingresults and working capital; and

•                  futuremethods and types of financing.

 

Such forward-lookingstatements involve assumptions and are subject to known and unknown risks anduncertainties that could cause actual results or performance to differmaterially from those expressed or implied by such forward-lookingstatements.  Although we believe that theassumptions reflected in such forward-looking statements are reasonable, we cangive no assurance that such assumptions will prove to have been correct.  Forward-looking statements speak only as ofthe date they are made and we undertake no obligation to update them.  Reserve estimates of oil and gas propertiesare generally different from the quantities of oil and natural gas that areultimately recovered or found. This is particularly true for estimates appliedto exploratory prospects and new production. Additionally, any statementscontained in this report regarding forward-looking statements are subject tovarious known and unknown risks, uncertainties and contingencies, many of whichare beyond our control.

 

Numerous importantfactors, risks and uncertainties may affect the Company’s operating results,including:

 

•                  therisks associated with exploration;

•                  theability to find, acquire, market, develop and produce new properties;

•                  naturalgas and oil price volatility;

•                  uncertaintiesin the estimation of proved reserves and in the projection of production ofproved reserves;

•                  futurerates of production and timing of development expenditures;

 

13

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•                  operatinghazards attendant to the natural gas and oil business;

•                  downholedrilling and completion risks that are generally not recoverable from thirdparties or insurance;

•                  potentialmechanical failure or under-performance of significant wells;

•                  climaticconditions;

•                  availabilityand cost of material and equipment;

•                  delaysin anticipated start-up dates;

•                  actionsor inactions of third-party operators of the Company’s properties;

•                  theability to find and retain skilled personnel;

•                  availabilityof capital;

•                  thestrength and financial resources of competitors;

•                  regulatorydevelopments;

•                  environmentalrisks; and

•                  generaleconomic conditions, including wars and acts of terrorism.

 

These and other risks anduncertainties, which are more fully described in our Annual Report on Form 10-K/Afiled with the SEC, could cause actual results and developments to bematerially different from those expressed or implied by any of theseforward-looking statements.  Such thingsmay cause actual results, performance, achievements or expectations to differmaterially from the anticipated results, performance, achievements orexpectations.

 

**PHAWK****, LLC Transaction**

 

On December 12, 2003, the Company entered into a securitiespurchase agreement with PHAWK, LLC pursuant to which we agreed to issue to PHAWK,LLC for an aggregate of $60,000,000 in cash:

 

•    7,575,757 shares of our common stock;

 

•      five year warrants to purchase upto an additional 5,000,000 shares of our common stock at an exercise price of $3.30per share; and

 

•      a convertible promissory note inthe face amount of $35,000,000 which will be convertible after two years intoshares of our common stock at a conversion price of $4.00 per share.

 

On May 25, 2004, the PHAWK, LLC Transaction was approved by the stockholdersof the Company. Because issuance of the shares of common stock to PHAWK, LLC inconnection with this transaction resulted in a change of control of the Companyas defined in the NASDAQ rules, we were required by the rules of The NasdaqStock Market to obtain stockholder approval of the issuance of the shares.

 

**Related Party Transaction**

Aspreviously noted, on August 11, 2004 the Company purchased workinginterests in certain oil and gas properties and various other assets fromPHAWK, LLC for $8.5 million.  Theeffective date of the acquisition is June 1, 2004.  Since the Company and PHAWK, LLC are undercommon control, the assets were recorded by the Company at the net book valueof PHAWK, LLC at the time of the sale. The purchase price exceeded the net book value by approximately $5.6million.  The excess is reflected as areturn of capital to PHAWK, LLC in the financial statements.

 

ASpecial Committee of one disinterested director was formed by the Company’sboard of directors to evaluate, negotiate and complete the purchase.  The Special Committee hired an independentreservoir engineering firm to provide a reserve evaluation and engaged anindependent financial advisor to evaluate the fairness, from a financial point ofview, to the Company.  The independentfinancial advisor has rendered a fairness opinion to the Special Committee.

 

14

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**Overview**

During the first nine monthsof 2004, a sustained improvement in our financial condition was a result ofhigher cash flows from operations and financing activities.  A continuation of favorable commodity priceenvironment and increasing production rates were the primary factors for theimproving cash flow.  With the success ofour exploration, exploitation and development activity in the last half of 2003and first nine months of 2004, our current production rates have increased.  Our net daily average production rate for thenine months ended September 30, 2004 was approximately 8.6 MMcfe comparedto 7.0 MMcfe for the same period ended in 2003, a 23% increase.  We continue to be optimistic about thelong-term outlook for natural gas and crude oil pricing, but realize that theoverall environment for commodity pricing is very volatile and can bematerially affected, favorably or unfavorably, by such factors as globaluncertainty, imports/exports, weather trends, power generation and industrialdemands.

 

**Liquidity and Capital Resources**

A company’s liquidity isthe amount of time expected to elapse until an asset can be converted to cashor conversely until a liability has to be paid. Liquidity is one indication of a company’s ability to meet itsobligations or commitments. Historically, our major sources of liquidity have come from internallygenerated cash flow from operations and proceeds from public and private stockofferings.

 

The following tablerepresents the sources and uses of cash for the periods indicated.

 
| ** **                                        | ** ** | **FOR THE NINE MONTHS ENDED  SEPTEMBER 30,** | ** ** |
|---------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                        | ** ** | **2004**                                          | ** ** | **2003** | ** ** |
| Beginning  cash balance                           |       | $                                                 | 2,109,681  |   | $ | 927,313 |   |
| Sources  of cash:                                 |       |                                              |       |   |   |
| Cash  provided by operations                      |       | 3,313,110                                         |       | 3,092,100 |   |
| Cash  provided by sales of oil and gas properties |       | 832,245                                           |       | 533,142 |   |
| Cash  provided by financing activities            |       | 60,249,120                                        |       | — |   |
| Total  sources of cash including cash on hand     |       | 66,504,156                                        |       | 4,552,555 |   |
| Uses  of cash:                                    |       |                                              |       |   |   |
| Oil  and gas expenditures                         |       | (8,889,071                                        | )          | (1,953,914 | ) |
| Gas  gathering and other equipment expenditures   |       | (1,009,022                                        | )          | (28,005 | ) |
| Cash  used by financing activities                |       | (21,509,827                                       | )          | (703,139 | ) |
| Total  uses of cash                               |       | (31,407,920                                       | )          | (2,685,058 | ) |
| Ending  cash balance                              |       | $                                                 | 35,096,236 |   | $ | 1,867,497 |   |
|                                                   |            |                                                   |            |  |  |  |  |  |

 

***Workingcapital and liquidity***

At September 30, 2004,the Company’s working capital was $37.6 million, compared to $2.2 million at December 31,2003.  Our working capital and liquidityhave shown continual improvement as a result of the PHAWK, LLC Transaction anddue to higher cash flows from operations.

 

Our principal source ofshort-term liquidity is from internally-generated cash flow, cash on hand andup to approximately $13.0 million available under the credit facility.  Should natural gas and crude oil pricesdecrease materially, our current operating cash flow would decrease and ourliquidity and working capital position would be negatively impacted and couldadversely impact our growth capability.

 

15

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***Long termliquidity and capital resources***

We have no materiallong-term commitments associated with our capital expenditure plans or operatingagreements. Consequently, we have a significant degree of flexibility to adjustthe level of such expenditures as circumstances warrant.  The level of capital expenditures will varyin future periods depending on the success we have with our exploitation,developmental and exploration activities in future periods, gas and oil priceconditions and other related economic factors. Currently no sources ofliquidity or financing are provided by off-balance sheet arrangements ortransactions with unconsolidated, limited-purpose entities.  The following tables show our contractualobligations and commitments:

 
| ** **                   | ** ** | **Payments Due by Period** | ** ** |
|------------------------------|------------|----------------------------|------------|
| **Contractual  Obligations** | ** ** | **Total**                  | ** ** | **Less than 1  year** | ** ** | **1-3 years** | ** ** | **4-5 years** | ** ** | **After 5 years** | ** ** |
|                         |       |                       |       |   |   |   |   |   |   |   |   |
| Subordinated  Debt           |       | $                          | 35,000,000 |   | $ | — |   | $ | — |   | $ | 35,000,000 |   | $ | — |   |
| Operating  Leases            |       | 1,659,143                  |       | 345,646 |   | 990,085 |   | 323,412 |   | — |   |
| Total  Cash Obligations      |       | $                          | 36,659,143 |   | $ | 345,646 |   | $ | 990,085 |   | $ | 35,323,412 |   | $ | — |   |

 
| ** **                         | ** ** | **Amount of Commitment Expiration per Period** | ** ** |
|------------------------------------|------------|------------------------------------------------|------------|
| **Other  Commercial  Commitments** | ** ** | **Total**                                      | ** ** | **Less than  1 year** | ** ** | **1-3 years** | ** ** | **4-5 years** | ** ** | **After 5 years** | ** ** |
|                               |       |                                           |       |   |   |   |   |   |   |   |   |
| Standby  letters of credit         |       | $                                              | 201,000    |   | $ | 201,000 |   | — |   | — |   | — |   |
|                                    |            |                                                |            |  |  |  |  |  |  |  |  |  |  |

 

We are obligated to paydividends of approximately $111,000 per quarter on the 8% Convertible PreferredStock.

 

The Company iscontractually obligated to acquire Wynn-Crosby and related limited partnershipsmanaged by Wynn-Crosby for $425 million. The Company intends to finance this acquisition using a combination ofcash, bank debt and equity.

 

16

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***Currentborrowing base***

The current creditagreement, which was re-determined and extended during the quarter ended June 30,2003, has a maturity date of April 1, 2005 and at September 30, 2004,had a borrowing capacity of $13,180,000 subject to an automatic monthlyreduction of $88,000, which commenced on July 31, 2003.  At September 30, 2004, there were noborrowings outstanding.

 

At September 30,2004, the Company had various outstanding letters of credit of $201,000, whichreduces the amount available under the borrowing base.  The Company pays an annual renewal of 2.25%of the face amount of the letter of credit.

 

**Capital Expenditures**

Forthe nine months ended September 30, 2004, we had capital expenditures ofapproximately $9.7 million.   The Company’s available capital as a result ofthe PHAWK, LLC Transaction would allow for the additional capital deploymentshould drilling or other opportunities be presented to the Company forconsideration.

 

**Significant Accounting Policies**

 

We rely on certainaccounting policies in the preparation of our financial statements.  Certain judgments and uncertainties affectthe application of such policies. Certain accounting principles are employed in the adherence andimplementation of these policies along with management judgments.  The following is a discussion of each policyand how certain judgments and/or uncertainties could materially impact thesepolicies:

 

*Use ofEstimates* - The preparation of our condensed consolidatedfinancial statements in conformity with generally accepted accountingprinciples requires our management to make estimates and assumptions thataffect the reported amounts of assets and liabilities and disclosure ofcontingent assets and liabilities, if any, at the date of the financialstatements, and the reported amounts of revenues and expenses during thereporting period.  The estimates includeoil and gas reserve quantities, which form the basis for the calculation ofamortization and impairment of oil and gas properties.  We emphasize that reserve estimates areinherently imprecise and that estimates of more recent discoveries are moreimprecise than those for properties with long production histories. Actualresults could materially differ from these estimates. Volatility in commodityprices also impacts reserve estimates since future revenues from production maydecline significantly if there is a material decrease in natural gas and/orcrude oil prices from the previous reserve estimation date, which is at eachquarter end.

 

*Oil and gas properties*- We account for our oil and gas producing activities using the full costmethod of accounting.  Accordingly, allcosts incurred in the acquisition, exploration, and development of proved oiland gas properties, including the costs of abandoned properties, dry holes,geophysical costs, and annual lease rentals are capitalized.  All general corporate costs are expensed asincurred.  In general, sales or otherdispositions of oil and gas properties are accounted for as adjustments tocapitalized costs, with no gain or loss recorded, unless the adjustments wouldsignificantly alter the relationship between capitalized costs and provedreserves.  Amortization of evaluated oiland gas properties is computed on the units of production method based on allproved reserve quantities.  The netcapitalized costs of evaluated oil and gas properties adjusted for deferred taxeffects (full cost ceiling limitation) are not to exceed their relatedestimated future net revenues discounted at 10%, and the lower of cost orestimated fair value of unevaluated properties, net of tax considerations.Unevaluated oil and gas properties are assessed at least annually forimpairment either individually or on an aggregate basis.  Unevaluated leasehold costs, includingbrokerage costs, are individually assessed quarterly based on the remainingprimary term of the leasehold.  Duringthe nine month period ended September 30, 2004, unevaluated seismic,geological and geophysical costs,  leaseholdcosts and related brokerage fees of $704,668 were transferred to U.S. evaluatedcosts, or the full cost pool.  For theremaining costs, which includes seismic and geological and geophysicalprimarily related to Jackson County, Texas, historically we have estimatedreserve potential for the unevaluated properties using comparable producingareas or wells and risk that estimate by 50-75%.  As mentioned previously in *Use of Estimates*, reserve estimations are more imprecise fornew or unevaluated areas. Consequently, should certain geological conditions orfactors exist, such as reservoir depletion, reservoir faulting, reservoirquality etc., but unknown to us at the time of our assessment, a materiallydifferent result could occur.

 

17

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*RecentlyIssued Accounting Standards*

InSeptember 2004, the SEC issued Staff Accounting Bulletin No. 106 (SAB 106)that provides guidance to oil and gas companies following the full costaccounting method regarding the application of SFAS 143.  SAB 106 requires companies calculating thefull cost ceiling test to exclude future cash outflows associated with settlingasset retirement obligations that have been accrued on the balance sheet asrequired by SFAS 143.  However, estimateddismantlement and abandonment costs related to future development activities,which are not required to be accrued under SFAS 143, should continue to beincluded in the full cost ceiling test. The SEC staff has also recommended that companies discuss how theadoption of SFAS 143 has affected their accounting for oil and gasoperations.  The accounting anddisclosure requirements of SAB 106 are to be applied prospectively beginningwith the first quarter of 2005.  TheCompany is currently evaluating the impact, if any, that SAB 106 may have onits calculations under the full cost ceiling test.

 

*Derivativeinstruments and hedging activity* – We use derivatives in alimited manner to protect against commodity price volatility.  Effectively, we sell a portion of our naturalgas and crude oil based on a NYMEX based price with a set floor (bottom) andceiling (top) price or a range.  Ourderivatives are recorded on the balance sheet at fair value and changes in thefair value of derivatives are recorded each period in current earnings or othercomprehensive income, depending on whether a derivative is designated as partof a hedge transaction and, if it is, depending on the type oftransaction.  Typically, our derivativecontract will consist of a cash flow hedge transaction in which it hedges thevariability of cash flow related to a forecasted transaction.  Changes in the fair value of these derivativeinstruments are recorded in other comprehensive income and reclassified asearnings in the periods in which earnings are impacted by the variability ofthe cash flows of the hedged item.  Thefair value of these contracts may vary materially with the fluctuations ofnatural gas and crude oil prices. However, the fluctuation in fair value will be offset by the actualvalue received from the hedged volume.

 

*Stock-basedcompensation* - On January 1, 2003, the Company adoptedStatement of Financial Accounting Standards No. 123, *Accounting for Stock-Based Compensation* (“SFAS No. 123”), asamended by Statement of Financial Accounting Standards No. 148, *Accounting for Stock-Based Compensation – Transitionand Disclosure* (“SFAS No. 148”), in accounting for our employee anddirector stock options using the “prospective method” as defined by SFAS No.148.  Under SFAS No. 123, the fair valueof each option granted is estimated on the date of grant using theBlack-Scholes option-pricing model. Previous to the adoption, the Company elected to follow Accounting PrinciplesBoard Opinion No. 25, *Accounting for StockIssued to Employees* (“APB No.25”) and related interpretations in accounting for its employee stockoptions.  However, as required by SFASNo. 123, the Company disclosed on a pro forma basis the impact of the fairvalue accounting for employee stock options. Transactions in equity instruments with non-employees for goods or serviceshave been accounted for using the fair value method as prescribed by SFAS No.123.

 

**Comparison of Results****of Operations**

*Quarter ended September 30,2004 and compared to quarter ended September 30, 2003*

The Company reported a netloss of $0.6 million for the three months ended September 30, 2004compared to net income of $0.4 million for the same period in 2003.  Increased revenues resulting from highernatural gas and crude oil prices and increased sales volumes were more thanoffset by higher production expenses, general and administrative expenses, stock-basedcompensation expense, unrealized losses on derivative contracts and interestexpense when compared to the same period for last year.

 

18

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The following tablesummarizes key items of comparison for the periods indicated.  Dollars, except for per unit data, andproduction data are in thousands.

 
| ** **                                                          | ** ** | **Three Months Ended September 30,** | ** ** |
|---------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                          | ** ** | **2004**                                  | ** ** | **2003** | ** ** |
| **Net Production Data:**                                            |       |                                      |       |   |   |
| Natural  Gas (MMcf)                                                 |       | 604.9                                     |       | 436.4 |   |
| Crude  Oil (MBbl)                                                   |       | 44.6                                      |       | 36.1 |   |
| Equivalent  Production (Mmcfe)                                      |       | 872.8                                     |       | 653.1 |   |
| Average  Daily Production (Mmcfe)                                   |       | 9.5                                       |       | 7.1 |   |
|                                                                |       |                                      |       |   |   |
| **Average Sales Price (1):**                                        |       |                                      |       |   |   |
| Natural  Gas (per Mcf)                                              |       | $                                         | 6.03       |   | $ | 5.10 |   |
| Crude  Oil (per Bbl)                                                |       | $                                         | 42.18      |   | $ | 27.40 |   |
| Equivalent  price (per Mcfe)                                        |       | $                                         | 6.34       |   | $ | 4.92 |   |
|                                                                |       |                                      |       |   |   |
| **Expenses ($ per Mcfe):**                                     |       |                                      |       |   |   |
| Lease  Operations                                                   |       | $                                         | 1.01       |   | $ | 0.87 |   |
| Production,  severance and ad valorem taxes                         |       | $                                         | 0.33       |   | $ | 0.32 |   |
| General  and administrative (2)                                     |       | $                                         | 1.83       |   | $ | 1.01 |   |
| Stock-based  compensation                                           |       | $                                         | 1.03       |   | $ | 0.07 |   |
| DD&A  (3)                                                       |       | $                                         | 1.39       |   | $ | 1.75 |   |
| Unrealized  losses on mark-to-market commodity derivative contracts |       | $                                         | 0.68       |   | $ | — |   |
| Interest                                                            |       | $                                         | 0.90       |   | $ | 0.19 |   |

 

----

(1)          Includes impact ofhedging

(2)          Excludes Stock-basedcompensation expense

(3)          Includes DD&A foroil and gas properties only

 

*Oil and gas sales:*

For the three monthsended September 30, 2004, oil and gas sales increased $2.3 million or 72%,from the same period in 2003, to $5.5 million. The increase for the three months was a result of higher natural gas andcrude oil prices received and higher sales volumes during the quarter ended September 30,2004.  Natural gas storage level concerns,crude oil supply uncertainty due to global events and a weaker U.S. dollar,which impacts the OPEC basket price, favorably impacted commodity prices duringthe period.  In turn, natural gas priceshave remained stronger due to the higher crude oil prices and seasonal demand duringthe quarter.  The prices received for ournatural gas and crude oil during the quarter ended September 30, 2003 werealso unfavorably impacted by our commodity hedges, as discussed further belowunder *Hedging*.

 

The higher commodityprices resulted in an increase in oil and gas revenues. The increase inproduction was a result of our drilling activity in the Broussard, Louisianaand Brookshire Dome, Texas properties and the drilling and recompletionactivity during the last half of 2003 and this quarter on the WEHLU, Oklahomaproperties.  Our incremental increase inproduction from these areas was partially offset by the natural decline in the productionrates from our offshore Louisiana and South Texas properties.

 

*Hedging:*

Generally, we sell ournatural gas and crude oil to various purchasers on an indexed-based or spotprice.  The indices for natural gas aregenerally affected by the NYMEX – Henry Hub spot prices while the posted pricesfor crude oil are generally affected by the NYMEX-Crude Oil West TexasIntermediate prices.  From time to time,we use financial derivative instruments on a limited basis to lessen the impactof price volatility.

 

19

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During the third quarterof 2004, the Company entered into natural gas derivative contracts to hedge aportion of Petrohawk’s natural gas production for calendar year 2005.  The derivative contracts are comprised ofcostless collars covering volumes of approximately 135,000 MMBTU per month in2005.  The Company elected not todesignate these derivative contracts as hedges for accounting purposes, andaccordingly, records the changes in mark-to-market of these derivativecontracts as gains or losses in the income statement.  During third quarter of 2004, the Companyrecognized an unrealized loss on mark-to-market of the natural gas derivativecontracts of $0.6 million.

 

Oil and gas revenues forthe three months ended September 30, 2003 were reduced by approximately $71,137due to our oil and gas hedges.  For the threemonths ended September 30, 2003, the average sales price received for ournatural gas was reduced by approximately $0.16 per Mcf from our natural gashedges and the average sales price received for our crude oil was reduced by approximately$0.82 per Bbl from our crude oil hedges

 

*Lease operations expense andproduction tax expenses:*

Lease operations expense increased$0.3 million, or 55%, to $0.9 million for the three months ended September 30,2004 compared to the same period for 2003. The increase was primarily due to higher operating expense associatedwith our offshore Louisiana properties, the Peace Creek and Zenith Field,Kansas properties and recently drilled wells in South Central Kansas and WEHLU,Oklahoma.

 

Production severance andad valorem taxes increased $84,900, or 41%, for the three months ended September 30,2004 as compared to the same period ended in 2003, due to higher natural gasand crude oil revenues.  Production taxesare generally assessed as a percentage of gross oil and/or natural gas salesamounts or volumes.

 

*General and administrativeexpense:*

General andadministrative expense for the three months ended  September 30, 2004 increased $0.9 million,or 143%, to $1.6 million compared to $0.7 million for the same period in 2003.  The increase was due primarily to costs incurredas a result of the closing of PHAWK, LLC Transaction.  The significant components of the increasewere $0.4 million of incremental salary and benefits for new employees, $0.3 millionof legal and other professional fees, and $0.2 million of costs associated withthe transition of the corporate headquarters from Tulsa, Oklahoma to Houston,Texas.

 

*Stock-based compensation expense:*

Stock-based compensationexpense for the three months ended September 30, 2004 was $0.9 million ascompared to $45,657 for the same period in 2003.  During the third quarter of 2004, the Companygranted stock options covering 702,500 shares of common stock to employees ofthe Company.

 

*Depreciation, depletion andamortization expense:*

Depletion, depreciation andamortization expense for oil and gas properties increased $0.1 million, or 6%,from the same period in 2003 to $1.2 million for the three months ended September 30,2004.  Depletion for oil and gasproperties is calculated using the “Unit of Production” method, whichessentially amortizes the capitalized costs associated with the evaluatedproperties based on the ratio of production volume for the current period tototal remaining reserve volume for the evaluated properties.  The depletion rates per Mcf for the threemonths ended September 30, 2004 and 2003 were $1.39 per Mcf and $1.75 perMcf, respectively.

 

Depreciation andamortization expense for other assets includes depreciation associated with thegathering assets, which is calculated on a “unit of revenue” method.  The “unit of revenue” method amortizes thecapitalized costs associated with the gathering assets based on the ratio ofgross actual revenues for the current period to the total remaining grossrevenues for the gathering assets. Depreciation expense for other assets for the three month periods ended September 30,2004 and 2003 was $57,849 and $52,310, respectively.

 

*Interest expense:*

Interest expenseincreased for three months ended September 30, 2004 as compared to thesame period 2003 by approximately $0.7 million due to the issuance of the $35million subordinated 8% note issued in the PHAWK, LLC Transaction.

 

20

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*Nine months ended September 30,2004 and compared to nine months ended September 30, 2003*

The Company reported a netloss of $1.0 million for the nine months ended September 30, 2004 comparedto net income of $0.6 million for the same period in 2003.  Increased revenues for the current periodresulting from higher natural gas and crude oil prices and sales volumes weremore than offset by higher production expense, general and administrativeexpense, unrealized losses on derivative contracts, stock-based compensationexpense and interest expense when compared to the same period for the lastyear.

 

The following tablesummarizes key items of comparison for the periods indicated.  Dollars, except for per unit data, andproduction data are in thousands.

 
| ** **                                                          | ** ** | **Nine Months Ended September 30,** | ** ** |
|---------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                          | ** ** | **2004**                                 | ** ** | **2003** | ** ** |
| **Net Production Data:**                                            |       |                                     |       |   |   |
| Natural  Gas (MMcf)                                                 |       | 1,662.7                                  |       | 1,362.0 |   |
| Crude  Oil (MBbl)                                                   |       | 114.7                                    |       | 93.5 |   |
| Equivalent  Production (Mmcfe)                                      |       | 2,350.8                                  |       | 1,923.0 |   |
| Average  Daily Production (Mmcfe)                                   |       | 8.6                                      |       | 7.0 |   |
|                                                                |       |                                     |       |   |   |
| **Average Sales Price (1):**                                        |       |                                     |       |   |   |
| Natural  Gas (per Mcf)                                              |       | $                                        | 6.03       |   | $ | 4.91 |   |
| Crude  Oil (per Bbl)                                                |       | $                                        | 37.93      |   | $ | 26.60 |   |
| Equivalent  price (per Mcfe)                                        |       | $                                        | 6.12       |   | $ | 4.77 |   |
|                                                                |       |                                     |       |   |   |
| **Expenses ($ per Mcfe):**                                     |       |                                     |       |   |   |
| Lease  Operations                                                   |       | $                                        | 1.05       |   | $ | 0.89 |   |
| Production,  severance and ad valorem taxes                         |       | $                                        | 0.33       |   | $ | 0.34 |   |
| General  and administrative (2)                                     |       | $                                        | 1.71       |   | $ | 0.99 |   |
| Stock-based  compensation                                           |       | $                                        | 1.24       |   | $ | 0.11 |   |
| DD&A  (3)                                                       |       | $                                        | 1.44       |   | $ | 1.90 |   |
| Unrealized  losses on mark-to-market commodity derivative contracts |       | $                                        | 0.25       |   | $ | — |   |
| Interest                                                            |       | $                                        | 0.54       |   | $ | 0.19 |   |

 

----

(1)          Includes impact ofhedging

(2)          Excludes Stock-basedcompensation expense

(3)          Includes DD&A foroil and gas properties only

 

*Oil and gas sales:*

For the nine months endedSeptember 30, 2004, oil and gas sales increased $5.2 million, or 57%, fromthe same period in 2003, to $14.4 million. The increase for the nine months was a result of higher natural gas andcrude oil prices received and higher sales volumes during the nine months endedSeptember 30, 2004.  Natural gasstorage level concerns, crude oil supply uncertainty due to global events and aweaker U.S. dollar, which impacts the OPEC basket price, favorably impactedcommodity prices during the period.  Inturn, natural gas prices have remained stronger due to the higher crude oilprices and seasonal demand during the quarter. The prices received for ournatural gas and crude oil during the nine months ended September 30, 2003were also unfavorably impacted by our commodity hedges, as discussed furtherbelow under *Hedging*.

 

The higher commodityprices resulted in an increase in oil and gas revenues of $2.6 million, withhigher natural gas prices comprising 50% of the increase. The increase inproduction was a result of our drilling activity in the Broussard, Louisianaand Brookshire Dome, Texas properties and the drilling and recompletionactivity during the last half of 2003 and this quarter on the WEHLU, Oklahomaproperties.  Our incremental increase inproduction from these areas was partially offset by the natural decline in theproduction rates from our offshore Louisiana and South Texas properties.

 

21

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*Hedging:*

As noted previously, we generallysell our natural gas and crude oil to various purchasers on an indexed-based orspot price.  The indices for natural gasare generally affected by the NYMEX – Henry Hub spot prices while the postedprices for crude oil are generally affected by the NYMEX-Crude Oil West TexasIntermediate prices.  From time to time,we use financial derivative instruments on a limited basis to lessen the impactof price volatility.

 

During the third quarterof 2004, the Company entered into natural gas derivative contracts to hedge aportion of Petrohawk’s natural gas production for calendar year 2005.  The derivative contracts are comprised ofcostless collars covering volumes of approximately 135,000 MMBTU per month in2005.  The Company elected not todesignate these derivative contracts as hedges for accounting purposes, andaccordingly, records the changes in mark-to-market of these derivativecontracts as gains or losses in the income statement.  During third quarter of 2004, the Companyrecognized an unrealized loss on mark-to-market of the natural gas derivativecontracts of $0.6 million.

 

For the nine months endedSeptember 30, 2003, hedges covered approximately 41% of the Company’snatural gas production and 32% of the Company’s oil production.  Oil and gas revenues for the nine monthsended September 30, 2003 were reduced by approximately $1.3 million due toour oil and gas hedges.  For the nine monthsended September 30, 2003, the average sales price received for our naturalgas was reduced by approximately $0.82 per Mcf from our natural gas hedges andthe average sales price received for our crude oil was reduced by approximately$2.47 per Bbl from our crude oil hedges.

 

*Lease operations expense andproduction tax expenses:*

Lease operations expense,excluding production taxes, increased $0.8 million, or 44%, to $2.5 million forthe nine months ended September 30, 2004 compared to the same period for2003.  The increase was primarily due tohigher operating expense associated with our offshore Louisiana properties, thePeace Creek and Zenith Field, Kansas properties and recently drilled wells inSouth Central Kansas and WEHLU, Oklahoma.

 

Production tax expenseincreased $126,100, or 19%, for the nine months ended September 30, 2004as compared to the same period ended in 2003, due to higher natural gas andcrude oil revenues.  Production taxes aregenerally assessed as a percentage of gross oil and/or natural gas salesamounts or volumes.

 

*General and administrativeexpense:*

General andadministrative expense for the nine months ended September 30, 2004increased $2.1 million, or 111%, to $4.0 million compared to $1.9 million forthe same period in 2003.  The increasewas due primarily to costs associated with the PHAWK, LLC Transaction. Thesignificant components of the increase were $0.7 million of severance expense,$0.5 million of incremental salary and benefits for new employee, $0.6 millionof legal and other professional fees and $0.3 million of costs associated withthe transition of the corporate headquarters from Tulsa, Oklahoma to Houston,Texas.

 

*Stock-based compensation expense:*

Stock-based compensationexpense for the nine months ended September 30, 2004 was $2.9 million ascompared to $0.2 million for the same period in 2003.  During the third quarter of 2004, the Companyrecognized $0.9 million of stock-based compensation expense resulting from thegrant of stock options covering 702,500 shares of common stock to employees ofthe Company.  During the second quarterof 2004, and in connection with the PHAWK, LLC Transaction, the Companyrecorded $1.8 million of stock-based compensation expense as a result of themodification of certain stock options of certain former employees whereby theperiod for which the employee has to exercise was extended.

 

*Depreciation, depletion andamortization expense:*

Depletion expense relatedto oil and gas properties decreased $0.3 million, or 7%, from the same periodin 2003 to $3.4 million for the nine months ended September 30, 2004.    Depletion for oil and gas properties iscalculated using the “Unit of Production” method, which essentially amortizesthe capitalized costs associated with the evaluated properties based on theratio of production volume for the current period to total remaining reservevolume for the evaluated properties.  Thedecrease in oil and gas depletion was due to a lower depletion rate for the ninemonths ended September 30, 2004, which resulted from an increase in our December 31,2003 proved reserves.  The depletionrates per Mcf for the nine months ended September 30, 2004 and 2003 were $1.44per Mcf and $1.90 per Mcf, respectively.

 

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Depreciation andamortization expense for other assets includes depreciation associated with thegathering assets, which is calculated on a “unit of revenue” method.  The “unit of revenue” method amortizes thecapitalized costs associated with the gathering assets based on the ratio ofgross actual revenues for the current period to the total remaining grossrevenues for the gathering assets. Depreciation expense for other assets for the nine month periods ended September 30,2004 and 2003 was $150,014 and $162,693, respectively.

 

*Interest expense:*

Interest expense increasedfor the nine months ended September 30, 2004 as compared to the sameperiod 2003 by approximately $0.9 million due to the issuance of the $35million subordinated 8% note issued in the PHAWK, LLC Transaction.

 

*Income Taxes*

As of September 30,2004, we had available, to reduce future taxable income, a U.S. federal regularnet operating loss (“NOL”) carryforward of approximately $27.7 million and aU.S. federal alternative minimum tax NOL carryforward of approximately $26.4million, which expire in the years 2018 through 2023.  We also had various state NOL carryforwardsat September 30, 2004, with varying lengths of allowable carryforwardperiods ranging from five to 20 years and can be used to offset future statetaxable income. Based on past results and current forecasts, we haveestablished a valuation allowance to reduce net deferred taxes to zero.  An income tax benefit of $24,000 for the ninemonths ended September 30, 2004 represents a refund of 2003 federal incometaxes.

 

As a result of the PHAWK,LLC Transaction and the resulting change of control, the Company’s utilizationof the NOL’s will be limited on an annual basis to 10% of the NOLcarryforward.  Given that the expirationdates of the NOL’s are 14 to 19 years away, the Company believes that all NOL’swill be available in future periods to reduce the Company’s taxable income.

 

**Item 3****.  Quantitative and Qualitative Disclosure AboutMarket Risk**

 

We are exposed to marketrisk related to adverse changes in oil and gas prices.  Our oil and gas revenues can be significantlyaffected by volatile oil and gas prices. This volatility can be mitigated through the use of oil and gasfinancial instruments.    We manage ourexposure to commodity price fluctuations by hedging portions of our oil and gasproduction through the use of derivative instruments. The derivativeinstruments currently consist of costless collars entered into with financialinstitutions. We do not enter into derivative instruments for speculativetrading purposes. Derivative instruments utilized to manage commodity pricerisk are accounted for in accordance with SFAS No. 133 “Accounting forDerivative Instruments and Hedging Activities”, as amended. Under SFAS 133, allderivative instruments are recorded on the balance sheet at fair value. If aderivative does not qualify as a hedge or is not designated as a hedge, thechanges in fair value are recognized currently in our earnings as other income(expense). If a derivative is designated as a cash flow hedge and qualifies forhedge accounting, the unrealized gain or loss on the derivative is deferred inaccumulated Other Comprehensive Income (“OCI”), a component of Stockholders’Equity until the sale of the hedged oil and gas production.

 

We are also exposed tomarket risk related to adverse changes in interest rates.  Our interest rate risk exposure resultsprimarily from short-term rates, mainly LIBOR-based on borrowing from ourcommercial bank.  At September 30,2004, none of our outstanding debt was at variable rates. Any future volatilitycould be mitigated through the use of financial derivative instruments.

 

###### **Item 4.  Controls and Procedures**

 

Based on theirevaluation, our Chief Executive Officer and Principal Financial Officer haveconcluded that the Company’s disclosure controls and procedures (as defined inRules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of theperiod covered by this report on Form 10-Q are effective to ensure thatinformation required to be disclosed by the Company in reports that it files orsubmits under the Exchange Act are recorded, processed, summarized and reportedwithin the time periods specified in Securities and Exchange Commission rulesand forms.

 

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During the period coveredby this report on Form 10-Q, there have been no changes in the Company’sinternal control over financial reporting that have materially affected or arereasonably likely to materially affect the Company’s internal control overfinancial reporting.

 

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**PART II. OTHER INFORMATION**

 

**Item2 – Changes in Securities, Use of Proceeds andIssuer Purchases of Equity Securities**

 

OnMay 25, 2004, the Company issued certain securities as part of the PHAWK, LLC Transaction.The following securities, which take into account the 1-for-2 reverse stocksplit implemented by the Company on May 26, 2004, were issued by the Companypursuant to the PHAWK, LLC Transaction:

 

•                  7,575,757 shares of common stock

•                  5,000,000 stock purchase warrants at anexercise price of $3.30 per share

•                  $35,000,000 subordinated note payable,convertible to common stock at $4.00 per share.

 

OnJuly 15, 2004, Beta Oil & Gas, Inc. (a Nevada corporation)reincorporated into the Company (a Delaware corporation).  The articles of incorporation, thecertificate of designation for the Company’s preferred stock, and the bylaws ofthe Company are substantially identical to the corresponding documents of BetaOil & Gas, Inc.  However, pursuant tostockholder approval obtained on July 15, 2004, the Company instituted aclassified board and cumulative voting rights of stockholders wereremoved.  In addition, provisions in thecertificate of incorporation relating to the indemnification of officers anddirectors, as well as other differences, due to differing laws in Nevada andDelaware were made.

 

**Item4 – Submission of Matters to a Vote of SecurityHolders**

 

Atour special meeting of the stockholders on May 25, 2004, the following itemswere voted upon:

1.               Consider proposal to approve the issuance ofcertain securities related to the PHAWK, LLC Transaction;

2.               To amend the articles of incorporation toincrease the authorized common stock from 50,000,000 to 100,000,000;

 

Thefollowing table summarizes the tabulation of votes with respect to theforegoing matters:

 
| ** **                                                                                           | ** ** | **For**   | ** ** | **Against** | ** ** | **Abstain** | ** ** |
|------------------------------------------------------------------------------------------------------|------------|-----------|------------|-------------|------------|-------------|------------|
| Proposal  1:                                                                                         |       |      |       |        |       |        |       |
|                                                                                                 |       |      |       |        |       |        |       |
| PHAWK,  LLC Transaction and related securities issuance:                                             |       | 7,303,556 |       | 287,647     |       | 64,781      |       |
|                                                                                                 |       |      |       |        |       |        |       |
| Proposal  2:                                                                                         |       |      |       |        |       |        |       |
|                                                                                                 |       |      |       |        |       |        |       |
| Amend  articles of incorporation to increase authorized common stock from 50,000,000  to 100,000,000 |       | 6,922,882 |       | 659,881     |       | 73,221      |       |

 

TheAnnual Meeting of Stockholders of the Company was held July 15, 2004 forthe purpose of voting on the followingitems:

 

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| Proposal  1 – Election of Directors:                                                                |   |       |   |    |   |   |   |
|----------------------------------------------------------------------------------------------------------|--------|------------|--------|---------|--------|--------|--------|
| Floyd  C. Wilson                                                                                         |   | 13,168,075 |   | 222,536 |   | 0      |   |
| Tucker  S. Bridwell                                                                                      |   | 13,075,600 |   | 313,511 |   | 0      |   |
| James  L. Irish III                                                                                      |   | 12,990,649 |   | 398,462 |   | 0      |   |
| David  B. Miller                                                                                         |   | 12,997,899 |   | 391,212 |   | 0      |   |
| D.  Martin Phillips                                                                                      |   | 13,166,075 |   | 223,036 |   | 0      |   |
| Daniel  Rioux                                                                                            |   | 13,243,776 |   | 145,335 |   | 0      |   |
| Robert  C. Stone, Jr.                                                                                    |   | 12,653,874 |   | 735,237 |   | 0      |   |
|                                                                                                     |   |       |   |    |   |   |   |
| Proposal  2 – Name change to Petrohawk                                                              |   |       |   |    |   |   |   |
| Energy  Corporation:                                                                                     |   | 13,337,044 |   | 38,770  |   | 13,297 |   |
|                                                                                                     |   |       |   |    |   |   |   |
| Proposal  3 – Reincorporation of the Company under the laws of Delaware:                            |   | 10,006,072 |   | 45,292  |   | 17,359 |   |
|                                                                                                     |   |       |   |    |   |   |   |
| Proposal  4 – Elimination of Cumulative Voting:                                                     |   | 9,270,080  |   | 766,330 |   | 32,313 |   |
|                                                                                                     |   |       |   |    |   |   |   |
| Proposal  5 – Adoption of a classified board of directors:                                          |   | 9,698,045  |   | 348,163 |   | 22,515 |   |
|                                                                                                     |   |       |   |    |   |   |   |
| Proposal  6 – Amendment of Stock Option agreements existing on May 25, 2004 for certain  employees: |   | 9,921,039  |   | 115,829 |   | 32,105 |   |
|                                                                                                     |   |       |   |    |   |   |   |
| Proposal  7 – Approval of 2004 Non-Employee Incentive Plan:                                         |   | 9,683,685  |   | 309,907 |   | 75,131 |   |
|                                                                                                     |   |       |   |    |   |   |   |
| Proposal  8 – Approval of 2004 Employee Incentive Plan:                                             |   | 9,672,891  |   | 321,616 |   | 74,216 |   |

 

**Item 6.  Exhibits**

 

The following documentsare included as exhibits to this Form 10-Q. Those exhibits incorporated by reference are so indicated by theinformation supplied with respect thereto. Those exhibits which are not incorporated by reference are attachedhereto.

 
|   | 2.1  |   | Agreement and Plan of Merger between Beta Oil &  Gas, Inc. and Petrohawk Energy Corporation (Form of Agreement and Plan of  Merger between Beta Oil & Gas, Inc. and Petrohawk Energy Corporation was  attached as Appendix F to the Company’s Definitive Proxy Statement filed  June 23, 2004 is incorporated herein by reference); |
|--------|------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   | 3.1  |   | Certificate of Incorporation for Petrohawk Energy  Corporation (attaches as Exhibit 3.1 to the Form S-8 that the Company filed  on July 29, 2004, which is incorporated herein by reference);                                                                                                                                                    |
|   | 3.2  |   | Amended and Restated  Bylaws of Petrohawk Energy Corporation attached hereto as Exhibit 3.2;                                                                                                                                                                                                                                                          |
|   | 31.1 |   | Certification of  Periodic Report by the Chief Executive Officer under Section 302 of the  Sarbanes-Oxley Act of 2002;                                                                                                                                                                                                                           |
|   | 31.2 |   | Certification of Periodic  Report by the Chief Financial Officer under Section 302 of  Sarbanes-Oxley Act of 2002; and                                                                                                                                                                                                                           |
|   | 32.1 |   | Certification of  Periodic Report by the Chief Executive Officer and Chief Financial Officer  under Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                               |

 

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**SIGNATURES**

 

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

 
|                          | **PETROHAWK ENERGY CORPORATION** |
|-------------------------------|----------------------------------|
|                          |                             |   |
| Date: November 15,  2004 | By:                              | /s/ Shane M. Bayless |   |
|                          |                             | Shane  M. Bayless |
|                          |                             | Vice President – Chief  Financial Officer  and Treasurer |
|                               |                                  |  |  |  |  |

 

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