**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**Washington,D.C. 20549**

** **

**Form10-Q**

 

ý           **QUARTERLY REPORT PURSUANT TO SECTION13 OR 15(d) OF THE**

**SECURITIESEXCHANGE ACT OF 1934**

 

**For the quarterly period ended March 31, 2006**

 

**or**

 

o           **TRANSITION REPORT PURSUANT TO SECTION13 OR 15(d) OF THE**

**SECURITIESEXCHANGE 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 2950**          |       | ** **     |
|------------------------------------------|------------|----------------|
| **Denver, Colorado**                     | ** ** | **80202-1370** |
| (Address of principal executive offices) |       | (Zip Code)     |

 

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

 

**N/A**

(Formername or former address, and former fiscal year, if changed since last report)

 

Indicate by checkmark whether the registrant (1) has filed all reports required by Section 13 or15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (orfor such shorter period that the registrant was required to file such reports),and (2) has been subject to such filing requirements for the past 90 days.

 

YES ý    NO o

 

Indicate by check mark whether the registrantis a large accelerated filer, an accelerated filer, or a non-accelerated filer(as defined in Rule 12b-2 of the Exchange Act).

 

LargeAccelerated Filer o  Accelerated Filer o             Non-accelerated filer ý

 

Indicate by check mark whether the registrantis a shell company (as defined in Rule 12b-2 of the Exchange Act).

 

YES o          NO ý

 

As of March 31, 2006, there were 32,692,500shares of the issuer’s common stock, par value $0.01 per share, issued andoutstanding.

 

 

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**VENOCO, INC.**

**Form 10-Q for theQuarterly Period Ended March 31, 2006**

**TABLE OF CONTENTS**

** **
|                   | ** **                                                                                                                                      | ** ** |
|-------------------|-------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| **PART I.**  | **FINANCIAL INFORMATION**                                                                                                                       | ** ** |
| Item  1.          | Financial  Statements (Unaudited)                                                                                                               |       |
|              | Condensed Consolidated  Balance Sheets at December 31, 2005 and March 31, 2006                                                        |       |
|              | Condensed Consolidated  Statements of Operations for the Three Months Ended March 31, 2005 and  the Three Months Ended March 31, 2006 |       |
|              | Condensed Consolidated  Statements of Comprehensive Income for the Three Months Ended March 31, 2005  and the Three Months Ended March 31, 2006 |       |
|              | Condensed Consolidated  Statements of Cash Flows for the Three Months Ended March 31, 2005 and  the Three Months Ended March 31, 2006 |       |
|              | Notes to Condensed  Consolidated Financial Statements                                                                                           |       |
| Item 2.           | Management’s Discussion and  Analysis of Financial Condition and Results of Operations                                                     |       |
| Item 3.           | Quantitative and Qualitative  Disclosures about Market Risk                                                                                     |       |
| Item 4.           | Controls and Procedures                                                                                                                         |       |
| **PART II.** | **OTHER INFORMATION**                                                                                                                           | ** ** |
| Item 1.           | Legal Proceedings                                                                                                                               |       |
| Item 1A.          | Risk Factors                                                                                                                                    |       |
| Item 2.           | Unregistered Sales of Equity  Securities and Use of Proceeds                                                                                    |       |
| Item 3.           | Defaults upon Senior  Securities                                                                                                                |       |
| Item 4.           | Submission of Matters to a  Vote of Security Holders                                                                                            |       |
| Item 5.           | Other Information                                                                                                                               |       |
| Item 6.           | Exhibits                                                                                                                                        |       |
| Signatures        |                                                                                                                                            |       |

 

2

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**PART I – FINANCIAL INFORMATION**

 

**VENOCO, INC. AND SUBSIDIARIES**

**CONDENSEDCONSOLIDATED BALANCE SHEETS (UNAUDITED)**

**(In thousands, except shares and per share amounts)**

 
| ** **                                                                                                                                                                                 | ** ** | **December 31,** | ** ** | **March 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------|------------|---------------|------------|
| ** **                                                                                                                                                                                 | ** ** | **2005**         | ** ** | **2006**      | ** ** |
| **ASSETS**                                                                                                                                                                                 |       |             |       |          |       |
| CURRENT  ASSETS:                                                                                                                                                                           |       |             |       |          |       |
| Cash and cash equivalents                                                                                                                                                                  |       | $                | 9,389      |          | $          | 14,485 |   |
| Accounts receivable, net of allowance for  doubtful accounts of $759 and $1,218 at December 31, 2005 and March 31,  2006, respectively                                                |       | 29,841           |       | 39,430        |       |
| Inventories                                                                                                                                                                                |       | 1,753            |       | 1,386         |       |
| Prepaid expenses and other current assets                                                                                                                                                  |       | 4,351            |       | 5,777         |       |
| Income tax receivable                                                                                                                                                                      |       | 4,107            |       | 4,252         |       |
| Deferred income taxes                                                                                                                                                                      |       | 8,611            |       | 8,635         |       |
| Commodity derivatives                                                                                                                                                                      |       | 3,391            |       | 6,399         |       |
| Total current assets                                                                                                                                                                       |       | 61,443           |       | 80,364        |       |
| PROPERTY,  PLANT AND EQUIPMENT, AT COST:                                                                                                                                                   |       |             |       |          |       |
| Oil and gas properties (full cost method, of  which $2,275 and $2,750 for unproved properties were excluded from  amortization at December 31, 2005 and March 31, 2006, respectively) |       | 269,922          |       | 759,235       |       |
| Drilling equipment                                                                                                                                                                         |       | 7,947            |       | 9,013         |       |
| Other property and equipment                                                                                                                                                               |       | 27,424           |       | 15,316        |       |
| Total property, plant and equipment                                                                                                                                                        |       | 305,293          |       | 783,564       |       |
| Accumulated depletion, depreciation,  amortization and impairment                                                                                                                          |       | (71,517          | )          | (77,981       | )          |
| Net property, plant and equipment                                                                                                                                                          |       | 233,776          |       | 705,583       |       |
| OTHER ASSETS:                                                                                                                                                                              |       |             |       |          |       |
| Commodity derivatives                                                                                                                                                                      |       | 69               |       | 7,359         |       |
| Deferred loan costs                                                                                                                                                                        |       | 5,658            |       | 19,121        |       |
| Other                                                                                                                                                                                      |       | 1,612            |       | 2,717         |       |
| Total other assets                                                                                                                                                                         |       | 7,339            |       | 29,197        |       |
| TOTAL ASSETS                                                                                                                                                                               |       | $                | 302,558    |          | $          | 815,144 |   |
|                                                                                                                                                                                       |       |             |       |          |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                             |       |             |       |          |       |
| CURRENT  LIABILITIES:                                                                                                                                                                      |       |             |       |          |       |
| Accounts payable and accrued liabilities                                                                                                                                                   |       | $                | 31,134     |          | $          | 45,949 |   |
| Undistributed revenue payable                                                                                                                                                              |       | 2,155            |       | 13,683        |       |
| Interest payable                                                                                                                                                                           |       | 720              |       | 4,011         |       |
| Current maturities of long-term debt                                                                                                                                                       |       | 126              |       | —        |       |
| Commodity derivatives                                                                                                                                                                      |       | 26,397           |       | 27,493        |       |
| Total current liabilities                                                                                                                                                                  |       | 60,532           |       | 91,136        |       |
| LONG-TERM  DEBT                                                                                                                                                                            |       | 178,943          |       | 628,743       |       |
| DEFERRED  INCOME TAXES                                                                                                                                                                     |       | 24,108           |       | 28,100        |       |
| COMMODITY  DERIVATIVES                                                                                                                                                                     |       | 11,992           |       | 22,616        |       |
| ASSET  RETIREMENT OBLIGATIONS                                                                                                                                                              |       | 22,649           |       | 33,619        |       |
| OTHER  LONG-TERM LIABILITIES                                                                                                                                                               |       | —           |       | 3,037         |       |
| Total liabilities                                                                                                                                                                          |       | 298,224          |       | 807,251       |       |
| COMMITMENTS  AND CONTINGENCIES                                                                                                                                                             |       |             |       |          |       |
| STOCKHOLDERS’  EQUITY:                                                                                                                                                                |       |             |       |          |       |
| Common stock, $.01 par value (200,000,000  shares authorized; 32,692,500 shares issued and outstanding at  December 31, 2005 and March 31, 2006)                                      |       | 327              |       | 327           |       |
| Additional paid-in capital                                                                                                                                                                 |       | 20,976           |       | 21,364        |       |
| Retained earnings (accumulated deficit)                                                                                                                                                    |       | (3,785           | )          | (2,934        | )          |
| Accumulated other comprehensive loss                                                                                                                                                       |       | (13,184          | )          | (10,864       | )          |
| Total stockholders’ equity                                                                                                                                                            |       | 4,334            |       | 7,893         |       |
| TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                           |       | $                | 302,558    |          | $          | 815,144 |   |

 

See notes to condensed consolidated financialstatements.

 

3

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**VENOCO, INC. AND SUBSIDIARIES**

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)**

 

**(In thousands, except per share amounts)**

 
| ** **                                               | ** ** | **Three Months Ended  March 31,** | ** ** |
|----------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                               | ** ** | **2005**                          | ** ** | **2006** | ** ** |
| REVENUES:                                                |       |                              |       |   |   |
| Oil and natural gas sales                                |       | $                                 | 42,038     |   | $ | 51,271 |   |
| Commodity derivative losses (realized)                   |       | (3,565                            | )          | (6,062 | ) |
| Commodity derivative losses (unrealized)                 |       | (25,595                           | )          | (9,508 | ) |
| Other                                                    |       | 1,079                             |       | 1,714 |   |
| Total revenues                                           |       | 13,957                            |       | 37,415 |   |
| EXPENSES:                                                |       |                              |       |   |   |
| Oil and natural gas production                           |       | 11,930                            |       | 12,322 |   |
| Transportation expense                                   |       | 680                               |       | 805 |   |
| Depletion, depreciation and amortization                 |       | 5,653                             |       | 6,694 |   |
| Accretion of abandonment liability                       |       | 442                               |       | 470 |   |
| General and administrative, net of amounts  capitalized  |       | 3,116                             |       | 4,406 |   |
| Amortization of deferred loan costs                      |       | 345                               |       | 338 |   |
| Interest, net                                            |       | 3,497                             |       | 3,773 |   |
| Total expenses                                           |       | 25,663                            |       | 28,808 |   |
| Income (loss) before minority interest and  income taxes |       | (11,706                           | )          | 8,607 |   |
| Income tax provision (benefit)                           |       | (4,930                            | )          | 3,500 |   |
| Net income (loss) before minority interest               |       | (6,776                            | )          | 5,107 |   |
| Minority interest in Marquez Energy                      |       | 42                                |       | — |   |
| Net income (loss)                                        |       | $                                 | (6,818     | ) | 5,107 |   |
|                                                     |       |                              |       |   |   |
| Earnings per  common share:                              |       |                              |       |   |   |
| Basic                                                    |       | $                                 | (0.21      | ) | $ | 0.16 |   |
| Diluted                                                  |       | $                                 | (0.21      | )  | $ | 0.15 |   |

 

See notes to condensed consolidated financialstatements.

 

4

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**VENOCO, INC. AND SUBSIDIARIES**

**CONDENSEDCONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME**

**(In thousands)**

 
| ** **                                                                   | ** ** | **Three Months Ended  March 31,** | ** ** |
|------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                   | ** ** | **2005**                                         | ** ** | **2006** | ** ** |
| ** **                                                                   | ** ** | ** **                                       | ** ** | ** ** | ** ** |
| Net income  (loss)                                                           |       | $                                                | (6,818     | ) | $ | 5,107 |   |
| OTHER COMPREHENSIVE INCOME (LOSS), NET OF  INCOME TAX:                       |       |                                             |       |   |   |
| Hedging  activities:                                                         |       |                                             |       |   |   |
| Reclassification adjustments for settled  contracts                          |       | 161                                              |       | (1,022 | )  |
| Changes in fair value of effective portion  of outstanding hedging positions |       | (11,647                                          | )          | (1,297 | ) |
| Other  comprehensive loss                                                    |       | (11,486                                          | )          | (2,319 | ) |
| Comprehensive  income (loss)                                                 |       | $                                                | (18,304    | ) | $ | 2,788 |   |

 

See notes to condensed consolidated financialstatements.

 

5

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**VENOCO, INC. AND SUBSIDIARIES**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)**

**(In thousands)**

 
| ** **                                                                         | ** ** | **Three Months Ended March 31,** | ** ** |
|------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                         | ** ** | **2005**                         | ** ** | **2006** | ** ** |
| CASH FLOWS  FROM OPERATING ACTIVITIES:                                             |       |                             |       |   |   |
| Net income                                                                         |       | $                                | (6,818     | ) | $ | 5,107 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities: |       |                             |       |   |   |
| Depletion, depreciation, amortization and  impairment                              |       | 5,653                            |       | 6,694 |   |
| Accretion of abandonment liability                                                 |       | 442                              |       | 470 |   |
| Deferred income taxes (benefit)                                                    |       | (6,167                           | )          | 2,186 |   |
| Share-based compensation                                                           |       | —                           |       | 647 |   |
| Amortization of deferred loan costs                                                |       | 353                              |       | 338 |   |
| Amortization of bond discounts                                                     |       | 34                               |       | 34 |   |
| Minority interest in undistributed earnings                                        |       | 42                               |       | — |   |
| Unrealized commodity derivative losses and  amortization of premiums               |       | 26,148                           |       | 11,246 |   |
| Changes in operating assets and liabilities:                                       |       |                             |       |   |   |
| Accounts receivable                                                                |       | (6,429                           | )          | 4,646 |   |
| Inventories                                                                        |       | (26                              | )          | 367 |   |
| Prepaid expenses and other current assets                                          |       | (963                             | )          | (523 | ) |
| Income tax receivable                                                              |       | 1,237                            |       | (145 | ) |
| Other assets                                                                       |       | (55                              | )          | (87 | ) |
| Accounts payable and accrued liabilities                                           |       | 2,438                            |       | 2,805 |   |
| Undistributed revenue payable                                                      |       | 136                              |       | (48 | ) |
| Net premiums paid on derivative contracts                                          |       | (5,420                           | )          | (1,781 | ) |
| Net cash provided by operating activities                                          |       | 10,785                           |       | 31,956 |   |
| CASH FLOWS  FROM INVESTING ACTIVITIES:                                             |       |                             |       |   |   |
| Capital expenditures for oil and gas  properties                                   |       | (14,302                          | )          | (28,834 | ) |
| Capital expenditures for drilling equipment                                        |       | (4                               | )          | (66 | ) |
| Capital expenditures for other property and  equipment                             |       | (110                             | )          | (737 | ) |
| Proceeds from sale of oil and gas properties                                       |       | 44,619                           |       | 3,031 |   |
| Increase in cash restricted for investment  in oil and gas properties              |       | (44,619                          | )          | — |   |
| Acquisition of TexCal Energy, net of cash  acquired                                |       | —                           |       | (445,523 | ) |
| Acquisition of Marquez Energy, LLC                                                 |       | (14,628                          | )          | — |   |
| Notes receivable—officers                                                     |       | 1,420                            |       | — |   |
| Net cash used in investing activities                                              |       | (27,624                          | )          | (472,129 | ) |
| CASH FLOWS  FROM FINANCING ACTIVITIES:                                             |       |                             |       |   |   |
| Proceeds from long-term debt                                                       |       | 13,000                           |       | 469,529 |   |
| Principal payments on long-term debt                                               |       | (4,648                           | )          | (10,033 | ) |
| Deferred loan costs                                                                |       | (290                             | )          | (13,801 | ) |
| Dividend paid to shareholder                                                       |       | (35,000                          | )          | (426 | ) |
| Distribution payments to Marquez Energy  members                                   |       | (707                             | )          | — |   |
| Repurchase of common shares                                                        |       | (5,207                           | )          | — |   |
| Net cash (used in) provided by financing  activities                               |       | (32,852                          | )          | 445,269 |   |
| Net (decrease) increase in cash and cash  equivalents                              |       | (49,691                          | )          | 5,096 |   |
| Cash and cash equivalents, beginning of  period                                    |       | 54,715                           |       | 9,389 |   |
| Cash and cash equivalents, end of period                                           |       | $                                | 5,024      |   | $ | 14,485 |   |
| **Supplemental  Disclosure of Cash Flow Information—**                        |       |                             |       |   |   |
| Cash paid for interest                                                             |       | $                                | 180        |   | $ | 619 |   |
| Cash paid for income taxes                                                         |       | $                                | —     |   | $ | 1,200 |   |
| **Supplemental  Disclosure of Noncash Activities—**                           |       |                             |       |   |   |
| Decrease (increase) in accrued capital  expenditures                               |       | $                                | (1,048     | ) | $ | 2,963 |   |
| Distribution of land and building                                                  |       | $                                | —     |   | $ | 13,399 |   |
| Distribution of building note payable                                              |       | $                                | —     |   | $ | 9,857 |   |
|                                                                                    |            |                                  |            |  |  |  |  |  |

 

**See notes to condensed consolidated financialstatements.**

** **

**6**

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** **

**VENOCO, INC. ANDSUBSIDIARIES**

**NOTESTO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**(UNAUDITED)**

** **

**1.   BASISOF PRESENTATION**

** **

***Description of Operations******—*** Venoco, Inc. (“Venoco” or the “Company”),a Delaware corporation, is engaged in the business of acquiring interests in,and exploring for and developing, oil and natural gas properties with a focusoffshore and onshore California and with additional operations in Texas.

 

***Condensed ConsolidatedFinancial Statements***—The condensed unauditedconsolidated financial statements include the accounts of Venoco and itssubsidiaries, all of which are wholly owned. The financial statements have beenprepared in accordance with U.S. generally accepted accounting principles forinterim financial reporting. All significant intercompany balances andtransactions have been eliminated in consolidation. In the opinion ofmanagement, all material adjustments considered necessary for a fairpresentation of the Company’s interim results have been reflected. Venoco’s2005 Annual Report on Form 10-K includes certain definitions and a summary ofsignificant accounting policies and should be read in conjunction with this report.The results for interim periods are not necessarily indicative ofannual results.

 

***Stock Split******—All common share amounts in theaccompanying financial statements have been adjusted for the 1,000-for-onereverse stock split effected on February 10, 2005 and a one-for-7,500stock split approved by the board of directors of the Company onOctober 13, 2005 and effected on November 8, 2005.***

 

***Earnings Per Share***—Statementof Financial Accounting Standards No. 128, *Earnings Per Share,* requires presentation of “basic” and “diluted”earnings per share. Basic net income per common share of stock is calculated bydividing net income by the weighted average number of common shares outstandingduring each period. Diluted net income per common share of stock is calculatedby dividing net income by the weighted average number of common sharesoutstanding and other dilutive securities. The only securities considereddilutive are the Company’s non-qualified stock option awards.

 

The followingtable sets forth the calculation of basic and diluted earnings per share (inthousands except per share amounts):

 
| ** **                                          | ** ** | **Three Months ended March 31,** | ** ** |
|-----------------------------------------------------|------------|----------------------------------|------------|
| ** **                                          | ** ** | **2005**                         | ** ** | **2006** | ** ** |
| Net income  (loss)                                  |       | $                                | (6,818     | ) | $ | 5,107 |   |
| Adjustments  to net income for dilution             |       | —                           |       | — |   |
|                                                |       |                             |       |   |   |
| Net income  adjusted for the effect of dilution     |       | $                                | (6,818     | ) | $ | 5,107 |   |
|                                                |       |                             |       |   |   |
| Basic  weighted average common shares outstanding   |       | 32,693                           |       | 32,693 |   |
| Add: dilutive effect of stock options               |       | —                           |       | 1,169 |   |
|                                                |       |                             |       |   |   |
| Diluted weighted  average common shares outstanding |       | 32,693                           |       | 33,862 |   |
|                                                |       |                             |       |   |   |
| Basic  earnings per common share                    |       | $                                | (0.21      | ) | $ | 0.16 |   |
| Diluted  earnings per common share                  |       | $                                | (0.21      | ) | $ | 0.15 |   |
|                                                     |            |                                  |            |  |  |  |  |  |  |

 

***Common Control Merger***—On March 21, 2005, the Company acquired Marquez Energy, a Colorado limitedliability company that was majority-owned and controlled by Tim Marquez.Because of the common ownership of Marquez Energy and the Company, thisacquisition has been recorded in a manner similar to a pooling-of-interests.Common control occurred in July 2004 when Tim Marquez acquired anadditional 53% of the Company’s common stock bringing his common stock holdingsto 94%. The Company’s financial statements have been adjusted to give effect tothe acquisition of Marquez Energy as if it had occurred in July 2004.

 

**2.   ACQUISITIONS**

 

7

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** **

*TexCal Energy.*OnMarch 31, 2006, the Company acquired 100% of the members’ interest inTexCal Energy (LP) LLC (the “TexCal Acquisition”), an independent explorationand production company with properties in Texas and California, forapproximately $456.6 million in cash and transaction costs of $14.4million. TexCal had proved reserves of 31.4 MMBOE as of December 31, 2005according to a reserve report prepared by TexCal’s independent engineers.TexCal’s operations are located entirely onshore and are concentrated in theGulf Coast region of Texas and in the Sacramento Basin in California. TheCompany financed the acquisition through loans advanced under a secondamendment and restatement of its existing revolving credit facility and a newsenior secured second lien term loan facility. The purchase price was allocatedto assets and liabilities, adjusted for tax effects, based on their estimatedfair values at the date of acquisition. The acquisition was accounted for usingthe purchase method of accounting and has been included in the consolidatedfinancial statements of Venoco as of the date of the acquisition.

 

The cash consideration paidfor the TexCal Acquisition was preliminarily allocated as follows (inthousands):

 
| ** **                    | ** ** | **Purchase Price  Allocation** | ** ** |
|-------------------------------|------------|-------------------------------------|------------|
| Current  assets               |       | $                                   | 25,834     |   |
| Oil and gas  properties       |       | 459,526                             |       |
| Other  non-current assets     |       | 1,018                               |       |
| Current  liabilities          |       | (22,052                             | )          |
| Asset  retirement obligations |       | (7,722                              | )          |
| Cash  consideration           |       | $                                   | 456,604    |   |

 

The following unaudited proforma condensed consolidated operating results for the three months endedMarch 31, 2006 give effect to the TexCal Acquisition as if it hadbeen completed as of January 1, 2005 and January 1, 2006. The proforma amounts shown below are not necessarily indicative of the operatingresults that would have occurred if the transaction had occurred on such date.The pro forma adjustments made are based on certain assumptions thatwe believe are reasonable and on currently available information (inthousands except per share amounts).

 
| ** **                               | ** ** | **Three Months Ended  March 31,** | ** ** |
|------------------------------------------|------------|-----------------------------------|------------|
| ** **                               | ** ** | **2005**                          | ** ** | **2006** | ** ** |
|                                     |       |                              |       |   |   |
| Net revenues                             |       | $                                 | 25,803     |   | $ | 66,166 |   |
| Net income  (loss)                       |       | $                                 | (6,844     | ) | $ | 13,105 |   |
| Basic  earnings (loss) per common share: |       | $                                 | (0.21      | ) | $ | 0.40 |   |

 

*MarquezEnergy*. On March 21, 2005, the Company acquired MarquezEnergy, a Colorado limited liability company that was majority-owned andcontrolled by Tim Marquez. The Company had paid a deposit of $2 million tothe members of Marquez Energy as of December 31, 2004 and onMarch 21, 2005 paid the remaining $14.6 million to the members ofMarquez Energy and $3.2 million to Bank of Oklahoma to repay MarquezEnergy’s existing debt. As discussed in Note 1, for financial reporting purposesthe acquisition was accounted for as a reorganization of entities under commoncontrol in a manner similar to a pooling of interests.

 

TheMarquez Energy acquisition added proved reserves of approximately 2.0 MMBOE asof December 31, 2004 based on a reserve report prepared by Netherland,Sewell and Associates, Inc. (NSAI). The $16.8 million purchase pricefor Marquez Energy was based on members’ equity per Marquez Energy’s unauditedDecember 31, 2004 balance sheet as adjusted to reflect the value of itsoil and natural gas properties (as determined by NSAI as of December 31,2004) and certain other adjustments. For the purpose of calculating thepurchase price, the following values were assigned to Marquez Energy’s provedreserves: (i) $1.75/Mcfe for its proved developed producing reserves,(ii) $1.00/Mcfe for

 

8

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itsproved developed non-producing reserves and (iii) $0.75/Mcfe for itsproved undeveloped reserves. Pursuant to the purchase agreement, NSAI conducteda supplemental evaluation of the Marquez Energy properties as of year-end 2005,and NSAI or another nationally recognized engineering firm will conduct afurther supplemental evaluation as of year-end 2006. In the event that theyear-end 2006 evaluation attributes proved reserves to the Marquez Energyproperties as of December 31, 2004 in excess of those reflected in NSAI’sinitial report, an additional payment will be made to the former holders ofinterests in Marquez Energy pursuant to the same formula, subject to a maximumaggregate price of $25 million. No additional payments were due as aresult of an evaluation performed by NSAI as of December 31, 2005.

 

**3.   SALESOF PROPERTIES**

 

InJanuary 2006, the Company sold 35% of its interests in the Willows-Beehive Bendand Bounde Creek gas fields for $3.0 million. No gain was recognized fromthe sale for financial reporting purposes. The Company applied the proceeds ofthe sale to reduce the capitalized cost of oil and natural gas properties.

 

InFebruary 2005, the Company entered into a purchase and sale agreement tosell its interest in the Big Mineral Creek field (“BMC”), located in GraysonCounty, Texas. The sales price was $45 million, subject to adjustmentsthat, among other things, gave economic effect to the transaction as ofFebruary 1, 2005. The closing of the transaction occurred onMarch 31, 2005. In order to facilitate a like-kind exchange of the Company’sBMC property under Section 1031 of the Internal Revenue Code, the proceedsfrom the sale of $44.6 million were deposited with a qualifiedintermediary. The Company acquired qualified replacement properties ofapproximately $15.6 million prior to the 180 day deadline, whichexpired on September 27, 2005. Included in the qualified replacementproperties acquired was a portion of the Marquez Energy properties. The Companyhas deferred a portion of the gain on sale of the BMC property under theprovisions of section 1031 of the Internal Revenue Code. However, sincethe qualified replacement property acquired is less than the proceeds from thesale of the BMC property, the Company recognized for tax purposes a gain on thesale of the BMC property of approximately $27.9 million and incurred anassociated tax liability of $11.1 million. In accordance with itsaccounting policies, the Company did not recognize a gain on sale for financialreporting purposes, but applied the proceeds to reduce the capitalized cost ofits oil and natural gas properties. At March 31, 2005, the Company had notrecorded a gain on the sale of the BMC property, but applied the sales proceedsof $44.6 million to reduce the capitalized cost of oil and natural gasproperties and recorded the cash received as restricted for investment in oiland natural gas properties.

 

**4.  LONG-TERM DEBT**

** **

Longterm debt consisted of the following as of the dates indicated (in thousands):

 

| ** **                                               | ** ** | **December 31,  2005** | ** ** | **March 31,  2006** | ** ** |
|----------------------------------------------------------|------------|-----------------------------|------------|--------------------------|------------|
| ** **                                               | ** ** | ** **                  | ** ** | ** **               | ** ** |
| Revolving  credit facility due March 2009                |       | $                           | 20,000     |                     | $          | 129,529 |   |
| Second lien  term loan due March 2011                    |       | —                      |       | 350,000                  |       |
| 8.75% senior  notes due December 2011               |       | 149,180                     |       | 149,214                  |       |
| 5.79% mortgage  on office building due January 2015 |       | 9,889                       |       | —                   |       |
| Total long-term debt                                     |       | 179,069                     |       | 628,743                  |       |
| Less: current  portion of long-term debt                 |       | (126                        | )          | —                   |       |
| Long-term debt, net of current portion                   |       | $                           | 178,943    |                     | $          | 628,743 |   |
|                                                          |            |                             |            |                          |            |  |  |  |

 

TheCompany financed the TexCal Acquisition through loans advanced under a secondamendment and restatement of its existing revolving credit facility and a newsenior secured second lien term loan facility. On March 30, 2006, theCompany borrowed $350 million pursuant to the second lien term loan. TheCompany entered into the second amendment and restatement of its existingrevolving credit facility on March 30, 2006. On March 31, 2006, theCompany borrowed approximately $119.5 million under the amended revolvingcredit facility to finance the remainder of the TexCal purchase price andtransaction costs of approximately $14.4 million. The term loan facilitywas amended and restated as of April 28, 2006 and the revolving creditfacility was further amended on May 2, 2006.  The following summarizes certain terms of thecredit facilities as amended.

 

Theamended revolving credit facility has an aggregate maximum loan amount of$300 million and an initial borrowing base of $200 million. Principalon the term loan facility is payable on March 30, 2011, and principal onthe revolving credit facility is payable on March 30, 2009.  Pursuantto mandatory prepayment provisions set forth in the credit facilities,substantially all of the proceeds of asset sales and additional borrowings(except for certain unsecured borrowings and additional borrowings under therevolving credit facility), and up to 50% of the proceeds of equity issuances,must be used to reduce amounts outstanding under one or both facilities. TheCompany may

 

9

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fromtime to time make optional prepayments on outstanding loans. Under the termloan facility, optional prepayments made prior to March 30, 2008 are subject toa prepayment premium. The revolving credit facility is securedby a first priority lien on substantially all of the Company’s assets and isguaranteed by each of its subsidiaries other than Ellwood Pipeline, Inc. The term loan facility is secured by secondpriority liens on the same collateral as the revolving credit facility. Acollateral trust agreement has been entered into in order to provide, for thebenefit of the holders of the Company’s senior notes, liens on the Company’sproperty that are equal and ratable with the liens securing the term loanfacility. At such time as all liens securing outstanding indebtedness under therevolving credit facility and the term loan facility constitute “PermittedLiens” (as defined in the indenture governing the senior notes), thecollateral trust agreement will be terminated and the senior notes will nolonger be secured obligations, but will be effectively junior in right ofpayment to the indebtedness under the revolving credit facility and the termloan facility to the extent of the value of the collateral securing thosefacilities.

 

Loansmade under both facilities are designated, at the Company’s option, as either “BaseRate Loans” or “LIBO Rate Loans.” Base Rate Loans under the revolving creditfacility bear interest at a floating rate equal to (i) the greater of Bankof Montreal’s announced base rate and the overnight federal funds rate plus0.50% plus (ii) a margin ranging from zero to 0.75%, based uponutilization. LIBO Rate Loans under the revolving credit facility bear interestat (i) LIBOR plus (ii) a margin ranging from 1.50% to 2.25%, basedupon utilization. A commitment fee ranging from 0.375% to 0.5% per annum ispayable with respect to unused borrowing availability under the facility.

 

BaseRate Loans under the term loan facility bear interest at a floating rate equalto (i) the greater of the administrative agent’s announced base rate andthe overnight federal funds rate plus 0.50% plus (ii) a margin rangingfrom 3.00% to 3.50%. LIBO Rate Loans under the term loan facility bear interestat (i) LIBOR plus (ii) a margin ranging from 4.00% to 4.50%. In eachcase, the applicable margin depends on the Company’s consolidated leverageratio and whether a public equity offering has occurred.

 

Theagreements governing the revolving credit facility and the term loan facilitycontain customary representations, warranties, events of default, indemnitiesand covenants, including financial covenants that require the Company tomaintain specified ratios of EBITDA to interest expense, current assets tocurrent liabilities, debt to EBITDA and PV-10 to total debt.

 

OnMarch 22, 2006, the Company paid a dividend consisting of 100% of itsinterest in 6267 Carpinteria Ave. LLC (“6267 Carpinteria”) to its solestockholder, a trust controlled by the Company’s CEO. The obligation for the5.79% mortgage on the office building owned by 6267 Carpinteria was transferredto the sole stockholder in connection with the dividend.

 

See note 10 for a description of an interest rate hedge entered into onMay 4, 2006.

 

**5.  **        HEDGING ANDDERIVATIVE FINANCIAL INSTRUMENTS

** **

TheCompany utilizes swap and collar agreements and option contracts to hedge theeffect of price changes on a portion of its future oil and natural gasproduction. The objective of the Company’s hedging activities and the use ofderivative financial instruments is to achieve more predictable cash flows.While the use of these derivative instruments limits the downside risk ofadverse price movements, they also limit future revenues from favorable pricemovements. The use of derivatives also involves the risk that thecounterparties to such instruments will be unable to meet the financial termsof such contracts.

 

Thecomponents of commodity derivative losses in the consolidated income statementsare as follows (in thousands):

 

| ** **                                                                    | ** ** | **Three Months Ended  March 31,** | ** ** |
|-------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                    | ** ** | **2005**                          | ** ** | **2006** | ** ** |
| ** **                                                                    | ** ** | ** **                        | ** ** | ** ** | ** ** |
| Realized  commodity derivative losses                                         |       | $                                 | 3,565      |   | $ | 6,062 |   |
| Unrealized  commodity derivative losses:                                      |       |                              |       |   |   |
| Change in fair value of derivatives that do  not qualify for hedge accounting |       | 23,096                            |       | 8,729 |   |
| Ineffective portion of derivatives  qualifying for hedge accounting           |       | 2,499                             |       | 779 |   |
| Total unrealized commodity derivative losses                                  |       | 25,595                            |       | 9,508 |   |
| Total  realized and unrealized commodity derivative losses                    |       | $                                 | 29,160     |   | $ | 15,570 |   |

 

Theestimated fair values of derivatives included in the consolidated balancesheets at December 31, 2005 and March 31, 2006 are summarized below. Theincrease in the net derivative liability from December 31, 2005 to March 31,2006 is primarily attributable to the effect of rising oil prices and theaddition of oil collars, partially offset by the effect of declining naturalgas prices, the addition of oil puts and natural gas puts and collars and cashsettlements of derivatives during the period (in thousands):

 

10

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| ** **                        | ** ** | **December 31,  2005** | ** ** | **March 31,  2006** | ** ** |
|-----------------------------------|------------|-----------------------------|------------|--------------------------|------------|
| Derivative  assets:               |       |                        |       |                     |       |
| Oil derivative contracts          |       | $                           | 1,899      |                     | $          | 2,601 |   |
| Gas derivative contracts          |       | 1,561                       |       | 11,157                   |       |
| Derivative  liabilities:          |       |                        |       |                     |       |
| Oil derivative contracts          |       | (26,540                     | )          | (43,127                  | )          |
| Gas derivative contracts          |       | (11,849                     | )          | (6,982                   | )          |
| Net  derivative asset (liability) |       | $                           | (34,929    | )                        | $          | (36,351 | ) |

 

Asof March 31, 2006, an unrealized derivative fair value loss of$18.0 million ($10.9 million after tax), related to cash flow hedges,was recorded in accumulated other comprehensive loss. Based on the estimatedfair values of derivative contracts that qualify for cash flow hedge accountingat March 31, 2006, the Company expects to reclassify net losses of$8.7 million ($5.2 million after tax) out of accumulated othercomprehensive loss into earnings during the next twelve months; however, actualgains or losses may vary materially based on actual prices at the contractsettlement dates.

 

*Crude Oil Agreements.*As of March 31, 2006, the Company hasentered into option, swap and collar agreements to receive average minimum andmaximum New York Mercantile Exchange (NYMEX) West Texas Intermediate (WTI)prices as summarized below. Location and quality differentials attributable tothe Company’s properties are not included in the following prices. Theagreements provide for monthly settlement based on the differential between theagreement price and the actual NYMEX crude oil price.

 
| ** **                                               | ** ** | **Minimum**     | ** ** | **Maximum**     | ** ** |
|----------------------------------------------------------|------------|-----------------|------------|-----------------|------------|
| ** **                                               | ** ** | **Barrels/day** | ** ** | **Avg. Prices** | ** ** | **Barrels/day** | ** ** | **Avg. Prices** | ** ** |
| Crude oil  hedges at March 31, 2006 for production: |       |            |       |            |       |   |   |   |   |
| April 1 - December 31, 2006                    |       | 10,500          |       | $               | 47.85      |   | 7,000 |   | $ | 59.86 |   |
| January 1 - December 31, 2007                  |       | 7,313           |       | $               | 49.72      |   | 6,115 |   | $ | 71.58 |   |
| January 1 - December 31, 2008                  |       | 4,950           |       | $               | 54.43      |   | 4,950 |   | $ | 75.38 |   |
| January 1 - December 31, 2009                  |       | 4,580           |       | $               | 53.94      |   | 4,580 |   | $ | 76.78 |   |

 

*Natural Gas Agreements.*As of March 31, 2006, the Company 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  hedges at March 31, 2006 for production: |       |          |       |            |       |   |   |   |   |
| April 1 - December 31, 2006                      |       | 26,345        |       | $               | 7.18       |   | 20,345 |   | $ | 10.73 |   |
| January 1 - December 31, 2007                    |       | 21,000        |       | $               | 7.42       |   | 15,436 |   | $ | 11.46 |   |
| January 1 - December 31, 2008                    |       | 13,500        |       | $               | 8.00       |   | 11,947 |   | $ | 12.24 |   |
| January 1 - December 31, 2009                    |       | 9,500         |       | $               | 7.61       |   | 9,500 |   | $ | 12.10 |   |

 

TheCompany entered into derivative contracts for options that contain provisionsfor the deferral of the payment or receipt of premiums until the period ofproduction for which the derivative contract relates. Both the derivative andthe net liability for the payment of premiums were recorded at their fairvalues at the inception of the derivative contracts. The premiums for thederivative contract options contain an implicit interest rate factor for thedifference in the derivative’s fair value at inception and the liability forpayment of premiums. The Company recorded $3.9 million for the net derivativepremiums payable at March 31, 2006 (including $0.9 million in accounts payableand accrued liabilities and $3.0 million in long-term liabilities), net of thediscount which will be amortized into interest expense over the term of therelated contracts. 

 

Asof March 31, 2006, the Company had entered into a forward sales contractwith a gas purchaser under which it is obligated for physical delivery ofspecified volumes of gas with a floor price. As this contract provides forphysical delivery of the gas, it is not considered a derivative because it hasbeen designated as a normal sale. The transaction will be recorded in thefinancial statements when the associated delivery occurs. The Company hascontracted for 2,000 MCF per day at a floor price of $4.85 per MCF for theperiod October 1, 2005 to December 31, 2006.

 

See note 10 fora description of an interest rate hedge entered into on May 4, 2006.

 

11

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**6.  ASSET RETIREMENT OBLIGATIONS**

** **

TheCompany’s asset retirement obligations primarily represent the estimatedpresent value of the amounts expected to be incurred to plug, abandon andremediate producing properties (including removal of certain onshore andoffshore facilities in California) 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 plug and abandonment liabilities. The asset retirement liability isaccreted to its present value each period and the capitalized asset retirementcost is depleted over the productive life of the related assets. Changesresulting from revisions to the timing or the amount of the original estimateof undiscounted cash flows are recognized as an increase or decrease in theasset retirement obligation and the related capitalized asset retirement costs.Capitalized costs are 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 three months ended March 31, 2006 (in thousands):

 

| ** **                                                                                             | ** ** | **March 31** | ** ** |
|--------------------------------------------------------------------------------------------------------|------------|--------------|------------|
| ** **                                                                                             | ** ** | **2006**     | ** ** |
|                                                                                                   |       |         |       |
| Asset retirement obligations at beginning of  period                                                   |       | $            | 22,757     |   |
| Revisions of estimated liabilities                                                                     |       | 2,594        |       |
| Liabilities incurred                                                                                   |       | 9,144        |       |
| Liabilities settled                                                                                    |       | —       |       |
| Accretion expense                                                                                      |       | 470          |       |
| Asset retirement obligations at end of  period                                                         |       | 34,965       |       |
| Less: current asset retirement obligations  (classified with accounts payable and accrued liabilities) |       | (1,346       | )          |
| Long-term asset retirement obligations                                                                 |       | $            | 33,619     |   |

 

Liabilities incurred includes $8.9 million of asset retirementobligations attributable to the acquisition of TexCal.

 

**7.   SHARE-BASEDPAYMENTS**

** **

 

12

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Prior to January 1, 2006, the Company accounted forstock-based compensation using the intrinsic value method prescribed inAccounting Principles Board (“APB”) Opinion No. 25, “Accounting for StockIssued to Employees,” and related interpretations. Under APB OpinionNo. 25, no compensation expense was recognized for stock options issued toemployees if the grant price equaled or exceeded the market price on the dateof the option grant. Effective January 1, 2006, the Company adopted theprovisions of Statement of Financial Accounting Standards (“SFAS”) No. 123(Revised), “Share-Based Payment” (“SFAS 123(R)”) using the modified prospectivemethod. Under this method, compensation cost is recorded for all unvested stockoptions beginning in the period of adoption and prior period financialstatements are not restated. Under the fair value recognition provisions ofSFAS 123(R), stock-based compensation is measured at the grant date based onthe value of the awards and the value is recognized on a straight-line basisover the requisite service period (usually the vesting period).  SFAS 123(R) also requires the recognition ofthe equity component of deferred compensation as additional paid-incapital.  

 

In accordance with the provisions of SFAS 123(R), totalstock-based compensation cost in the amount of $0.6 million was recorded asgeneral and administrative expense for the three months ended March 31,2006. SFAS 123(R) requires the Company to estimate forfeitures incalculating the cost related to stock-based compensation as opposed torecognizing these forfeitures and the corresponding reduction in expense asthey occur. The cumulative adjustment from adopting SFAS 123(R) as ofJanuary 1, 2006 to include estimated forfeitures in the calculation wasnot material and had no impact on earnings per share.

 

*Equity Incentive Plan -* During 2005, the Company enteredinto non-qualified stock option agreements with certain employees, officers anddirectors of the Company other than Mr. Marquez. Total options granted in2005 through March 31, 2006 were 4,153,663 with a weighted averageexercise price of $7.40 ($6.00 to $20.00). The options vest over a four yearperiod, with 20% vesting on the grant date and 20% vesting on each subsequentanniversary of the grant date. 

 

The following summarizes the Company’s stock option activity forthe three months ended March 31, 2006:  

 
| ** **                                                        | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|-------------------------------------------------------------------|------------|------------|------------|----------------------------------------|------------|
|                                                              |       |       |       |                                   |       |
| Outstanding at  January 1, 2006                                   |       | 4,013,663  |       | $                                      | 7.04       |   |
| Granted                                                           |       | 140,000    |       | $                                      | 17.71      |   |
| Exercised                                                         |       | —     |       | —                                 |       |
| Cancelled                                                         |       | —     |       | —                                 |       |
| Outstanding,  end of period                                       |       | 4,153,663  |       | $                                      | 7.40       |   |
| Exercisable,  end of period                                       |       | 830,733    |       |                                   |       |
| Weighted  average fair value of options granted during the period |       | $          | 9.84       |                                   |       |   |
|                                                                   |            |            |            |                                        |            |  |  |

 

13

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Additional informationrelated to options outstanding as of March 31, 2006 is as follows:

 
| ** **                     | ** ** | **Options Outstanding** | ** ** | **Options Exercisable**                             | ** ** |
|--------------------------------|------------|-------------------------|------------|-----------------------------------------------------|------------|
| **Range of  Exercise  Prices** | ** ** | **Number  Outstanding** | ** ** | **Weighted  Average  Remaining  Contractual  Life** | ** ** | **Weighted-  Average  Exercise  Prices** | ** ** | **Number  Exercisable** | ** ** | **Weighted  Average  Exercise  Prices** | ** ** |
| $6.00-$7.33                    |       | 2,995,200               |       | 8.9 years                                      |       | $ | 6.12 |   | 599,040 |   | $ | 6.12 |   |
| $8.00-$8.68                    |       | 560,963                 |       | 8.9 years                                      |       | $ | 8.33 |   | 112,193 |   | $ | 8.33 |   |
| $10.67-$13.33                  |       | 497,500                 |       | 9.4 years                                      |       | $ | 11.53 |   | 99,500 |   | $ | 11.53 |   |
| $20.00                         |       | 100,000                 |       | 9.8 years                                      |       | $ | 20.00 |   | 20,000 |   | $ | 20.00 |   |
|                           |       | 4,153,663               |       | 9.0 years                                      |       | $ | 7.40 |   | 830,733 |   | $ | 7.40 |   |

 

*Pro Forma Effects -*No compensationcost was recorded prior to January 1, 2006 because the issuances of the stockoptions were at exercise prices that were equal to or higher than their fairmarket value on the date of the grant. Had the Company recognized compensation expense for all options grantedbased upon the estimated fair value on the grant date under the fair valuemethodology prescribed by SFAS 123, its pro forma net earnings and earnings percommon share for the three months ended March 31, 2005 would have been asfollows (in thousands, except per share amounts):

 
| Net income (loss) as reported                                                                                                   |   | $      | (6,818 | ) |
|---------------------------------------------------------------------------------------------------------------------------------|--------|--------|--------|---|
| Add:                                                                                                                            |   |   |   |
| Stock-based compensation expense included in  the income statement, net of related tax effects                                  |   | — |   |
| Deduct:                                                                                                                         |   |   |   |
| Total stock based compensation expense  determined under the fair value method for all awards, net of related  tax effects |   | (963   | )      |
| Pro forma net income (loss)                                                                                                     |   | $      | (7,781 | ) |
|                                                                                                                            |   |   |   |
| Basic earnings per common share:                                                                                                |   |   |   |
| As reported                                                                                                                     |   | $      | (0.21  | ) |
| Pro forma                                                                                                                       |   | $      | (0.24  | ) |
| Diluted earnings per common share:                                                                                              |   |   |   |
| As reported                                                                                                                     |   | $      | (0.21  | ) |
| Pro forma                                                                                                                       |   | $      | (0.24  | ) |

 

The fair value of each option is estimated on the grant date usingthe Black-Scholes option valuation model. Option valuation models require the input of highly subjectiveassumptions, including the expected volatility of the price of the underlyingstock. The Company’s stock options have characteristics significantly differentfrom those of traded options, and because changes in the subjective inputassumptions can materially affect the fair value estimate, it is management’s 

 

14

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opinion that the valuations afforded by the existing modelsare different from the value that the options would realize if traded in themarket.

 

The followingassumptions were used during the quarters ended March 31, 2005 and 2006 tocompute the weighted average fair market value of options granted during theperiods presented:

 

| ** **                                             | ** ** | **Three Months Ended** | ** ** |
|--------------------------------------------------------|------------|------------------------|------------|
| ** **                                             | ** ** | **March 31,**     | ** ** |
| ** **                                             | ** ** | **2005**               | ** ** | **2006** | ** ** |
| Expected option life                                   |       | 5 years                |       | 7 years |   |
| Risk free interest rates                               |       | 3.89                   | %          | 4.06 | % |
| Estimated volatility                                   |       | 76                     | %          | 61 | % |
| Dividend yield                                         |       | 0.0                    | %          | 0.0 | % |
| Weighted average fair market value of  options granted |       | $                      | 4.00       |   | $ | 9.84 |   |
|                                                        |            |                        |            |  |  |  |  |

 

The expected life of the options is based, in part, on historicalexercise patterns of the holders of options with similar terms withconsideration given to how historical patterns may differ from future exercisepatterns based on current or expected market conditions and employee turnover.On January 1, 2006, the Company began calculating the expected life of optionsgranted using the “simplified method’ set forth in Staff Accounting Bulletin107 (average of vesting period and the term of the option).  The risk free interest rate was based on theU.S. Treasury yield curve in effect at the time of grant. The expectedvolatility was based on the historical volatility of other public companieswith characteristics similar to the company for the past five years.  

 

As of March 31, 2006, there was $6.3 million of totalunrecognized compensation cost related to stock options which is expected to beamortized over a weighted-average period of 3.1 years.  

 

**8.   SHAREHOLDERS’EQUITY**

** **

OnJanuary 3, 2005, a dividend of $35.0 million was paid to the Company’ssole stockholder, a trust controlled by the Company’s CEO, from the proceeds ofthe issuance of the senior notes.

 

OnMarch 22, 2006, the Company paid a dividend consisting of 100% of itsinterest in 6267 Carpinteria to its sole stockholder, a trust controlled by theCompany’s CEO. 6267 Carpinteria owns the office building and related land leasedby the Company in Carpinteria, California. 6267 Carpinteria had net assets of$4.7 million, including $0.4 million in cash, at the date of thedividend, including land and building with a net book value of $13.4 millionand a note payable of $9.9 million.

 

**9.  LITIGATION**

** **

***BeverlyHills Litigation***

*** ***

Eightlawsuits have been filed by persons who are graduates of the Beverly Hills HighSchool or citizens of Beverly Hills/Century City or visitors to that area fromthe time period running from the 1930s to date. Six of these lawsuits name theCompany as a defendant. There are approximately 1,000 plaintiffs who claim theyare suffering from various forms of cancer or some other medical ailment, fearthey may suffer from such maladies in the future, or are related in some mannerto someone that suffered from cancer (e.g. heirs or spouses). Plaintiffs’claims are based on alleged exposure to levels of some substances in the air,soil and water which derive from either oil field or other operations in thearea. The Company has owned an oil and gas facility adjacent to the schoolsince 1995. For the majority of the plaintiffs, their alleged exposuresoccurred before the Company owned the facility. It is anticipated thatadditional plaintiffs may be added to the litigation over time. The Company hasdefense and indemnity obligations to certain other defendants in the actions.Management believes that the claims made in the suits are without merit and theCompany intends to defend against the claims vigorously. However, the Companycannot predict, at this time, the outcome of the suits. All cases areconsolidated before one judge. The judge has ordered that all of the cases bestayed except for a test case consisting of twelve plaintiffs. The trial datefor the twelve “test” plaintiffs has been moved to October 2006.

 

Oneof the Company’s insurers is currently paying for the defense of these lawsuitsunder a reservation of its rights. Two other insurers that provided insurancecoverage to the Company (the “Declining Insurers”) have taken the position thatthey are not required to provide coverage relating to the lawsuits because of apollution exclusion contained in their policies. The Beverly Hills SchoolDistrict (the “District”), as an additional insured on those policies, broughta declaratory relief action against those insurers in Los Angeles CountySuperior Court. In November 2005, the court ruled in favor of one of theinsurers. The District is appealing that decision. On February 10, 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 policyissued by the insurer that is currently providing defense of the lawsuitscontains a pollution exclusion similar to that at issue in the action broughtby the District. However, the Company has no reason to believe that the insurercurrently providing defense of these actions will cease providing such defense.If it does, and the Company is unsuccessful in enforcing its rights in anysubsequent litigation, it may be required to bear the costs of the defense, andthose costs may be material. If it is ultimately determined that the pollutionexclusion or another exclusion contained in one or more of the Company’spolicies applies, it will not have the protection of those policies withrespect to any damages or settlement costs ultimately incurred in the lawsuits.

 

15

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TheCompany cannot predict the cost of defense and indemnity obligations relatingto the Beverly Hills litigation, if any, at the present time. In accordancewith SFAS No. 5, *Accounting forContingencies*, the Company has not accrued for a loss contingencyrelating to the litigation because it believes that, although unfavorableoutcomes in the proceedings may be possible, they are not considered bymanagement to be probable or reasonably estimable. If one or more of thesematters are resolved in a manner adverse to the Company, and if insurancecoverage is determined to not be applicable, their impact on the Company’sresults of operations, financial position and/or liquidity could be material.

 

***PersonalInjury Claims***

*** ***

OnFebruary 23, 2006, a complaint was filed in Santa Barbara Superior Courtagainst the Company on behalf of a boy who was severely injured after fallingfrom a cliff located on property jointly owned by the Company and anothercompany. The complaint asserts that the Company is responsible for the boy’sinjuries and that the boy is entitled to damages, including reimbursement ofpast medical expenses, future expenses, loss of earning capacity and generaldamages. The Company believes that it has no liability in this matter andintends to defend itself vigorously. The extent of the Company’s liability withrespect to the claim, if any, cannot be predicted at this time but the Companydoes not expect it to be material. In accordance with SFAS No. 5, *Accounting for Contingencies*, the Companyhas not accrued for a loss contingency related to this claim because itbelieves that, although an unfavorable outcome may be possible, losses are notconsidered by management to be probable or reasonably estimable.

 

OnMarch 31, 2006, a complaint was filed in District Court in Madison County,Texas against a subsidiary of the Company by the widow of an individual who wasfatally injured while working as a gauger/pumper at a well operated by thesubsidiary. The cause of the accident is still being investigated. The Companybelieves that it has insurance coverage with respect to the accident.

 

***Other***

*** ***

Inaddition, the Company is subject to other claims and legal actions that mayarise in the ordinary course of business. The Company believes that theultimate liability, if any, with respect to these other claims and legalactions will not have a material effect on the Company’s consolidated financialposition, results of operations or liquidity.

 

**10.   SUBSEQUENTEVENTS**

** **

On May 4, 2006,the Company entered into a swap transaction pursuant to which it hedged itsinterest cost on $200 million of borrowings under the term loan facility at afixed rate of 9.9225% through May 8, 2008.

 

**11.   RECENTACCOUNTING PRONOUNCEMENTS**

** **

InJune 2005, the FASB issued SFAS No. 154, *Accounting Changes and Error Corrections*, which replaces APBOpinion No. 20, *Accounting Changes*,and SFAS No. 3, *Reporting AccountingChanges in Interim Financial Statements*. Statement 154 changesthe requirements for the accounting and reporting of a change in accountingprinciple. APB Opinion No. 20 previously required that most voluntarychanges in an accounting principle be recognized by including the cumulativeeffect of the new accounting principle in net income of the period of thechange. SFAS No. 154 now requires retrospective application of changes inan accounting principle to prior period financial statements, unless it isimpracticable to determine either the period-specific effects or the cumulativeeffect of the change. The Statement is effective for fiscal years beginningafter December 15, 2005. The adoption of this statement did not have amaterial impact on the Company’s financial statements.

 

InFebruary 2006, the FASB issued SFAS No. 155, *Accountingfor Certain Hybrid Financial Instruments—an amendment of FASB StatementsNo. 133 and 140*(“SFAS 155”). This statement amends *SFAS No. 133,**Accounting for Derivative Instrumentsand Hedging Activities*(“SFAS 133”), and SFAS No. 140, *Accounting for Transfers and Servicing of Financial Assets andExtinguishments of Liabilities*and resolves issues addressed inSFAS 133 Implementation Issue No. D1, “Application ofStatement 133 to Beneficial Interest in Securitized Financial Assets.”This Statement: (a) permits fair value remeasurement for any hybridfinancial instrument that contains an embedded derivative that otherwise wouldrequire bifurcation; (b) clarifies which interest-only strips andprincipal-only strips are not subject to the requirements of SFAS 133;(c) establishes a requirement to evaluate beneficial interests insecuritized financial assets to identify interests that are freestandingderivatives or that are hybrid financial instruments that contain an embeddedderivative requiring bifurcation; (d) clarifies that concentrations ofcredit risk in the form of subordination are not embedded derivatives; and,(e) eliminates restrictions on a qualifying special-purpose entity’sability to hold passive derivative financial instruments that pertain tobeneficial interests that are or contain a derivative financial instrument. Thestandard also requires presentation within the financial statements thatidentifies those hybrid financial instruments for which the fair value electionhas been applied and information on the income statement impact of the changesin fair value of those instruments. The Company is required to applySFAS 155 to all financial instruments acquired, issued or subject to aremeasurement event beginning January 1, 2007, although early adoption ispermitted as of the beginning of an entity’s fiscal year. The Company isevaluating the provisions of SFAS 155. The effects of adopting ofSFAS 155 on the Company’s financial statements are not known at this time.

 

16

----

 

**12.   GUARANTORFINANCIAL INFORMATION**

** **

Inconnection with the issuance of the senior notes in December 2004,BMC, Ltd., Whittier Pipeline Corp. and 217 State Street, Inc. (“Guarantors”)fully and unconditionally guaranteed, on a joint and several basis, the Company’sobligations under the senior notes. On March 31, 2005, Marquez Energybecame a Guarantor. The Company has one subsidiary, EllwoodPipeline, Inc., that is not a Guarantor. On November 1, 2005, theCompany merged Marquez Energy and 217 State Street, Inc. with and intoVenoco, Inc., leaving BMC and Whittier as the only Guarantors until theTexCal Acquisition. On March 31, 2006, TexCal and its four subsidiariesbecame Guarantors. All Guarantors are 100% owned by the Company.

 

The following iscondensed consolidating financial information for the three months endedMarch 31, 2005 and 2006 and as of December 31, 2005 and March 31,2006.

 

17

----

**CONDENSED CONSOLIDATING STATEMENTS OF OPERATIONS**

**THREE MONTHS ENDED MARCH 31, 2005 (Unaudited)**

**(in thousands)**

 
| ** **                                                | ** ** | ** **       | ** ** | **Guarantor**    | ** ** | **Non-Guarantor** | ** ** | ** **       | ** ** | ** **       | ** ** |
|-----------------------------------------------------------|------------|------------------|------------|------------------|------------|-------------------|------------|------------------|------------|------------------|------------|
| ** **                                                | ** ** | **Venoco, Inc.** | ** ** | **Subsidiaries** | ** ** | **Subsidiaries**  | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| **REVENUES:**                                             | ** ** | ** **       | ** ** | ** **       | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** |
| Oil and natural gas sales                                 |       | $                | 39,645     |             | $          | 2,393             |       | $                | —     |             |       |   |   | $ | 42,038 |   |
| Commodity derivative losses (realized)                    |       | (3,565           | )          |             |       |              |       |             |       | (3,565           | )          |
| Commodity derivative losses (unrealized)                  |       | (25,595          | )          |             |       |              |       |             |       | (25,595          | )          |
| Other                                                     |       | 785              |       | 21,670           |       | 2,047             |       | (23,423          | )          | 1,079            |       |
| Total revenues                                            |       | 11,270           |       | 24,063           |       | 2,047             |       | (23,423          | )          | 13,957           |       |
| **EXPENSES:**                                             | ** ** | ** **       | ** ** | ** **       | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** |
| Oil and natural gas production                            |       | 11,063           |       | 464              |       | 403               |       | —           |       | 11,930           |       |
| Transportation expense                                    |       | 1,994            |       | —           |       | —            |       | (1,314           | )          | 680              |       |
| Depletion, depreciation and amortization                  |       | 5,325            |       | 253              |       | 75                |       | —           |       | 5,653            |       |
| Accretion of abandonment liability                        |       | 412              |       | 24               |       | 6                 |       | —           |       | 442              |       |
| General and administrative, net of amounts  capitalized   |       | 3,573            |       | 124              |       | 130               |       | (711             | )          | 3,116            |       |
| Amortization of deferred loan costs                       |       | 345              |       | —           |       | —            |       | —           |       | 345              |       |
| Interest, net                                             |       | 3,778            |       | —           |       | (281              | )          | —           |       | 3,497            |       |
| Total expenses                                            |       | 26,490           |       | 865              |       | 333               |       | (2,025           | )          | 25,663           |       |
| Equity in  subsidiary income                              |       | 2,034            |       | —           |       | —            |       | (2,034           | )          | —           |       |
| Income (loss)  before income taxes                        |       | (13,186          | )          | 23,198           |       | 1,714             |       | (23,432          | )          | (11,706          | )          |
| Income tax  provision (benefit)                           |       | (6,410           | )          | 9,771            |       | 722               |       | (9,013           | )          | (4,930           | )          |
| Income (loss) before minority interest in  Marquez Energy |       | (6,776           | )          | 13,427           |       | 992               |       | (14,419          | )          | (6,776           | )          |
| Minority  interest in Marquez Energy                      |       | 42               |       | —           |       | —            |       | —           |       | 42               |       |
| Net income  (loss)                                        |       | $                | (6,818     | )                | $          | 13,427            |       | $                | 992        |             | $          | (14,419 | ) | $ | (6,818 | ) |
|                                                           |            |                  |            |                  |            |                   |            |                  |            |                  |            |  |  |  |  |  |  |  |  |  |

 

18

----

**CONDENSED CONSOLIDATING STATEMENTS OF OPERATIONS**

**THREE 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 (realized)                  |       | (6,062           | )          | —           |       | —            |       | —           |       | (6,062           | )          |
| Commodity derivative losses (unrealized)                |       | (9,508           | )          | —           |       | —            |       | —           |       | (9,508           | )          |
| 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                     |       | 341              |       | —           |       | —            |       | —           |       | 341              |       |
| Interest, net                                           |       | 4,211            |       | —           |       | (441              | )          | —           |       | 3,770            |       |
| 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 |   |
|                                                         |            |                  |            |                  |            |                   |            |                  |            |                  |            |  |  |  |  |  |  |  |  |  |

 

19

----

**CONDENSEDCONSOLIDATING BALANCE SHEETS**

**ATDECEMBER 31, 2005**

**(in thousands)**

 
| ** **                                      | ** ** | **Venoco, Inc.** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|-------------------------------------------------|------------|-----------------------|------------|-----------------------------|------------|---------------------------------|------------|------------------|------------|------------------|------------|
| **ASSETS**                                      |       |                  |       |                        |       |                            |       |             |       |             |       |
| CURRENT  ASSETS:                                |       |                  |       |                        |       |                            |       |             |       |             |       |
| Cash and cash equivalents                       |       | $                     | 9,041      |                        | $          | —                          |       | $                | 348        |             | $          | — |   | $ | 9,389 |   |
| Accounts receivable                             |       | 29,253                |       | 490                         |       | 98                              |       | —           |       | 29,841           |       |
| Inventories                                     |       | 1,753                 |       | —                      |       | —                          |       | —           |       | 1,753            |       |
| Commodity derivatives                           |       | 3,391                 |       | —                      |       | —                          |       | —           |       | 3,391            |       |
| Prepaid expenses and other current assets       |       | 3,894                 |       | —                      |       | 457                             |       | —           |       | 4,351            |       |
| Income taxes receivable                         |       | 4,107                 |       | —                      |       | —                          |       | —           |       | 4,107            |       |
| Deferred income taxes                           |       | 8,611                 |       | —                      |       | —                          |       | —           |       | 8,611            |       |
| TOTAL CURRENT  ASSETS                           |       | 60,050                |       | 490                         |       | 903                             |       | —           |       | 61,443           |       |
| PROPERTY, PLANT & EQUIPMENT, NET       |       | 222,798               |       | 17,756                      |       | 14,868                          |       | (21,646          | )          | 233,776          |       |
| COMMODITY DERIVATIVES                           |       | 69                    |       | —                      |       | —                          |       | —           |       | 69               |       |
| INVESTMENTS IN AFFILIATES                       |       | 69,651                |       | —                      |       | —                          |       | (69,651          | )          | —           |       |
| OTHER                                           |       | 7,270                 |       | —                      |       | —                          |       | —           |       | 7,270            |       |
| TOTAL ASSETS                                    |       | $                     | 359,838    |                        | $          | 18,246                          |       | $                | 15,771     |             | $          | (91,297 | ) | $ | 302,558 |   |
|                                            |       |                  |       |                        |       |                            |       |             |       |             |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**  |       |                  |       |                        |       |                            |       |             |       |             |       |
| CURRENT  LIABILITIES:                           |       |                  |       |                        |       |                            |       |             |       |             |       |
| Accounts payable and accrued liabilities        |       | $                     | 31,784     |                        | 10         |                            | 60         |             | —     |             | $          | 31,854 |   |
| Undistributed revenue payable                   |       | 2,155                 |       | —                      |       | —                          |       | —           |       | 2,155            |       |
| Current maturities of long-term debt            |       | —                |       | —                      |       | 126                             |       | —           |       | 126              |       |
| Commodity derivatives                           |       | 26,397                |       | —                      |       | —                          |       | —           |       | 26,397           |       |
| TOTAL CURRENT  LIABILITIES                      |       | 60,336                |       | 10                          |       | 186                             |       | —           |       | 60,532           |       |
| LONG-TERM  DEBT                                 |       | 169,180               |       | —                      |       | 9,763                           |       | —           |       | 178,943          |       |
| DEFERRED  INCOME TAXES                          |       | 24,108                |       | —                      |       | —                          |       | —           |       | 24,108           |       |
| ASSET RETIREMENT OBLIGATIONS                    |       | 21,507                |       | 701                         |       | 441                             |       | —           |       | 22,649           |       |
| INTERCOMPANY PAYABLES (RECEIVABLES)             |       | 68,381                |       | (49,325                     | )          | (19,056                         | )          | —           |       | —           |       |
| OTHER  LIABILITIES                              |       | 11,992                |       | —                      |       | —                          |       | —           |       | 11,992           |       |
| TOTAL  LIABILITIES                              |       | 355,504               |       | (48,614                     | )          | (8,666                          | )          | —           |       | 298,224          |       |
| TOTAL STOCKHOLDERS’ EQUITY                 |       | 4,334                 |       | 66,860                      |       | 24,437                          |       | (91,297          | )          | 4,334            |       |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY |       | $                     | 359,838    |                        | $          | 18,246                          |       | $                | 15,771     |             | $          | (91,297 | ) | $ | 302,558 |   |
|                                                 |            |                       |            |                             |            |                                 |            |                  |            |                  |            |  |  |  |  |  |  |  |  |  |  |

 

 

20

----

**CONDENSED CONSOLIDATING BALANCESHEETS**

**AT MARCH 31, 2006 (Unaudited)**

**(in thousands)**

 
| ** **                                      | ** ** | ** **       | ** ** | **Guarantor**    | ** ** | **Non-Guarantor** | ** ** | ** **       | ** ** | ** **       | ** ** |
|-------------------------------------------------|------------|------------------|------------|------------------|------------|-------------------|------------|------------------|------------|------------------|------------|
| ** **                                      | ** ** | **Venoco, Inc.** | ** ** | **Subsidiaries** | ** ** | **Subsidiaries**  | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| **ASSETS:**                                     | ** ** | ** **       | ** ** | ** **       | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** |
| CURRENT  ASSETS:                                |       |             |       |             |       |              |       |             |       |             |       |
| Cash and cash equivalents                       |       | $                | 4,076      |             | $          | 10,409            |       | $                | —     |             | $          | — |   | $ | 14,485 |   |
| Accounts receivable                             |       | 24,746           |       | 14,582           |       | 102               |       | —           |       | 39,430           |       |
| Inventories                                     |       | 1,386            |       | —           |       | —            |       | —           |       | 1,386            |       |
| Prepaid expenses and other current assets       |       | 4,542            |       | 1,235            |       | —            |       | —           |       | 5,777            |       |
| Income taxes receivable                         |       | 4,252            |       | —           |       | —            |       | —           |       | 4,252            |       |
| Deferred income taxes                           |       | 8,635            |       | —           |       | —            |       | —           |       | 8,635            |       |
| Commodity derivatives                           |       | 6,399            |       | —           |       | —            |       | —           |       | 6,399            |       |
| TOTAL CURRENT  ASSETS                           |       | 54,036           |       | 26,226           |       | 102               |       | —           |       | 80,364           |       |
| PROPERTY, PLANT & EQUIPMENT, NET            |       | 251,998          |       | 474,253          |       | 995               |       | (21,663          | )          | 705,583          |       |
| COMMODITY DERIVATIVES                           |       | 7,359            |       | —           |       | —            |       | —           |       | 7,359            |       |
| INVESTMENTS IN AFFILIATES                       |       | 528,562          |       | —           |       | —            |       | (528,562         | )          | —           |       |
| OTHER                                           |       | 20,820           |       | 1,018            |       | —            |       | —           |       | 21,838           |       |
| TOTAL ASSETS                                    |       | $                | 862,775    |             | $          | 501,497           |       | $                | 1,097      |             | $          | (550,225 | ) | $ | 815,144 |   |
|                                            |       |             |       |             |       |              |       |             |       |             |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**  | ** ** | ** **       | ** ** | ** **       | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** |
| CURRENT  LIABILITIES:                           |       |             |       |             |       |              |       |             |       |             |       |
| Accounts payable and accrued liabilities        |       | $                | 35,463     |             | $          | 10,485            |       | $                | 1          |             | $          | — |   | $ | 45,949 |   |
| Undistributed revenue payable                   |       | 2,107            |       | 11,576           |       | —            |       | —           |       | 13,683           |       |
| Accrued interest                                |       | 4,011            |       | —           |       | —            |       | —           |       | 4,011            |       |
| Commodity derivatives                           |       | 27,493           |       | —           |       | —            |       | —           |       | 27,493           |       |
| TOTAL CURRENT  LIABILITIES                      |       | 69,074           |       | 22,061           |       | 1                 |       | —           |       | 91,136           |       |
| LONG-TERM  DEBT                                 |       | 628,743          |       | —           |       | —            |       | —           |       | 628,743          |       |
| DEFERRED  INCOME TAXES                          |       | 28,100           |       | —           |       | –—      |       | —           |       | 28,100           |       |
| COMMODITY  DERIVATIVES                          |       | 22,616           |       | —           |       | —            |       | —           |       | 22,616           |       |
| ASSET  RETIREMENT OBLIGATIONS                   |       | 24,735           |       | 8,438            |       | 446               |       | —           |       | 33,619           |       |
| INTERCOMPANY PAYABLES (RECEIVABLES)             |       | 78,577           |       | (50,889          | )          | (27,688           | )          | —           |       | —           |       |
| OTHER  LONG-TERM LIABILITIES                    |       | 3,037            |       | —           |       | —            |       | —           |       | 3,037            |       |
| TOTAL  LIABILITIES                              |       | 854,882          |       | (20,390          | )          | (27,241           | )          | —           |       | 807,251          |       |
| TOTAL  STOCKHOLDERS’ EQUITY                |       | 7,893            |       | 521,887          |       | 28,338            |       | (550,225         | )          | 7,893            |       |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY |       | $                | 862,775    |             | $          | 501,497           |       | $                | 1,097      |             | $          | (550,225 | ) | $ | 815,144 |   |
|                                                 |            |                  |            |                  |            |                   |            |                  |            |                  |            |  |  |  |  |  |  |  |  |  |  |  |

 

21

----

**CONDENSED CONSOLIDATING STATEMENTOF CASH FLOWS**

**THREE MONTHS ENDED MARCH 31, 2005(Unaudited)**

**(in thousands)**

 
| ** **                                                            | ** ** | ** **       | ** ** | **Guarantor**    | ** ** | **Non-Guarantor** | ** ** | ** **       | ** ** | ** **       | ** ** |
|-----------------------------------------------------------------------|------------|------------------|------------|------------------|------------|-------------------|------------|------------------|------------|------------------|------------|
| ** **                                                            | ** ** | **Venoco, Inc.** | ** ** | **Subsidiaries** | ** ** | **Subsidiaries**  | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| OPERATING  ACTIVITIES                                                 |       |             |       |             |       |              |       |             |       |             |       |
| Net cash provided by operating activities                             |       | $                | 8,039      |             | $          | 1,133             |       | $                | 1,613      |             | —     |   | $ | 10,785 |   |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                 |       |             |       |             |       |              |       |             |       |             |       |
| Capital expenditures for oil and gas  properties                      |       | (13,721          | )          | (581             | )          | —            |       | —           |       | (14,302          | )          |
| Acquisition of Marquez Energy, LLC                                    |       | (14,628          | )          | —           |       | —            |       | —           |       | (14,628          | )          |
| Proceeds from sale of oil and gas properties                          |       | —           |       | 44,619           |       | —            |       | —           |       | 44,619           |       |
| Increase in cash restricted for investment  in oil and gas properties |       | —           |       | (44,619          | )          | —            |       | —           |       | (44,619          | )          |
| Notes receivable - officers and employees                             |       | 1,420            |       | —           |       | —            |       | —           |       | 1,420            |       |
| Capital expenditures for property and  equipment and other            |       | (114             | )          | —           |       | —            |       | —           |       | (114             | )          |
| Net cash provided by (used in) investing  activities                  |       | (27,043          | )          | (581             | )          | —            |       | —           |       | (27,624          | )          |
| Net proceeds from (repayments of)  intercompany borrowings            |       | 2,094            |       | (552             | )          | (1,542            | )     | —           |       | —           |       |
| Proceeds from long-term debt                                          |       | 13,000           |       | —           |       | —            |       | —           |       | 13,000           |       |
| Principal payments on long-term debt                                  |       | (4,684           | )          | —           |       | 36                |       | —           |       | (4,648           | )          |
| Distribution payments to Marquez Energy  member                       |       | (707             | )          | —           |       | —            |       | —           |       | (707             | )          |
| Payments of dividends                                                 |       | (35,000          | )          | —           |       | —            |       | —           |       | (35,000          | )          |
| Repurchase of common stock                                            |       | (5,207           | )          | —           |       | —            |       | —           |       | (5,207           | )          |
| Increase in deferred loan costs                                       |       | (290             | )          | —           |       | —            |       | —           |       | (290             | )          |
| Net cash used in financing activities                                 |       | (30,794          | )          | (552             | )          | (1,506            | )          | —           |       | (32,852          | )          |
| Net increase (decrease) in cash and cash  equivalents                 |       | (49,798          | )          | —           |       | 107               |       | —           |       | (49,691          | )          |
| Cash and cash equivalents, beginning of  period                       |       | 54,665           |       | —           |       | 50                |       | —           |       | 54,715           |       |
| Cash and cash equivalents, end of period                              |       | $                | 4,867      |             | $          | —            |       | $                | 157        |             | $          | — |   | $ | 5,024 |   |
|                                                                       |            |                  |            |                  |            |                   |            |                  |            |                  |            |  |  |  |  |  |

 

22

----

**CONDENSED CONSOLIDATING STATEMENTOF CASH FLOWS**

**THREE MONTHS ENDED MARCH 31, 2006(Unaudited)**

**(in thousands)**

 
| ** **                                                 | ** ** | ** **       | ** ** | **Guarantor**    | ** ** | **Non-Guarantor** | ** ** | ** **       | ** ** | ** **       | ** ** |
|------------------------------------------------------------|------------|------------------|------------|------------------|------------|-------------------|------------|------------------|------------|------------------|------------|
| ** **                                                 | ** ** | **Venoco, Inc.** | ** ** | **Subsidiaries** | ** ** | **Subsidiaries**  | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| OPERATING  ACTIVITIES                                      |       |             |       |             |       |              |       |             |       |             |       |
| Net cash provided by operating activities                  |       | $                | 29,705     |             | $          | 855               |       | $                | 1,396      |             | $          | — |   | $ | 31,956 |   |
| CASH FLOWS FROM INVESTING ACTIVITIES:                      |       |             |       |             |       |              |       |             |       |             |       |
| Capital expenditures for oil and gas  properties           |       | (28,813          | )          | (21              | )          | —            |       | —           |       | (28,834          | )          |
| Acquisition of Marquez Energy, LLC                         |       | —           |       | —           |       | —            |       | —           |       | —           |       |
| 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         | )          |
| Capital expenditures for property and  equipment and other |       | (803             | )          | —           |       | —            |       | —           |       | (803             | )          |
| Net cash provided by (used in) investing  activities       |       | (485,548         | )          | 13,419           |       | —            |       | —           |       | (472,129         | )          |
| 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          | )          |
| Payments of dividends                                      |       | (426             | )          | —           |       | —            |       | —           |       | (426             | )          |
| Increase in deferred loan costs                            |       | (13,801          | )          | —           |       | —            |       | —           |       | (13,801          | )          |
| Net cash provided by (used in) financing  activities       |       | 450,878          |       | (3,865           | )          | (1,744            | )          | —           |       | 445,269          |       |
| 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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**Item 2.****  ****MANAGEMENT’S****DISCUSSION AND ANALYSISOF FINANCIAL CONDITION ANDRESULTS OF OPERATIONS**

 

The following discussion andanalysis should be read in conjunction with “Management’s Discussion andAnalysis of Financial Condition and Results of Operations” contained in our AnnualReport on Form 10-K for the year ended December 31, 2005 as filedwith the Securities and Exchange Commission on April 5, 2006, as well aswith the financial statements and related notes and the other informationappearing elsewhere in this report. For further information on our businessstrategy, the opportunities we intend to pursue and the risks and uncertaintiesto which our business is subject, see “Business and Properties—Our Strategy”and “Risk Factors” as set forth in the above referenced report on Form 10-K. Certainstatements 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 gas and oil reserves and pricingassumptions relating to those reserves, potential delays in the timing ofplanned operations, competition and other risks associated with permitting andwith leasing gas and oil properties, potential cost overruns, potential dryholes and regulatory uncertainties and the availability of capital to fundplanned expenditures, as well as general industry and market conditions. Asused in this report, unless the context otherwise indicates, references to “we,”“our,” “ours,” and “us” refer to Venoco, Inc. and its subsidiariescollectively.

 

**Overview**

 

Weare an independent energy company primarily engaged in the acquisition,exploration, exploitation and development of oil and natural gas properties.Since the change in our senior management that occurred in June 2004, wehave returned to our historical strategy of devoting substantial resources toexploration, exploitation and development projects on our properties, and tothe acquisition of additional properties. Pursuit of this strategy has led toincreases in our oil and natural gas production. Our average net production for2005 was 11,555 BOE/d, up 4% from an average of 11,125 BOE/d for 2004. Our netproduction for the first quarter of 2006 was 11,215 BOE/d, not includingproduction attributable to our acquisition of TexCal Energy (LP) LLC, orTexCal, on March 31, 2006. We expect to increase production from ourDecember 31, 2005 asset base in 2006 relative to 2005. Because of theanticipated overall increases in production and the effect of our hedgingprogram, we expect revenues, not including the effect of non-cash, unrealizedderivative gains and losses, to increase in 2006 compared to 2005 even if oiland natural gas prices decline moderately. We expect substantial production andrevenue increases beginning in the second quarter as a result of  the TexCal Acquisition, which was completedon March 31, 2006. TexCal had average net production of 5,468 BOE/d in thefirst quarter of 2006. See “—Acquisitions and Divestitures—Acquisition of TexCal.”We believe that continued pursuit of our business strategy will lead to anincrease in our proved reserves in 2006 and subsequent years. In theexecution of our business strategy, management is principally focused onincreasing our reserves of oil and natural gas and on continuing andstrengthening the trend of increasing annual production through exploration,exploitation and development activities, acquisitions and the resolution ofoperational problems as they arise. Our management is also focused on the risksand opportunities associated with current oil and natural gas prices, which aregenerally high compared to historical averages, and on the goal of maximizingproduction rates while operating in a safe manner. Rising oil and natural gasprices created substantial unrealized commodity derivative losses in 2005 andin the first quarter of 2006 which served to suppress earnings reported in thoseperiods. These unrealized losses, which totaled $9.5 million in the firstquarter of 2006, resulted from mark-to-market valuations for non-highlyeffective or ineffective portions of our derivative positions and are reflectedas commodity derivative losses in our income statement. Any payments actuallydue to counterparties in the future on these derivatives will ultimately befunded by higher prices received from the sale of our production. Ourdisciplined hedging strategy, which includes the use of collars, swaps andpurchased floors, has allowed us to lock in minimum future floor prices weconsider attractive on substantial production volumes throughDecember 2009, while often allowing upside participation. See “—Qualitativeand Quantitative Disclosures About Market Risk.”

 

***Capital Expenditures***

 

Wehave developed an active capital expenditure program to take advantage of ourextensive inventory of drilling prospects. We estimate that our exploration,exploitation and development capital expenditures will be between$165 million and $195 million in 2006, including over$40 million on projects acquired as part of the TexCal Acquisition. In thefirst quarter of 2006, we incurred $30.8 million of capital expenditures on ourprojects, not including accrued capital expenditures of $2.0 million or expendituresmade by TexCal prior to our acquisition of that company. Projects we expect topursue in 2006 in the Sockeye and South Ellwood fields include over 20redrills, recompletions and workovers. In the first quarter of 2006, wecompleted two workovers in the South Ellwood field and one in the Sockeyefield. We also drilled two wells in the Sockeye field, one of which wascompleted. The other is an exploratory well that was dry at its deep targetdepth and is currently being tested in uphole zones. We also expect to increase water injectioncapabilities at these fields and to incorporate system upgrades to

 

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mitigateoperating risks and enhance reliability. In the Sacramento Basin, we plan todrill over 80 new wells and to complete approximately 50 to75 workovers and recompletions. In the first quarter of 2006, we drilled andcompleted eight new wells and completed nine workovers and recompletions in theSacramento Basin. In Texas, we expect to drill approximately seven new wellsand to conduct operations to increase the operating efficiency and productionrates in some of the fields acquired as part of the TexCal Acquisition.Exploration activities planned for 2006 include the drilling of approximatelyseven exploration wells. Two of these wells were drilled in the first quarterof 2006 and both are currently being tested. We also expect to continue our aggressiveleasing program in key areas. The aggregate levels of capital expenditures for2006, and the allocation of such expenditures, are dependent on a variety offactors, including the availability of service contractors and equipment,permitting issues, weather and limits on the number of activities that can beconducted at any one time on our offshore platforms. Accordingly, the actuallevels of capital expenditures and the allocation of such expenditures may varymaterially from the above estimates.

 

***Acquisitions and Divestitures***

 

*Acquisition of**TexCal.*We acquired TexCal onMarch 31, 2006 for $456 million in cash and transaction costs of $14.4 million.According to a reserve report prepared by DeGolyer & MacNaughton, asof December 31, 2005, TexCal had proved reserves of 31.4 MMBOE. It hadaverage net production in the first quarter of 2006 of 5,468 BOE/d, of which61% was natural gas and 39% was oil and condensate. The acquisition isconsistent with our strategy of acquiring large, mature fields with establishedreserves and significant exploitation and development potential, and willprovide us with substantial additions to our existing multi-year drillinginventory. TexCal acquired all of its properties in October 2004 fromTri-Union Development Corporation, or Tri-Union, which was then a debtor inproceedings under Chapter 11 of the U.S. bankruptcy code. In part due tothe circumstances leading to the Tri-Union bankruptcy, capital expendituresdevoted to the TexCal properties have been limited in recent years.

 

Theacquisition was completed pursuant to a merger agreement entered into onMarch 30, 2006. As contemplated by the agreement, TexCal merged with oneof our wholly owned subsidiaries, with TexCal as the surviving entity. TexCalmade customary representations in the merger agreement regarding its business,operations and other matters, all of which expired at the closing of thetransaction.

 

Wefinanced the acquisition through loans advanced under our revolving creditfacility and a new second lien term loan facility. We borrowed approximately$119.5 million under the revolving credit facility and $350 millionunder the second lien term loan facility to finance the $456 millionpurchase price and related transaction costs. The revolving credit facility hasan aggregate maximum loan amount of $300 million and an initial borrowingbase of $200 million.

 

*Acquisition of Marquez Energy.*We completed our acquisition of MarquezEnergy, a Colorado limited liability company majority owned and controlled byTimothy Marquez, on March 21, 2005. According to a reserve report preparedby Netherland, Sewell & Associates, Inc., or NSAI, Marquez Energy hadproved reserves of approximately 2.0 MMBOE as of December 31, 2004. Thepurchase price for the membership interests in Marquez Energy was$16.8 million (including a $2.0 million deposit paid in 2004). Thepurchase price was based on the members’ equity on Marquez Energy’s unauditedDecember 31, 2004 balance sheet, as adjusted to reflect the value of itsoil and natural gas properties (as determined by NSAI as of December 31,2004) and certain other adjustments. For the purpose of calculating thepurchase price, the following values were assigned to Marquez Energy’s provedreserves: (i) $1.75/Mcfe for its proved developed producing reserves,(ii) $1.00/Mcfe for its proved developed non-producing reserves and(iii) $0.75/Mcfe for its proved undeveloped reserves. Pursuant to thepurchase agreement, NSAI conducted a supplemental evaluation of the Marquez Energyproperties as of year-end 2005, and NSAI or another nationally recognizedengineering firm will conduct a further evaluation as of year-end 2006. In theevent the year-end 2006 evaluation attributes proved reserves to the MarquezEnergy properties as of December 31, 2004 in excess of those reflected inNSAI’s initial report, an additional payment will be made to the former holdersof interests in Marquez Energy pursuant to the same formula, subject to amaximum aggregate price of $25.0 million, including assumption of debt. Noadditional payments were due as a result of an evaluation conducted by NSAI asof December 31, 2005.

 

Bypurchasing Marquez Energy, we acquired natural gas properties in the SacramentoBasin that we believe possess significant exploitation, development andexploration potential. These properties, which Marquez Energy acquiredbeginning in January 2004, are complementary to our other properties inthe Sacramento Basin. Because Marquez Energy was a company under common controlsince July 12, 2004, our financial statements and production informationfor the entire year 2005 and for the third and fourth quarters of 2004 includeMarquez Energy. For the same reason, the acquisition was accounted for in amanner similar to a pooling of interests whereby the historical results ofMarquez Energy have been combined with our financial results since July 1,2004.

 

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*Sale of Big Mineral Creek.*On March 31, 2005, we completed the saleof our Big Mineral Creek field, located in Grayson County, Texas, to BlackWellEnergy Group, LLC for $44.6 million. The transaction was given economiceffect as of February 1, 2005. As of December 31, 2004, the field hadproved reserves of approximately 3.4 MMBOE, according to a report by NSAI.Average net production at the field was approximately 547 BOE/d in the firstquarter of 2005. Pursuant to Section 1031 of the Internal Revenue Code, weeffected a like-kind exchange of a portion of the Big Mineral Creek fieldrepresenting approximately $15.0 million of the total sale price forcertain Marquez Energy properties and properties acquired from third parties.The like-kind exchange provisions resulted in the deferral of a portion ofincome taxes related to the gain on sale. We did not recognize a gain on salefor financial reporting purposes, but applied the net sales proceeds to reducethe capitalized costs of our oil and natural gas properties in accordance withour full-cost accounting method.

 

*Other.*In September 2005, we acquired a 100% working interest in theWillows-Beehive Bend gas field, a 100% working interest in the Bounde Creek gasfield and a 65% working interest in the Arbuckle field for an aggregate priceof $10.1 million, net of certain participation rights held by thirdparties. We operate all of the acquired fields, which are located in theSacramento Basin. In January 2006, wesold 35% of the interests we acquired in the Willows-Beehive Bend and BoundeCreek fields for $3.0 million. In the fourth quarter of 2005, we purchasedthe Union Island pipeline, a 32-mile natural gas pipeline that runs from theUnion Island field to a location near Pittsburg, California, for$6.1 million. We believe that ownership of the pipeline will provide usgreater marketing flexibility and will allow us to maximize the value of ournatural gas production from the Union Island field. We also believe that wewill benefit from third party transactions involving the pipeline.

 

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

 

Oiland natural gas prices have increased significantly since the beginning of2004. Rising prices contributed to an increase in our oil and natural gas salesand revenues in both 2005 compared to 2004 and 2004 compared to 2003. Oil andnatural gas prices have remained at high levels in 2006 compared to historicalaverages. Price increases in 2005, together with an increase in productionvolumes, resulted in a 37% increase in our oil and natural gas sales comparedto 2004, although because of unrealized commodity derivative losses, our totalrevenues increased only 10%. Unrealized commodity derivative losses result frommark-to-market valuations of some of our derivative positions due to rising oiland natural gas prices. Any payments due to counterparties in the future onthese derivatives will ultimately be funded by higher oil and natural gasprices received from the sale of production.

 

Ourproduction of oil and natural gas has increased since the change in our seniormanagement that occurred in June 2004. The management in place betweenmid-2002 and mid-2004 reduced capital expenditures, in part in their discretionand in part because, commencing in February 2003, a large portion of ourcash flow from operations was needed to amortize the credit facility then inplace, which had become a term loan. As our oil properties generally have ashallow decline rate, our oil production did not decline significantly duringthe period despite limited capital expenditures. We averaged oil production of8.8 MBbl/d in 2002, 8.5 MBbl/d in 2003 and 8.5 MBbl/d in 2004. Our natural gasproduction declines at a higher rate when exploitation and developmentactivities are curtailed. As a result, average natural gas production decreasedfrom 19,655 Mcf/d in 2002 to 15,362 Mcf/d in 2003 and 14,660 Mcf/d in 2004(excluding production from Marquez Energy). As noted above (see “—Overview”),our renewed focus on exploration, exploitation and development projects hasreversed these declines overall, with average net production rising from 11,125BOE/d in 2004 to approximately 11,555 BOE/d in 2005. Our net production for thefirst quarter of 2006 was 11,215 BOE/d, not including any productionattributable to our acquisition of TexCal on March 31, 2006. Relative tothe first quarter of 2005, production volumes in the first quarter of 2006 weresignificantly impacted by heavy rain and flooding in northern California in2006, which resulted in shut in production, the delayed timing of additionalsaltwater injection facilities, which timing limited production from some wellsin the first quarter of 2006, and the sale of our Big Mineral Creek field,which averaged net production of 547 BOE/d in the first quarter of 2005and was sold on March 31, 2005. TexCalhad average net production of 5,468 BOE/d in the first quarter of 2006,compared to 3,076 BOE/d in the first quarter of 2005. The addition ofproduction from the TexCal properties will significantly increase our averagenet production in the second quarter. We also expect to increase productionfrom our December 31, 2005 asset base in 2006 relative to 2005.

 

In order to manage and maximize our growth, we have been increasing ourprofessional staff, and this has resulted in increased general andadministrative costs. The TexCal Acquisition will further increase those costs.We do not expect those costs to grow on a per barrel basis. However, we havenot to date fully quantified the costs we expect to incur with respect toSarbanes-Oxley Act compliance, and those costs may be significant.

 

Theindebtedness we incurred in the TexCal transaction significantly increased ourdebt service obligations. Satisfaction of those obligations will require asubstantial portion of the operating cash flow generated from the properties weacquired in the transaction. See “—Liquidity and Capital Resources—CapitalResources and Requirements.”

 

***Internal Control Over Financial Reporting***

 

InNovember 2005, we restated the financial statements included in ourQuarterly Reports on Form 10-Q for the first two quarters of 2005. Inaddition, we have historically operated with a relatively small number ofemployees in the accounting and financial reporting area. If we had previouslyconducted an assessment of our internal controls under the standards set forthin Section 404 of the Sarbanes-Oxley Act and related rules, either or bothof these factors likely would have led us to conclude that we had one or morematerial weaknesses in our internal controls. In addition, our outsideauditors, in the

 

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performanceof their 2005 audit, concluded that material weaknesses in our internalcontrols existed in 2005. We are addressing these issues by adopting moreextensive accounting controls and financial review procedures and by hiring aChief Accounting Officer to oversee our financial reporting processes. We havealso retained an independent consulting firm with considerable experience inthe area of Sarbanes-Oxley Act compliance to assist us in documenting ourpolicies, procedures and internal control over financial reporting, assessingthe effectiveness of the design of those controls and testing whether thosecontrols are operating as designed. In the course of this process, we havehired additional accounting staff in the first quarter of 2006 and expect tohire additional accounting staff and to take other measures to further enhanceour internal controls. We will continue to engage additional outside advisorsas appropriate.

 

***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, 2005 and 2006.

 
| ** **                                    | ** ** | **Quarter Ended March 31,** | ** ** |
|-----------------------------------------------|------------|----------------------------------|------------|
| ** **                                    | ** ** | **2005**                         | ** ** | **2006** | ** ** |
| **Production  Volume:**                       |       |                             |       |   |   |
| Natural gas  (MMcf)                           |       | 1,886                            |       | 1,862 |   |
| Oil (MBbls)                                   |       | 843                              |       | 699 |   |
| MBOE                                          |       | 1,157                            |       | 1,009 |   |
| **Daily  Average Production Volume:**         |       |                             |       |   |   |
| Natural gas  (Mcf/d)                          |       | 20,951                           |       | 20,689 |   |
| Oil (Bbls/d)                                  |       | 9,365                            |       | 7,767 |   |
| BOE/d                                         |       | 12,857                           |       | 11,215 |   |
| **Oil Price  per Bbl Produced (in dollars):** |       |                             |       |   |   |
| Realized  price before hedging loss           |       | $                                | 39.88      |   | $ | 51.87 |   |
| Realized  hedging loss                        |       | (4.03                            | )          | (8.12 | ) |
| Net realized                                  |       | $                                | 35.85      |   | $ | 43.75 |   |
| **Natural  Gas Price per Mcf (in dollars):**  |       |                             |       |   |   |
| Realized  price before hedging loss           |       | $                                | 6.06       |   | $ | 7.60 |   |
| Realized  hedging loss                        |       | (0.09                            | )          | (0.21 | ) |
| Net realized                                  |       | $                                | 5.97       |   | $ | 7.39 |   |
| **Average  Sale Price per BOE**               |       | $                                | 36.14      |   | $ | 45.82 |   |
| **Expense  per BOE:**                         |       |                             |       |   |   |
| Production  expenses(1)                       |       | $                                | 10.31      |   | $ | 12.21 |   |
| Transportation  expenses                      |       | 0.59                             |       | 0.80 |   |
| Depreciation,  depletion and amortization     |       | 4.89                             |       | 6.63 |   |
| General and  administrative expense(2)        |       | 2.69                             |       | 4.37 |   |
| Interest  expense, net(2)                     |       | 3.02                             |       | 3.74 |   |

 

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(1)           Production expenses are comprised of oil andnatural gas production expenses and production taxes.

 

(2)           Net of amounts capitalized.

 

***Comparison of Quarter Ended March 31,2006 to Quarter Ended March 31, 2005***

* *

*Oil and Natural Gas Revenues.*Oil and natural gas revenues increased $9.2 million,or 22%, to $51.3 million for the quarter ended March 31, 2006 from$42.0 million for the same period in 2005. The increase was attributableto rising oil and natural gas prices.

 

Oilrevenues increased by $6.5 million in the first quarter of 2006, or 21%,to $37.1 million compared to $30.6 million in the first quarter of2005. Oil production fell 17%, with production of 699 MBbl in the first quarterof 2006 compared to 843 MBbl in the first quarter of 2005. Productionvolumes in the first quarter of 2006 were significantly impacted relative tothe same period in 2005 by the delayed timing of additional saltwater injectionfacilities, which timing limited production from some wells in the firstquarter 2006, and the sale of our Big Mineral Creek field, which averaged netproduction of 547 BOE/d in the first quarter of 2005 and was sold on March31, 2005. Our average realizedprice for oil increased $11.99, or 30%, to $51.87 per Bbl for the period. Wehedged 64% of our oil production during the period (excluding floors),resulting in realized hedging losses of $8.12 per Bbl and unrealized hedginglosses of $16.25 per Bbl. Total hedging losses on oil were $24.37 per Bbl.

 

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Naturalgas revenues increased $2.7 million in the first quarter of 2006, or 24%,to $14.2 million compared to $11.4 million in the first quarter of2005. Natural gas production decreased 1%, with production of 1,862 MMcfcompared to 1,886 MMcf in the first quarter of 2005. Natural gas production wasnegatively impacted by heavy rain and flooding in northern California in 2006,which resulted in shut in production. Our average realized price for naturalgas increased $1.54, or 25%, to $7.60 per Mcf for the period. We hedged 72% ofour natural gas production during the period (excluding floors), resulting inrealized hedging losses of $0.21 per Mcf and unrealized hedging gains of $0.99per Mcf. Total hedging gains on natural gas were $0.78 per Mcf.

 

Totalrevenues increased $23.5 million, or 168%, to $37.4 million in thefirst quarter of 2006 compared to $14.0 million in the first quarter of2005. This increase primarily resulted from the 22% increase in oil and naturalgas revenues and the net effect on total revenues of commodity derivativelosses. Realized commodity derivative losses increased $2.5 million, or 70% to$6.1 million, in the first quarter of 2006 as compared with the sameperiod in 2005. Unrealized commodity derivative losses were $9.5 millionin the first quarter of 2006, a 63% reduction from the $25.6 million inunrealized commodity derivative losses in the first quarter of 2005. The changesin commodity derivative losses are due to the effect changes in market pricesof oil and natural gas have on our net sales, in the case of realized losses,and the effect of mark to market pricing adjustments on the carrying value ofour derivative positions, in the case of unrealized losses. Other revenue alsoincreased 59%, from $1.1 million in the first quarter of 2005 to $1.7 millionin the first quarter of 2006. This increase was primarily due to revenues of $0.5million from a pipeline which we acquired in the fourth quarter of 2005.

 

*Production Expenses.*Production expenses increased $0.4 million,or 3%, to $12.3 million in the first quarter of 2006 from$11.9 million in the first quarter of 2005. This change represents additionaloperated wells and typical variation in production costs due to the timing ofrecurring expenditures. On a per unit basis, the incurred expenses resulted inan increase in costs in the quarter of $1.90 per BOE, from $10.31 per BOE inthe first quarter of 2005 to $12.21 per BOE in the first quarter of 2006. Thischange is primarily due to changes in our oil production volumes between theperiods. A significant component of our oil production expenses consists offixed costs associated with our offshore platforms. Accordingly, per unit costsfluctuate based on changes in volumes of oil produced.

 

*Transportation Expenses.*Transportation expenses increased 18%, from$0.7 million in the first quarter of 2005 to $0.8 million in the first quarterof 2006. This was primarily attributable to an increase in the number of bargeshipments related to our South Ellwood production in first quarter of 2006compared to the first quarter of 2005. On a per BOE basis, transportationexpenses increased $0.21 per BOE, from $0.59 per BOE in the first quarter of2005 to $.80 per BOE in the first quarter of 2006.

 

*Depletion, Depreciation and Amortization (DD&A).*DD&A expense increased $1.0 million,or 18%, to $6.7 million in the first quarter of 2006 from$5.7 million in the first quarter of 2005. DD&A expense rose $1.74 perBOE, from $4.89 per BOE in the first quarter of 2005 to $6.63 per BOE in thefirst quarter of 2006. This was due to changes in estimated future developmentcosts and development costs incurred in 2005 and downward revisions in provedreserves during 2005, which had the collective effect of increasing thedepletion rate per unit. The majority of this change occurred in 2005.

 

*Accretion of Abandonment Liability.*Accretion expense increased by a minimalamount. Accretion expense was $470,000 in the first quarter of 2006 compared to$442,000 in the first quarter of 2005. The increase was due to an increase inabandonment liability associated with additional wells.

 

*General and Administrative (G&A).*G&A expense increased $1.3 million, or41%, to $4.4 million in the first quarter of 2006 from $3.1 millionin the first quarter of 2005. Of the total increase, $0.6 million, or 46%,related to the implementation of FAS 123R, share based payments, whichamount is a non cash expense. The incurrence of $0.4 million in costs relatedto systems conversions and Sarbanes Oxley compliance activities represented 31%of the increase. We have increased the depth of our organization in order toposition us for growth and to more effectively exploit our asset base by addingprofessional, technical and support staff, and this also contributed to theincrease in G&A expense.

* *

*Interest Expense and Amortization of Deferred Loan Costs.*Interest expense, net of interest income andcapitalized interest, increased $0.3 million, or 8%, to $3.8 millionin the first quarter of 2006 from $3.5 million in the first quarter of2005. The change was primarily due to increased debt incurred in late March2006. Amortization of deferred loan costs did not change significantly.

 

*Income tax expense.*Income tax expense in the first quarter of2006 was $3.5 million, representing a $8.4 million increase, ascompared to a tax (benefit) provision of ($4.9) million in the firstquarter of 2005. The increase was due to the increase in taxable income in theperiod.

 

*Net Income.*Net income for the first quarter of 2006 was$5.1 million as compared to a net loss of $6.8 million in the firstquarter of 2005. The largest factors in the change were the effect of commodityderivative losses and increase in oil and gas prices.

 

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**Liquidity and Capital Resources**

 

Ourprimary sources of liquidity are cash generated from our operations and amountsavailable under our revolving credit facility.

 

***Cash Flows***

 
| ** **                                       | ** ** | **Quarter Ended March 31,** | ** ** |
|--------------------------------------------------|------------|----------------------------------|------------|
| ** **                                       | ** ** | **2005**                         | ** ** | **2006** | ** ** |
| ** **                                       | ** ** | **(in thousands)**          | ** ** |
| Cash provided  by operating activities           |       | $                                | 10,785     |   | $ | 31,956 |   |
| Cash used in  investing activities               |       | (27,624                          | )          | (472,129 | ) |
| Cash provided  by (used in) financing activities |       | (32,852                          | )          | 445,269 |   |
|                                                  |            |                                  |            |  |  |  |  |

 

Net cash provided by operating activities was $32.0 million in the firstquarter of 2006 compared with $10.8 million in the first quarter of 2005. Cashflows from operating activities during the first quarter of 2006 were favorablyimpacted by a $9.2 million increase in oil and natural gas sales (primarilyrelated to an increase in oil and natural gas prices), a $10.9 million increasein cash generated from receivable collections and a $3.6 million decrease incash paid for premiums on derivative contracts.

 

Net cash used in investing activities was $472.1 million in the firstquarter of 2006 compared with $27.6 million in the first quarter of 2005. Theprimary investing activities in the first quarter of 2006 include $445.5million paid in cash to acquire TexCal (net of TexCal cash) and $28.8 millionin expenditures for oil and gas properties, net of accrued capital expendituresof $2.0 million. The primary investing activities in the first quarter of2005 consisted of $14.6 million paid to acquire Marquez Energy, $14.3 millionin expenditures for oil and gas properties and proceeds received from the saleof the Big Mineral Creek field of $44.6 million. At March 31, 2005, theproceeds from the sale of Big Mineral Creek were held as restricted cashpending reinvestment in like-kind oil and gas properties.

 

Net cash provided by financing activities was $445.3 million in thefirst quarter of 2006 compared to a use of cash of $32.9 million in the firstquarter of 2005. Proceeds from long-term debt in the first quarter of 2006included $350.0 million borrowed under the term loan facility and $119.5million borrowed under the revolving credit facility, which amounts were usedto fund the acquisition of TexCal and $13.8 million in loan costs. Net cashused in financing activities in the first quarter of 2005 was $32.9 million andprimarily resulted from the payment of a $35.0 million dividend to our solestockholder and $5.2 million paid to repurchase common shares, partially offsetby $13.0 million in new borrowings and principal payments on long-term debt of$4.6 million. In addition, we paid a dividend to our sole stockholder in thefirst quarter of 2006 that consisted of our interest in 6267 Carpinteria AvenueLLC, and that entity held $0.4 million in cash at the time the dividend waspaid.

 

***Capital Resources and Requirements***

 

Weplan to make substantial capital expenditures in the future for theacquisition, exploration, exploitation and development of oil and natural gasproperties. We expect that our exploration, exploitation and development capitalexpenditures in 2006 will be between $165 million and $195 million,including over $40 million on projects acquired as a part of the TexCal Acquisition.In the first quarter of 2006, we incurred $30.8 million of capital expenditureson our projects, not including accrued capital expenditures of $2 millionor expenditures made by TexCal prior to our acquisition of that company. Weintend to finance our exploration, exploitation and development capitalexpenditures for 2006 primarily with cash flow from operations and, as needed,additional borrowings under our revolving credit facility. The revolving creditfacility has an aggregate maximum loan amount of $300 million andcurrently has a borrowing base of $200 million. As of May 10, 2006, therewas approximately $149.5 million outstanding under the revolving creditfacility.

 

Weentered into a second lien term loan facility and increased borrowings underour revolving credit facility in order to finance the TexCal Acquisition. OnMarch 30, 2006, we borrowed $350 million pursuant to the second lienterm loan facility. On March 31, 2006, we borrowed $119.5 millionunder the revolving credit facility. Principal on the second lien term loanfacility is payable on March 30, 2011, and principal on the revolvingcredit facility is payable on March 30, 2009. Pursuant to mandatoryprepayment provisions set forth in the credit facilities, substantially all ofthe proceeds of asset sales and additional borrowings (except for certain unsecuredborrowings and additional borrowings under the revolving credit facility), andup to 50% of the proceeds of equity issuances, must be used to reduce amountsoutstanding under one or both facilities. We may from time to time makeoptional prepayments on outstanding loans. Under the second lien term loanfacility, optional prepayments made prior to March 2008 are subject to aprepayment premium.

 

Loansmade under both facilities are designated, at our option, as either “Base RateLoans” or “LIBO Rate Loans.” Base Rate Loans under the revolving creditfacility bear interest at a floating rate equal to (i) the greater of Bankof Montreal’s announced base rate and the overnight federal funds rate plus0.50% plus (ii) a margin ranging from zero to

 

29

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0.75%,based upon the percentage of the total borrowing base represented byoutstanding borrowings. LIBO Rate Loans under the revolving credit facilitybear interest at (i) LIBOR plus (ii) a margin ranging from 1.50% to2.25%, also based upon utilization. A commitment fee ranging from 0.375% to0.5% per annum is payable with respect to unused borrowing availability underthe facility.

 

BaseRate Loans under the second lien term loan facility bear interest at a floatingrate equal to (i) the greater of the administrative agent’s announced baserate and the overnight federal funds rate plus 0.50% plus (ii) 3.50%. LIBORate Loans under the second lien term loan facility bear interest at LIBOR plus4.50%. Each of the applicable margins could decrease 0.50% in the event ofcompletion of a public offering of our common stock for so long as ourconsolidated leverage ratio is less than 3:1.

 

Theagreements governing the revolving credit facility and the second lien term loanfacility contain customary representations, warranties, events of default,indemnities and covenants, including financial covenants that require us tomaintain specified ratios of EBITDA to interest expense, current assets tocurrent liabilities, debt to EBITDA and PV-10 to total debt.

 

Asof April 30, 2006, amounts outstanding under the credit facilities boreinterest at a weighted average interest rate of 9.16%. We expect that debtservice obligations under our debt agreements will total approximately $14.3million for the second quarter of 2006. Our debt service obligations under thecredit facilities may increase if market interest rates rise. See “—Quantitativeand Qualitative Disclosures About Market Risk.”

 

Becausewe must dedicate a substantial portion of our cash flow from operations to thepayment of interest on our debt, that portion of our cash flow is not availablefor other purposes. Our ability to make scheduled interest payments on ourindebtedness and pursue our capital expenditure plan will depend to asignificant extent on our financial and operating performance, whichperformance is subject to prevailing economic conditions, commodity prices anda variety of other factors. We have filed with the Securities and ExchangeCommission a Registration Statement on Form S-1 with respect to a plannedpublic offering of our common stock. In the event the offering is consummated,we intend to use the net proceeds to reduce amounts outstanding under ourcredit facilities and thereby gain greater financial flexibility.

 

Ifour cash flow and other capital resources are insufficient to fund our debtservice obligations and our capital expenditure budget, we may be forced toreduce or delay 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. Until we increase our liquidity, our ability to makesignificant acquisitions will be limited. If we seek additional capital forthat or other reasons, we may do so through traditional reserve baseborrowings, joint venture partnerships, asset sales, offerings of debt andequity securities or other means. We cannot assure you that needed capital willbe 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, issuingequity securities or incurring additional indebtedness would be limited byprovisions in the facilities that require us to use some or all of the proceedsof such transactions to reduce amounts outstanding under one or both of thefacilities. If we are unable to obtain funds when needed or on acceptableterms, we may not be able to complete acquisitions that may be favorable to usor finance the capital expenditures necessary to replace our reserves.

 

**Item 3.****   ****Quantitative and QualitativeDisclosures About Market Risk**

 

Thediscussion in this section provides information about derivative financialinstruments we use to manage commodity price volatility. Due to the historicalvolatility of crude oil and natural gas prices, we have implemented a hedgingstrategy aimed at reducing the variability of the prices we receive for ourproduction and providing a minimum revenue stream. Currently, we use options(including collars) and fixed price swaps for hedging commodity prices. Allcontracts are settled with cash and do not require the delivery of a physicalquantity to satisfy settlement. While this hedging strategy may result in ushaving lower revenues than we would have if we were unhedged in times of higheroil and natural gas prices, management believes that the stabilization ofprices and protection afforded us by providing a revenue floor is beneficial.We had hedging contracts (excluding floors) in place for approximately 71% ofour oil production and approximately 14% of our natural gas production duringthe year ended December 31, 2005. We had hedging contracts (excludingfloors) in place for approximately 64% of our oil production and approximately 72%of our natural gas production during the quarter ended March 31, 2006.

 

30

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Weare subject to interest rate risk with respect to amounts borrowed under ourcredit facilities because such amounts bear interest at variable rates. AtMarch 29, 2006, immediately prior to the TexCal Acquisition, we had$10 million of indebtedness outstanding under our revolving creditfacility. In connection with that transaction, we drew down an additional$119.5 million under that facility, and we borrowed $350 millionunder the second lien term loan facility. As of March 31, 2006, there wasapproximately $479.5 million outstanding under those facilities. OnMay 4, 2006, we entered into a swap transaction pursuant to which we hedged ourinterest cost on $200 million of borrowings under the term loan facility at afixed rate of 9.9225% through May 8, 2008. A 1.0% increase in interest rates on unhedged variable rate borrowingsof $279.5 million at March 31, 2006 would result in additional interest expenseof $2.8 million.

 

**Cumulative Effect of Derivative Transactions**

 

***Oil.***As of March 31, 2006, we had entered into option(including collar) and swap agreements to receive average minimum and maximumNYMEX West Texas Intermediate prices as summarized below. Location and qualitydifferentials attributable to our properties are not reflected in those prices.The agreements provide for monthly settlement based on the differential betweenthe agreement price and the actual NYMEX crude oil price.

 
| ** **                                         | ** ** | **Minimum** | ** ** | **Maximum**               | ** ** |
|----------------------------------------------------|------------|-------------|------------|---------------------------|------------|
| ** **                                         | ** ** | **Bbls/d**  | ** ** | **Weighted Avg.  Prices** | ** ** | **Bbls/d** | ** ** | **Weighted Avg.  Prices** | ** ** |
| Oil  hedges at March 31, 2006 for production: |       |        |       |                      |       |   |   |   |   |
| April 1—December 31,  2006          |       | 10,500      |       | $                         | 47.85      |   | 7,000 |   | $ | 59.86 |   |
| January 1—December 31,  2007        |       | 7,313       |       | $                         | 49.72      |   | 6,115 |   | $ | 71.58 |   |
| January 1—December 31,  2008        |       | 4,950       |       | $                         | 54.43      |   | 4,950 |   | $ | 75.38 |   |
| January 1—June 30,  2009            |       | 4,580       |       | $                         | 53.94      |   | 4,580 |   | $ | 76.78 |   |

 

***Natural Gas.***As of March 31, 2006, we had enteredinto option, swap and collar agreements to receive average minimum and maximumPG&E Citygate prices as follows:

 
| ** **                                                 | ** ** | **Minimum** | ** ** | **Maximum**               | ** ** |
|------------------------------------------------------------|------------|-------------|------------|---------------------------|------------|
| ** **                                                 | ** ** | **MMBtu/d** | ** ** | **Weighted Avg.  Prices** | ** ** | **MMBtu/d** | ** ** | **Weighted Avg.  Prices** | ** ** |
| Natural gas  hedges at March 31, 2006 for production: |       |        |       |                      |       |   |   |   |   |
| April 1—December 31,  2006                  |       | 26,345      |       | $                         | 7.18       |   | 20,345 |   | $ | 10.73 |   |
| January 1—December 31,  2007                |       | 21,000      |       | $                         | 7.42       |   | 15,436 |   | $ | 11.46 |   |
| January 1—December 31,  2008                |       | 13,500      |       | $                         | 8.00       |   | 11,947 |   | $ | 12.24 |   |
| January 1—December 31,  2009                |       | 9,500       |       | $                         | 7.61       |   | 9,500 |   | $ | 12.10 |   |

 

**Portfolio of Derivative Transactions**

 

Ourportfolio of commodity derivative transactions as of March 31, 2006 issummarized below:

** **
| ** **            | ** ** | ** ** | ** ** | **Oil**               | ** ** | ** **               | ** ** | ** **              | ** ** |
|-----------------------|------------|------------|------------|-----------------------|------------|--------------------------|------------|-------------------------|------------|
| **Type  of Contract** | ** ** | **Basis**  | ** ** | **Quantity  (Bbl/d)** | ** ** | **Strike Price ($/Bbl)** | ** ** | **Term**                | ** ** |
| Swap                  |       | NYMEX      |       | 1,000                 |       | $57.00 Fixed             |       | Jan 1 – Dec 31, 06 |       |
| Collar                |       | NYMEX      |       | 2,000                 |       | $40.00/$51.00            |       | Jan 1 – Dec 31, 06 |       |
| Collar                |       | NYMEX      |       | 1,000                 |       | $40.00/$51.05            |       | Jan 1 – Dec 31, 06 |       |
| Collar                |       | NYMEX      |       | 1,000                 |       | $40.00/$57.75            |       | Jan 1 – Dec 31, 06 |       |
| Collar                |       | NYMEX      |       | 1,500                 |       | $58.00/$74.60            |       | Apr 1 – Dec 31, 06 |       |
| Collar                |       | NYMEX      |       | 500                   |       | $60.00/$78.70            |       | Apr 1 – Dec 31, 06 |       |
| Put                   |       | NYMEX      |       | 1,000                 |       | $40.00 Floor             |       | Jan 1 – Dec 31, 06 |       |
| Put                   |       | NYMEX      |       | 1,000                 |       | $42.90 Floor             |       | Jan 1 – Dec 31, 06 |       |
| Put                   |       | NYMEX      |       | 1,500                 |       | $57.00 Floor             |       | Jan 1 – Dec 31, 06 |       |
| 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 |       |
| 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 |       |
| 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 |       |

 

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(1)           Option Premium deferred until each month’ssettlement period ($3,087,900 total deferred)

(2)           Option Premium deferred until each month’ssettlement period ($405,409 total deferred)

(3)           Option Premium deferred until each month’ssettlement period ($754,206 total deferred)

 

**NaturalGas**

 
| **Type  of Contract** | ** ** | **Basis**          | ** ** | **Quantity  (MMBtu/d)** | ** ** | **Strike Price  ($/MMBtu)** | ** ** | **Term**                 | ** ** |
|-----------------------|------------|--------------------|------------|-------------------------|------------|-----------------------------|------------|--------------------------|------------|
| Physical Sale         |       | SoCal              |       | 2,000                   |       | $5.90 Floor                 | (1)        | 11/01/05 – 12/31/06 |       |
| Swap                  |       | NYMEX              |       | 2,000                   |       | $6.71 Fixed                 |       | Jan 1 – Dec 31, 06  |       |
| Collar                |       | NYMEX              |       | 4,000                   |       | $6.00/$8.50                 |       | Jan 1 – Dec 31, 06  |       |
| Collar                |       | NYMEX              |       | 6,000                   |       | $9.00/$15.00                |       | Jan 1 – Dec 31, 06  |       |
| Collar                |       | PG&E  Citygate |       | 3,000                   |       | $7.00/$9.45                 |       | Jan 1 – Dec 31, 06  |       |
| Basis Swap            |       | PG&E  Citygate |       | 6,000                   |       | ($0.035                     | )(2)       | Jan 1 – Dec 31, 06  |       |
| Put                   |       | PG&E  Citygate |       | 6,000                   |       | $6.00 Floor                 |       | Jan 1 – Dec 31, 06  |       |
| Swap                  |       | NYMEX              |       | 3,000                   |       | $8.05 Fixed                 |       | May 1 – Dec 31, 06  |       |
| Collar                |       | NYMEX              |       | 3,000                   |       | $7.25/$11.70                |       | May 1 – Dec 31, 06  |       |
| Collar                |       | PG&E  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 (3)               |       | NYMEX              |       | 10,000                  |       | $7.985 Floor                |       | Jan 1 – Dec 31, 07  |       |
| Call (4)              |       | NYMEX              |       | 4,564                   |       | $12.15 Cap                  |       | Jan 1 – Jun 30, 07  |       |
| Call (5)              |       | NYMEX              |       | 4,310                   |       | $11.95 Cap                  |       | Jul 1 – Dec 31, 07  |       |
| Put (6)               |       | NYMEX              |       | 6,000                   |       | $8.00 Floor                 |       | Jan 1 – Dec 31, 08  |       |
| Call (7)              |       | NYMEX              |       | 4,513                   |       | $12.15 Cap                  |       | Jan 1 – Jun 30, 08  |       |
| Call (8)              |       | NYMEX              |       | 4,382                   |       | $10.60 Cap                  |       | Jul 1 – Dec 31, 08  |       |
| Collar                |       | NYMEX              |       | 7,500                   |       | $8.00/$12.75                |       | 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  |       |

 

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(1)           The price of this contract is the first ofthe month NGI SoCal Border Index less $0.10 per MMBtu, with a floor of $5.899.

(2)           This basis swap locks the $6.71 NYMEX swapinto a $6.675 PG&E Citygate location swap and the $6.00-$8.50 collar into a$5.965-$8.465 collar with a PG&E Citygate location for 2006.

(3)           Option Premium deferred until each month’ssettlement period ($3,650,000 total deferred)

(4)           Option Premium deferred until each month’ssettlement period ($776,465 total deferred)

(5)           Option Premium deferred until each month’ssettlement period ($745,445 total deferred)

(6)           Option Premium deferred until each month’ssettlement period ($2,755,980 total deferred)

(7)           Option Premium deferred until each month’ssettlement period ($928,153 total deferred)

(8)           Option Premium deferred until each month’ssettlement period ($911,203 total deferred)

 

32

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SinceMarch 31, 2006 and through May 10, 2006, we have not entered into anyadditional commodity price hedging contracts.

 

Weenter into derivative contracts, primarily collars, swaps and option contracts,to hedge future crude oil and natural gas production in order to mitigate therisk of market price fluctuations. The objective of our hedging activities andthe use of derivative financial instruments is to achieve more predictable cashflows. Our hedging activities mitigate our exposure to price declines and allowus the flexibility to continue to execute our capital plan even if pricesdecline. Our collar and swap contracts, however, prevent us from receiving thefull advantage of increases in oil or natural gas prices above the maximumfixed amount specified in the hedge agreement. Also, if production is less thanthe amount we have hedged and the price of oil or natural gas exceeds a fixedprice in a hedge contract, we will be required to make payments against whichthere are no offsetting sales of production. This could impact our ability tofund future capital expenditures. In addition, we have incurred, and may incurin the future, substantial unrealized commodity derivative losses in connectionwith our hedging activities, although we do not expect such losses to have amaterial effect on our ability to fund expected capital expenditures. Finally,the use of derivatives involves the risk that the counterparties to suchinstruments will be unable to meet the financial terms of such contracts.

 

Inorder to qualify for hedge accounting, the relationship between the hedging instrumentand the hedged item must be highly effective in achieving the offset of changesin cash flows attributable to the hedged risk both at the inception of thecontract and on an ongoing basis. We measure effectiveness on a quarterlybasis. Hedge accounting is discontinued prospectively when a hedge instrumentis no longer considered highly effective.

 

Allderivative instruments are recorded on the balance sheet at fair value. Fairvalue is generally determined based on the difference between the fixed contractprice and the underlying market price at the determination date, and/orconfirmed by the counterparty. Changes in the fair value of the effectiveportion of the cash flow hedges are recorded as a component of accumulatedother comprehensive income (loss), which is later transferred to the incomestatement as a component of commodity derivative income (loss) when the hedgedtransaction occurs. Changes in the fair value of derivatives that do notqualify as a hedge or are not designated as a hedge, as well as the ineffectiveportion of hedge derivatives, are recorded in commodity derivative income(loss) on the income statement. We determine hedge ineffectiveness based onchanges during the period in the price differentials between the index price ofthe derivative contracts (which uses a NYMEX index in the case of oil hedges,and NYMEX and PG&E Citygate in the case of natural gas hedges) and thecontract price for the point of sale for the cash flow that is being hedged.Hedge ineffectiveness occurs only if the cumulative gain or loss on thederivative hedging instrument exceeds the cumulative change in the expectedfuture cash flows on the hedged transaction. Ineffectiveness is recorded inearnings to the extent the cumulative changes in fair value of the actualderivative exceed the cumulative changes in fair value of the hypotheticalderivative.

 

***Changes in Fair Value***

 

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, 2006** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                                                                                    | ** ** | **Fair  Value**         | ** ** | **Effect of  $5.00/Bbl and  $1.00/MMbtu  Price  Increases** | ** ** |
|                                                                                                                          |       |                    |       |   |   |   |   |
| Effective  portion of derivatives designated as cash flow hedges                                                              |       | $                       | (15.4      | ) | $ | (24.7 | ) |
| Derivatives not designated as hedging  instruments and the ineffective portion of derivatives designated as cash  flow hedges |       | $                       | (28.9      | ) | $ | (34.2 | ) |

 

Thefair value of the swaps and option contracts are estimated based on quotedprices from independent reporting services compared to the contract price ofthe agreement, and approximate the cash gain or loss that would have beenrealized if the contracts had been closed out at period end. All hedgepositions offset physical positions exposed to the cash market. None of theseoffsetting physical positions are included in the above table. Price risksensitivities were calculated by assuming across-the-board increases in priceof $5.00 per Bbl for oil and $1.00 per MMBtu for natural gas regardless of termor historical relationships between the contractual price of the instrumentsand the underlying commodity price. In the event of

 

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actualchanges in prompt month prices equal to the assumptions, the fair value of ourderivative portfolio would typically change by less than the amount shown inthe table due to lower volatility in out-month prices. In the event of actualchanges in all months equal to the assumptions, the fair value of ourderivative portfolio would typically change by less than the amount shown inthe table due to the fact that many of the changes would be within the range ofour derivative collars where the movement in fair value would typically be lessthan the changes in commodity prices.

 

Withrespect to oil, we had, as of March 31, 2006, NYMEX put options with aweighted average strike price of $48.11 per Bbl on 3,500 Bbl/d in the second,third and fourth quarters of 2006. With respect to natural gas, we had, as ofMarch 31, 2006, put options with a weighted average strike price of $6.00per MMBtu on 6,000 MMBtu/d in the second, third and fourth quarters of 2006.These put options cost an average of $2.83 per Bbl and $0.46 per MMBtu for thesecond, third and fourth quarters of 2006 (a total of $4.6 million), whichwas paid when the put options were contracted. This amount is not included inthe fair value of derivatives in the table above.

 

Seenote 4 to our financial statements for a discussion of our long-term debtas of December 31, 2005 and March 31, 2006.

 

# **Item 4. Controls andProcedures**

# ** **

# **Disclosure Controls andProcedures**

# ** **

Timothy Marquez, our Chief Executive Officer, and David Christofferson,our Chief Financial Officer, evaluated the effectiveness of our disclosurecontrols and procedures as of March 31, 2006. Based on the evaluation, theybelieve that:

 

•      our disclosure controls and procedures wereeffective to ensure that information required to be disclosed by us in thereports we file or submit under the Securities Exchange Act of 1934 isrecorded, processed, summarized and reported within the time periods specifiedin the SEC’s rules and forms; and

 

•      our disclosure controls and procedures wereeffective to ensure that information required to be disclosed by us in thereports we file or submit under the Securities Exchange Act of 1934 wasaccumulated and communicated to our management, including our Chief ExecutiveOfficer and Chief Financial Officer, as appropriate to allow timely decisionsregarding required disclosure.

 

We are currently taking steps intended to enhanceour internal control over financial reporting. See “Management’s Discussion andAnalysis of Financial Condition and Results of Operation—Overview—Internal ControlOver Financial Reporting.” 

# ** **

# **Internal Control OverFinancial Reporting**

# ** **

We appointed Douglas Griggs as our ChiefAccounting Officer in January 2006. In addition, during the quarterly periodended March 31, 2006, we continued to take other actions designed to enhanceour internal control over financial reporting as described in “Management’sDiscussion and Analysis of Financial Condition and Results ofOperations—Overview—Internal Control Over Financial Reporting.”  We expect that the foregoing actions willsignificantly enhance our internal control over financial reporting. The TexCalAcquisition may adversely affect our internal control over financial reportinguntil we are able to fully integrate TexCal into our internal controls systems.There have not been any other changes in our internal control over financialreporting that occurred during the quarterly period ended March 31, 2006 thathas materially affected, or is reasonably likely to materially affect, ourinternal control over financial reporting.

 

# **PART II – OTHERINFORMATION**

# ** **

# **Item 1.**            LegalProceeding

# ** **

On March 31,2006, a complaint was filed in District Court in Madison County, Texas againsta subsidiary of ours by the widow of an individual who was fatally injuredwhile working as a gauger/pumper at a well operated by the subsidiary. Thecause of the accident is still being investigated.

 

# **Item 1A.**         Risk Factors

# ** **

In addition tothe other information set forth in this report, you should carefully considerthe factors discussed in “Risk Factors” in our Annual Report onForm 10-K for the year ended December 31, 2005, which could materially affectour business, financial condition or future results. The risks described in ourAnnual Report on Form 10-K

 

34

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are 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.

 

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

# ** **

In thequarterly period ended March 31, 2006, we granted options to purchase 100,000shares of our common stock to Mark DePuy, our Chief Operating Officer. Theseoptions have an exercise price of $20.00 per share. We also granted options topurchase 40,000 shares of our common stock to Douglas Griggs, our ChiefAccounting Officer. These options have an exercise price of $12.00 per share.The grant of the options was exempt from the registration requirements of theSecurities Act of 1933 pursuant to Section 4(2) of that act. The options weregranted without general solicitation or advertising. In addition, the officersto whom options were granted had access to information concerning our company,including through our public filings with the SEC, comparable to theinformation that would have been provided in a registration statement had thegrant of the options been registered.

 

# **Item 3.**            DefaultsUpon Senior Securities.

# ** **

Not Applicable

 

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

# ** **

On May 9, 2006,at our annual stockholder’s meeting, our sole stockholder (i) re-elected Ed O’Donnelland Tim Brittan to our board of directors for three-year terms and (ii)approved our amended and restated 2005 Stock Incentive Plan. The term of officeof each of our other directors continued after the meeting.

 

**Item 5.**            **Other Information.**

 

Not Applicable

 

**Item 6.**            **Exhibits.**

 
| **Exhibit  Number** | ** ** | **Exhibit**                                                                                                                               |
|---------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------|
| 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**

 

Pursuant to the requirements of the Securities Exchange Act of 1934,the registrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized.

 
| May 16, 2006 | VENOCO, INC.                                 |
|--------------|----------------------------------------------|
|         |                                         |
|         | By:                                          | /s/ Timothy  M. Marquez |
|         | Name: Timothy  M. Marquez                    |
|         | Title:  Chairman and Chief Executive Officer |
|         |                                         |
|         |                                         |
|         | By:                                          | /s/ David B.  Christofferson |
|         | Name: David  B. Christofferson               |
|         | Title: Chief  Financial Officer              |
|              |                                              |  |  |

 

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