**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

**Form 10-Q**

**x**                              QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

**SECURITIES EXCHANGE ACT OF 1934**

**Forthe quarterly period ended March 31, 2007**

**or**

**o**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

**SECURITIES EXCHANGE ACT OF 1934**

**CommissionFile Number: 333-123711**

**Venoco, Inc.**

| **Delaware**                                                     |   | **77-0323555**                           |
|------------------------------------------------------------------|--------|------------------------------------------|
| (State or other  jurisdiction of  incorporation or organization) |   | (I.R.S. Employer  Identification Number) |

 

| **370 17th Street, Suite 3900**      |   | ** **     |
|-------------------------------------------|--------|----------------|
| **Denver,  Colorado**                     |   | **80202-1370** |
| (Address of  principal executive offices) |   | (Zip Code)     |

 

Registrant’s telephonenumber, including area code: **(303) 626-8300**

**N/A**

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

Indicate by check mark whether the registrant (1) hasfiled all reports required by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days.

YES x    NO o

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer (as defined in Rule 12b-2of the Exchange Act).

| Large Accelerated Filer o |   | Accelerated Filer o |   | Non-accelerated  filer x |
|--------------------------------|--------|--------------------------|--------|-------------------------------|

 

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Exchange Act).

YES o    NO x

As of March 31, 2006, there were 43,005,182shares of the issuer’s common stock, par value $0.01 per share, issued andoutstanding.

 

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**VENOCO, INC.Form 10-Q for the Quarterly Period Ended March 31, 2007TABLE OF CONTENTS**

| **PART I.**  | ** ** | **FINANCIAL INFORMATION**                                                                                                  | ** ** | 3      | ** ** |
|-------------------|------------|----------------------------------------------------------------------------------------------------------------------------|------------|--------|------------|
| Item  1.          |       | Financial  Statements (Unaudited)                                                                                          |       |   |       |
|              |       | Condensed  Consolidated Balance Sheets at December 31, 2006 and March 31, 2007                                   |       | 3      |       |
|              |       | Condensed  Consolidated Statements of Operations for the Three Months Ended  March 31, 2006 and 2007                  |       | 4      |       |
|              |       | Condensed  Consolidated Statements of Comprehensive Income (Loss) for the Three Months  Ended March 31, 2006 and 2007 |       | 5      |       |
|              |       | Condensed  Consolidated Statements of Cash Flows for the Three Months Ended  March 31, 2006 and 2007                  |       | 6      |       |
|              |       | Notes to  Condensed Consolidated Financial Statements                                                                      |       | 7      |       |
| Item 2.           |       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                |       | 24     |       |
| Item 3.           |       | Quantitative  and Qualitative Disclosures about Market Risk                                                                |       | 33     |       |
| Item 4.           |       | Controls and  Procedures                                                                                                   |       | 37     |       |
| **PART II.** | ** ** | **OTHER INFORMATION**                                                                                                      | ** ** | 38     | ** ** |
| Item 1.           |       | Legal Proceedings                                                                                                          |       | 38     |       |
| Item 1A.          |       | Risk Factors                                                                                                               |       | 38     |       |
| Item 2.           |       | Unregistered  Sales of Equity Securities and Use of Proceeds                                                               |       | 38     |       |
| Item 3.           |       | Defaults upon  Senior Securities                                                                                           |       | 39     |       |
| Item 4.           |       | Submission of  Matters to a Vote of Security Holders                                                                       |       | 39     |       |
| Item 5.           |       | Other Information                                                                                                          |       | 39     |       |
| Item 6.           |       | Exhibits                                                                                                                   |       | 39     |       |
| Signatures        |       | 40                                                                                                                         |       |

 

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**PART I—FINANCIALINFORMATION**

**VENOCO, INC.AND SUBSIDIARIESCONDENSED CONSOLIDATED BALANCE SHEETS(UNAUDITED)(In thousands, except share data)**

| ** **                                                                                                                                                                                          | ** ** | **December 31,** | ** ** | **March 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|--------------------|------------|
| ** **                                                                                                                                                                                          | ** ** | **2006**              | ** ** | **2007**           | ** ** |
| **ASSETS**                                                                                                                                                                                          | ** ** |                  | ** ** | ** **         |       | ** ** | ** ** |
| CURRENT ASSETS:                                                                                                                                                                                     |       |                  |       |               |       |   |   |
| Cash and cash  equivalents                                                                                                                                                                          |       |                  | $          | 8,364              |       |   | $ | 6,220 |   |
| Accounts  receivable, net of allowance for doubtful accounts of $1,250 at  December 31, 2006 and March 31, 2007                                                                           |       |                  | 48,042     |               |       | 49,753 |   |
| Inventories                                                                                                                                                                                         |       |                  | 3,211      |               |       | 3,359 |   |
| Prepaid expenses  and other current assets                                                                                                                                                          |       |                  | 7,226      |               |       | 6,075 |   |
| Income tax  receivable                                                                                                                                                                              |       |                  | 8,098      |               |       | 3,883 |   |
| Deferred income  taxes                                                                                                                                                                              |       |                  | 879        |               |       | 4,300 |   |
| Commodity  derivatives                                                                                                                                                                              |       |                  | 10,348     |               |       | 4,144 |   |
| Total current  assets                                                                                                                                                                               |       |                  | 86,168     |               |       | 77,734 |   |
| PROPERTY, PLANT AND  EQUIPMENT, AT COST:                                                                                                                                                            |       |                  |       |               |       |   |   |
| Oil and natural gas  properties (full cost method, of which unproved properties of $4,850 and $6,315 were excluded from depletion  at December 31, 2006 and March 31, 2007, respectively) |       |                  | 881,570    |               |       | 967,546 |   |
| Drilling equipment                                                                                                                                                                                  |       |                  | 13,731     |               |       | 13,760 |   |
| Other property and  equipment                                                                                                                                                                       |       |                  | 12,380     |               |       | 14,178 |   |
| Total property,  plant and equipment                                                                                                                                                                |       |                  | 907,681    |               |       | 995,484 |   |
| Accumulated  depletion, depreciation, amortization and impairment                                                                                                                                   |       |                  | (133,428   | )                  |       | (154,027 | ) |
| Net property,  plant and equipment                                                                                                                                                                  |       |                  | 774,253    |               |       | 841,457 |   |
| OTHER ASSETS:                                                                                                                                                                                       |       |                  |       |               |       |   |   |
| Commodity  derivatives                                                                                                                                                                              |       |                  | 8,591      |               |       | 4,931 |   |
| Deferred loan  costs                                                                                                                                                                                |       |                  | 17,318     |               |       | 16,185 |   |
| Other                                                                                                                                                                                               |       |                  | 6,863      |               |       | 6,854 |   |
| Total other assets                                                                                                                                                                                  |       |                  | 32,772     |               |       | 27,970 |   |
| TOTAL ASSETS                                                                                                                                                                                        |       |                  | $          | 893,193            |       |   | $ | 947,161 |   |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY**                                                                                                                                                      | ** ** |                  | ** ** | ** **         |       | ** ** | ** ** |
| CURRENT LIABILITIES:                                                                                                                                                                                |       |                  |       |               |       |   |   |
| Accounts payable  and accrued liabilities                                                                                                                                                           |       |                  | $          | 53,900             |       |   | $ | 73,127 |   |
| Undistributed  revenue payable                                                                                                                                                                      |       |                  | 15,596     |               |       | 15,639 |   |
| Interest payable                                                                                                                                                                                    |       |                  | 5,295      |               |       | 5,848 |   |
| Current maturities  of long-term debt                                                                                                                                                               |       |                  | 3,557      |               |       | 3,689 |   |
| Commodity  derivatives                                                                                                                                                                              |       |                  | 8,574      |               |       | 12,160 |   |
| Total current  liabilities                                                                                                                                                                          |       |                  | 86,922     |               |       | 110,463 |   |
| LONG-TERM DEBT                                                                                                                                                                                      |       |                  | 529,616    |               |       | 571,688 |   |
| DEFERRED INCOME  TAXES                                                                                                                                                                              |       |                  | 40,424     |               |       | 31,663 |   |
| COMMODITY  DERIVATIVES                                                                                                                                                                              |       |                  | 6,931      |               |       | 14,945 |   |
| ASSET RETIREMENT  OBLIGATIONS                                                                                                                                                                       |       |                  | 38,984     |               |       | 39,848 |   |
| Total liabilities                                                                                                                                                                                   |       |                  | 702,877    |               |       | 768,607 |   |
| COMMITMENTS AND  CONTINGENCIES                                                                                                                                                                      |       |                  |       |               |       |   |   |
| STOCKHOLDERS’ EQUITY:                                                                                                                                                                          |       |                  |       |               |       |   |   |
| Common stock, $.01  par value (200,000,000 shares authorized; 42,783,300 and 43,005,182 shares  issued and outstanding at December 31, 2006 and March 31, 2007,  respectively)            |       |                  | 428        |               |       | 430 |   |
| Additional paid-in  capital                                                                                                                                                                         |       |                  | 181,444    |               |       | 182,655 |   |
| Retained earnings                                                                                                                                                                                   |       |                  | 10,910     |               |       | 545 |   |
| Accumulated other  comprehensive loss                                                                                                                                                               |       |                  | (2,466     | )                  |       | (5,076 | ) |
| Total  stockholders’ equity                                                                                                                                                                    |       |                  | 190,316    |               |       | 178,554 |   |
| TOTAL LIABILITIES  AND STOCKHOLDERS’ EQUITY                                                                                                                                                    |       |                  | $          | 893,193            |       |   | $ | 947,161 |   |

 

See notes to condensed consolidated financial statements.

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**VENOCO, INC.AND SUBSIDIARIESCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS(UNAUDITED)**

**(Inthousands, except per share amounts)**

| ** **                                              | ** ** | **Three Months Ended  March 31,** | ** ** |
|---------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                              | ** ** | **2006**                                         | ** ** | **2007** | ** ** |
| REVENUES:                                               |       |                                             |       |   |   |
| Oil and natural gas sales                               |       | $                                                | 51,271     |   | $ | 73,639 |   |
| Commodity derivative losses, net                        |       | (15,570                                          | )          | (18,714 | ) |
| Other                                                   |       | 1,714                                            |       | 813 |   |
| Total revenues                                          |       | 37,415                                           |       | 55,738 |   |
| EXPENSES:                                               |       |                                             |       |   |   |
| Oil and natural gas production                          |       | 12,322                                           |       | 25,087 |   |
| Transportation expense                                  |       | 805                                              |       | 1,877 |   |
| Depletion, depreciation and amortization                |       | 6,694                                            |       | 20,599 |   |
| Accretion of abandonment liability                      |       | 470                                              |       | 773 |   |
| General and administrative, net of amounts  capitalized |       | 4,406                                            |       | 9,795 |   |
| Amortization of deferred loan costs                     |       | 338                                              |       | 1,245 |   |
| Interest, net                                           |       | 3,773                                            |       | 13,327 |   |
| Total expenses                                          |       | 28,808                                           |       | 72,703 |   |
| Income (loss)  before income taxes                      |       | 8,607                                            |       | (16,965 | ) |
| Income tax  provision (benefit)                         |       | 3,500                                            |       | (6,600 | ) |
| Net income (loss)                                       |       | $                                                | 5,107      |   | $(10,365 | ) |
| Earnings (loss) per  common share:                      |       |                                             |       |   |   |
| Basic                                                   |       | $                                                | 0.16       |   | $ | (0.24 | ) |
| Diluted                                                 |       | $                                                | 0.15       |   | $ | (0.24 | ) |
| Weighted average common  shares outstanding:            |       |                                             |       |   |   |
| Basic                                                   |       | 32,693                                           |       | 42,790 |   |
| Diluted                                                 |       | 33,862                                           |       | 42,790 |   |

 

See notes to condensed consolidated financial statements.

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**VENOCO, INC.AND SUBSIDIARIESCONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)(UNAUDITED)(In thousands)**

| ** **                                                                   | ** ** | **Three Months Ended  March 31,** | ** ** |
|------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                   | ** ** | **2006**                                         | ** ** | **2007** | ** ** |
| Net income (loss)                                                            |       | $                                                | 5,107      |   | $ | (10,365 | ) |
| OTHER COMPREHENSIVE  INCOME (LOSS), NET OF INCOME TAX:                       |       |                                             |       |   |   |
| Hedging activities:                                                          |       |                                             |       |   |   |
| Reclassification adjustments for settled contracts                           |       | (1,022                                           | )          | 130 |   |
| Changes in fair value of effective portion of  outstanding hedging positions |       | (1,297                                           | )          | (2,740 | ) |
| Other  comprehensive loss                                                    |       | (2,319                                           | )          | (2,610 | ) |
| Comprehensive income  (loss)                                                 |       | $                                                | 2,788      |   | $ | (12,975 | ) |

 

See notes to condensed consolidated financial statements.

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**VENOCO, INC.AND SUBSIDIARIESCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS(UNAUDITED)(In thousands)**

| ** **                                                                                | ** ** | **Three Months Ended  March 31,** | ** ** |
|-------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                                | ** ** | **2006**                                         | ** ** | **2007** | ** ** |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                                     |       |                                             |       |   |   |
| Net income (loss)                                                                         |       | $                                                | 5,107      |   | $ | (10,365 | ) |
| Adjustments to reconcile net income (loss) to net  cash provided by operating activities: |       |                                             |       |   |   |
| Depletion, depreciation  and amortization                                                 |       | 6,694                                            |       | 20,599 |   |
| Accretion of abandonment  liability                                                       |       | 470                                              |       | 773 |   |
| Deferred income tax  provision (benefit)                                                  |       | 2,186                                            |       | (10,542 | ) |
| Share-based compensation                                                                  |       | 647                                              |       | 1,140 |   |
| Amortization of deferred  loan costs                                                      |       | 338                                              |       | 1,245 |   |
| Amortization of bond  discounts and other non-cash interest                               |       | 34                                               |       | 268 |   |
| Unrealized commodity  derivative losses and amortization of premiums                      |       | 11,246                                           |       | 18,888 |   |
| Changes in operating assets and liabilities:                                              |       |                                             |       |   |   |
| Accounts receivable                                                                       |       | 4,646                                            |       | (1,711 | ) |
| Inventories                                                                               |       | 367                                              |       | (148 | ) |
| Prepaid expenses and  other current assets                                                |       | (523                                             | )          | 1,117 |   |
| Income tax receivable                                                                     |       | (145                                             | )          | 4,215 |   |
| Other assets                                                                              |       | (87                                              | )          | (14 | ) |
| Accounts payable and  accrued liabilities                                                 |       | 2,805                                            |       | 9,859 |   |
| Undistributed revenue  payable                                                            |       | (48                                              | )          | 43 |   |
| Net premiums paid on  derivative contracts                                                |       | (5,684                                           | )          | (1,676 | ) |
| Net cash provided by  operating activities                                                |       | 28,053                                           |       | 33,691 |   |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                                     |       |                                             |       |   |   |
| Expenditures for oil and  natural gas properties                                          |       | (28,834                                          | )          | (61,549 | ) |
| Acquisitions of oil and  natural gas properties                                           |       | —                                           |       | (14,305 | ) |
| Expenditures for  drilling equipment                                                      |       | (66                                              | )          | (128 | ) |
| Expenditures for other  property and equipment                                            |       | (737                                             | )          | (1,806 | ) |
| Proceeds from sale of  oil and gas properties                                             |       | 3,031                                            |       | — |   |
| Acquisition of TexCal  Energy, net of cash acquired                                       |       | (445,523                                         | )          | — |   |
| Net cash used in  investing activities                                                    |       | (472,129                                         | )          | (77,788 | ) |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                                     |       |                                             |       |   |   |
| Proceeds from long-term  debt                                                             |       | 469,529                                          |       | 41,421 |   |
| Principal payments on  long-term debt                                                     |       | (10,033                                          | )          | (1,138 | ) |
| Deferred loan costs                                                                       |       | (13,801                                          | )          | (78 | ) |
| Proceeds from derivative  premium financing                                               |       | 3,903                                            |       | 1,676 |   |
| Proceeds from exercise  of stock options                                                  |       | —                                           |       | 72 |   |
| Dividend paid to  shareholder                                                             |       | (426                                             | )          | — |   |
| Net cash provided by  financing activities                                                |       | 449,172                                          |       | 41,953 |   |
| Net increase (decrease) in  cash and cash equivalents                                     |       | 5,096                                            |       | (2,144 | ) |
| Cash and cash  equivalents, beginning of period                                           |       | 9,389                                            |       | 8,364 |   |
| Cash and cash  equivalents, end of period                                                 |       | $                                                | 14,485     |   | $ | 6,220 |   |
| **Supplemental Disclosure of Cash Flow  Information—**                               |       |                                             |       |   |   |
| Cash paid for interest                                                                    |       | $                                                | 619        |   | $ | 12,643 |   |
| Cash paid (received) for  income taxes                                                    |       | $                                                | 1,200      |   | $ | (273 | ) |
| **Supplemental Disclosure of Noncash Activities—**                                   |       |                                             |       |   |   |
| Decrease (increase) in  accrued capital expenditures                                      |       | $                                                | (2,963     | ) | $ | (8,459 | ) |
| Distribution of land and  building                                                        |       | $                                                | 13,399     |   | $ | — |   |
| Distribution of building note payable                                                     |       | $                                                | 9,857      |   | $ | — |   |

 

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**VENOCO, INC.AND SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(UNAUDITED)**

**1.**                 BASIS OFPRESENTATION

***Description of Operations***—Venoco, Inc. (the “Company”),a Delaware corporation, is engaged in the acquisition, exploration,exploitation and development of oil and natural gas properties with a focusoffshore and onshore California and the Gulf Coast of Texas.

***Condensed Consolidated Financial Statements***—The condensed consolidatedfinancial statements include the accounts of Venoco and its subsidiaries, allof which are wholly owned. The financial statements have been prepared inaccordance with U.S. generally accepted accounting principles for interimfinancial reporting. All significant intercompany balances and transactionshave been eliminated in consolidation. In the opinion of management, allmaterial adjustments considered necessary for a fair presentation of the Company’sinterim results have been reflected. Venoco’s Annual Report on Form 10-Kfor the year ended December 31, 2006 includes certain definitions and asummary of significant accounting policies and should be read in conjunctionwith this report. The results for interim periods are not necessarilyindicative of annual results.

***In thecourse of preparing the condensed consolidated financial statements, managementmakes various assumptions, judgments and estimates to determine the reportedamount of assets, liabilities, revenue and expenses, and in the disclosures ofcommitments and contingencies. Changes in these assumptions, judgments andestimates will occur as a result of the passage of time and the occurrence offuture events and, accordingly, actual results could differ from amountsinitially established. The more significant areas requiring the use ofassumptions, judgments and estimates relate to volumes of oil and gas reservesused in calculating depletion, the amount of future net revenues used in computingthe ceiling test limitations and the amount of future capital costs andabandonment obligations used in such calculations. Assumptions, judgments andestimates are also required in determining impairments of undevelopedproperties, valuing deferred tax assets and estimating fair values ofderivative instruments.***

***Earnings Per Share***—Statement of Financial AccountingStandards No. 128, Earnings Per Share, requires presentation of “basic” and “diluted” earnings pershare. Basic earnings per common share of stock is calculated by dividing netincome (loss) by the weighted average number of common shares outstandingduring each period including vested restricted shares. The weighted averagecommon shares outstanding used to calculate basic net income (loss) per shareexcludes the effect of non-vested restricted shares subject to future vesting. Asthese restricted shares vest, they will be included in the shares outstandingused to calculate basic earnings per common share (although all restrictedstock is issued and outstanding upon grant). Diluted earnings per common shareof stock is calculated by dividing net income (loss) by the weighted averagenumber of common shares outstanding and other dilutive securities. The Company’sdilutive securities include non-qualified stock option awards and non-vestedrestricted shares. For the three months ended March 31, 2007, the Companyexcluded the dilutive effects of 1,140,000 options and 12,000 restricted sharesfrom its diluted weighted average shares outstanding because the impact wasanti-dilutive.

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Thefollowing table sets forth the calculation of basic and diluted earnings pershare (in thousands except per share amounts):

| ** **                                             | ** ** | **Three Months Ended  March 31,** | ** ** |
|--------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                             | ** ** | **2006**                                         | ** ** | **2007** | ** ** |
| Net income (loss)                                      |       | $                                                | 5,107      |   | $ | (10,365 | ) |
| Adjustments to  net income for dilution                |       | —                                           |       | — |   |
| Net income (loss) adjusted for the effect of  dilution |       | $                                                | 5,107      |   | $ | (10,365 | ) |
| Basic weighted  average common shares outstanding      |       | 32,693                                           |       | 42,790 |   |
| Add: dilutive  effect of stock options                 |       | 1,169                                            |       | — |   |
| Add: dilutive effect  of non-vested restricted stock   |       | —                                           |       | — |   |
| Diluted weighted average common shares outstanding     |       | 33,862                                           |       | 42,790 |   |
| Basic earnings  per common share                       |       | $                                                | 0.16       |   | $ | (0.24 | ) |
| Diluted earnings per  common share                     |       | $                                                | 0.15       |   | $ | (0.24 | ) |

 

***Reclassifications***—The consolidated statements ofoperations were modified to combine commodity derivative gains and losses intoone caption. The components of the caption are disclosed in the footnotes tothe financial statements. This reclassification had no impact on totalrevenues.

**RecentlyAdopted Accounting Pronouncement**

In June 2006, theFinancial Accounting Standards Board (“FASB”) issued Interpretation 48(“FIN 48”), *Accounting for Uncertainties in Income Taxes*,an interpretation of FASB Statement No. 109, *Accountingfor Income Taxes*. This interpretation addresses how tax benefits claimedor expected to be claimed on a tax return should be recorded in the financialstatements. Under FIN 48, the Company may recognize the tax benefit froman uncertain tax position only if it is more likely than not that the taxposition will be sustained on examination by the taxing authorities based on thetechnical merits of the position. The tax benefits recognized in the financialstatements from such a position should be measured based on the largest benefitthat has a greater than fifty percent likelihood of being realized uponultimate settlement. FIN 48 also provides guidance on derecognition,classification, interest and penalties on income taxes, accounting in interimperiods and requires increased disclosures.

The Company adopted theprovisions of FIN 48 as of January 1, 2007. As a result of theimplementation of FIN 48, the Company recognized a $3.8 millionreduction in prepaid income taxes for unrecognized tax benefits which wasoffset by a corresponding reduction to deferred income tax liabilities. Therewas no cumulative adjustment made to the opening balance of retained earningsat January 1, 2007. As of the beginning of 2007, the Company had aliability for unrecognized tax benefits of $3.8 million. The amount ofunrecognized tax benefits did not materially change as of March 31, 2007. TheCompany’s uncertain tax positions relate primarily to timing differences and managementdoes not believe any such uncertain tax positions will materially impact theCompany’s effective tax rate in future periods.

The Company’s policy is torecognize interest and penalties related to uncertain tax positions as part ofgeneral and administrative expense. The Company has not incurred anysignificant interest and penalties related to income tax filings.

The Company is subject totaxation at the federal and various state levels. The Company’s tax years 2002and forward are subject to examination by state tax authorities. The Company’sfederal income tax returns for the 2003 and 2004 tax years are currently underexamination by the Internal Revenue Service and tax years 2005 and 2006 remainopen to examination. Any proposed adjustments from the existing examinationshave been considered in the measurement of uncertain tax positions. The Companyanticipates that approximately $1.0 million of uncertain tax positions willbe recognized within the next twelve month period.

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**New Accounting Standards**

In September 2006,the FASB issued Statement of Financial Accounting Standards No 157, “*Fair Value Measurements*” (“SFAS 157”). This statementclarifies the definition of fair value, establishes a framework for measuringfair value, and expands the disclosures on fair value measurements. SFAS 157is effective for fiscal years beginning after November 15, 2007. TheCompany has not determined the effect, if any, the adoption of this statementwill have on its financial position or results of operations.

In February 2007, theFinancial Accounting Standards Board issued Statement of Financial AccountingStandards No. 159, “*The Fair Value Option forFinancial Assets and Financial Liabilities*” (“SFAS 159”). Thisstatement permits entities to choose to measure many financial instruments andcertain other items at fair value. This statement expands the use of fair valuemeasurement and applies to entities that elect the fair value option. The fairvalue option established by this statement permits all entities to choose tomeasure eligible items at fair value at specified election dates. SFAS 159 iseffective for fiscal years beginning after November 15, 2007. The Companyhas not determined the effect, if any, the adoption of this statement will haveon its financial position or results of operations.

**2.**                 ACQUISITIONS

*West Montalvo and Manvelacquisitions.**  *TheCompany acquired the West Montalvo field in Ventura County, California in May 2007for approximately $61.3 million. The field includes an offshoreportion that is reachable from onshore locations. The Company acquired theManvel field in Brazoria County, Texas, and certain other fields in Texas,in April 2007 for $46.1 million. As of December 31,2006, the fields acquired in the two transactions had aggregate provedreserves of approximately 9.7 MMBOE. As of March 31, 2007, the Companyplaced deposits totaling $4.5 million in connection with these acquisitions. Thesedeposits were included in oil and gas properties as of March 31, 2007 butwere excluded from the Company’s depletion calculation.

*TexCal Energy Acquisition.**  *On March 31, 2006, the Companyacquired 100% of the members’ interest in TexCal Energy (LP) LLC (the “TexCalAcquisition”), an independent exploration and production company with propertiesin Texas and California, for approximately $456.8 million in cash andrelated financing costs of $14.4 million. TexCal had proved reserves of31.4 MMBOE as of December 31, 2005 according to a reserve report preparedby TexCal’s independent engineers. TexCal’s operations are located entirelyonshore and are concentrated in the Gulf Coast region of Texas and in theSacramento Basin in California. The Company financed the acquisition throughloans advanced under a second amendment and restatement of its existingrevolving credit facility and a new senior secured second lien term loanfacility. The purchase price was allocated to assets and liabilities, adjustedfor tax effects, based on their estimated fair values at the date ofacquisition. The acquisition was accounted for using the purchase method ofaccounting and has been included in the Company’s consolidated financialstatements as of the date of the acquisition.

Thecash consideration paid for the TexCal Acquisition was allocated as follows (inthousands):

| ** **                              | ** ** | **Purchase Price  Allocation** | ** ** |
|-----------------------------------------|------------|-------------------------------------|------------|
| Current assets                          |       |                                | $          | 25,834 |   |   |
| Oil and natural  gas properties         |       |                                | 461,907    |   |   |
| Other non-current  assets               |       |                                | 1,018      |   |   |
| Current  liabilities                    |       |                                | (22,411    | ) |   |
| Long-term  asset retirement obligations |       |                                | (9,538     | ) |   |
| Cash consideration                      |       |                                | $          | 456,810 |   |   |

 

Thefollowing unaudited pro forma condensed consolidated operating results for thequarter ended March 31, 2006 gives effect to the TexCal Acquisition as ifit had been completed as of January 1, 2006. The pro forma amounts shownbelow are not necessarily indicative of the operating results that would have 

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occurred if the transaction had occurred on such date.The pro forma adjustments made are based on certain assumptions that theCompany believes are reasonable based on information available at the time theywere prepared (in thousands except per share amounts) (unaudited).

| ** **                          | ** ** | **Quarter Ended,  March 31,** | ** ** |
|-------------------------------------|------------|-----------------------------------------|------------|
| ** **                          | ** ** | **2006**                                | ** ** |
| Total revenues                      |       |                                    | $          | 66,166 |   |   |
| Net income                          |       |                                    | $          | 16,282 |   |   |
| Basic earnings  per common share    |       |                                    | $          | 0.50 |   |   |
| Dilutive earnings per  common share |       |                                    | $          | 0.49 |   |   |

 

**3.      LONG-TERM DEBT**

As ofthe dates indicated, the Company’s long-term debt consisted of thefollowing (in thousands):

| ** **                                      | ** ** | **December 31,  2006** | ** ** | **March 31,  2007** | ** ** |
|-------------------------------------------------|------------|-----------------------------|------------|--------------------------|------------|
| Revolving credit  agreement due March 2009 |       |                        | $          | 30,579                   |       |   | $ | 72,000 |   |
| Second lien term  loan due March 2011      |       |                        | 348,882    |                     |       | 348,882 |   |
| 8.75% senior  notes due December 2011      |       |                        | 149,317    |                     |       | 149,351 |   |
| Financed  derivative premiums due 2008          |       |                        | 4,395      |                     |       | 5,144 |   |
| Total long-term debt                            |       |                        | 533,173    |                     |       | 575,377 |   |
| Less: current  portion of long-term debt        |       |                        | (3,557     | )                        |       | (3,689 | ) |
| Long-term  debt, net of current portion         |       |                        | $          | 529,616                  |       |   | $ | 571,688 |   |

 

*Seniornotes.**  *OnDecember 20, 2004, the Company issued $150.0 million in 8.75% seniornotes (the “senior notes”) due December 2011. Interest on the senior notesis due each June 15 and December 15. The senior notes are seniorobligations and contain covenants that, among other things, limit the Company’sability to make investments, incur additional debt, issue preferred stock,create liens or sell assets. The senior notes were issued as unsecuredobligations, but became secured equally and ratably with the second lien termloan on March 30, 2006, as amended.

*Revolvingcredit facility.*   The Company has a$300 million revolving credit facility with a syndicate of banks (“revolvingcredit facility”) with a maturity date of March 30, 2009. AtMarch 31, 2007, the revolving credit facility had a borrowing base of$229 million, was secured by a first priority lien on substantially all ofthe Company’s oil and natural gas properties and other assets, including thestock of all of the Company’s subsidiaries, and was unconditionally guaranteedby each of the Company’s subsidiaries other than Ellwood Pipeline, Inc. Thecollateral also secured the Company’s obligations to hedging counterpartiesthat were also lenders, or affiliates of lenders, under the revolving creditagreement. As of March 31, 2007, the Company had available borrowingcapacity of $156.3 million (net of $0.7 million in outstandingletters of credit). The revolving credit facility was amended on May 7,2007 in connection with the Company’s new second lien term loan (see discussionbelow under *New term loan facility and amendment to revolvingcredit facility*).

*Secondlien term loan facility.*   The Company enteredinto a $350 million senior secured second lien term loan facility in connectionwith the TexCal Acquisition. Principal on amounts borrowed under the facilitywas payable on March 30, 2011. Optional prepayments were subject to aprepayment premium. The facility was secured by second priority liens onsubstantially all of the Company’s assets.  This facility was refinanced and replaced witha new second lien term loan facility in March 2007 (see discussion below under*New term loan facility and amendment to revolvingcredit facility*).

The Company was in compliance with all debt covenantsat March 31, 2007.

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*FinancedDerivative Premiums.**  *TheCompany entered into derivative contracts in the first quarter of 2006 and thefirst quarter of 2007 for options that contain provisions for the deferral ofthe payment or receipt of premiums until the period of production for which thederivative contract relates. Both the derivative and the net liability for thepayment of premiums were recorded at their fair values at the inception of thederivative contracts.

*Mortgage.**  *On December 9, 2004, 6267Carpinteria Avenue, LLC (“6267 Carpinteria”), a wholly-ownedsubsidiary of the Company, purchased an office building in Carpinteria,California for $14.2 million. The purchase was financed in part by asecured 5.79% $10 million promissory note due January 1, 2015. On March 22,2006, the Company paid a dividend consisting of 100% of the membershipinterests in 6267 Carpinteria to its sole stockholder, a trust controlledby the Company’s CEO. The obligation for the 5.79% mortgage on the officebuilding owned by 6267 Carpinteria was transferred to the sole stockholderin connection with the dividend.

*Newterm loan facility and amendment to revolving credit facility.*   OnMay 7, 2007, the Company entered into (i) a new second lien term loanagreement (the “new term loan agreement”) to refinance and replace its existingsecond lien term loan facility and (ii) a fifth amendment to the secondamended and restated credit agreement governing its revolving credit facility(the “revolving credit agreement amendment”). The following is a summary of thematerial terms of the new term loan agreement and the revolving creditagreement amendment.

The company borrowed $500.0 million pursuant tothe new term loan agreement on May 8, 2007. Of the total amount borrowed,$350.5 million was used to repay all amounts outstanding under theexisting second lien term loan facility plus accrued interest, $3.5 millionwas used to pay a prepayment premium on those amounts and $4.6 million wasused to pay transaction costs associated with the new facility. The remainingborrowings were used to reduce amounts outstanding under the revolving creditfacility.

Loans made under the new term loan agreement aredesignated, at the company’s option, as either “Base Rate Loans” or “LIBO RateLoans.” Base Rate Loans bear interest at a floating rate equal to (i) thegreater of the overnight federal funds rate plus 0.50% and the administrativeagent’s announced base rate, plus (ii) 3.00%. LIBO Rate Loans bearinterest at LIBOR plus 4.00%.

The new term loan agreement contains customaryrepresentations, warranties, events of default, indemnities and covenants,including covenants that restrict the company’s ability to incur additionalindebtedness. The covenants and other terms of the agreement contain exceptionsthat are intended to permit the company to form a master limited partnershipand certain related entities (collectively, the “partnership”), to contribute assetsto the partnership, to sell securities of the partnership and to cause thepartnership to incur indebtedness and issue securities, subject in each case tothe satisfaction of certain requirements. The agreement requires the company tomaintain derivative contracts covering at least 70% of its projected proveddeveloped producing oil and natural gas production through May 8, 2010, and atleast 50% of such production on an annual basis thereafter. The company cannot,however, enter into derivative contracts covering more than 80% of such oil andgas production in any month.

The new term loan facility is secured by secondpriority liens on substantially all of the company’s oil and natural gasproperties and other assets, including the stock of all of its subsidiaries,and is unconditionally guaranteed by each of the company’s subsidiaries otherthan Ellwood Pipeline, Inc. Under the new term loan agreement, principal on thesecond lien term loan facility is payable on May 8, 2014. However, if thecompany’s 8.75% senior notes due 2011 are not refinanced in full prior toSeptember 20, 2011, principal on the second lien term loan facility willbe payable on that date.

The company may from time to time make optionalprepayments of amounts borrowed under the second lien term loan facility if noamounts are outstanding under the revolving credit facility. Optionalprepayments made prior to May 8, 2008 are subject to a prepayment premiumof 2%. The premium will be 

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reduced to 1% forprepayments made between May 9, 2008 and May 8, 2009, after which nopremium will be payable with respect to any optional prepayment. Amountsprepaid under the new term loan facility may not be reborrowed.

The principal effects of the revolving creditagreement amendment are (i) to permit the company to enter into the newterm loan agreement, (ii) to reduce the borrowing base under the revolvingcredit facility to $125.0 million and (iii) to change the rate atwhich amounts outstanding under the revolving credit agreement accrue interest.Pursuant to the amendment, Base Rate Loans under the revolving credit facilitybear interest at a floating rate equal to (i) the greater of Bank ofMontreal’s announced base rate and the overnight federal funds rate plus 0.50%plus (ii) an applicable margin ranging from zero to 0.75%, based uponutilization. LIBO Rate Loans under the revolving credit facility bear interestat (i) LIBOR plus (ii) an applicable margin ranging from 1.50% to2.25%, based upon utilization. A commitment fee ranging from 0.375% to 0.5% perannum is payable with respect to unused borrowing availability under thefacility.

**4.**                 HEDGINGAND DERIVATIVE FINANCIAL INSTRUMENTS

The Company utilizes swap and collar agreements andoption contracts to hedge the effect of price changes on a portion of itsfuture oil and natural gas production. The objective of the Company’s hedgingactivities and the use of derivative financial instruments is to achieve morepredictable cash flows. While the use of these derivative instruments limitsthe downside risk of adverse price movements, some of those derivativeinstruments also limit future revenues from favorable price movements. The useof derivatives also involves the risk that the counterparties to suchinstruments will be unable to meet the financial terms of such contracts.

Thecomponents of commodity derivative losses in the condensed consolidated statementsof operations are as follows (in thousands):

| ** **                                                                    | ** ** | **Quarter ended March 31,** | ** ** |
|-------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                    | ** ** | **2006**                                   | ** ** | **2007** | ** ** |
| Realized commodity  derivative gains (losses)                                 |       |                                       | $          | (4,274 | ) |   |   | $ | 174 |   |   |
| Amortization of  commodity derivative premiums                                |       |                                       | (1,788     | ) |   |   | (1,898 | ) |   |
| Unrealized commodity  derivative gains (losses):                              |       |                                       |       |   |   |   |   |   |   |
| Change in fair value of  derivatives that do not qualify for hedge accounting |       |                                       | (8,729     | ) |   |   | (17,103 | ) |   |
| Ineffective portion of  derivatives qualifying for hedge accounting           |       |                                       | (779       | ) |   |   | 113 |   |   |
| Net unrealized commodity  derivative gains (losses)                           |       |                                       | (9,508     | ) |   |   | (16,990 | ) |   |
| Net realized and unrealized commodity derivative gains  (losses)              |       |                                       | $          | (15,570 | ) |   |   | $ | (18,714 | ) |   |

 

Theestimated fair values of derivatives included in the condensed consolidatedbalance sheets at December 31, 2006 and March 31, 2007 are summarizedbelow. The net fair value of the Company’s derivatives decreased by$21.5 million from a net asset of $3.4 million at December 31,2006 to a net liability of $18.0 million at March 31, 2007 due tohigher prices for crude oil and natural gas (in thousands):

| ** **                       | ** ** | **December 31,  2006** | ** ** | **March 31,  2007** | ** ** |
|----------------------------------|------------|-----------------------------|------------|--------------------------|------------|
| Derivative assets:               |       |                        |       |                     |       |   |   |
| Oil derivative contracts         |       |                        | $          | 1,658                    |       |   | $ | 593 |   |
| Gas derivative contracts         |       |                        | 17,281     |                     |       | 8,482 |   |
| Derivative liabilities:          |       |                        |       |                     |       |   |   |
| Oil derivative contracts         |       |                        | (8,905     | )                        |       | (21,378 | ) |
| Gas derivative contracts         |       |                        | (6,600     | )                        |       | (5,727 | ) |
| Net derivative asset (liability) |       |                        | $          | 3,434                    |       |   | $ | (18,030 | ) |

 

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As of March 31, 2007, an unrealized derivativefair value loss of $8.3 million ($5.1 million after tax), related to derivativecontracts designated as cash flow hedges, was recorded in accumulated othercomprehensive loss. The Company expects to reclassify net unrealized derivativelosses of $4.8 million ($3.0 million after tax) out of accumulatedother comprehensive loss into earnings during the next twelve months.

*Because a large portion of the Company’s commodityderivatives do not qualify for hedge accounting and to increase clarity in itsfinancial statements, the Company elected to discontinue hedge accountingprospectively for its commodity derivatives beginning April 1, 2007.Consequently, from that date forward, the Company will recognize mark-to-marketgains and losses in earnings currently, rather than deferring such amounts inaccumulated other comprehensive income for those commodity derivatives that qualifyas cash flow hedges. The net mark-to-market loss on outstanding derivatives atMarch 31, 2007 included in accumulated other comprehensive income will bereported in future earnings as the original hedged transactions occur. Thischange in reporting will have no impact on the Company’s reported cash flows,although future results of operations will be affected by mark-to-market gainsand losses which fluctuate with volatile oil and gas prices.*

*Crude Oil Agreements.**  *As of March 31, 2007, theCompany has entered into option, swap and collar agreements to receive averageminimum and maximum New York Mercantile Exchange (NYMEX) West TexasIntermediate (WTI) prices as summarized below. Location and qualitydifferentials attributable to the Company’s properties are not included in thefollowing prices. The agreements provide for monthly settlement based on thedifferential between the agreement price and the actual NYMEX crude oil price.

| ** **                                                    | ** ** | **Minimum**     | ** ** | **Maximum**          | ** ** |
|---------------------------------------------------------------|------------|-----------------|------------|----------------------|------------|
| ** **                                                    | ** ** | **Barrels/day** | ** ** | **Avg. Prices** | ** ** | **Barrels/day** | ** ** | **Avg. Prices** | ** ** |
| Crude oil derivatives at March 31, 2007 for  production: |       |            |       |                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| April 1—December 31,  2007                     |       |            | 9,219      |                 |       |   | $ | 51.26 |   |   |   | 8,098 |   |   |   | $ | 72.16 |   |   |
| January 1—December 31,  2008                   |       |            | 7,450      |                 |       |   | $ | 58.73 |   |   |   | 7,450 |   |   |   | $ | 72.65 |   |   |
| January 1—December 31,  2009                   |       |            | 6,580      |                 |       |   | $ | 57.97 |   |   |   | 6,580 |   |   |   | $ | 73.87 |   |   |
| January 1—December 31, 2010                    |       |            | 5,500      |                 |       |   | $ | 61.23 |   |   |   | 5,500 |   |   |   | $ | 71.83 |   |   |

 

*Natural Gas Agreements.**  *As of March 31, 2007, theCompany had entered into option, swap and collar agreements to receive averageminimum and maximum PG&E Citygate prices as follows:

| ** **                                                      | ** ** | **Minimum**   | ** ** | **Maximum**          | ** ** |
|-----------------------------------------------------------------|------------|---------------|------------|----------------------|------------|
| ** **                                                      | ** ** | **MMBtu/Day** | ** ** | **Avg. Prices** | ** ** | **MMBtu/Day** | ** ** | **Avg. Prices** | ** ** |
| Natural gas derivatives  at March 31, 2007 for production: |       |          |       |                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| April 1—December 31,  2007                       |       |          | 32,500     |                 |       |   | $ | 7.13 |   |   |   | 26,894 |   |   |   | $ | 10.59 |   |   |
| January 1—December 31,  2008                     |       |          | 19,200     |                 |       |   | $ | 7.56 |   |   |   | 17,647 |   |   |   | $ | 11.14 |   |   |
| January 1—December 31,  2009                     |       |          | 13,500     |                 |       |   | $ | 7.63 |   |   |   | 13,500 |   |   |   | $ | 11.54 |   |   |
| January 1—December 31,  2010                     |       |          | 11,000     |                 |       |   | $ | 7.20 |   |   |   | 11,000 |   |   |   | $ | 10.44 |   |   |

 

The Company entered intoan interest rate swap transaction during 2006 to lock in its interest cost on$200 million of borrowings at a fixed rate of 9.9225% through May 2008.The Company pays a fixed interest rate of 5.4225% and receives a floatinginterest rate based on the three-month LIBO rate. Settlements are madequarterly. The Company has not designated this interest rate swap as a hedge.The fair value of the interest rate swap of $0.5 million at December 31,2006 and March 31, 2007 has been recorded in accrued liabilities.

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**5.**                 ASSETRETIREMENT OBLIGATIONS

The Company’s asset retirement obligations primarilyrepresent the estimated present value of the amounts expected to be incurred toplug, abandon and remediate producing properties (including removal of certainonshore and offshore facilities) at the end of their productive lives inaccordance with applicable state and federal laws. The Company determines assetretirement obligations by calculating the present value of estimated cash flowsrelated to plugging and abandonment liabilities. The asset retirement liabilityis accreted to its present value each period and the capitalized assetretirement cost is depleted as a component of the full cost pool using theunits-of-production method.

Thefollowing table summarizes the activities for the Company’s asset retirementobligations for the quarters ended March 31, 2006 and 2007 (in thousands):

| ** **                                                                                              | ** ** | **Quarter Ended  March 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                                              | ** ** | **2006**                               | ** ** | **2007** | ** ** |
| Asset retirement  obligations at beginning of period                                                    |       | $                                      | 22,757     |   | $ | 42,049 |   |
| Revisions of  estimated liabilities                                                                     |       | 2,594                                  |       | 639 |   |
| Liabilities  incurred                                                                                   |       | 9,144                                  |       | 916 |   |
| Liabilities  settled                                                                                    |       | —                                 |       | — |   |
| Accretion expense                                                                                       |       | 470                                    |       | 773 |   |
| Asset retirement obligations at end of period                                                           |       | 34,965                                 |       | 44,377 |   |
| Less: current  asset retirement obligations (classified with accounts payable and accrued  liabilities) |       | (1,346                                 | )          | (4,529 | ) |
| Long-term asset  retirement obligations                                                                 |       | $                                      | 33,619     |   | $ | 39,848 |   |

 

**6.**                 CAPITALSTOCK AND STOCKHOLDERS’ EQUITY

All of the Company’s outstanding common stock wascontrolled by the Company’s CEO from December, 2004 until August 2006,when the Company’s then sole stockholder donated shares of stock to twocharitable institutions. The Company issued 10,090,800 shares of its commonstock in the fourth quarter of 2006 in an initial public offering and receivednet proceeds of $160.4 million. The Company has 48.5 million shares ofcommon stock issued or reserved for issuance at March 31, 2007, including 5.7million shares issued or reserved for issuance under the Company’s stock incentiveplans. At March 31, 2007, the Company has 43,005,182 common shares issuedand outstanding, of which 212,882 shares are restricted stock granted under theCompany’s 2005 stock incentive plan. At March 31, 2007, the Company had 692,000shares available to be made subject to awards under its stock incentive plans.

On March 22, 2006,the Company paid a dividend consisting of 100% of its membership interest in6267 Carpinteria to its then sole stockholder, a trust controlled by theCompany’s CEO. 6267 Carpinteria owns the office building and related landused by the Company in Carpinteria, California. At the date of the dividend,6267 Carpinteria had net assets of $4.7 million, including$0.4 million in cash and land and building with a net book value of$13.4 million, and a note payable of $9.9 million.

**7.**                 SHARE-BASEDPAYMENTS

The Company has granted options to certain employeesand officers of the Company other than its CEO. As of March 31, 2007, thereare a total of 4,800,213 options outstanding with a weighted average exerciseprice of $8.65 ($6.00 to $20.00). The options vest over a four year period,with 20% vesting on the grant date and 20% vesting on each subsequentanniversary of the grant date. The options will generally vest upon a change incontrol of the Company. The agreements with employee option holders generallyprovide that all of the holder’s options will vest if the Company terminatesthe holder’s employment, unless 

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the termination is forspecified types of misconduct. The agreements with director option holdersprovide that any unvested options will terminate when the director’s service tothe Company ceases.

During the quarter ended March 31, 2007, theCompany granted 212,882 shares of restricted stock under the Company’s 2005stock incentive plan, including 205,882 shares to its CEO. The restrictedshares have provisions similar to options granted under the Company’s stockincentive plan except that the restricted shares generally vest over a fouryear service period subject to market conditions based on the Company’s totalshareholder return in comparison to peer group companies. At the end of thefour year service period, the Company may repurchase any unvested restrictedshares at $0.00001 per share.

Thefollowing summarizes the Company’s stock option activity for the quarter ended March 31,2007:

| ** **                                                                   | ** ** | **Quarter Ended March 31,** | ** ** |
|------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                   | ** ** | **2007**                                   | ** ** |
| ** **                                                                   | ** ** | **Shares**                                 | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| Outstanding,  beginning of period                                            |       | 4,740,663                                  |       |   | $ | 8.55 |   |   |
| Granted                                                                      |       | 105,000                                    |       |   | $ | 14.97 |   |   |
| Exercised                                                                    |       | (9,000                                     | )          |   | $ | 8.00 |   |   |
| Cancelled                                                                    |       | (36,450                                    | )          |   | $ | 13.67 |   |   |
| Outstanding, end  of period                                                  |       | 4,800,213                                  |       |   | $ | 8.65 |   |   |
| Exercisable, end  of period                                                  |       | 2,467,508                                  |       |   | $ | 7.64 |   |   |
| Weighted average grant-date  fair value of options granted during the period |       |                                       |       |   | $ | 6.67 |   |   |

 

As of March 31, 2007,there was $10.6 million of total unrecognized compensation cost related tostock options and restricted stock which is expected to be amortized over aweighted-average period of 3.1 years.

**8.**                 LITIGATION

***Beverly Hills Litigation***

Between June 2003 and April 2005, sixlawsuits were filed against the Company and certain other energy companies inLos Angeles County Superior Court by persons who attended Beverly Hills HighSchool or who were or are citizens of Beverly Hills/Century City or visitors tothat area during the time period running from the 1930s to date. There areapproximately 1,000 plaintiffs (including plaintiffs in two related lawsuits inwhich the Company has not been named) who claimed to be suffering from variousforms of cancer or other illnesses, fear they may suffer from such maladies inthe future, or are related to persons who have suffered from cancer or otherillnesses. Plaintiffs alleged that exposure to substances in the air, soil andwater that originated from either oil-field or other operations in the areawere the cause of the cancers and other maladies. The Company has owned an oiland natural gas facility adjacent to the school since 1995. For the majority ofthe plaintiffs, their alleged exposures occurred before the Company acquiredthe facility. All cases were consolidated before one judge. Twelve “representative”plaintiffs were selected to have their cases tried first, while all of theother plaintiffs’ cases were stayed. In November 2006, the judge enteredsummary judgment in favor of all defendants in the test cases, including theCompany. The judge dismissed all claims by the test case plaintiffs on theground that they offered no evidence of medical causation between the allegedemissions and the plaintiffs’ alleged injuries. Plaintiffs have appealed theruling. The Company vigorously defended the actions, and will continue to do sountil they are resolved. The Company also has defense and indemnity obligationsto certain other defendants in the actions who have asserted claims forindemnity for events occurring after we acquired the property in 

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1995. In addition, certaindefendants have made claims for indemnity for events occurring prior to 1995,which the Company is disputing. The Company cannot predict the cost of defenseand indemnity obligations at the present time.

One of the Company’s insurers currently is paying forthe defense of these lawsuits under a reservation of its rights. Three otherinsurers that provided insurance coverage to the Company (the “DecliningInsurers”) have taken the position that they are not required to provide coveragefor losses arising out of, or to defend against, the lawsuits because of apollution exclusion contained in their policies. The Beverly Hills UnifiedSchool District (the “District”), as an additional insured on those policies,brought a declaratory relief action against two of those insurers in LosAngeles County Superior Court. In November 2005, the court ruled in favorof one of the insurers and in February 2007, an appellate court affirmedthe decision of the Superior Court. In July 2006, the same Los AngelesCounty Superior Court that ruled in favor of one of the insurers denied amotion for summary judgment brought by another of the insurers against theDistrict on the issue of the insurer’s duty to defend. In February 2006,the Company filed its own declaratory relief action against the DecliningInsurers in Santa Barbara County Superior Court seeking a determination thatthose insurers have a duty to defend the Company in the lawsuits. The Companyhas entered into settlement agreements with two of the three Declining Insurers.The action against the third Declining Insurer is ongoing. The policy issued bythe insurer that currently is providing defense of the lawsuits contains apollution exclusion similar to that at issue in the actions brought against theDeclining Insurers. However, the Company has no reason to believe that theinsurer currently providing defense of these actions will cease providing suchdefense. If it does, and the Company is unsuccessful in enforcing its rights inany subsequent litigation, the Company may be required to bear the costs of thedefense, and those costs may be material. If it ultimately is determined thatthe pollution exclusion or another exclusion contained in one or more of theCompany’s policies applies, it will not have the protection of those policieswith respect to any damages or settlement costs ultimately incurred in thelawsuits.

In accordance with SFAS No. 5,Accounting for Contingencies, the Company has not accrued for a losscontingency relating to the Beverly Hills litigation because the Companybelieves that, although unfavorable outcomes in the proceedings may bereasonably possible, the Company does not consider them to be probable orreasonably estimable. If one or more of these matters are resolved in a manneradverse to the Company, and if insurance coverage is determined not to beapplicable, their impact on the Company’s results of operations, financialposition and/or liquidity could be material.

***Personal Injury Claim***

On March 31, 2006, acomplaint was filed in District Court in Madison County, Texas against asubsidiary of the Company by the widow of an individual who was fatally injuredwhile working as a gauger/pumper at a well operated by the subsidiary. The caseis scheduled to go to trial in August 2007. The Company plans tovigorously defend this action. The Company believes that it has legitimatedefenses to all allegations in the suit. The Company also believes that it hasinsurance coverage with respect to the accident. It does not currently believethat it is subject to material exposure in association with this lawsuit. Norelated liability has been recorded in the Company’s condensed consolidatedfinancial statements.

***Landowner Dispute***

On May 28, 1997, ArchW. Helton and Helton Properties, Inc. and later joined by Linda Barnhill(collectively “Helton parties”) filed a lawsuit against Tri-Union DevelopmentCorporation (“TDC”), *Helton v. Tri-Union**,*** in the 80th Judicial DistrictCourt of Harris County, Texas, alleging that TDC owed additional royalties onoil and natural gas produced beginning in February 1987 through theinitiation of the lawsuit with respect to 18 acres of property in Alvin, Texas.As to the Helton parties’ largest claim, TDC received a favorable decision fromthe Texas Railroad Commission, which was upheld on appeal. 

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TheHelton parties appealed this decision to the 5th Circuit Court of Appeals. Approximately$1.1 million has been segregated pursuant to bankruptcy court order inaccordance with the initial plan of reorganization pending resolution of thisclaim. The Company acquired TDC’s interest and claim in the $1.1 millionof escrowed funds and the right to defend against any further claims brought bythe Helton parties. The Company expects to be successful in defeating theHelton appeal.

***Other***

In addition, the Companyis subject from time to time to other claims and legal actions that arise inthe ordinary course of business. The Company believes that the ultimateliability, if any, with respect to these other claims and legal actions willnot have a material adverse effect on its consolidated financial position, resultsof operations or liquidity.

**9.**                 GUARANTORFINANCIAL INFORMATION

In connection with the issuance of the senior notes inDecember 2004, BMC, Ltd., Whittier Pipeline Corp. and 217 State Street, Inc.(“Guarantors”) fully and unconditionally guaranteed, on a joint and severalbasis, the Company’s obligations under the senior notes. On March 31,2005, Marquez Energy became a Guarantor of the senior notes. The Company hadtwo subsidiaries, 6267 Carpinteria and Ellwood Pipeline, Inc., that are notGuarantors (the “Non-Guarantor Subsidiaries”). 6267 Carpinteria ceased being asubsidiary on March 22, 2006. On November 1, 2005, the Company mergedMarquez Energy and 217 State Street with and into Venoco, Inc., leavingBMC and Whittier as the only Guarantors until the TexCal Acquisition. On March 31,2006, TexCal and its four subsidiaries became Guarantors. All Guarantors are100% owned by the Company. Presented below are the Company’s condensedconsolidating balance sheets, statements of operations and cash flows asrequired by Rule 3-10 of Regulation S-X of the Securities ExchangeAct of 1934.

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**CONDENSEDCONSOLIDATING STATEMENTS OF OPERATIONSTHREE MONTHS ENDED MARCH 31, 2006 (Unaudited)(in thousands)**

| ** **                                              | ** ** | ** **            | ** ** | **Guarantor**    | ** ** | **Non-Guarantor** | ** ** | ** **       | ** ** | ** **       | ** ** |
|---------------------------------------------------------|------------|-----------------------|------------|------------------|------------|-------------------|------------|------------------|------------|------------------|------------|
| ** **                                              | ** ** | **Venoco, Inc.** | ** ** | **Subsidiaries** | ** ** | **Subsidiaries**  | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| **REVENUES:**                                           | ** ** |                  | ** ** | ** **       |       |              | ** ** | ** **       |       |             | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Oil and natural gas sales                               |       |                  | $          | 49,881           |       |              |       | $                | 1,390      | ** **       |       |   | $ | — |   |   |   | $ | — |   |   |   | $ | 51,271 |   |   |
| Commodity derivative losses                             |       |                  | (15,570    | )                |       |              | —     | ** **       |       |             | —     |   |   |   | — |   |   |   | (15,570 | ) |   |
| Other                                                   |       |                  | 1,435      |             |       |              | —     | ** **       |       |             | 1,541      |   |   |   | (1,262 | ) |   |   | 1,714 |   |   |
| Total revenues                                          |       |                  | 35,746     |             |       |              | $          | 1,390            | ** ** |             |       | 1,541 |   |   |   | (1,262 | ) |   |   | 37,415 |   |   |
| **EXPENSES:**                                           | ** ** |                  | ** ** | ** **       |       |              | ** ** | ** **       |       |             | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Oil and natural gas production                          |       |                  | 11,743     |             |       |              | 81         | ** **       |       |             | 498        |   |   |   | — |   |   |   | 12,322 |   |   |
| Transportation expense                                  |       |                  | 1,640      |             |       |              | —     | ** **       |       |             | —     |   |   |   | (835 | ) |   |   | 805 |   |   |
| Depletion, depreciation and amortization                |       |                  | 6,601      |             |       |              | 19         | ** **       |       |             | 74         |   |   |   | — |   |   |   | 6,694 |   |   |
| Accretion of abandonment liability                      |       |                  | 449        |             |       |              | 15         | ** **       |       |             | 6          |   |   |   | — |   |   |   | 470 |   |   |
| General and administrative, net of amounts  capitalized |       |                  | 4,697      |             |       |              | —     | ** **       |       |             | 136        |   |   |   | (427 | ) |   |   | 4,406 |   |   |
| Amortization of deferred loan costs                     |       |                  | 338        |             |       |              | —     | ** **       |       |             | —     |   |   |   | — |   |   |   | 338 |   |   |
| Interest, net                                           |       |                  | 4,214      |             |       |              | —     | ** **       |       |             | (441       | ) |   |   | — |   |   |   | 3,773 |   |   |
| Total expenses                                          |       |                  | 29,682     |             |       |              | 115        | ** **       |       |             | 273        |   |   |   | (1,262 | ) |   |   | 28,808 |   |   |
| Equity in  subsidiary income                            |       |                  | 1,526      |             |       |              | —     | ** **       |       |             | —     |   |   |   | (1,526 | ) |   |   | — |   |   |
| Income before  income taxes                             |       |                  | 7,590      |             |       |              | 1,275      | ** **       |       |             | 1,268      |   |   |   | (1,526 | ) |   |   | 8,607 |   |   |
| Income tax provision                                    |       |                  | 2,483      |             |       |              | 510        | ** **       |       |             | 507        |   |   |   | — |   |   |   | 3,500 |   |   |
| Net income                                              |       |                  | $          | 5,107            |       |              |       | $                | 765        | ** **       |       |   | $ | 761 |   |   |   | $ | (1,526 | ) |   |   | $ | 5,107 |   |   |

 

18

----

**CONDENSEDCONSOLIDATING STATEMENTS OF OPERATIONSTHREE MONTHS ENDED MARCH 31, 2007 (Unaudited)(in thousands)**

| ** **                                              | ** ** | ** **            | ** ** | **Guarantor**    | ** ** | **Non-Guarantor** | ** ** | ** **       | ** ** | ** **       | ** ** |
|---------------------------------------------------------|------------|-----------------------|------------|------------------|------------|-------------------|------------|------------------|------------|------------------|------------|
| ** **                                              | ** ** | **Venoco, Inc.** | ** ** | **Subsidiaries** | ** ** | **Subsidiaries**  | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| **REVENUES:**                                           | ** ** |                  | ** ** | ** **       |       |              | ** ** | ** **       |       |             | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Oil and natural gas sales                               |       |                  | $          | 47,277           |       |              |       | $                | 26,362     |             |       |   | $ | — |   |   |   | $ | — |   |   |   | $ | 73,639 |   |   |
| Commodity derivative losses                             |       |                  | (18,714    | )                |       |              | —     |             |       |             | —     |   |   |   | — |   |   |   | (18,714 | ) |   |
| Other                                                   |       |                  | 682        |             |       |              | 2          |             |       |             | 1,183      |   |   |   | (1,054 | ) |   |   | 813 |   |   |
| Total revenues                                          |       |                  | 29,245     |             |       |              | 26,364     |             |       |             | 1,183      |   |   |   | (1,054 | ) |   |   | 55,738 |   |   |
| **EXPENSES:**                                           | ** ** |                  | ** ** | ** **       |       |              | ** ** | ** **       |       |             | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Oil and natural gas production                          |       |                  | 15,349     |             |       |              | 9,214      |             |       |             | 524        |   |   |   | — |   |   |   | 25,087 |   |   |
| Transportation expense                                  |       |                  | 2,770      |             |       |              | 91         |             |       |             | —     |   |   |   | (984 | ) |   |   | 1,877 |   |   |
| Depletion, depreciation and amortization                |       |                  | 14,180     |             |       |              | 6,405      |             |       |             | 14         |   |   |   | — |   |   |   | 20,599 |   |   |
| Accretion of abandonment liability                      |       |                  | 567        |             |       |              | 202        |             |       |             | 4          |   |   |   | — |   |   |   | 773 |   |   |
| General and administrative, net of amounts  capitalized |       |                  | 8,748      |             |       |              | 1,046      |             |       |             | 71         |   |   |   | (70 | ) |   |   | 9,795 |   |   |
| Amortization of deferred loan costs                     |       |                  | 1,245      |             |       |              | —     |             |       |             | —     |   |   |   | — |   |   |   | 1,245 |   |   |
| Interest, net                                           |       |                  | 13,975     |             |       |              | (19        | )                |       |             | (629       | ) |   |   | — |   |   |   | 13,327 |   |   |
| Total expenses                                          |       |                  | 56,834     |             |       |              | 16,939     |             |       |             | (16        | ) |   |   | (1,054 | ) |   |   | 72,703 |   |   |
| Equity in  subsidiary income                            |       |                  | 6,481      |             |       |              | —     |             |       |             | —     |   |   |   | (6,481 | ) |   |   | — |   |   |
| Income (loss)  before income taxes                      |       |                  | (21,108    | )                |       |              | 9,425      |             |       |             | 1,199      |   |   |   | (6,481 | ) |   |   | (16,965 | ) |   |
| Income tax  provision (benefit)                         |       |                  | (10,743    | )                |       |              | 3,676      |             |       |             | 467        |   |   |   | — |   |   |   | (6,600 | ) |   |
| Net income (loss)                                       |       |                  | $          | (10,365          | )          |              |       | $                | 5,749      |             |       |   | $ | 732 |   |   |   | $ | (6,481 | ) |   |   | $ | (10,365 | ) |   |

 

19

----

**CONDENSEDCONSOLIDATING BALANCE SHEETSAT DECEMBER 31, 2006(in thousands)**

| ** **                                       | ** ** | **Venoco, Inc.** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|--------------------------------------------------|------------|-----------------------|------------|-----------------------------|------------|---------------------------------|------------|------------------|------------|------------------|------------|
| **ASSETS**                                       |       |                  |       |                        |       |                            |       |             |       |             |       |   |   |   |   |   |   |   |   |
| CURRENT ASSETS:                                  |       |                  |       |                        |       |                            |       |             |       |             |       |   |   |   |   |   |   |   |   |
| Cash and cash  equivalents                       |       | $                     | (12        | )                           |       | $                               | 8,358      |             |       |             | $          | 18 |   |   |   | $ | — |   |   |   | $ | 8,364 |   |   |
| Accounts  receivable                             |       | 24,894                |       |                        | 23,026     |                            |       |             | 122        |             |       |   | — |   |   |   | 48,042 |   |   |
| Inventories                                      |       | 3,150                 |       |                        | 61         |                            |       |             | —     |             |       |   | — |   |   |   | 3,211 |   |   |
| Prepaid expenses  and other current assets       |       | 5,753                 |       |                        | 1,473      |                            |       |             | —     |             |       |   | — |   |   |   | 7,226 |   |   |
| Income taxes receivable                          |       | 8,098                 |       |                        | —     |                            |       |             | —     |             |       |   | — |   |   |   | 8,098 |   |   |
| Deferred income  taxes                           |       | 879                   |       |                        | —     |                            |       |             | —     |             |       |   | — |   |   |   | 879 |   |   |
| Commodity  derivatives                           |       | 10,348                |       |                        | —     |                            |       |             | —     |             |       |   | — |   |   |   | 10,348 |   |   |
| TOTAL CURRENT  ASSETS                            |       | 53,110                |       |                        | 32,918     |                            |       |             | 140        |             |       |   | — |   |   |   | 86,168 |   |   |
| PROPERTY,  PLANT & EQUIPMENT, NET       |       | 363,947               |       |                        | 431,198    |                            |       |             | 772        |             |       |   | (21,664 | ) |   |   | 774,253 |   |   |
| COMMODITY  DERIVATIVES                           |       | 8,591                 |       |                        | —     |                            |       |             | —     |             |       |   | — |   |   |   | 8,591 |   |   |
| INVESTMENTS IN  AFFILIATES                       |       | 562,104               |       |                        | —     |                            |       |             | —     |             |       |   | (562,104 | ) |   |   | — |   |   |
| OTHER                                            |       | 18,413                |       |                        | 5,768      |                            |       |             | —     |             |       |   | — |   |   |   | 24,181 |   |   |
| TOTAL ASSETS                                     |       | $                     | 1,006,165  |                        |       | $                               | 469,884    |             |       |             | $          | 912 |   |   |   | $ | (583,768 | ) |   |   | $ | 893,193 |   |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**    |       |                  |       |                        |       |                            |       |             |       |             |       |   |   |   |   |   |   |   |   |
| CURRENT  LIABILITIES:                            |       |                  |       |                        |       |                            |       |             |       |             |       |   |   |   |   |   |   |   |   |
| Accounts payable  and accrued liabilities        |       | $                     | 48,319     |                        |       | $                               | 5,581      |             |       |             | $          | — |   |   |   | $ | — |   |   |   | $ | 53,900 |   |   |
| Undistributed  revenue payable                   |       | 7,831                 |       |                        | 7,765      |                            |       |             | —     |             |       |   | — |   |   |   | 15,596 |   |   |
| Interest payable                                 |       | 5,300                 |       |                        | (5         | )                               |       |             | —     |             |       |   | — |   |   |   | 5,295 |   |   |
| Current  maturities of long-term debt            |       | 3,557                 |       |                        | —     |                            |       |             | —     |             |       |   | — |   |   |   | 3,557 |   |   |
| Commodity  derivatives                           |       | 8,574                 |       |                        | —     |                            |       |             | —     |             |       |   | — |   |   |   | 8,574 |   |   |
| TOTAL CURRENT LIABILITIES:                       |       | 73,581                |       |                        | 13,341     |                            |       |             | —     |             |       |   | — |   |   |   | 86,922 |   |   |
| LONG-TERM  DEBT                                  |       | 529,616               |       |                        | —     |                            |       |             | —     |             |       |   | — |   |   |   | 529,616 |   |   |
| DEFERRED INCOME  TAXES                           |       | 40,424                |       |                        | —     |                            |       |             | —     |             |       |   | — |   |   |   | 40,424 |   |   |
| COMMODITY  DERIVATIVES                           |       | 6,931                 |       |                        | —     |                            |       |             | —     |             |       |   | — |   |   |   | 6,931 |   |   |
| ASSET RETIREMENT  OBLIGATIONS                    |       | 29,296                |       |                        | 9,408      |                            |       |             | 280        |             |       |   | — |   |   |   | 38,984 |   |   |
| INTERCOMPANY  PAYABLES (RECEIVABLES)             |       | 136,001               |       |                        | (104,837   | )                               |       |             | (31,164    | )                |       |   | — |   |   |   | — |   |   |
| TOTAL LIABILITIES                                |       | 815,849               |       |                        | (82,088    | )                               |       |             | (30,884    | )                |       |   | — |   |   |   | 702,877 |   |   |
| TOTAL  STOCKHOLDERS’ EQUITY                 |       | 190,316               |       |                        | 551,972    |                            |       |             | 31,796     |             |       |   | (583,768 | ) |   |   | 190,316 |   |   |
| TOTAL LIABILITIES AND  STOCKHOLDERS’ EQUITY |       | $                     | 1,006,165  |                        |       | $                               | 469,884    |             |       |             | $          | 912 |   |   |   | $ | (583,768 | ) |   |   | $ | 893,193 |   |   |

 

20

----

**CONDENSEDCONSOLIDATING BALANCE SHEETSAT MARCH 31, 2007 (Unaudited)(in thousands)**

| ** **                                         | ** ** | **Venoco, Inc.** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|----------------------------------------------------|------------|-----------------------|------------|-----------------------------|------------|---------------------------------|------------|------------------|------------|------------------|------------|
| **ASSETS:**                                        | ** ** | ** **            | ** ** |                        | ** ** | ** **                      |       |             | ** ** | ** **       |       |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| CURRENT ASSETS:                                    |       |                  |       |                        |       |                            |       |             |       |             |       |   |   |   |   |   |   | ** ** |   |
| Cash and cash equivalents                          |       | $                     | 1,228      |                        |       | $                               | 4,992      |             |       |             | $          | — |   |   |   | $ | — |   |   |   | $ | 6,220 | ** ** |   |
| Accounts receivable                                |       | 28,450                |       |                        | 21,179     |                            |       |             | 124        |             |       |   | — |   |   |   | 49,753 | ** ** |   |
| Inventories                                        |       | 3,299                 |       |                        | 60         |                            |       |             | —     |             |       |   | — |   |   |   | 3,359 | ** ** |   |
| Prepaid expenses and other current assets          |       | 4,647                 |       |                        | 1,428      |                            |       |             | —     |             |       |   | — |   |   |   | 6,075 | ** ** |   |
| Income taxes receivable                            |       | 3,883                 |       |                        | —     |                            |       |             | —     |             |       |   | — |   |   |   | 3,883 | ** ** |   |
| Deferred income taxes                              |       | 4,300                 |       |                        | —     |                            |       |             | —     |             |       |   | — |   |   |   | 4,300 | ** ** |   |
| Commodity derivatives                              |       | 4,144                 |       |                        | —     |                            |       |             | —     |             |       |   | — |   |   |   | 4,144 | ** ** |   |
| TOTAL CURRENT  ASSETS                              |       | 49,951                |       |                        | 27,659     |                            |       |             | 124        |             |       |   | — |   |   |   | 77,734 | ** ** |   |
| PROPERTY, PLANT & EQUIPMENT, NET          |       | 397,539               |       |                        | 464,825    |                            |       |             | 757        |             |       |   | (21,664 | ) |   |   | 841,457 | ** ** |   |
| COMMODITY DERIVATIVES                              |       | 4,931                 |       |                        | —     |                            |       |             | —     |             |       |   | — |   |   |   | 4,931 | ** ** |   |
| INVESTMENTS IN AFFILIATES                          |       | 572,728               |       |                        | —     |                            |       |             | —     |             |       |   | (572,728 | ) |   |   | — | ** ** |   |
| OTHER                                              |       | 17,283                |       |                        | 5,756      |                            |       |             | —     |             |       |   | — |   |   |   | 23,039 | ** ** |   |
| TOTAL ASSETS                                       |       | $                     | 1,042,432  |                        |       | $                               | 498,240    |             |       |             | $          | 881 |   |   |   | $ | (594,392 | ) |   |   | $ | 947,161 | ** ** |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY** | ** ** | ** **            | ** ** |                        | ** ** | ** **                      |       |             | ** ** | ** **       |       |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| CURRENT  LIABILITIES:                              |       |                  |       |                        |       |                            |       |             |       |             |       |   |   |   |   |   |   | ** ** |   |
| Accounts payable and accrued liabilities           |       | $                     | 67,846     |                        |       | $                               | 5,281      |             |       |             | $          | — |   |   |   | $ | — |   |   |   | $ | 73,127 | ** ** |   |
| Undistributed revenue payable                      |       | 7,850                 |       |                        | 7,789      |                            |       |             | —     |             |       |   | — |   |   |   | 15,639 | ** ** |   |
| Interest payable                                   |       | 5,848                 |       |                        | —     |                            |       |             | —     |             |       |   | — |   |   |   | 5,848 | ** ** |   |
| Current maturities of long-term debt               |       | 3,689                 |       |                        | —     |                            |       |             | —     |             |       |   | — |   |   |   | 3,689 | ** ** |   |
| Commodity derivatives                              |       | 12,160                |       |                        | —     |                            |       |             | —     |             |       |   | — |   |   |   | 12,160 | ** ** |   |
| TOTAL CURRENT  LIABILITIES                         |       | 97,393                |       |                        | 13,070     |                            |       |             | —     |             |       |   | — |   |   |   | 110,463 | ** ** |   |
| LONG-TERM DEBT                                     |       | 571,688               |       |                        | —     |                            |       |             | —     |             |       |   | — |   |   |   | 571,688 | ** ** |   |
| DEFERRED INCOME  TAXES                             |       | 31,663                |       |                        | —     |                            |       |             | —     |             |       |   | — |   |   |   | 31,663 | ** ** |   |
| COMMODITY  DERIVATIVES                             |       | 14,945                |       |                        | —     |                            |       |             | —     |             |       |   | — |   |   |   | 14,945 | ** ** |   |
| ASSET RETIREMENT  OBLIGATIONS                      |       | 29,122                |       |                        | 10,443     |                            |       |             | 283        |             |       |   | — |   |   |   | 39,848 | ** ** |   |
| INTERCOMPANY  PAYABLES (RECEIVABLES)               |       | 119,067               |       |                        | (86,669    | )                               |       |             | (32,398    | )                |       |   | — |   |   |   | — | ** ** |   |
| OTHER LONG-TERM  LIABILITIES                       |       | —                |       |                        | —     |                            |       |             | —     |             |       |   | — |   |   |   | — | ** ** |   |
| TOTAL LIABILITIES                                  |       | 863,878               |       |                        | (63,156    | )                               |       |             | (32,115    | )                |       |   | — |   |   |   | 768,607 | ** ** |   |
| TOTAL  STOCKHOLDERS’ EQUITY                   |       | 178,554               |       |                        | 561,396    |                            |       |             | 32,996     |             |       |   | (594,392 | ) |   |   | 178,554 | ** ** |   |
| TOTAL LIABILITIES AND  STOCKHOLDERS’ EQUITY   |       | $                     | 1,042,432  |                        |       | $                               | 498,240    |             |       |             | $          | 881 |   |   |   | $ | (594,392 | ) |   |   | $ | 947,161 | ** ** |   |

 

21

----

**CONDENSEDCONSOLIDATING STATEMENT OF CASH FLOWSTHREE MONTHS ENDED MARCH 31, 2006 (Unaudited)(in thousands)**

| ** **                                                      | ** ** | **Venoco, Inc.** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|-----------------------------------------------------------------|------------|-----------------------|------------|-----------------------------|------------|---------------------------------|------------|------------------|------------|------------------|------------|
| CASH FLOWS FROM  OPERATING ACTIVITIES:                          |       |                  |       |                        |       |                            |       |             |       |             |       |   |   |   |   |   |   |   |   |   |   |
| Net cash provided by operating activities                  |       |                  | $          | 25,802                      |       |                            |       | $                | 855        |             |       |   | $ | 1,396 |   |   |   | $ | — |   |   |   | $ | 28,053 |   |   |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                          |       |                  |       |                        |       |                            |       |             |       |             |       |   |   |   |   |   |   |   |   |   |   |
| Capital expenditures for oil and gas properties            |       |                  | (28,813    | )                           |       |                            | (21        | )                |       |             | —     |   |   |   | — |   |   |   | (28,834 | ) |   |
| Acquisitions of oil and gas properties                          |       |                  | —     |                        |       |                            | —     |             |       |             | —     |   |   |   | — |   |   |   | — |   |   |
| Capital expenditures for property and equipment  and other |       |                  | (803       | )                           |       |                            | —     |             |       |             | —     |   |   |   | — |   |   |   | (803 | ) |   |
| Proceeds from sale of oil and gas properties               |       |                  | —     |                        |       |                            | 3,031      |             |       |             | —     |   |   |   | — |   |   |   | 3,031 |   |   |
| Investment in Texcal, net of cash received                      |       |                  | (455,932   | )                           |       |                            | 10,409     |             |       |             | —     |   |   |   | — |   |   |   | (445,523 | ) |   |
| Net cash provided by (used in) investing  activities       |       |                  | (485,548   | )                           |       |                            | 13,419     |             |       |             | —     |   |   |   | — |   |   |   | (472,129 | ) |   |
| CASH FLOWS FROM  FINANCING ACTIVITIES:                          |       |                  |       |                        |       |                            |       |             |       |             |       |   |   |   |   |   |   |   |   |   |   |
| Net proceeds from (repayments of) intercompany  borrowings |       |                  | 5,576      |                        |       |                            | (3,865     | )                |       |             | (1,711     | ) |   |   | — |   |   |   | — |   |   |
| Proceeds from long-term debt                                    |       |                  | 469,529    |                        |       |                            | —     |             |       |             | —     |   |   |   | — |   |   |   | 469,529 |   |   |
| Principal payments on long-term debt                            |       |                  | (10,000    | )                           |       |                            | —     |             |       |             | (33        | ) |   |   | — |   |   |   | (10,033 | ) |   |
| Increase in deferred loan costs                                 |       |                  | (13,801    | )                           |       |                            | —     |             |       |             | —     |   |   |   | — |   |   |   | (13,801 | ) |   |
| Proceeds from derivative premium financing                      |       |                  | 3,903      |                        |       |                            | —     |             |       |             | —     |   |   |   | — |   |   |   | 3,903 |   |   |
| Payments of dividends                                           |       |                  | (426       | )                           |       |                            | —     |             |       |             | —     |   |   |   | — |   |   |   | (426 | ) |   |
| Net cash provided by (used in) financing  activities       |       |                  | 454,781    |                        |       |                            | (3,865     | )                |       |             | (1,744     | ) |   |   | — |   |   |   | 449,172 |   |   |
| Net increase (decrease) in cash and cash equivalents            |       |                  | (4,965     | )                           |       |                            | 10,409     |             |       |             | (348       | ) |   |   | — |   |   |   | 5,096 |   |   |
| Cash and cash equivalents, beginning of period                  |       |                  | 9,041      |                        |       |                            | —     |             |       |             | 348        |   |   |   | — |   |   |   | 9,389 |   |   |
| Cash and cash  equivalents, end of period                  |       |                  | $          | 4,076                       |       |                            |       | $                | 10,409     |             |       |   | $ | — |   |   |   | $ | — |   |   |   | $ | 14,485 |   |   |

 

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**CONDENSEDCONSOLIDATING STATEMENT OF CASH FLOWSTHREE MONTHS ENDED MARCH 31, 2007 (Unaudited)(in thousands)**

| ** **                                                      | ** ** | **Venoco, Inc.** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|-----------------------------------------------------------------|------------|-----------------------|------------|-----------------------------|------------|---------------------------------|------------|------------------|------------|------------------|------------|
| CASH FLOWS FROM  OPERATING ACTIVITIES:                          |       |                  |       |                        |       |                            |       |             |       |             |       |   |   |   |   |   |   |   |   |   |   |
| Net cash provided by operating activities                       |       |                  | $          | 21,572                      |       |                            |       | $                | 11,649     |             |       |   | $ | 470 |   |   |   | $— |   |   |   | $ | 33,691 |   |   |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                          |       |                  |       |                        |       |                            |       |             |       |             |       |   |   |   |   |   |   |   |   |   |   |
| Capital expenditures for oil and gas properties                 |       |                  | (43,834    | )                           |       |                            | (17,715    | )                |       |             | —     |   |   |   | — |   |   |   | (61,549 | ) |   |
| Acquisitions of oil and gas properties                          |       |                  | (12,801    | )                           |       |                            | (1,504     | )                |       |             | —     |   |   |   | — |   |   |   | (14,305 | ) |   |
| Capital expenditures for property and equipment  and other |       |                  | (1,838     | )                           |       |                            | (96        | )                |       |             | —     |   |   |   | — |   |   |   | (1,934 | ) |   |
| Proceeds from sale of oil and gas properties               |       |                  | —     |                        |       |                            | —     |             |       |             | —     |   |   |   | — |   |   |   | — |   |   |
| Net cash provided by (used in) investing activities             |       |                  | (58,473    | )                           |       |                            | (19,315    | )                |       |             | —     |   |   |   | — |   |   |   | (77,788 | ) |   |
| CASH FLOWS FROM  FINANCING ACTIVITIES:                          |       |                  |       |                        |       |                            |       |             |       |             |       |   |   |   |   |   |   |   |   |   |   |
| Net proceeds from (repayments of) intercompany  borrowings      |       |                  | (3,812     | )                           |       |                            | 4,300      |             |       |             | (488       | ) |   |   | — |   |   |   | — |   |   |
| Proceeds from long-term debt                                    |       |                  | 41,421     |                        |       |                            | —     |             |       |             | —     |   |   |   | — |   |   |   | 41,421 |   |   |
| Principal payments on long-term debt                       |       |                  | (1,138     | )                           |       |                            | —     |             |       |             | —     |   |   |   | — |   |   |   | (1,138 | ) |   |
| Deferred loan costs                                             |       |                  | (78        | )                           |       |                            | —     |             |       |             | —     |   |   |   | — |   |   |   | (78 | ) |   |
| Proceeds from derivative premium financing                      |       |                  | 1,676      |                        |       |                            | —     |             |       |             | —     |   |   |   | — |   |   |   | 1,676 |   |   |
| Repurchase of common stock                                      |       |                  | —     |                        |       |                            | —     |             |       |             | —     |   |   |   | — |   |   |   | — |   |   |
| Proceeds from exercise of stock options                         |       |                  | 72         |                        |       |                            | —     |             |       |             | —     |   |   |   | — |   |   |   | 72 |   |   |
| Net cash used in financing activities                           |       |                  | 38,141     |                        |       |                            | 4,300      |             |       |             | (488       | ) |   |   | — |   |   |   | 41,953 |   |   |
| Net increase (decrease) in cash and cash equivalents            |       |                  | 1,240      |                        |       |                            | (3,366     | )                |       |             | (18        | ) |   |   | — |   |   |   | (2,144 | ) |   |
| Cash and cash equivalents, beginning of period                  |       |                  | (12        | )                           |       |                            | 8,358      |             |       |             | 18         |   |   |   | — |   |   |   | 8,364 |   |   |
| Cash and cash  equivalents, end of period                  |       |                  | $          | 1,228                       |       |                            |       | $                | 4,992      |             |       |   | $ | — |   |   |   | $ | — |   |   |   | $ | 6,220 |   |   |
|                                                                 |            |                       |            |                             |            |                                 |            |                  |            |                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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**Item 2.**                        MANAGEMENT’S DISCUSSION AND ANALYSISOF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussionand analysis should be read in conjunction with “Management’s Discussion andAnalysis of Financial Condition and Results of Operations” contained in ourAnnual Report on Form 10-K for the year ended December 31, 2006as filed with the Securities and Exchange Commission on April 2, 2007, aswell as with the financial statements and related notes and the otherinformation appearing elsewhere in this report. For further information on ourbusiness strategy, the opportunities we intend to pursue and the risks anduncertainties to which our business is subject, see “Business and Properties—OurStrategy” and “Risk Factors” as set forth in the above referenced report on Form 10-K.Certain statements contained herein that set forth management’s intentions,plans, beliefs, expectations or predictions of the future are forward-lookingstatements. It is important to note that actual results could differ materiallyfrom those projected in such forward-looking statements. The risks anduncertainties include but are not limited to potential unfavorable or uncertainresults of exploration, development and exploitation activities, drilling costsand operational uncertainties, risks associated with quantities of totalreserves and rates of production from existing natural gas and oil reserves andpricing assumptions relating to those reserves, potential delays in the timingof planned operations, unanticipated operational disruptions,  competition and other risks associated withpermitting and with leasing gas and oil properties, potential cost overruns,potential dry holes and regulatory uncertainties and the availability ofcapital to fund planned expenditures, as well as general industry and marketconditions. As used in this report, unless the context otherwise indicates,references to “we,” “our,” “ours,” and “us” refer to Venoco, Inc. and itssubsidiaries collectively.

**Overview**

We are an independentenergy company primarily engaged in the acquisition, exploration, exploitationand development of oil and natural gas properties. Our strategy is to growthrough exploration, exploitation and development projects we believe to berelatively low risk and through selective acquisitions of underdevelopedproperties. Our average net production was 17,670 BOE/d in the first quarter of2007, compared to 11,215 BOE/d in the first quarter of 2006 and 17,349 BOE/d inthe year ended December 31, 2006. Our first quarter 2007 results includethe impact of our acquisition of TexCal, which was completed on March 31,2006. We expect our 2007 capital expenditure program and property acquisitionsto result in increases in our production through the remainder of 2007. See “—TrendsAffecting Our Results of Operations—Expected 2007 Production.”

***Recent Developments***

***In April and May of 2007, we consummatedtwo acquisitions of properties in Texas and Southern California. As of December 31,2006, the acquired properties had aggregate proved reserves of approximately 9.7MMBOE. See “—Acquisitions.”***

***On May 7, 2007, we entered into (i) anew second lien term loan agreement to refinance and replace our existingsecond lien term loan facility and (ii) a fifth amendment to the secondamended and restated credit agreement governing our revolving credit facility.  See “Liquidity and Capital Resources—CapitalResources and Requirements.”***

***In April 2007, we entered intoagreements pursuant to which we expect to be able to deliver oil from our SouthEllwood field to Long Beach, California and then transport the production viapipeline for sale to any of several refineries in the Long Beach area.  See “—Trends Affecting our Results ofOperations—South Ellwood Delivery Arrangements.”***

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***Capital Expenditures***

We have developed anactive capital expenditure program to take advantage of our extensive inventoryof drilling prospects and other projects. We expect that our exploration,exploitation and development capital expenditures will be approximately$230.0 million in 2007, of which $70.1 million was spent in the firstquarter of the year (excluding the effect of changes in accrued capitalexpenditures). The following summarizes certain significant aspects of ourcapital spending program in 2007:

*Coastal California—Exploitationand Development*

In Coastal California, we continued our horizontaldevelopment drilling program in the Monterey formation in the Sockeye fieldduring the first quarter of 2007. We will evaluate the performance of our threehorizontal wells in the field over the next several quarters. Based onencouraging results to date, we are also evaluating the possibility ofexpanding the waterflood in the Sockeye field. In addition, we are continuingto pursue the return to production of platform Grace, although we do not expectmaterial production from the platform in 2007. In the recently acquired WestMontalvo field, we plan to spud our first development well in the secondquarter. In addition, we will be implementing an aggressive workover program onthe existing producing wells.

*Sacramento Basin—Exploitationand Development*

In the Sacramento Basin,our primary focus is on infill drilling in the greater Grimes and Willowsfields. Drilling activities accelerated in the first quarter of 2007 as weincreased the number of rigs drilling in these fields from three to six. Wespud 34 wells in the basin during the first quarter and we plan to drill over120 wells there during 2007. Our drilling in this area includes a significantnumber of wells drilled to locations that are not on our reserve report, andare targeted at expanding reserves and the boundaries of the field. We continueto expand our land position in this area. On March 31, 2007, our acreageposition in the basin consisted of approximately 164,000 net acres (192,000gross).

*Texas—Exploitationand Development*

In Texas, we expect to further increase production inthe Hastings complex through continuation of our aggressive recompletion andworkover program. In addition, we are planning to spud the first of several newwells in the complex during the second quarter. Based on the results of thesewells, we may expand this program in the second half of 2007.

In the first quarter of 2007, we spud four wells inthe Giddings, AWP and Barbers Hill fields. We expect to complete and place onproduction all four wells during the second quarter. We recently acquiredseveral fields in Texas, including the Manvel field, and plan to beginremediation work in these fields during the second quarter. We believe that theManvel field is analogous to the Hastings complex. We plan to implement aworkover program at Manvel similar to our successful program in the Hastingscomplex.

*HigherImpact Exploration Activities.**  *In 2007, we expect to drillapproximately ten higher impact exploration wells, including six in theSacramento Basin, three in Coastal California and one in Texas. We drilled onewell in this category in the first quarter of the year. This well, which wasdrilled in the Sacramento Basin, was successful.

The aggregate levels ofcapital expenditures for 2007, and the allocation of those expenditures, aredependent on a variety of factors, including the availability of capitalresources to fund the expenditures, the availability of service contractors andequipment, permitting issues, weather, limits on the number of activities thatcan be conducted at any one time on our offshore platforms and changes in ourbusiness assessments as to where our capital can be most profitably employed.Accordingly, the actual levels of capital expenditures and the allocation ofthose expenditures may vary materially from the estimates described above.

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***Acquisitions***

*TexCalTransaction.**  *Weacquired TexCal on March 31, 2006 for $456.8 million in cash.According to a reserve report prepared by DeGolyer & MacNaughton, asof December 31, 2005, TexCal had proved reserves of 31.4 MMBOE. Theacquisition is consistent with our strategy of acquiring large, mature fieldswith established reserves and significant exploitation and developmentpotential, and provided us with substantial additions to our multi-yeardrilling inventory.

*West Montalvoand Manvel acquisitions.**  *We acquired the West Montalvo field in Ventura County,California in May 2007 for approximately $61.3 million. The fieldincludes an offshore portion that is reachable from onshore locations. Weacquired the Manvel field in Brazoria County, Texas, and certain relatedfields, in April 2007 for $46.1 million. As of December 31,2006, these fields had aggregate proved reserves of approximately 9.7 MMBOE.We believe that the Manvel field provides us with exploitation and developmentopportunities that are similar to those in the Hastings complex, which isnearby and geologically similar.

*Other.**  *We have an active acreageacquisition program and we regularly engage in acquisitions (and, to a lesserextent, dispositions) of oil and natural gas properties in and around ourexisting core areas of operations.

***Trends Affecting our Results of Operations***

*Expected2007 Production.**  *Weexpect that implementation of our capital expenditure program in 2007 and our recentlycompleted acquisitions will result in a significant increase in our average netproduction for 2007 relative to 2006. We intend to focus our efforts on theexecution of development and workover/recompletion programs in the SacramentoBasin, Texas, and our recently acquired fields, and maintenance of productionfrom the majority of our other properties at rates consistent with year-end2006 levels. We are pursuing a multi-year drilling program in the SacramentoBasin, and have six drilling rigs and a growing number of completion/workoverrigs operating in the basin. We plan to drill more than 120 wells in the basinin 2007. We expect that additional completion rigs will be available to us inthe basin in the remainder of 2007, and that this will allow us to increase thenumber of recompletions and reduce the backlog of wells awaiting completion. Inthe Hastings complex, we are continuing our active workover and recompletionprogram and have three to four workover rigs consistently active in the area.We expect to continue this program throughout 2007. In addition, we haveinitiated a replacement well pilot program in the Hastings complex and expectto be in a position to assess the results of the program early in the thirdquarter. If the pilot program is successful, we would plan to drill up to 15additional replacement wells in the second half of 2007. We are also in theprocess of implementing a development and workover program on our recentlyacquired assets. This program is expected to show production gains by the endof the year. Our expectations with respect to future production rates aresubject to a number of uncertainties, including those associated with theavailability and cost of rigs and third party services, oil and natural gasprices, the potential for mechanical problems or other events resulting inunexpected downtime, permitting issues, drilling success rates, theavailability of acceptable delivery and sales arrangements with respect to oilproduction from the South Ellwood field, pipeline capacity, the accuracy of ourassumptions regarding the sustainability of historical growth rates and theperformance of existing wells, weather and other factors, including thosereferenced in “Risk Factors.”

*Production Expenses.**  *Production expenses increased to $15.78per BOE in the first quarter of 2007 from $15.09 per BOE in 2006, primarily asa result of substantial remedial work we conducted in the Hastings complex andrelatively flat first quarter 2007 production. Production during the quarterwas negatively affected by a temporary disruption in barge deliveries of oilproduction from the South Ellwood field. We expect to significantly reduce theamount of the remedial work conducted in the Hastings complex after the end ofthe second quarter of 2007. Also, we are in the process of adding productionfrom our lower operating cost gas wells in the Sacramento Basin. These factorsare expected to result in our 

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2007 productionexpenses trending downward on a per BOE basis. Our expectations with respect tofuture per-unit expenses are based in part on the projected increases in ourproduction described in the preceding paragraph and are subject to numerousrisks and uncertainties, including those described and referenced therein.

*General and AdministrativeExpenses.**  *Inorder to manage and maximize our growth, we have been increasing ourprofessional staff and related infrastructure, which has resulted in increasedgeneral and administrative expenses. Primarily as a result of these costs andcertain non-recurring costs incurred in the quarter and an increase in non-cashFAS 123R share-based compensation expense, our general and administrativeexpenses increased from $4.88 per BOE in 2006 to $6.16 per BOE in thefirst quarter of 2007. While we expect our overall general and administrativeexpenses to be higher in 2007 than 2006, on a per BOE basis, we expect that thoseexpenses, excluding expenses relating to FAS 123R and capitalized generaland administrative expenses, will decline in 2007 relative to 2006. As withproduction expenses, our expectations in this regard are based in part on ourprojected increases in production, which are subject to numerous risks anduncertainties. In addition, we have not to date fully quantified the expenses weexpect to incur with respect to Sarbanes-Oxley Act compliance, and thoseexpenses may be significant.

*South Ellwood deliveryarrangements.*   We recently entered intoagreements pursuant to which we expect to be able to deliver shipments of oilproduction from our South Ellwood field to Long Beach, California andthen transport the production via pipeline for sale to any of severalrefineries in the Long Beach area. Subject to our ability to enter into anacceptable sales agreement with any of the available refineries, receipt ofnecessary permits and the resolution of any logistical or operating issues thatmay arise, we expect to begin making deliveries pursuant to the arrangement in June 2007.We expect that the new arrangement will provide a more competitive environmentfor sales of our production and will ultimately enable us to obtain pricing comparableto the pricing we received historically.

*Unrealized CommodityDerivative Gains and Losses.**  *Rising oil and natural gas prices created substantialunrealized commodity derivative losses in the first quarter of 2007, whilefluctuating oil prices and lower natural gas prices led to unrealized commodityderivative gains in 2006. These unrealized gains and losses resulted frommark-to-market valuations for non-highly effective or ineffective portions ofour derivative positions and are reflected as unrealized commodity derivativegains or losses in our income statement. Payments actually due to or fromcounterparties in the future on these derivatives will typically be offset bycorresponding changes in prices ultimately received from the sale of ourproduction. We may incur significant gains or losses of this type for theremainder of 2007 and in subsequent years. As described in note 4 to the condensedconsolidated financial statements included in this report, we have discontinuedhedge accounting as of April 1, 2007. This may increase volatility ingains and losses of this type in subsequent periods.

***Internal ControlOver Financial Reporting***

In November 2005, werestated the financial statements included in our Quarterly Reports on Form 10-Qfor the first two quarters of 2005. In addition, we have historically operatedwith a relatively small number of employees in the accounting and financialreporting area. If we had previously conducted an assessment of our internalcontrols under the standards set forth in Section 404 of the Sarbanes-OxleyAct and related rules, either or both of these factors likely would have led usto conclude that we had one or more material weaknesses in our internalcontrols. In addition, our outside auditors, in the performance of their 2005and 2006 audits, concluded that it was likely that material weaknesses existed inour internal controls in 2005 and 2006. We have taken a variety of actions toaddress these issues, including the adoption of more extensive accountingcontrols and financial review procedures and the hiring of additionalaccounting staff. A substantial part of our efforts in this regard in 2006focused on the design of a more comprehensive system of internal controls. Ourefforts during 2007 will focus on refining the design of our controls and onthe implementation and testing of this system.

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***Results of Operations***

Thefollowing table reflects the components of our oil and natural gas productionand sales prices and sets forth our operating revenues, costs and expenses on aBOE basis for the quarters ended March 31, 2006 and 2007.

| ** **                                   | ** ** | **Quarter Ended March 31,** | ** ** |
|----------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                   | ** ** | **2006**                                   | ** ** | **2007** | ** ** |
| **Production Volume:**                       | ** ** |                                       | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Natural gas (MMcf)                           |       |                                       | 1,862      |   |   |   | 4,244 |   |   |
| Oil (MBbls)                                  |       |                                       | 699        |   |   |   | 883 |   |   |
| MBOE                                         |       |                                       | 1,009      |   |   |   | 1,590 |   |   |
| **Daily Average Production Volume:**         | ** ** |                                       | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Natural gas (Mcf/d)                          |       |                                       | 20,689     |   |   |   | 47,156 |   |   |
| Oil (Bbls/d)                                 |       |                                       | 7,767      |   |   |   | 9,811 |   |   |
| BOE/d                                        |       |                                       | 11,215     |   |   |   | 17,670 |   |   |
| **Oil Price per Bbl Produced (in dollars):** | ** ** |                                       | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Realized price before hedging gain (loss)    |       |                                       | $          | 51.87 |   |   |   | $ | 49.26 |   |   |
| Realized hedging gain (loss)                 |       |                                       | (8.12      | ) |   |   | 0.35 |   |   |
| Net realized                                 |       |                                       | $          | 43.75 |   |   |   | $ | 49.61 |   |   |
| **Natural Gas Price per Mcf (in dollars):**  | ** ** |                                       | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Realized price before hedging loss           |       |                                       | $          | 7.60 |   |   |   | $ | 7.12 |   |   |
| Realized hedging loss                        |       |                                       | (0.21      | ) |   |   | (0.03 | ) |   |
| Net realized                                 |       |                                       | $          | 7.39 |   |   |   | $ | 7.09 |   |   |
| **Average Sale Price per BOE**               |       |                                       | $          | 45.82 |   |   |   | $ | 45.54 |   |   |
| **Expense per BOE:**                         | ** ** |                                       | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Production expenses(1)                       |       |                                       | $          | 12.21 |   |   |   | $ | 15.78 |   |   |
| Transportation expenses                      |       |                                       | 0.80       |   |   |   | 1.18 |   |   |
| Depreciation, depletion and  amortization    |       |                                       | 6.63       |   |   |   | 12.96 |   |   |
| General and administrative  expense(2)       |       |                                       | 4.37       |   |   |   | 6.16 |   |   |
| Interest  expense, net                       |       |                                       | 3.74       |   |   |   | 8.38 |   |   |

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(1)          Production expenses arecomprised of oil and natural gas production expenses and production taxes.

(2)          Netof amounts capitalized.

***Comparison of Quarter Ended March 31, 2007 toQuarter Ended March 31, 2006***

*Oiland Natural Gas Revenues.**  *Oil and natural gas revenues increased$22.4 million (44%) to $73.6 million for the quarter ended March 31,2007 from $51.3 million for the same period in 2006. The increase was primarily due to productionattributable to the TexCal acquisition and increased natural gas productionfrom our legacy properties, partially offset by slightly lower average realizedoil and natural gas prices.

Oil revenues increased by $6.3 million in thefirst quarter of 2007 (17%), to $43.4 million compared to$37.1 million in the first quarter of 2006. Oil production rose 26%, withproduction of 883 MBbl in the first quarter of 2007 compared to 699 MBbl in thefirst quarter of 2006. The productionincrease was attributable to the TexCal properties, partially offset by a 9%decline in production volumes from other Venoco properties. The productiondecline for the other Venoco properties primarily resulted from a temporaryshut-in of production at the South Ellwood field due to a disruption in barge deliveriesfrom the field. Our average realized price for oil decreased $2.61 (5%),to $49.26 per Bbl for the period. We hedged 83% of our oil production duringthe period resulting in realized hedging gains of $0.35 per Bbl.

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Natural gas revenues increased $16.1 million inthe first quarter of 2007 (114%) to $30.2 million compared to$14.2 million in the first quarter of 2006. Natural gas productionincreased 128%, with production of 4,244 MMcf compared to 1,862 MMcf in the firstquarter of 2006. The majority of theincrease was due to production attributable to the TexCal acquisition.Approximately 35% of the increase resulted from increased production from otherVenoco properties. The increased production from other Venoco propertiesrelates to our ongoing field development activities. Our averagerealized price for natural gas decreased $0.48 (6%) to $7.12 per Mcf for theperiod. We hedged 54% of our natural gas production during the period,resulting in realized hedging losses of $0.03 per Mcf.

*CommodityDerivatives and Other Revenues.**  *Total commodity derivative lossesincreased $3.1 million (20%) from $15.6 million in the first quarterof 2006 to $18.7 million in the first quarter of 2007. Realized commodityderivative gains were $0.2 million in the first quarter of 2007 comparedwith realized losses of $4.3 million in the same period in 2006.Amortization of derivative premiums increased $0.1 million, from$1.8 million in the first quarter of 2006 to $1.9 million in the sameperiod in 2007. Unrealized commodity derivative losses were $17.0 millionin the first quarter of 2007, compared to net unrealized losses of$9.5 million in the same period in 2006. The changes in commodityderivative gains (losses) are due to the effect changes in market prices of oiland natural gas have on our net sales, in the case of realized losses, and theeffect of mark to market pricing adjustments on the carrying value of ourderivative positions, in the case of unrealized losses. The increase in totalcommodity derivative losses in the first quarter of 2007 was caused by theincreases in commodity prices that occurred during the quarter relative to ourderivative positions. Other revenue decreased 53%, from $1.7 million inthe first quarter of 2006 to $0.8 million in the first quarter of 2007.The decrease was primarily due to lower transportation income received frompurchasers of oil production from the South Ellwood field.

As a result of the foregoing factors, total revenuesincreased $18.3 million (49%) to $55.7 million in the first quarterof 2006, compared to $37.4 million in the first quarter of 2006.

*ProductionExpenses.**  *Productionexpenses increased $12.8 million (104%) to $25.1 million in the firstquarter of 2007 from $12.3 million in the first quarter of 2006. The increase was primarily due to productionexpenses attributable to the TexCal acquisition and a 29% increase inproduction expenses from other Venoco properties. The increase in productionexpenses for other Venoco properties relates to an increase in the number ofproducing wells, normal variances of timing of production expenses, includingexpenses relating to periodic maintenance projects which continued into thefirst quarter of 2007, and increased costs of third party services. On aper unit basis, production expenses rose to $15.78 per BOE in the first quarterof 2007 compared to $12.21 per BOE in the same period in 2006. A significant part of this increase wasattributable to remedial work projects performed in the Hastings complex thatbegan in mid-2006. Per unit production expenses attributable to theTexCal properties rose from $14.02 per BOE in 2006 to $18.04 per BOE in thefirst quarter of 2007 primarily as a result of those projects. In addition,production expenses for other Venoco properties increased 20% on a per unitbasis in the first quarter of 2007 primarily as a result of lower production fromthe South Ellwood field due to a temporary disruption in barge deliveries andadditional maintenance work that was performed during the shut-in period.

*TransportationExpenses.**  *Transportationexpenses increased 133%, from $0.8 million in the first quarter of 2006 to $1.9million in the first quarter of 2007. This was primarily attributable toincreased transportation costs for barge deliveries. On a per BOE basis,transportation expenses increased $0.38 per BOE, from $0.80 per BOE in thefirst quarter of 2006 to $1.18 per BOE in the first quarter of 2007.

*Depletion,Depreciation and Amortization (DD&A).**  *DD&A expense increased$13.9 million (208%) to $20.6 million in the first quarter of 2007from $6.7 million in the first quarter of 2006. DD&A expense rose$6.33 per BOE, from $6.63 per BOE in the first quarter of 2006 to $12.96 perBOE in the first quarter of 2007. Theincrease was primarily due to a higher depletion expense resulting from theincrease in the oil and natural gas properties obtained in the TexCalacquisition and an increase in future development costs.

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*Accretionof Abandonment Liability.**  *Accretion expense was $0.8 million in the firstquarter of 2007 compared to $0.5 million in the first quarter of 2006. The increase was due to accretion from theacquired TexCal properties and from new wells drilled and completed in 2006.

*Generaland Administrative (G&A).**  *G&A expense increased $5.4 million(122%), to $9.8 million in the first quarter of 2007 from$4.4 million in the first quarter of 2006. The increase resulted primarilyfrom increases in our professional staff andrelated infrastructure resulting from the March 31, 2006 acquisition ofTexCal and other growth. Other significant increases in general and administrativeexpenses in the first quarter of 2007 relate to a non-recurring charge of$0.7 million attributable to a settlement of an employment contract and anincrease in non-cash FAS 123R share-based compensation expense from$0.6 million in the first quarter of 2006 to $1.1 million in thefirst quarter of 2007.

*InterestExpense and Amortization of Deferred Loan Costs.**  *Interest expense, net of interestincome and capitalized interest, increased $9.6  million (253%), to$13.3 million in the first quarter of 2007 from $3.8 million in thefirst quarter of 2006. The changes wereprimarily due to debt incurred in late March 2006 to acquire TexCal.

*Incometax expense.**  *Thenet loss in the first quarter of 2007 resulted in an income tax benefit of $6.6million compared to income tax expense of $3.5 million for the first quarter of2006. Our effective tax rate decreased from40.0% in the first quarter of 2006 to 39.3% in the first quarter of 2007 due toan increase of business activity in lower taxing jurisdictions.

*Net Income.**  **The net loss*for the first quarterof 2007 was $10.4 million compared to net income of $5.1 million for thesame period in 2006. The change between periods is the result of the itemsdiscussed above.

**Liquidity andCapital Resources**

Our primary sources ofliquidity are cash generated from our operations and amounts available underour revolving credit facility.

***Cash Flows***

| ** **                             | ** ** | **Quarter Ended March 31,** | ** ** |
|----------------------------------------|------------|--------------------------------------------|------------|
| ** **                             | ** ** | **2006**                                   | ** ** | **2007** | ** ** |
| ** **                             | ** ** | **(in thousands)**                    | ** ** |
| Cash provided by  operating activities |       | $                                          | 28,053     |   | $ | 33,691 |   |
| Cash used in  investing activities     |       | (472,129                                   | )          | (77,788 | ) |
| Cash provided by financing  activities |       | 449,172                                    |       | 41,953 |   |
|                                        |            |                                            |            |  |  |  |  |

 

Net cash provided by operating activities was $33.7million in the first quarter of 2007 compared with $28.0 million in the firstquarter of 2006. Cash flows from operatingactivities in the first quarter of 2007 were favorably impacted by productionattributable to the TexCal acquisition.

Net cash used in investing activities was $77.8million in the first quarter of 2007 compared with $472.1 million in the firstquarter of 2006. The primary investing activities in the first quarter of 2007include $75.9 million in expenditures for oil and gas properties. The primaryinvesting activities in the first quarter of 2006 include $445.5 million paidin cash to acquire TexCal (net of TexCal cash) and $28.8 million inexpenditures for oil and gas properties, net of accrued capital expenditures of$2.0 million.

Net cash provided byfinancing activities was $42.0 million in the first quarter of 2007 compared to$449.2 million in the first quarter of 2006. The primary financing activitiesin the first quarter of 2007 were borrowings under the Company’s revolvingcredit facility to fund capital expendituresand working capital needs. Proceeds from long-term debt in the firstquarter of 2006 included $350.0 million borrowed under 

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the termloan facility and $119.5 million borrowed under the revolving credit facility,which amounts were used to fund the acquisition of TexCal and $13.8 million inloan costs.

***Capital Resources and Requirements***

We plan to make substantial capital expenditures inthe future for the acquisition, exploration, exploitation and development ofoil and natural gas properties. We expect that our exploration, exploitationand development capital expenditures in 2007 will be approximately $230.0million, of which we spent $70.1 million in the first quarter of the year.We completed two acquisitions in the second quarter of 2007 for an aggregatepurchase price of approximately $105.9 million and will continue to pursueacquisition opportunities on an opportunistic basis. We intend to finance ourcapital expenditures in 2007 primarily with cash flow from operations,supplemented with additional borrowings under our revolving credit facility. Asof May 11, 2007, approximately $70.0 million was outstanding under therevolving credit facility, which had a borrowing base of $125.0 million as ofthat date. We may also engage in additional financing transactions in order tosupplement our capital budget, to restructure or refinance indebtedness or tocomplete acquisitions.

On May 7, 2007, we entered into a new second lien termloan agreement to refinance and replace our existing second lien term loanfacility. We entered into the new term loan agreement to facilitate thefinancing of the West Montalvo and Manvel acquisitions and to amend certaincovenants included in the agreement governing the existing second lien termloan facility. We borrowed $500.0 million pursuant to the new term loanagreement on May 8, 2007. Of the total amount borrowed, $350.5 million wasused to repay all amounts outstanding under the existing second lien term loanfacility plus accrued interest, $3.5 million was used to pay a prepaymentpremium on those amounts and $4.6 million was used to pay transaction costsassociated with the new facility. The remaining borrowings were used to reduceamounts outstanding under the revolving credit facility. Loans made under thenew term loan agreement are designated, at our option, as either “Base RateLoans” or “LIBO Rate Loans.” Base Rate Loans bear interest at a floating rateequal to (i) the greater of the overnight federal funds rate plus 0.50%and the administrative agent’s announced base rate, plus (ii) 3.00%. LIBORate Loans bear interest at LIBOR plus 4.00%. The new term loan agreementcontains customary representations, warranties, events of default, indemnitiesand covenants, including covenants that restrict the company’s ability to incuradditional indebtedness. The covenants and other terms of the agreement containexceptions that are intended to permit us to form a master limited partnershipand certain related entities (collectively, the “partnership”), to contributeassets to the partnership, to sell securities of the partnership and to causethe partnership to incur indebtedness and issue securities, subject in eachcase to the satisfaction of certain requirements. The agreement requires us tomaintain derivative contracts covering at least 70% of our projected proveddeveloped producing oil and natural gas production through May 8, 2010, and atleast 50% of such production on an annual basis thereafter. We cannot, however,enter into derivative contracts covering more than 80% of such oil and gasproduction in any month. The agreement also prohibits us from paying dividendson our common stock.

Also on May 7, 2007, we entered into a fifthamendment to the second amended and restated credit agreement governing ourrevolving credit facility. The principal effects of the amendment are (i) topermit us to enter into the new term loan agreement, (ii) to reduce theborrowing base under the revolving credit facility to $125.0 million and (iii) tochange the rate at which amounts outstanding under the revolving creditagreement accrue interest. Pursuant to the amendment, Base Rate Loans under therevolving credit facility bear interest at a floating rate equal to (i) thegreater of Bank of Montreal’s announced base rate and the overnight federalfunds rate plus 0.50% plus (ii) an applicable margin ranging from zero to0.75%, based upon utilization. LIBO Rate Loans under the revolving creditfacility bear interest at (i) LIBOR plus (ii) an applicable margin rangingfrom 1.50% to 2.25%, based upon utilization. A commitment fee ranging from0.375% to 0.5% per annum is payable with respect to unused borrowingavailability under the facility.

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Principal on the revolving credit facility is payableon March 30, 2009. The agreement governing the facility contains customaryrepresentations, warranties, events of default, indemnities and covenants,including operational covenants that restrict our ability to incur indebtednessand financial covenants that require us to maintain specified ratios of EBITDA (asdefined in the agreement) to interest expense, current assets to currentliabilities, debt to EBITDA and PV-10 to total debt. The ratios requiredto be met in order to remain in compliance with our financial covenants changeat specified times over the duration of the loans. On March 31, 2007, therequired ratio of EBITDA to interest expense changed from 2.5:1 to 3:1 and themaximum permitted ratio of debt to EBITDA changed from 4.5:1 to 4:1. Thesecovenant levels will remain in effect until September 30, 2007, at whichtime new EBITDA to interest expense and debt to EBITDA ratios come into effectthat will require higher levels of financial performance and/or reducedindebtedness.

The new term loan agreement and the agreementgoverning the revolving credit facility will require us to reduce amountsoutstanding under the revolving credit facility and/or make offers to prepayamounts outstanding under the second lien term loan facility with the proceedsof certain transactions or events, including sales of assets, in certaincircumstances. Amounts prepaid under the new term loan facility may not bereborrowed.

As of May 11, 2007, amounts outstanding under thecredit facilities bore interest at a weighted average interest rate of 9.22%.Our debt service obligations under the credit facilities may increase if marketinterest rates rise. See “—Quantitative and Qualitative Disclosures AboutMarket Risk.”

We issued $150.0 million of our senior notes in December 2004.The notes bear interest at 8.75% per year and will mature on December 15,2011. The notes are guaranteed by all of our subsidiaries other than EllwoodPipeline, Inc. and are secured with the new second lien term loan on anequal and ratable basis.

We may redeem the notes after December 15, 2008,initially at a redemption price equal to 104.375% of the principal amount. Inaddition, before December 15, 2008, we may redeem all or part of the notesat a specified “make-whole” price, and before December 15, 2007, we mayredeem up to 35% of the notes with the net proceeds of certain public orprivate equity offerings at a redemption price of 108.75% of the principalamount of the notes. Upon the occurrence of a change of control of our company,each holder of notes may require us to repurchase all or a portion of its notesfor cash at a price equal to 101% of the aggregate principal amount of thosenotes, plus any accrued and unpaid interest. The indenture governing the notesalso contains operational covenants that, among other things, limit our abilityto make investments, incur additional indebtedness or create liens on ourassets.

Because we must dedicate asubstantial portion of our cash flow from operations to the payment of intereston our debt, that portion of our cash flow is not available for other purposes.Our ability to make scheduled interest payments on our indebtedness and pursueour capital expenditure plan will depend to a significant extent on ourfinancial and operating performance, which is subject to prevailing economicconditions, commodity prices and a variety of other factors. If our cash flowand other capital resources are insufficient to fund our debt serviceobligations and our capital expenditure budget, we may be forced to reduce ordelay scheduled capital projects, sell material assets or operations orrestructure our debt. If cash flow from operations does not meet ourexpectations, we may reduce the expected level of capital expenditures and/orfund a portion of the expenditures using borrowings under our revolving creditfacility or other sources. If we seek additional capital to pursue our capitalexpenditure plan, make acquisitions or for other reasons, we may do so throughtraditional reserve base borrowings, joint venture partnerships, asset sales,offerings of debt and equity securities or other means. Needed capital may notbe available on acceptable terms or at all. Our ability to raise funds throughthe incurrence of additional indebtedness and certain other means is limited bycovenants in our debt agreements. In addition, pursuant to the mandatoryprepayment provisions in our credit facilities described above, our ability torespond to a shortfall in our expected liquidity by selling assets or incurringadditional indebtedness would be limited by provisions in 

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thefacilities that require us to use some or all of the proceeds of suchtransactions to reduce amounts outstanding under one or both of the facilitiesin some circumstances. If we are unable to obtain funds when needed and onacceptable terms, we may not be able to complete acquisitions that may befavorable to us or finance the capital expenditures necessary to replace ourreserves.

**Item 3.**                        Quantitativeand Qualitative Disclosures About Market Risk

The discussion in this section provides informationabout derivative financial instruments we use to manage commodity pricevolatility. Due to the historical volatility of crude oil and natural gasprices, we have implemented a hedging strategy aimed at reducing thevariability of the prices we receive for our production and providing a minimumrevenue stream. Currently, we purchase puts, sell calls and enter into otherderivative transactions such as collars and fixed price swaps in order to hedgeour exposure to changes in commodity prices. All contracts are settled withcash and do not require the delivery of a physical quantity to satisfysettlement. While this hedging strategy may result in us having lower revenuesthan we would have if we were unhedged in times of higher oil and natural gasprices, management believes that the stabilization of prices and protectionafforded us by providing a revenue floor on a portion of our production isbeneficial. We had hedging contracts in place for approximately 83% of our oilproduction and approximately 54% of our natural gas production for the quarterended March 31, 2007.

We are subject to interestrate risk with respect to amounts borrowed under our credit facilities becausesuch amounts bear interest at variable rates. As of May 11, 2007, therewas approximately $570 million outstanding under those facilities. In May 2006,we entered into an interest rate swap transaction to lock in our interest coston $200.0 million of borrowings at a fixed rate of 9.4225%, including a 4.0%margin, through May 2008. A 1.0% increase in interest rates on unhedgedvariable rate borrowings of $370 million at March 31, 2007 wouldresult in additional annualized interest expense of $3.7 million.

**Cumulative Effectof Derivative Transactions**

*Oil.*   Asof March 31, 2007, we had entered into option (including collar)agreements to receive average minimum and maximum NYMEX West Texas Intermediateprices as summarized below. Location and quality differentials attributable toour properties are not reflected in those prices. The agreements provide formonthly settlement based on the differential between the agreement price andthe actual NYMEX crude oil price.

| ** **                                                    | ** ** | **Minimum**     | ** ** | **Maximum**          | ** ** |
|---------------------------------------------------------------|------------|-----------------|------------|----------------------|------------|
| ** **                                                    | ** ** | **Barrels/day** | ** ** | **Avg. Prices** | ** ** | **Barrels/day** | ** ** | **Avg. Prices** | ** ** |
| Crude oil derivatives at  March 31, 2007 for production: |       |            |       |                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| April 1—December 31,  2007                     |       |            | 9,219      |                 |       |   | $ | 51.26 |   |   |   | 8,098 |   |   |   | $ | 72.16 |   |   |
| January 1—December 31,  2008                   |       |            | 7,450      |                 |       |   | $ | 58.73 |   |   |   | 7,450 |   |   |   | $ | 72.65 |   |   |
| January 1—December 31,  2009                   |       |            | 6,580      |                 |       |   | $ | 57.97 |   |   |   | 6,580 |   |   |   | $ | 73.87 |   |   |
| January 1—December 31,  2010                   |       |            | 5,500      |                 |       |   | $ | 61.23 |   |   |   | 5,500 |   |   |   | $ | 71.83 |   |   |

 

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*Natural Gas.**  *As of March 31, 2007, we hadentered into option, swap and collar agreements to receive average minimum andmaximum PG&E Citygate prices as follows:

| ** **                                                      | ** ** | **Minimum**   | ** ** | **Maximum**          | ** ** |
|-----------------------------------------------------------------|------------|---------------|------------|----------------------|------------|
| ** **                                                      | ** ** | **MMBtu/Day** | ** ** | **Avg. Prices** | ** ** | **MMBtu/Day** | ** ** | **Avg. Prices** | ** ** |
| Natural gas derivatives  at March 31, 2007 for production: |       |          |       |                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| April 1—December 31,  2007                       |       |          | 32,500     |                 |       |   | $ | 7.13 |   |   |   | 26,894 |   |   |   | $ | 10.59 |   |   |
| January 1—December 31,  2008                     |       |          | 19,200     |                 |       |   | $ | 7.56 |   |   |   | 17,647 |   |   |   | $ | 11.14 |   |   |
| January 1—December 31,  2009                     |       |          | 13,500     |                 |       |   | $ | 7.63 |   |   |   | 13,500 |   |   |   | $ | 11.54 |   |   |
| January 1—December 31,  2010                     |       |          | 11,000     |                 |       |   | $ | 7.20 |   |   |   | 11,000 |   |   |   | $ | 10.44 |   |   |

 

**Portfolio ofDerivative Transactions**

Ourportfolio of commodity derivative transactions as of March 31, 2007 issummarized below:

**Oil**

| **Type of  Contract** | ** ** | ** ** | ** ** | **Basis** | ** ** | **Quantity  (Bbl/d)** | ** ** | **Strike Price ($/Bbl)** | ** **   | **Term**     | ** ** |
|----------------------------|------------|------------|------------|-----------|------------|-----------------------|------------|------------------------------------|--------------|--------------|------------|
| Collar                     |       | NYMEX      |       |      | 2,000      |                  |       |                               | $            | 40.00/$65.80 |       |   | Jan  1—Dec 31, 07 |   |
| Collar                     |       | NYMEX      |       |      | 1,000      |                  |       |                               | $            | 40.00/$67.50 |       |   | Jan  1—Dec 31, 07 |   |
| Collar                     |       | NYMEX      |       |      | 1,000      |                  |       |                               | $            | 58.00/$76.25 |       |   | Jan  1—Dec 31, 07 |   |
| Collar                     |       | NYMEX      |       |      | 1,600      |                  |       |                               | $            | 53.00/$75.00 |       |   | Jan  1—Jun 30, 07 |   |
| Collar                     |       | NYMEX      |       |      | 1,030      |                  |       |                               | $            | 53.00/$75.00 |       |   | Jul  1—Dec 31, 07 |   |
| Put(1)                     |       | NYMEX      |       |      | 2,000      |                  |       |                               | $58.00 Floor |         |       | Jan  1—Dec 31, 07 |   |
| Call(2)                    |       | NYMEX      |       |      | 566        |                  |       |                               | $77.15 Cap   |         |       | Jan  1—Jun 30, 07 |   |
| Collar                     |       | NYMEX      |       |      | 2,000      |                  |       |                               | $            | 57.00/$73.55 |       |   | Apr  1—Dec 31, 07 |   |
| Call(3)                    |       | NYMEX      |       |      | 1,035      |                  |       |                               | $81.00 Cap   |         |       | Jul  1—Dec 31, 07 |   |
| Collar                     |       | NYMEX      |       |      | 3,450      |                  |       |                               | $            | 52.00/$75.00 |       |   | Jan  1—Jun 30, 08 |   |
| Collar                     |       | NYMEX      |       |      | 2,450      |                  |       |                               | $            | 52.00/$75.00 |       |   | Jul  1—Dec 31, 08 |   |
| Collar                     |       | NYMEX      |       |      | 1,000      |                  |       |                               | $            | 58.00/$78.00 |       |   | Jul  1—Dec 31, 08 |   |
| Collar                     |       | NYMEX      |       |      | 1,500      |                  |       |                               | $            | 58.00/$75.25 |       |   | Jan  1—Dec 31, 08 |   |
| Swap                       |       | NYMEX      |       |      | 2,500      |                  |       |                               | $67.25       |         |       | Jan  1—Dec 31, 08 |   |
| Collar                     |       | NYMEX      |       |      | 2,170      |                  |       |                               | $            | 50.00/$75.00 |       |   | Jan  1—Jun 30, 09 |   |
| Collar                     |       | NYMEX      |       |      | 1,000      |                  |       |                               | $            | 56.00/$79.25 |       |   | Jul  1—Dec 31, 09 |   |
| Collar                     |       | NYMEX      |       |      | 3,000      |                  |       |                               | $            | 55.00/$77.00 |       |   | Jan  1—Dec 31, 09 |   |
| Swap                       |       | NYMEX      |       |      | 2,000      |                  |       |                               | $67.22       |         |       | Jan  1—Dec 31, 09 |   |
| Collar                     |       | NYMEX      |       |      | 1,000      |                  |       |                               | $            | 60.00/$72.80 |       |   | Jan  1—Dec 31, 10 |   |
| Collar                     |       | NYMEX      |       |      | 3,500      |                  |       |                               | $            | 60.00/$73.00 |       |   | Jan  1—Dec 31, 10 |   |
| Swap                       |       | NYMEX      |       |      | 1,000      |                  |       |                               | $66.75       |         |       | Jan 1—Dec 31, 10 |   |

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(1)          Option premium deferreduntil each month’s settlement period ($3,087,900 total deferred).

(2)          Option premium deferreduntil each month’s settlement period ($405,409 total deferred).

(3)          Option premium deferreduntil each month’s settlement period ($754,206 total deferred).

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**NaturalGas**

| **Type of  Contract** | ** ** | ** **         | ** ** | **Basis** | ** ** | **Quantity  (MMBtu/d)** | ** ** | **Strike Price  ($/MMBtu)** | ** **  | **Term**               | ** **             |
|----------------------------|------------|--------------------|------------|-----------|------------|-------------------------|------------|----------------------------------|-------------|------------------------|------------------------|
| Collar                     |       | Citygate           |       |      | 6,000      |                    |       | $6.00/$8.40                      |        | Jan  1—Dec 31, 07 |                   |
| Collar                     |       | NYMEX              |       |      | 5,000      |                    |       | $                                | 8.00/$14.60 |                   | Jan  1—Dec 31, 07 |   |
| Put(1)                     |       | NYMEX              |       |      | 10,000     |                    |       | $                                | 7.985 Floor |                   | Jan  1—Dec 31, 07 |   |
| Call(2)                    |       | NYMEX              |       |      | 4,564      |                    |       | $12.15 Cap                       |        | Jan  1—Jun 30, 07 |                   |
| Call(3)                    |       | NYMEX              |       |      | 4,310      |                    |       | $11.95 Cap                       |        | Jul  1—Dec 31, 07 |                   |
| Basis Swap                 |       | PG&E  Citygate |       |      | 10,000     |                    |       | $(0.58)                          |        | Jan  1—Dec 31, 07 |                   |
| Basis Swap                 |       | PG&E  Citygate |       |      | 10,000     |                    |       | $(0.46)                          |        | Jan  1—Dec 31, 07 |                   |
| Collar(7)                  |       | NYMEX              |       |      | 11,500     |                    |       | $                                | 7.50/$10.35 |                   | Apr  1—Dec 31, 07 |   |
| Put(4)                     |       | NYMEX              |       |      | 6,000      |                    |       | $8.00 Floor                      |        | Jan  1—Dec 31, 08 |                   |
| Call(5)                    |       | NYMEX              |       |      | 4,513      |                    |       | $12.15 Cap                       |        | Jan  1—Jun 30, 08 |                   |
| Call(6)                    |       | NYMEX              |       |      | 4,382      |                    |       | $10.60 Cap                       |        | Jul  1—Dec 31, 08 |                   |
| Collar                     |       | NYMEX              |       |      | 7,500      |                    |       | $                                | 8.00/$12.75 |                   | Jan  1—Dec 31, 08 |   |
| Collar(8)                  |       | NYMEX              |       |      | 5,700      |                    |       | $                                | 7.75/$10.05 |                   | Jan  1—Dec 31, 08 |   |
| Basis Swap                 |       | PG&E  Citygate |       |      | 10,000     |                    |       | $(0.32)                          |        | Jan  1—Dec 31, 08 |                   |
| Basis Swap                 |       | PG&E  Citygate |       |      | 10,000     |                    |       | $(0.38)                          |        | Jan  1—Dec 31, 08 |                   |
| Swap                       |       | NYMEX              |       |      | 1,250      |                    |       | $8.72 Fixed                      |        | Jan  1—Jun 30, 09 |                   |
| Collar                     |       | NYMEX              |       |      | 1,250      |                    |       | $                                | 7.75/$13.05 |                   | Jan  1—Jun 30, 09 |   |
| Swap                       |       | NYMEX              |       |      | 1,250      |                    |       | $8.00 Fixed                      |        | Jul  1—Dec 31, 09 |                   |
| Collar                     |       | NYMEX              |       |      | 1,250      |                    |       | $                                | 7.25/$11.30 |                   | Jul  1—Dec 31, 09 |   |
| Collar                     |       | NYMEX              |       |      | 7,000      |                    |       | $                                | 7.50/$12.75 |                   | Jan  1—Dec 31, 09 |   |
| Basis Swap                 |       | PG&E  Citygate |       |      | 6,000      |                    |       | $0.10                            |        | Jan  1—Dec 31, 09 |                   |
| Basis Swap                 |       | PG&E  Citygate |       |      | 7,500      |                    |       | $0.11                            |        | Jan  1—Dec 31, 09 |                   |
| Collar(9)                  |       | NYMEX              |       |      | 4,000      |                    |       | $7.30/$9.85                      |        | Jan  1—Dec 31, 09 |                   |
| Collar                     |       | NYMEX              |       |      | 10,000     |                    |       | $                                | 7.00/$10.35 |                   | Jan  1—Dec 31, 10 |   |
| Basis Swap                 |       | PG&E  Citygate |       |      | 10,000     |                    |       | $0.22                            |        | Jan  1—Dec 31, 10 |                   |
| Collar(10)                 |       | NYMEX              |       |      | 1,000      |                    |       | $7.00/$9.10                      |        | Jan 1—Dec 31, 10  |                   |

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       (1) Option premium deferred until each month’s settlement period($3,650,000 total deferred).

       (2) Option premium deferred until each month’s settlement period($776,465 total deferred).

       (3) Option premium deferred until each month’s settlement period($745,445 total deferred).

       (4) Option premium deferred until each month’s settlement period($2,755,980 total deferred).

       (5) Option premium deferred until each month’s settlement period($928,153 total deferred).

       (6) Option premium deferred until each month’s settlement period($911,203 total deferred).

       (7) Option premium deferred until each month’s settlement period($790,625 total deferred).

       (8) Option premium deferred until each month’s settlement period($520,125 total deferred).

       (9) Option premium deferred until each month’s settlement period($365,000 total deferred).

(10) Option premium deferred until each month’s settlement period($91,250 total deferred).

We enter into derivative contracts, primarily collars,swaps and option contracts, to hedge future crude oil and natural gasproduction in order to mitigate the risk of market price fluctuations. Theobjective of our hedging activities and the use of derivative financialinstruments is to achieve more predictable cash flows. Our hedging activitiesmitigate our exposure to price declines and therefore 

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increase the likelihoodthat we will be able to continue to execute our capital plan if prices decline.Our collar and swap contracts, however, prevent us from receiving the fulladvantage of increases in oil or natural gas prices above the maximum fixedamount specified in the hedge agreement. Also, if production is less than theamount we have hedged and the price of oil or natural gas exceeds a fixed pricein a hedge contract, we will be required to make payments against which thereare no offsetting sales of production. This could cause us to incur losses andcould impact our ability to fund future capital expenditures. In addition, wehave incurred, and may incur in the future, substantial unrealized commodityderivative losses in connection with our hedging activities, although we do notexpect such losses to have a material effect on our ability to fund expectedcapital expenditures. Finally, the use of derivatives involves the risk thatthe counterparties to such instruments will be unable to meet the financialterms of such contracts.

In order to qualify for hedge accounting, therelationship between the hedging instrument and the hedged item must be highlyeffective in achieving the offset of changes in cash flows attributable to thehedged risk both at the inception of the contract and on an ongoing basis. Wemeasure effectiveness on a quarterly basis. Hedge accounting is discontinuedprospectively when a hedge instrument is no longer considered highly effective.

All derivative instrumentsare recorded on the balance sheet at fair value. Fair value is generallydetermined based on the difference between the fixed contract price and theunderlying market price at the determination date, and/or confirmed by thecounterparty. Changes in the fair value of the effective portion of the cash flowhedges are recorded as a component of accumulated other comprehensive income(loss), which is later transferred to the income statement as a component ofcommodity derivative income (loss) when the hedged transaction occurs. Changesin the fair value of derivatives that do not qualify as a hedge or are notdesignated as a hedge, as well as the ineffective portion of hedge derivatives,are recorded in commodity derivative income (loss) on the income statement. Wedetermine hedge ineffectiveness based on changes during the period in the pricedifferentials between the index price of the derivative contracts (which uses aNYMEX index in the case of oil hedges, and NYMEX and PG&E Citygate in thecase of natural gas hedges) and the contract price for the point of sale forthe cash flow that is being hedged. Hedge ineffectiveness occurs only if thecumulative gain or loss on the derivative hedging instrument exceeds thecumulative change in the expected future cash flows on the hedged transaction.Ineffectiveness is recorded in earnings to the extent the cumulative changes infair value of the actual derivative exceed the cumulative changes in fair valueof the hypothetical derivative. As described in note 4 to the condensedconsolidated financial statements included in this report, we have discontinuedhedge accounting as of April 1, 2007.

**Changes in FairValue**

Thefair value of outstanding oil and natural gas commodity derivative instrumentsand the change in fair value that would be expected from a $5.00 per Bblincrease in the price of oil and a $1.00 per MMBtu increase in the price ofnatural gas are shown in the table below (in millions):

| ** **                                                                                                                    | ** ** | **March 31, 2007** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|
| ** **                                                                                                                    | ** ** | **Fair Value**          | ** ** | **Effect of  $5.00/Bbl and  $1.00/MMbtu  Price Increases** | ** ** |
| Effective portion  of derivatives designated as cash flow hedges                                                              |       |                         | $          | (7.5 | ) |   |   | $ | (15.2 | ) |   |
| Derivatives not  designated as hedging instruments and the ineffective portion of derivatives  designated as cash flow hedges |       |                         | $          | (15.0 | ) |   |   | $ | (47.4 | ) |   |

 

The fair value of the swaps and option contracts areestimated based on quoted prices from independent reporting services comparedto the contract price of the agreement, and approximate the cash gain or lossthat would have been realized if the contracts had been closed out at periodend. All hedge 

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positions offset physicalpositions exposed to the cash market. None of these offsetting physicalpositions are included in the above table. Price risk sensitivities werecalculated by assuming across-the-board increases in price of $5.00 per Bbl foroil and $1.00 per MMBtu for natural gas regardless of term or historicalrelationships between the contractual price of the instruments and theunderlying commodity price. In the event of actual changes in prompt monthprices equal to the assumptions, the fair value of our derivative portfoliowould typically change by less than the amount shown in the table due to lowervolatility in out-month prices. In the event of actual changes in all monthsequal to the assumptions, the fair value of our derivative portfolio wouldtypically change by less than the amount shown in the table due to the factthat many of the changes would be within the range of our derivative collarswhere the movement in fair value would typically be less than the changes incommodity prices.

With respect to oil, we had, as of March 31,2007, NYMEX put options with a weighted average strike price of $58.00 per Bblon 2,000 Bbl/d for 2007 oil production. With respect to natural gas, we had, asof March 31, 2007, put options with a weighted average strike price of$7.985 per MMBtu on 10,000 MMBtu/d for 2007 natural gas production. These putoptions cost an average of $4.23 per Bbl and $1.00 per MMBtu (a total of$6.7 million), which payment is deferred until the put options settle. Thefair value of the put options is not included in the fair value of derivativesin the table above.

See note 3 to our condensedconsolidated financial statements for a discussion of our long-term debt as of March 31,2007.

**Item 4.**                        Controlsand Procedures

**Disclosure Controlsand Procedures**

Timothy Marquez,our Chief Executive Officer, and Timothy Ficker, our Chief Financial Officer,evaluated the effectiveness of our disclosure controls and procedures as of March 31,2007. Based on the evaluation, they believe that:

·       ourdisclosure controls and procedures were effective to ensure that informationrequired to be disclosed by us in the reports we file or submit under theSecurities Exchange Act of 1934 is recorded, processed, summarized and reportedwithin the time periods specified in the SEC’s rules and forms; and

·       ourdisclosure controls and procedures were effective to ensure that informationrequired to be disclosed by us in the reports we file or submit under theSecurities Exchange Act of 1934 was accumulated and communicated to ourmanagement, including our Chief Executive Officer and Chief Financial Officer,as appropriate to allow timely decisions regarding required disclosure.

We are currently takingsteps intended to enhance our internal control over financial reporting. See “Management’sDiscussion and Analysis of Financial Condition and Results of Operation—Overview—InternalControl Over Financial Reporting.”

**Internal ControlOver Financial Reporting**

Other than in connectionwith the steps we are taking to enhance our internal control over financialreporting as described in “Management’s Discussion and Analysis of FinancialCondition and Results of Operation—Overview—Internal Control Over FinancialReporting,” there has not been any change in our internal control overfinancial reporting that occurred during the quarterly period ended March 31,2007 that has materially affected, or is reasonably likely to materiallyaffect, our internal control over financial reporting.

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**PART II—OTHERINFORMATION**

**Item 1.**                        LegalProceedings

Not Applicable

**Item 1A.**                RiskFactors

In addition to the other information set forth in thisreport, you should carefully consider the factors discussed in “Risk Factors”in our Annual Report on Form 10-K for the year ended December 31,2006, which could materially affect our business, financial condition and/orfuture results. The risks described in our Annual Report on Form 10-Kare not the only risks facing us. Additional risks and uncertainties notcurrently known to us or that we currently deem to be immaterial also maymaterially adversely affect our business, financial condition and/or operatingresults. The following sets forth additional and/or updated information withrespect to certain of the risks described in our Annual Report on Form 10-K:

***The market price of our commonstock could be adversely affected by sales of substantial amounts of our commonstock in the public markets or the issuance of additional shares of commonstock.***

Sales of a substantial number of shares of our commonstock in the public market, or the perception that these sales may occur, couldcause the market price of our common stock to decline. In addition, the sale ofthese shares in the public market or the possibility of such sales could impairour ability to raise capital through the sale of additional common or preferredstock. As of December 31, 2006, our CEO and his wife beneficially ownedapproximately 67.6% of our common stock, primarily through the Marquez Trust, afamily trust they control. In addition, as of March 31, 2007, we hadgranted options to purchase approximately 4.8 million shares of our commonstock to our directors and employees, approximately 51% of which had vested asof that date. We, the Marquez Trust, our directors and certain of our employeesentered into agreements with the underwriters of our initial public offeringpursuant to which each of those persons agreed not to sell or otherwise disposeof shares of our common stock for a “lock-up” period of 180 days followingthe offering, subject to an extension of up to 34 days in certaincircumstances. We expect that this lock-up period will expire on June 2,2007. Therefore, persons previously unable to sell shares of our common stock,including shares issuable upon the exercise of vested options, will bepermitted to sell shares after June 2, 2007, subject to compliance withthe registration requirements of the Securities Act of 1933.  Similarly, after that date, we will not beprohibited from issuing shares of common stock in order to raise capital orcomplete acquisitions. The substantial number of shares potentially eligiblefor sale following the expiration of the lock-up, either by us or by ourdirectors, officers and significant stockholders, could cause the market priceof our stock to decline.

***Our recently-increased debt leveland the covenants in the agreements governing our debt could negatively impactour financial condition, results of operations and business prospects.***

As described in “Management's Discussion and Analysisof Financial Condition and Results of Operation—Liquidity and CapitalResources—Capital Resources and Requirements,” we borrowed $500.0 million inMay 2007 under a new second lien term loan facility, which replaced, andwas used to refinance, our existing $350.0 million second lien term loanfacility. As of May 11, 2007, we had total indebtedness of$719.4 million under our credit facilities and our 8.75% senior notes,compared to total indebtedness of $529.0 million as of December 31, 2006.Accordingly, the risks described in our Annual Report on Form 10-K under “RiskFactors—Our debt level and the covenants in the agreements governing our debtcould negatively impact our financial condition, results of operations andbusiness prospects” have in some respects increased.

**Item 2.**                        UnregisteredSales of Equity Securities and Use of Proceeds

Not Applicable

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**Item 3.**                        DefaultsUpon Senior Securities

NotApplicable

**Item 4.**                        Submissionof Matters to a Vote of Security Holders

Not Applicable

**Item 5.**                        OtherInformation

Not Applicable

**Item6.**                        Exhibits

| Exhibit  Number | ** ** | **Exhibit** | ** ** |
|-----------------|------------|-------------|------------|
|            | 10.1       |        |       | Amendment No. 1 to the Venoco, Inc. Amended and  Restated 2005 Stock Incentive Plan. |   |
|            | 10.2       |        |       | Venoco, Inc. 2007 Long-Term Incentive Program. |   |
|            | 10.3       |        |       | Form of Notice of Award and Restricted Stock Award  Agreement Pursuant to the Venoco, Inc. Amended and Restated 2005 Stock  Incentive Plan. |   |
|            | 10.4       |        |       | Venoco, Inc. 2007 Senior Executive Bonus Plan. |   |
|            | 31.1       |        |       | Certification of the Chief Executive Officer  Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |   |
|            | 31.2       |        |       | Certification of the Chief Financial Officer  Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |   |
|            | 32         |        |       | Certification of  the Chief Executive Officer and the Chief Financial Officer Pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002. |   |

 

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**SIGNATURES**

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.
| May 15, 2007 | VENOCO, INC.                                 |
|-------------------|----------------------------------------------|
|              | By:                                          | /s/ Timothy M.  Marquez |
|              | Name: Timothy M. Marquez                     |
|              | Title: Chairman and  Chief Executive Officer |
|              | By:                                          | /s/ Timothy A.  Ficker |
|              | Name: Timothy A. Ficker                      |
|              | Title: Chief Financial Officer               |

 

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