**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

**Form 10-Q**

**x        QUARTERLY REPORT PURSUANT TO SECTION 13OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

**Forthe quarterly period ended September 30, 2005**

**or**

**o        TRANSITION REPORT PURSUANT TO SECTION 13OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

**CommissionFile Number: 333-123711**

**Venoco, Inc.**

(Exact name of registrantas specified in its charter)

| **Delaware**                              |   | **77-0323555**          |
|-------------------------------------------|--------|-------------------------|
| (State or other  jurisdiction of          |   | (I.R.S. Employer        |
| incorporation or  organization)           |   | Identification  Number) |
| **370 17th Street, Suite 2950**      |   | ** **              |
| **Denver,  Colorado**                     |   | **80202-1370**          |
| (Address of  principal executive offices) |   | (Zip Code)              |

 

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

**N/A**

(Former name or formeraddress, if changed since last report)

Indicateby check mark whether the registrant (1) has filed all reports required bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such report(s), and (2) has been subject to such filingrequirements for the past 90 days.

YES x     NO o

Indicateby check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2of the Exchange Act).

YES o     NO x

Indicateby check mark whether the registrant is a shell company (as defined in Rule12b-2 of the Exchange Act).

YES o     NO x

As of November 14,2005, there were 32,692,500 shares of the issuer’s common stock, par value$0.01 per share, issued and outstanding.

 

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**VENOCO, INC. Form 10-Q for the Quarterly Period Ended September 30, 2005 TABLE OF CONTENTS**

|                   | ** ** | ** **                                                                                                                                                                                               | **Page** |
|-------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|----------|
| **PART I.**  | ** ** | **FINANCIAL  INFORMATION**                                                                                                                                                                               |     |   |   |
| Item  1.          |       | Financial  Statements (Unaudited)                                                                                                                                                                        |     |   |   |
|              |       | Condensed Consolidated Balance Sheets at  September 30, 2005 (Successor) and  December 31, 2004 (Successor)                                                                               |     | 3 |   |
|              |       | Condensed Consolidated Statements of Operations for  the Three and Nine Months Ended September 30, 2005 (Successor) and the  Three and Nine Months Ended September 30, 2004 (Predecessor) |     | 4 |   |
|              |       | Condensed Consolidated Statements of Cash Flows for  the Nine Months Ended September 30, 2005 (Successor) and the Nine Months  Ended September 30, 2004 (Predecessor)                          |     | 5 |   |
|              |       | Notes to Condensed Consolidated  Financial Statements                                                                                                                                                    |     | 6 |   |
| Item  2.          |       | Management’s Discussion and  Analysis of Financial Condition and  Results of Operations                                                                                                             |     | 24 |   |
| Item  3.          |       | Quantitative and Qualitative  Disclosures about Market Risk                                                                                                                                              |     | 32 |   |
| Item 4.           |       | Controls and Procedures                                                                                                                                                                                  |     | 35 |   |
| **PART II.** | ** ** | **OTHER INFORMATION**                                                                                                                                                                                    |     |   |   |
| Item 1.           |       | Legal Proceedings                                                                                                                                                                                        |     | 37 |   |
| Item  2.          |       | Unregistered Sales of Equity  Securities and Use of Proceeds                                                                                                                                             |     | 37 |   |
| Item  3.          |       | Defaults upon Senior  Securities                                                                                                                                                                         |     | 37 |   |
| Item  4.          |       | Submission of Matters to a  Vote of Security Holders                                                                                                                                                     |     | 37 |   |
| Item 5.           |       | Other Information                                                                                                                                                                                        |     | 37 |   |
| Item  6.          |       | Exhibits and Reports on  Form 8-K                                                                                                                                                                   |     | 37 |   |
| Signatures        |       | 38                                                                                                                                                                                                       |     |

 

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**PART I—FINANCIALINFORMATION**

**VENOCO, INC. AND SUBSIDIARIESCONDENSED CONSOLIDATEDBALANCE SHEETS (UNAUDITED)(in thousands, except shares and per share amounts)**

| ** **                                                                                                                                                                           | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                           | ** ** | **2005**               | ** ** | **2004**              | ** ** |
| ** **                                                                                                                                                                           | ** ** | **(Successor)**        | ** ** | **(Successor)**       | ** ** |
| **ASSETS**                                                                                                                                                                           |       |                   |       |                  |       |   |   |   |   |
| CURRENT ASSETS:                                                                                                                                                                      |       |                   |       |                  |       |   |   |   |   |
| Cash and cash  equivalents                                                                                                                                                           |       |                   | $          | 13,023                |       |   |   | $ | 54,715 |   |   |
| Accounts  receivable                                                                                                                                                                 |       |                   | 26,449     |                  |       |   | 17,755 |   |   |
| Inventories                                                                                                                                                                          |       |                   | 1,784      |                  |       |   | 1,079 |   |   |
| Income tax  receivable                                                                                                                                                               |       |                   | —     |                  |       |   | 3,906 |   |   |
| Commodity  derivatives                                                                                                                                                               |       |                   | 3,680      |                  |       |   | 5,300 |   |   |
| Notes  receivable—officer                                                                                                                                                       |       |                   | —     |                  |       |   | 1,420 |   |   |
| Prepaid expenses  and other current assets                                                                                                                                           |       |                   | 7,025      |                  |       |   | 3,640 |   |   |
| Total current  assets                                                                                                                                                                |       |                   | 51,961     |                  |       |   | 87,815 |   |   |
| PROPERTY, PLANT AND EQUIPMENT, AT COST:                                                                                                                                              |       |                   |       |                  |       |   |   |   |   |
| Oil and natural  gas properties (full cost method, of which $2,226 and $3,317 were excluded  from amortization at September 30, 2005 and December 31, 2004,  respectively) |       |                   | 239,340    |                  |       |   | 214,842 |   |   |
| Drilling equipment                                                                                                                                                                   |       |                   | 7,767      |                  |       |   | 7,594 |   |   |
| Other property and  equipment                                                                                                                                                        |       |                   | 27,001     |                  |       |   | 25,857 |   |   |
| Total property,  plant and equipment                                                                                                                                                 |       |                   | 274,108    |                  |       |   | 248,293 |   |   |
| Less accumulated  depletion, depreciation, amortization and impairment                                                                                                               |       |                   | 64,857     |                  |       |   | 49,730 |   |   |
| Net property,  plant and equipment                                                                                                                                                   |       |                   | 209,251    |                  |       |   | 198,563 |   |   |
| OTHER ASSETS:                                                                                                                                                                        |       |                   |       |                  |       |   |   |   |   |
| Commodity derivatives                                                                                                                                                                |       |                   | 950        |                  |       |   | 4,855 |   |   |
| Deferred loan  costs                                                                                                                                                                 |       |                   | 5,918      |                  |       |   | 6,596 |   |   |
| Other                                                                                                                                                                                |       |                   | 1,127      |                  |       |   | 1,053 |   |   |
| Total other assets                                                                                                                                                                   |       |                   | 7,995      |                  |       |   | 12,504 |   |   |
| TOTAL ASSETS                                                                                                                                                                         |       |                   | $          | 269,207               |       |   |   | $ | 298,882 |   |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT)**                                                                                                                              |       |                   |       |                  |       |   |   |   |   |
| CURRENT LIABILITIES:                                                                                                                                                                 |       |                   |       |                  |       |   |   |   |   |
| Accounts payable  and accrued liabilities                                                                                                                                            |       |                   | $          | 33,164                |       |   |   | $ | 19,385 |   |   |
| Undistributed  revenue payable                                                                                                                                                       |       |                   | 4,492      |                  |       |   | 4,774 |   |   |
| Income taxes  payable                                                                                                                                                                |       |                   | 4,853      |                  |       |   | — |   |   |
| Current maturities  of long-term debt                                                                                                                                                |       |                   | 124        |                  |       |   | 127 |   |   |
| Commodity derivatives                                                                                                                                                                |       |                   | 39,603     |                  |       |   | 1,520 |   |   |
| Repurchase of  common stock                                                                                                                                                          |       |                   | —     |                  |       |   | 5,316 |   |   |
| Total current  liabilities                                                                                                                                                           |       |                   | 82,236     |                  |       |   | 31,122 |   |   |
| LONG-TERM  DEBT                                                                                                                                                                      |       |                   | 158,942    |                  |       |   | 163,542 |   |   |
| DEFERRED INCOME  TAXES                                                                                                                                                               |       |                   | 1,000      |                  |       |   | 32,208 |   |   |
| ASSET RETIREMENT  OBLIGATIONS                                                                                                                                                        |       |                   | 24,540     |                  |       |   | 23,184 |   |   |
| COMMODITY  DERIVATIVES                                                                                                                                                               |       |                   | 21,874     |                  |       |   | — |   |   |
| Total liabilities                                                                                                                                                                    |       |                   | 288,592    |                  |       |   | 250,056 |   |   |
| COMMITMENTS AND CONTINGENCIES                                                                                                                                                        |       |                   |       |                  |       |   |   |   |   |
| MINORITY INTEREST                                                                                                                                                                    |       |                   | —     |                  |       |   | 387 |   |   |
| STOCKHOLDERS’ EQUITY (DEFICIT):                                                                                                                                                 |       |                   |       |                  |       |   |   |   |   |
| Common stock, $.01  par value (200,000,000 shares authorized; 32,692,500 shares issued and  outstanding at September 30, 2005 and December 31, 2004)                       |       |                   | 327        |                  |       |   | 327 |   |   |
| Additional paid-in  capital                                                                                                                                                          |       |                   | 21,057     |                  |       |   | 31,085 |   |   |
| Retained earnings  (accumulated deficit)                                                                                                                                             |       |                   | (19,766    | )                     |       |   | 15,104 |   |   |
| Accumulated other  comprehensive income (loss)                                                                                                                                       |       |                   | (21,003    | )                     |       |   | 1,923 |   |   |
| Total  stockholders’ equity (deficit)                                                                                                                                           |       |                   | (19,385    | )                     |       |   | 48,439 |   |   |
| TOTAL LIABILITIES  AND STOCKHOLDERS’ EQUITY (DEFICIT)                                                                                                                           |       |                   | $          | 269,207               |       |   |   | $ | 298,882 |   |   |

 

See notes to condensed consolidated financial statements.

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**VENOCO, INC. AND SUBSIDIARIESCONDENSED CONSOLIDATEDSTATEMENTS OF OPERATIONS (UNAUDITED)(in thousands)**

| ** **                                              | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|---------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                              | ** ** | **2005**                                             | ** ** | **2004**                                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                              | ** ** | **(Successor)**                                      | ** ** | **(Predecessor)**                                   | ** ** | **(Successor)** | ** ** | **(Predecessor)** | ** ** |
| REVENUES:                                               |       |                                                 |       |                                                |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Oil and natural gas sales                               |       |                                                 | $          | 47,278                                              |       |   |   | $ | 36,844 |   |   |   | $ | 134,668 |   |   |   | $ | 99,761 |   |   |
| Commodity derivative losses (realized)                  |       |                                                 | (8,287     | )                                                   |       |   | (4,968 | ) |   |   | (15,442 | ) |   |   | (11,076 | ) |   |
| Commodity derivative losses (unrealized)                |       |                                                 | (16,242    | )                                                   |       |   | (851 | ) |   |   | (44,241 | ) |   |   | (1,692 | ) |   |
| Other                                                   |       |                                                 | 776        |                                                |       |   | 1,953 |   |   |   | 2,867 |   |   |   | 4,134 |   |   |
| Total revenues                                          |       |                                                 | 23,525     |                                                |       |   | 32,978 |   |   |   | 77,852 |   |   |   | 91,127 |   |   |
| EXPENSES:                                               |       |                                                 |       |                                                |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Oil and natural gas production                          |       |                                                 | 13,748     |                                                |       |   | 12,583 |   |   |   | 38,030 |   |   |   | 35,298 |   |   |
| Transportation expense                                  |       |                                                 | 464        |                                                |       |   | 783 |   |   |   | 1,680 |   |   |   | 2,222 |   |   |
| Depletion, depreciation, amortization and impairment    |       |                                                 | 5,634      |                                                |       |   | 3,611 |   |   |   | 15,127 |   |   |   | 10,992 |   |   |
| Accretion of abandonment liability                      |       |                                                 | 293        |                                                |       |   | 373 |   |   |   | 1,311 |   |   |   | 1,093 |   |   |
| General and administrative, net of amounts  capitalized |       |                                                 | 2,955      |                                                |       |   | 2,957 |   |   |   | 10,654 |   |   |   | 8,697 |   |   |
| Amortization of deferred loan costs                     |       |                                                 | 320        |                                                |       |   | 103 |   |   |   | 1,341 |   |   |   | 233 |   |   |
| Interest, net                                           |       |                                                 | 3,361      |                                                |       |   | 443 |   |   |   | 10,181 |   |   |   | 1,076 |   |   |
| Total expenses                                          |       |                                                 | 26,775     |                                                |       |   | 20,853 |   |   |   | 78,324 |   |   |   | 59,611 |   |   |
| Income (loss) before income taxes                       |       |                                                 | (3,250     | )                                                   |       |   | 12,125 |   |   |   | (472 | ) |   |   | 31,516 |   |   |
| Income tax provision (benefit)                          |       |                                                 | (1,417     | )                                                   |       |   | 5,143 |   |   |   | (643 | ) |   |   | 13,227 |   |   |
| Income (loss) before minority interest                  |       |                                                 | (1,833     | )                                                   |       |   | 6,982 |   |   |   | 171 |   |   |   | 18,289 |   |   |
| Minority interest in consolidated subsidiary            |       |                                                 | —     |                                                |       |   | 36 |   |   |   | 42 |   |   |   | 36 |   |   |
| Net income (loss)                                       |       |                                                 | (1,833     | )                                                   |       |   | 6,946 |   |   |   | 129 |   |   |   | 18,253 |   |   |
| Preferred stock dividends                               |       |                                                 | —     |                                                |       |   | (2,116 | ) |   |   | — |   |   |   | (6,348 | ) |   |
| Net income (loss)  applicable to common equity     |       |                                                 | $          | (1,833                                              | )          |   |   | $ | 4,830 |   |   |   | $ | 129 |   |   |   | $ | 11,905 |   |   |

 

See notes to condensed consolidated financial statements.

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**VENOCO, INC. AND SUBSIDIARIESCONDENSED CONSOLIDATEDSTATEMENTS OF CASH FLOWS (UNAUDITED)(in thousands)**

| ** **                                                                                | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                                | ** ** | **2005**                                            | ** ** | **2004** | ** ** |
| ** **                                                                                | ** ** | **(Successor)**                                     | ** ** | **(Predecessor)** | ** ** |
| CASH FLOWS FROM OPERATING  ACTIVITIES:                                                    |       |                                                |       |   |   |   |   |   |   |
| Net income (loss)                                                                         |       |                                                | $          | 129 |   |   |   | $ | 18,253 |   |   |
| Adjustments to  reconcile net income (loss) to net cash provided by operating activities: |       |                                                |       |   |   |   |   |   |   |
| Depletion, depreciation, amortization and impairment                                      |       |                                                | 15,127     |   |   |   | 10,992 |   |   |
| Accretion of abandonment liability                                                        |       |                                                | 1,311      |   |   |   | 1,093 |   |   |
| Deferred income taxes (benefit)                                                           |       |                                                | (12,180    | ) |   |   | 6,419 |   |   |
| Amortization of deferred loan costs and bond discount                                     |       |                                                | 1,469      |   |   |   | 174 |   |   |
| Gain on sale of subsidiary                                                                |       |                                                | —     |   |   |   | (100 | ) |   |
| Change in other liabilities                                                               |       |                                                | —     |   |   |   | (533 | ) |   |
| Change in  operating assets and liabilities:                                              |       |                                                |       |   |   |   |   |   |   |
| Accounts receivable                                                                       |       |                                                | (9,418     | ) |   |   | (2,855 | ) |   |
| Inventories                                                                               |       |                                                | (705       | ) |   |   | (93 | ) |   |
| Prepaid expenses and other current assets                                                 |       |                                                | (3,547     | ) |   |   | (1,127 | ) |   |
| Income tax receivable                                                                     |       |                                                | 3,907      |   |   |   | 1,185 |   |   |
| Accounts payable and accrued liabilities                                                  |       |                                                | 5,175      |   |   |   | 892 |   |   |
| Income taxes payable                                                                      |       |                                                | 4,730      |   |   |   | 272 |   |   |
| Undistributed revenue payable                                                             |       |                                                | 369        |   |   |   | 146 |   |   |
| Net premiums paid on derivative contracts                                                 |       |                                                | (18,434    | ) |   |   | (3,026 | ) |   |
| Changes in unrealized commodity derivatives and  amortization of premiums                 |       |                                                | 45,900     |   |   |   | 1,692 |   |   |
| Minority interest in undistributed earnings of  subsidiary                                |       |                                                | 42         |   |   |   | 36 |   |   |
| Net cash provided by operating activities                                                 |       |                                                | 33,875     |   |   |   | 33,420 |   |   |
| CASH FLOWS FROM INVESTING  ACTIVITIES:                                                    |       |                                                |       |   |   |   |   |   |   |
| Expenditures for oil and gas properties                                                   |       |                                                | (59,183    | ) |   |   | (12,007 | ) |   |
| Acquisition of Marquez Energy, LLC                                                        |       |                                                | (14,628    | ) |   |   | 1,328 |   |   |
| Proceeds from sale of oil and gas properties                                              |       |                                                | 44,619     |   |   |   | 1,526 |   |   |
| Proceeds from sale of other property and equipment                                        |       |                                                | —     |   |   |   | 2,476 |   |   |
| Notes receivable—officers and employees                                              |       |                                                | 1,370      |   |   |   | 3,530 |   |   |
| Expenditures for property and equipment and other                                         |       |                                                | (1,367     | ) |   |   | (258 | ) |   |
| Net cash used in investing activities                                                     |       |                                                | (29,189    | ) |   |   | (3,405 | ) |   |
| CASH FLOWS FROM FINANCING  ACTIVITIES:                                                    |       |                                                |       |   |   |   |   |   |   |
| Proceeds from long-term debt                                                              |       |                                                | 39,000     |   |   |   | 4,685 |   |   |
| Principal payments on long-term debt                                                      |       |                                                | (43,706    | ) |   |   | (23,625 | ) |   |
| Distribution payments to Marquez Energy members                                           |       |                                                | (707       | ) |   |   | (10 | ) |   |
| Payments of dividends to shareholder                                                      |       |                                                | (35,000    | ) |   |   | — |   |   |
| Repurchase of common shares                                                               |       |                                                | (5,301     | ) |   |   | — |   |   |
| Increase in deferred loan costs                                                           |       |                                                | (664       | ) |   |   | (60 | ) |   |
| Net cash used in financing activities                                                     |       |                                                | (46,378    | ) |   |   | (19,010 | ) |   |
| Net (decrease) increase in cash and cash equivalents                                      |       |                                                | (41,692    | ) |   |   | 11,005 |   |   |
| Cash and cash equivalents, beginning of period                                            |       |                                                | 54,715     |   |   |   | 8,417 |   |   |
| Cash and cash equivalents, end of period                                                  |       |                                                | $          | 13,023 |   |   |   | $ | 19,422 |   |   |
| **Supplemental Disclosure of Cash  Flow Information—**                               |       |                                                |       |   |   |   |   |   |   |
| Cash paid during  the year for:                                                           |       |                                                |       |   |   |   |   |   |   |
| Interest                                                                                  |       |                                                | $          | 7,474 |   |   |   | $ | 1,685 |   |   |
| Income taxes                                                                              |       |                                                | $          | 2,900 |   |   |   | $ | 5,350 |   |   |

 

See notes to condensed consolidated financial statements.

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**VENOCO, INC. AND SUBSIDIARIESNOTES TO CONDENSEDCONSOLIDATED FINANCIAL STATEMENTSTHREE AND NINE MONTHS ENDED SEPTEMBER 30, 2005 AND 2004 (UNAUDITED)**

**1.**   BASIS OFPRESENTATION

***InterimFinancial Statements—***The accompanying condensedconsolidated financial statements of Venoco Inc. are unaudited. In the opinionof management, the accompanying unaudited condensed consolidated financialstatements contain all adjustments (consisting only of normal recurringaccruals) necessary to present fairly the Company’s financial position at September 30,2005, the results of operations for the three and nine months ended September 30,2005 and 2004 and cash flows for the nine months ended September 30, 2005and 2004. Certain disclosures have been condensed or omitted from thesefinancial statements. Accordingly, these financial statements should be read inconjunction with the Company’s audited 2004 financial statements contained in itsRegistration Statement on Form S-4/A (Registration No. 333-123711)as filed with the Securities and Exchange Commission on April 20, 2005. Theresults for interim periods are not necessarily indicative of annual results.

***Stock Split—***Allcommon share amounts in the accompanying financial statements have beenadjusted for the 1,000-for-one reverse stock split effected on February 10,2005 and a one-for-7,500 stock split approved by the board of directors of theCompany on October 13, 2005 and effected on November 8, 2005.

***New Company Basis******—***During 2004, the Company’s CEO, TimMarquez, increased his ownership in the Company from 41% to 100%. As a resultof a transaction that closed on July 12, 2004, Mr. Marquez purchased53% of the common shares (18,510,000 common shares) of the Company from two ofthe Company’s former officers and their respective affiliates. On December 22,2004, the Company merged with a corporation the sole stockholder of which was atrust controlled by Mr. Marquez. As a result of this merger, Mr. Marquezacquired beneficial ownership of the remaining 6% of the Company’s commonstock.

As a result of Mr. Marquez obtaining control ofover 95% of the common stock of the Company on December 22, 2004, SECStaff Accounting Bulletin No. 54 requires the acquisition by Mr. Marquezto be “pushed-down”, meaning the post-transaction condensed consolidatedbalance sheet and the condensed consolidated statements of operations and cashflows of the Company reflect a new basis of accounting (“successor basis”). Thepre-transaction condensed consolidated statements of operations and cash flowsare presented on the historical basis (“predecessor basis”).

***Common Control Merger—******On***March 21,2005 the Company completed the acquisition of Marquez Energy, LLC, a Coloradolimited liability company (“Marquez Energy”) majority-owned and controlled byTimothy Marquez, the Company’s CEO and sole shareholder. Due to the commoncontrol aspects of the transaction, the financial statements of Marquez Energyhave been combined with the consolidated financial statements of the Companyand its subsidiaries in a manner similar to a pooling-of-interests, from thedate common control was achieved. Therefore, the Company’s financial statementssince July 1, 2004 were restated to include Marquez Energy’s financialresults.

**2.**   ACQUISITIONS

On March 21, 2005, the Company completed theacquisition of Marquez Energy. The transaction added proved reserves ofapproximately 2.0 MMBOE as of December 31, 2004, based on a reserve reportprepared by Netherland, Sewell and Associates, Inc. (NSAI). The purchaseprice for the membership interests in Marquez Energy was $16.6 million. Thepurchase price was based on the member’s equity on 

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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/Mcfefor its proved developed non-producing reserves and (iii) $0.75/Mcfe forits proved undeveloped reserves. Quantities of proven reserves were as setforth by NSAI in the December 31, 2004 reserve report. NSAI or anothernationally recognized engineering firm will conduct supplemental evaluations ofthe Marquez Energy properties as of year-end 2005 and 2006. In the event thoseevaluations attribute proved reserves to the Marquez Energy properties as of December 31,2004 in excess of those reflected in NSAI’s initial report, additional paymentswill be made to the former holders of interests in Marquez Energy pursuant tothe same formula, subject to a maximum aggregate price, including debtassumption, of $25 million. The Company had paid a deposit of $2 million to themembers of Marquez Energy as of December 31, 2004 and on March 21,2005 paid the remaining $14.6 million to the members of Marquez Energy and $3.2million to Bank of Oklahoma to repay the existing debt. As discussed inNote 1, 91.383% of the voting equity of this entity was owned by theCompany’s CEO and 100% beneficial shareholder, therefore, the assets andliabilities on a net basis were recorded at their historical cost. The amountof the purchase price in excess of the historical cost, net of tax, has beencharged directly against equity. The remaining 8.617% of the assets andliabilities were recorded at the purchase price paid to the minorityshareholders of Marquez Energy.

In September 2005, theCompany acquired a 100% working interest in the Willows-Beehive Bend Gas Field,a 100% working interest in the Bounde Creek Gas Field and a 65% workinginterest in the Arbuckle Field for an aggregate net price of $10.1 million incash. The Company operates all of the acquired fields, which are located in theSacramento Basin in California.

**3.**   SALES OF PROPERTIES

In February 2005, the Company entered into apurchase and sale agreement to sell the Big Mineral Creek field (“BMC”),located in Grayson County, Texas. The sales price was $45 million, subject toadjustments that, among other things, gave economic effect to the transactionas of February 1, 2005. The closing of the transaction occurred on March 31,2005.

In order to facilitate a like-kind exchange of theCompany’s BMC property under Section 1031 of the Internal Revenue Code,the proceeds from 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, which expired on September 27,2005. Included in the Company’s qualified replacement properties acquired was aportion of the Marquez Energy properties. The Company has deferred a portion ofthe gain on sale of the BMC property under the provisions of section 1031 ofthe Internal Revenue Code. However, since the qualified replacement propertyacquired is less than the proceeds on sale of the BMC property, the Companyrecognized for tax purposes a gain on the sale of the BMC property ofapproximately $27.9 million and incurred an associated tax liability of $11.1million during the three months ended September 30, 2005. In accordancewith its accounting policies, the Company did not recognize a gain on the salefor financial reporting purposes, but applied the net sales proceeds to reducethe capitalized costs of its oil and natural gas properties.

In March 2004, theCompany sold its subsidiary, Venoco Patagonia, Ltd., a Bermuda corporation, for$0.2 million. The $0.2 million sales price was comprised of cash of $0.1million and payment of liabilities of $0.1 million.

In February 2004, the Company sold its interestin the North and South Afton, California, natural gas properties for a netsales price of approximately $1.5 million. In accordance with its accountingpolicies, 

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the Company did not recognizeany gain or loss on the transaction, but applied the net sales proceeds toreduce the capitalized cost of its oil and natural gas properties.

**4.**   HEDGINGAND DERIVATIVE FINANCIAL INSTRUMENTS

The Company enters into derivative contracts,primarily collars, swaps and option contracts, to hedge future crude oil andnatural gas production in order to mitigate the risk of market pricefluctuations. The objective of the Company’s hedging activities and the use ofderivative financial instruments is to achieve more predictable cash flows. Whilethe use of these derivative instruments limits the downside risk of adverseprice movements, they also limit future revenues from favorable price movements.The use of derivatives also involves the risk that the counterparties to such instruments will beunable to meet the financial terms of such contracts.

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

All derivative instruments are recorded on the balancesheet at fair value. Fair value is generally determined based on the differencebetween the fixed contract price and the underlying market price at thedetermination date, and/or confirmed 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 which 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. The Company determines hedgeineffectiveness based on changes during the period in the price differentialsbetween the index price of the derivative contracts (which uses a New YorkMercantile Exchange (“NYMEX”) index in the case of oil hedges, and NYMEX andPG&E Citygate in the case of natural gas hedges) and the contract price forthe point of sale for the cash flow that is being hedged. Hedge ineffectivenessoccurs only if the cumulative gain or loss on the derivative hedging instrumentexceeds the cumulative change in the expected future cash flows on the hedgedtransaction. Ineffectiveness is recorded in earnings to the extent thecumulative changes in fair value of the actual derivative exceed the cumulativechanges in fair value of the hypothetical derivative.

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

| ** **                                                                    | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                    | ** ** | **2005**                                             | ** ** | **2004**                                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                    | ** ** | **(Successor)**                                      | ** ** | **(Predecessor)**                                   | ** ** | **(Successor)** | ** ** | **(Predecessor)** | ** ** |
| Realized  commodity derivative losses                                         |       |                                                 | $          | 8,287                                               |       |   |   | $ | 4,968 |   |   |   | $ | 15,442 |   |   |   | $ | 11,076 |   |   |
| Unrealized commodity  derivative losses:                                      |       |                                                 |       |                                                |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Change in fair  value of derivatives that do not qualify for hedge accounting |       |                                                 | 18,830     |                                                |       |   | (218 | ) |   |   | 47,266 |   |   |   | — |   |   |
| Ineffective  portion of derivatives qualifying for hedge accounting      |       |                                                 | (2,588     | )                                                   |       |   | 1,069 |   |   |   | (3,025 | ) |   |   | 1,692 |   |   |
| Total unrealized  commodity derivative losses                                 |       |                                                 | 16,242     |                                                |       |   | 851 |   |   |   | 44,241 |   |   |   | 1,692 |   |   |
| Total realized and  unrealized commodity derivative losses               |       |                                                 | $          | 24,529                                              |       |   |   | $ | 5,819 |   |   |   | $ | 59,683 |   |   |   | $ | 12,768 |   |   |

 

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Theestimated fair values of derivatives included in the consolidated balancesheets at September 30, 2005 and December 31, 2004 are summarized below.The increase in the net derivative liability from December 31, 2004 to September 30,2005 is primarily attributable to the effect of rising oil and natural gasprices, partially offset by cash settlements of derivatives during the period(in thousands):

| ** **                         | ** ** | **September 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| Derivative assets:                 |       |                         |       |                        |       |   |   |   |   |
| Oil derivative contracts           |       |                         | $          | 2,378                       |       |   |   | $ | 6,775 |   |   |
| Gas derivative contracts           |       |                         | 2,252      |                        |       |   | 3,380 |   |   |
| Derivative liabilities:            |       |                         |       |                        |       |   |   |   |   |
| Oil derivative contracts           |       |                         | (44,104    | )                           |       |   | (1,383 | ) |   |
| Gas derivative contracts           |       |                         | (17,373    | )                           |       |   | (137 | ) |   |
| Net derivative asset  (liability). |       |                         | $          | (56,847                     | )          |   |   | $ | 8,635 |   |   |

 

As of September 30, 2005, an unrealizedderivative fair value loss of $34.8 million ($21.0 million after tax), relatedto cash flow hedges, was recorded in accumulated other comprehensive loss. Basedon September 30, 2005 mark-to-market prices, the Company expects toreclassify as decreases to earnings $21.3 million ($12.8 million aftertax) from accumulated other comprehensive loss during the twelve months endingSeptember 30, 2006. The actual reclassification to earnings will be basedon mark-to-market prices at the contract settlement date.

***Crude Oil Agreements—******As***of September 30,2005, the Company had entered into option, swap and collar agreements toreceive average minimum and maximum New York Mercantile Exchange (NYMEX) WestTexas Intermediate (WTI) prices as summarized below. Location and qualitydifferentials attributable to the Company’s properties are not included in thefollowing prices. The agreements provide for monthly settlement based on thedifferential between the agreement price and the actual NYMEX crude oil price.

| ** **                                                   | ** ** | **Minimum**     | ** ** | **Maximum**          | ** ** |
|--------------------------------------------------------------|------------|-----------------|------------|----------------------|------------|
| ** **                                                   | ** ** | **Barrels/day** | ** ** | **Avg. Prices** | ** ** | **Barrels/day** | ** ** | **Avg. Prices** | ** ** |
| Crude oil hedges  at September 30, 2005 for production: |       |            |       |                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| October 1 – December 31,  2005                |       |            | 9,471      |                 |       |   | $ | 37.73 |   |   |   | 5,471 |   |   |   | $ | 47.17 |   |   |
| January 1 – December 31,  2006                |       |            | 8,500      |                 |       |   | $ | 45.34 |   |   |   | 5,000 |   |   |   | $ | 53.56 |   |   |
| January 1 – December 31,  2007                |       |            | 4,313      |                 |       |   | $ | 43.96 |   |   |   | 4,313 |   |   |   | $ | 68.99 |   |   |
| January 1 – December 31,  2008                |       |            | 2,946      |                 |       |   | $ | 52.00 |   |   |   | 2,946 |   |   |   | $ | 75.00 |   |   |
| January 1 – June 30,  2009                    |       |            | 2,170      |                 |       |   | $ | 50.00 |   |   |   | 2,170 |   |   |   | $ | 75.00 |   |   |

 

***Natural Gas Agreements—******As***of September 30,2005, the Company had entered into option, swap and collar agreements toreceive average minimum and maximum PG&E Citygate prices as follows: 

| ** **                                                          | ** ** | **Minimum**   | ** ** | **Maximum**          | ** ** |
|---------------------------------------------------------------------|------------|---------------|------------|----------------------|------------|
| ** **                                                          | ** ** | **MMBtu/Day** | ** ** | **Avg. Prices** | ** ** | **MMBtu/Day** | ** ** | **Avg. Prices** | ** ** |
| Natural gas hedges at  September 30, 2005 for production: |       |          |       |                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| October 1 – December 31,  2005                       |       |          | 14,000     |                 |       |   | $ | 6.09 |   |   |   | 4,000 |   |   |   | $ | 6.77 |   |   |
| January 1 – December 31,  2006                       |       |          | 21,000     |                 |       |   | $ | 7.06 |   |   |   | 15,000 |   |   |   | $ | 11.04 |   |   |
| January 1 – December 31,  2007                       |       |          | 6,000      |                 |       |   | $ | 6.00 |   |   |   | 6,000 |   |   |   | $ | 8.40 |   |   |

 

9

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As of September 30, 2005, the Company had enteredinto a forward sales contract with a gas purchaser under which it is obligatedfor physical delivery of specified volumes of gas with a floor price. As thiscontract provides for physical delivery of the gas, it is not considered aderivative because it has been designated as a normal sale and the transactionwill be recorded in the financial statements when the associated deliveryoccurs. The Company has contracted for 2,000 MCF per day at a floor price of$4.85 per MCF for the period October 1, 2005 to September 30,2006.

**5.   LONG-TERMDEBT**

Longterm debt consists of the following (in thousands):

| ** **                                                  | ** ** | **September 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|-------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| 8.75% senior  notes due December 15, 2011              |       |                         | $          | 149,146                     |       |   |   | $ | 149,043 |   |   |
| Marquez Energy  Credit Agreement due August 31, 2006   |       |                         | —     |                        |       |   | 4,684 |   |   |
| 5.79% Mortgage on  office building due January 1, 2015 |       |                         | 9,920      |                        |       |   | 9,942 |   |   |
| Total long-term  debt                                       |       |                         | 159,066    |                        |       |   | 163,669 |   |   |
| Less: current  portion of long-term debt                    |       |                         | (124       | )                           |       |   | (127 | ) |   |
| Long-term debt,  net of current portion                     |       |                         | $          | 158,942                     |       |   |   | $ | 163,542 |   |   |

 

On December 20, 2004, the Company sold $150million in 8.75% senior notes (the “notes”). The notes were issued at 99.362%of par to yield 8.80% to maturity in December 2011. Interest on the notesis due each June 15 and December 15 beginning June 15, 2005. Thenotes are senior unsecured obligations and contain covenants that, among otherthings, limit the Company’s ability to make investments, incur additional debtor issue preferred stock, create liens and sell assets.

In November 2004, the Company borrowed$96.7 million under a credit facility, the proceeds of which were used torepurchase outstanding preferred stock and repay prior borrowings. InDecember 2004, proceeds from the sale of the notes were used to repayexisting borrowings under the Company’s credit facility, which was amended andrestated in December 2004 to provide for a revolving credit facility with aninitial borrowing base of $50 million and no associated term loan facility (“restatedCredit Agreement”). The borrowing base under the restated Credit Agreement wasreduced to $40 million on March 31, 2005 due to the sale of the BigMineral Creek field and, effective September 30, 2005, was increased to$80.0 million based upon an updated reserve report and additional propertypledged as collateral. The restated Credit Agreement contains a number ofrestrictive operating and financial covenants and other terms customary in acredit facility secured by oil and natural gas properties. At September 30,2005, there were no borrowings outstanding under the restated Credit Agreement.As of September 30,2005, the Company was in compliance with all of its covenants under therestated Credit Agreement.

At December 31, 2004, Marquez Energy, now merged withthe Company, had a $5.0 million revolving credit facility with the Bank ofOklahoma. Interest accrued at the JP Morgan Chase Bank prime rate plus 1 percent.The agreement was collateralized by Marquez Energy’s oil and gas properties andwas guaranteed by Marquez Energy’s principal shareholder and president. Thecredit agreement also contained certain net worth, leverage and ratiorequirements and limited the payment of distributions. At December 31,2004, Marquez Energy had approximately $4.7 million of outstanding borrowingsunder this credit facility. On March 21, 2005, the Company repaid theoutstanding borrowings of $3.2 million on this credit facility and terminatedthe facility.

On December 9, 2004,the Company purchased an office building in Carpinteria, California for $14.2 million. Thepurchase was financed in part by a secured 5.79% $10 million promissory notedue January 1, 2015. The promissory note provides for a monthly payment of$58,612 beginning February 1, 

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2005 andcontinuing through December 1, 2014. The balance of unpaid principal andall accrued but unpaid interest is due and payable on January 1, 2015.

**6.   COMPREHENSIVE INCOME (LOSS)**

Comprehensiveincome (loss) includes net income and certain items recorded directly toStockholders’ Equity and classified as Accumulated Other Comprehensive Income (“OCI”).The following table reflects comprehensive income for the three and nine monthperiods ended September 30, 2005 and 2004.

| ** **                                                                   | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                   | ** ** | **2005**                                             | ** ** | **2004**                                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                   | ** ** | **(Successor)**                                      | ** ** | **(Predecessor)**                                   | ** ** | **(Successor)** | ** ** | **(Predecessor)** | ** ** |
| Net income (loss)                                                            |       |                                                 | $          | (1,833                                              | )          |   |   | $ | 6,946 |   |   |   | $129 |   |   |   | $ | 18,253 |   |   |
| OTHER COMPREHENSIVE  INCOME (LOSS), NET OF INCOME TAX:                       |       |                                                 |       |                                                |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Hedging activities:                                                          |       |                                                 |       |                                                |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Reclassification adjustments for settled contracts                      |       |                                                 | —     |                                                |       |   | — |   |   |   | 161 |   |   |   | 615 |   |   |
| Changes in fair value of effective portion of outstanding  hedging positions |       |                                                 | (10,443    | )                                                   |       |   | (3,998 | ) |   |   | (23,087 | ) |   |   | (6,053 | ) |   |
| Other  comprehensive loss                                                    |       |                                                 | (10,443    | )                                                   |       |   | (3,998 | ) |   |   | (22,926 | ) |   |   | (5,438 | ) |   |
| Comprehensive income  (loss)                                                 |       |                                                 | $          | (12,276                                             | )          |   |   | $ | 2,948 |   |   |   | $ | (22,797 | ) |   |   | $ | 12,815 |   |   |
|                                                                              |            |                                                      |            |                                                     |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**7.   LITIGATION**

***Beverly Hills Litigation***

Six lawsuits have been filed against the Company andcertain other energy companies in Los Angeles County Superior Court by personswho attended Beverly Hills High School or who are citizens of Beverly Hills/CenturyCity or visitors to that area from the time period running from the 1930s todate. There are approximately 1,000 plaintiffs (including plaintiffs in tworelated lawsuits in which the Company has not been named) who claim to besuffering from various forms of cancer or some other illnesses, fear they maysuffer from such maladies in the future, or are related in some manner topersons who have suffered from cancer or other illnesses. Plaintiffs allegethat exposure to substances in the air, soil and water which derive from eitheroil field or other operations in the area are the cause of the cancers andother maladies. The Company has owned an oil and gas facility adjacent to theschool since 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. All cases havebeen consolidated before one judge. The judge has ordered that all of the casesbe stayed except for an initial trial group consisting of twelve “representative”plaintiffs. Discovery relating to the initial trial group is ongoing, with atrial set for March 2006. Management believes that the claims made in thesuits are without merit and the Company intends to defend against the claimsvigorously. However, the Company cannot predict, at this time, the outcome ofthe suits. The Company also has defense and indemnity obligations to certainother defendants in the actions. The Company cannot predict the cost of defenseand indemnity obligations, if any, at the present time.

In accordance with Statementof Financial Accounting Standard (“SFAS”) No. 5, Accounting forContingencies, the Company has not accrued for a loss contingency relating tothe Beverly Hills litigation because it believes that, although unfavorableoutcomes in the proceedings may be reasonably possible, they are not consideredby management 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 

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beapplicable, their impact on the Company’s results of operations, financialposition and/or liquidity could be material.

***Litigation by former directors and former preferredstockholders***

In December 2004, alawsuit was filed against the Company by two of its former directors and theformer preferred shareholders. The claim was for indemnification of attorneys’fees and expenses incurred in defending the former directors in litigationfiled by the former CEO in connection with the termination of his employmentfrom Venoco. Fees incurred in the defense total approximately $1,000,000. On July 28**,**2005, the Company entered into asettlement agreement with the former directors and the former preferred shareholdersand settled the litigation****for an amountwhich did not differ materially from the amount previously accrued. The casewas dismissed in August 2005.

***Former Chief Operating Officer (COO) Litigation***

In December 2004, aformer COO of the Company filed a lawsuit against the Company and its CEO inSanta Barbara County Superior Court, claiming that the Company breached hisemployment agreement and wrongfully failed to pay him wages due, primarily inconnection with stock bonuses. In April 2005 the former COO, in connectionwith the merger effected on December 22, 2004 and described innote 1, filed a Petition for Appraisal in the Delaware Court of Chanceryasking for an appraisal of the shares he held as well as those shares whichwere the subject of the employment contract dispute. In August 2005, theCompany and the former COO agreed to settle the lawsuits for amounts accrued asof June 30, 2005 in the financial statements. The Santa Barbara Countyaction was dismissed on September 19, 2005, and the Delaware action wasdismissed October 5, 2005.

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**8.**   STOCKOPTION PLANS

During2005, the Company entered into non-qualified stock option agreements withcertain employees, officers and directors of the Company other than Mr.Marquez. Total options granted in 2005 through September 30, 2005 were4,013,662 at a weighted average exercise price of $7.09 ($6.00 to $13.33). Theoptions vest over a four year period, with 20% vesting on the grant date and20% of the options vesting on each subsequent anniversary of the grant date.The non-qualified stock option agreements provide that all options will becomeimmediately vested following a change in control of the Company. The agreementswith director option holders provide that any unvested options will terminatewhen the director’s service to the Company ceases. The agreements with employeeand officer option holders provide that all of the holder’s options will vestif the company terminates the holder’s employment, unless the termination isfor specified misconduct. We have previously recorded stock compensationpursuant to the intrinsic value method under Accounting Principles Board (“APB”) OpinionNo. 25, whereby no compensation was recognized for these stock optionawards. Had compensation expense for the options granted to our employees,officers and directors been determined based on the fair value at the grantdate for the options, consistent with the provisions of SFAS No. 123,the Company’s net income (loss) for the three and nine months endedSeptember 30, 2005 and 2004 would have been increased to the pro formaamounts indicated below:

| ** **                                                                                                             | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                                                             | ** ** | **2005**                                             | ** ** | **2004**                                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                                                             | ** ** | **(in thousands)**                              | ** ** |
| Net income as reported                                                                                                 |       | $                                                    | (1,833     | )                                                   | $          | 6,946 |   | $ | 129 |   | $ | 18,253 |   |
| Stock-based compensation  expense included in the income statement, net of related tax effects                         |       | 0                                                    |       | 0                                                   |       | 0 |   | 0 |   |
| Deduct:                                                                                                                |       |                                                 |       |                                                |       |   |   |   |   |
| Total stock-based  compensation expense determined under fair value method for all awards, net  of related tax effects |       | (648                                                 | )          | 0                                                   |       | (1,969 | ) | 0 |   |
| Pro forma net income                                                                                                   |       | $                                                    | (2,481     | )                                                   | $          | 6,949 |   | $ | (1,840 | ) | $ | 18,253 |   |

 

**9.**   SHAREHOLDERS’EQUITY

On June 1, 2004, an agreement was reached betweencertain shareholders of the Company that ultimately resulted in the acquisitionof 53.5% of the outstanding common shares in the Company by Timothy Marquezin a transaction that closed on July 12, 2004. The terms of thetransaction were contained in a private agreement among Timothy Marquez and theselling shareholders. On June 2, 2004 Timothy Marquez was elected Chairmanof the Board and CEO of the Company and the selling shareholders resigned fromthe Board of Directors.

On January 3, 2005, adividend of $35 million was paid to the Company’s sole stockholder, a trustcontrolled by Timothy Marquez and his wife, from the proceeds of the seniornotes.

**10.   ASSET RETIREMENT OBLIGATIONS**

The Company adopted SFAS No. 143, *Accounting for Asset Retirement Obligations*as of January 1, 2003. Under SFAS No. 143, liabilities are accretedto their present value each period and the capitalized asset retirement costsare depleted over the productive life of the related assets. Changes resultingfrom revisions to the timing or the amount of the original estimate ofundiscounted cash flows are recognized as an increase or decrease in the assetretirement obligation (“ARO”) and the related capitalized asset retirementcosts.

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TheCompany’s asset retirement obligations represent expected future costsassociated with site reclamation, facilities dismantlement, and plugging andabandonment of wells. The following is a summary of the asset retirementobligation activity (in thousands):

| ** **                                                            | ** ** | **2005**        | ** ** | **2004**          | ** ** |
|-----------------------------------------------------------------------|------------|-----------------|------------|-------------------|------------|
| ** **                                                            | ** ** | **(Successor)** | ** ** | **(Predecessor)** | ** ** |
| Balance of ARO as  of January 1,                                 |       |            | $          | 23,390            |       |   |   | $ | 19,248 |   |   |
| Revisions in  estimated cash flows                                    |       |            | —     |              |       |   | 494 |   |   |
| Liabilities  incurred during the nine months ended September 30, |       |            | 587        |              |       |   | 409 |   |   |
| Liabilities  settled during the nine months ended September 30,  |       |            | (547       | )                 |       |   | (59 | ) |   |
| Accretion expense                                                     |       |            | 1,311      |              |       |   | 1,093 |   |   |
| Balance of ARO as of  September 30,                              |       |            | $          | 24,741            |       |   |   | $ | 21,185 |   |   |

 

Of the liability for assetretirement obligations balance at September 30, 2005, $0.2 million isclassified as current and included in accrued liabilities in the accompanyingconsolidated balance sheet. The balance of ARO as of September 30, 2005represents the Company’s estimate of the present value of its aggregate assetretirement obligations as of that date. The discount rates used to calculatethe present value varied depending on the estimated timing of the obligation,but typically ranged between 6% and 8%.

**11.   SUBSEQUENT EVENTS**

On November 1, 2005,the Company merged two of its wholly-owned subsidiaries, Marquez Energy LLC, aColorado limited liability company, and 217 State Street, Inc., aCalifornia corporation, with and into Venoco, Inc.

**12.**   RECENTACCOUNTING PRONOUNCEMENTS

In December 2004, the Financial AccountingStandards Board (“FASB”) issued SFAS No. 123 (Revised 2004), *Share-Based Payment*, which requires that compensationrelated to all stock-based awards, including stock options, be recognized inthe financial statements. This pronouncement replaces SFAS No. 123, *Accounting for Stock-Based Compensation*, and supersedesAPB Opinion No. 25, *Accounting for StockIssued to Employees*. In April 2005, the Securities and ExchangeCommission postponed the required implementation date for this new statement toannual periods beginning after June 15, 2005. The Company currently planto adopt SFAS No. 123R as of January 1, 2006. We have previouslyrecorded stock compensation pursuant to the intrinsic value method underAPB Opinion No. 25, whereby no compensation was recognized for moststock option awards. The Company expects that stock option grants will continueto be a significant part of employee compensation, and, therefore, SFASNo. 123R will have a significant impact on its financial statements. Forthe pro forma effect of recording compensation for all stock awards at fairvalue, utilizing the Black-Scholes method, see Note 8 to the CondensedConsolidated Financial Statements. The Company has not yet completed itsevaluation but expects the adoption of SFAS No. 123R to have an effect onthe financial statements similar to the pro forma effects. The Company iscurrently considering alternative valuation methods to determine the fair valueof stock options granted after December 31, 2005.

SFAS No. 123R permits companies to adopt itsrequirements using either a “modified prospective” method, or a “modifiedretrospective” method. Under the “modified prospective” method, compensationcost is recognized in the financial statements beginning with the effectivedate, based on the requirements of SFAS No. 123R for all share-basedpayments granted after that date, and based on the requirements ofSFAS No. 123 for all unvested awards granted prior to the effectivedate of SFAS No. 123R. Under the “modified retrospective” method, therequirements are the same as under the “modified prospective” method, but alsopermits entities to restate financial statements of previous periods, eitherfor all periods presented or to the beginning of the fiscal year in which thestatement is adopted, based on previous pro 

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forma disclosures made inaccordance with SFAS No. 123. The Company has not yet determinedwhich of the methods it will use upon adoption. 

In March 2005, the FASB issued FASBInterpretation (“FIN”) No. 47, *Accountingfor Conditional Asset Retirement Obligations*. This Interpretationclarifies the definition and treatment of conditional asset retirementobligations as discussed in FASB Statement No. 143, *Accounting for Asset Retirement Obligations*.A conditional asset retirement obligation is defined as an asset retirementactivity in which the timing and/or method of settlement are dependent onfuture events that may be outside the control of a company. FIN 47 states thata company must record a liability when incurred for conditional assetretirement obligations if the fair value of the obligation is reasonablyestimable. This Interpretation is intended to provide more information aboutlong-lived assets, more information about future cash outflows for theseobligations and more consistent recognition of these liabilities. FIN 47 iseffective for fiscal years ending after December 15, 2005. The Companydoes not believe that its financial position, results of operations or cashflows will be impacted by this Interpretation. 

In June 2005, the FASB issued SFAS No. 154, *Accounting Changes and Error Corrections*,which replaces APB Opinion No. 20, *AccountingChanges*, and SFAS No. 3, *ReportingAccounting Changes in Interim Financial Statements*. Statement 154changes the requirements for the accounting and reporting of a change inaccounting principle. APB Opinion No. 20 previously required that mostvoluntary changes in an accounting principle be recognized by including thecumulative effect of the new accounting principle in net income of the periodof the change. SFAS No. 154 now requires retrospective application ofchanges in an accounting principle to prior period financial statements, unlessit is impracticable to determine either the period-specific effects or thecumulative effect of the change. The Statement is effective for fiscal yearsbeginning after December 15, 2005. We do not expect the adoption of thisstatement will have a material impact on our financial statements. 

In October 2005, theFASB issued FSP FAS No. 13-1, *Accountingfor Rental Costs Incurred during a Construction Period*, which iseffective for reporting periods beginning after December 15, 2005. ThisPosition requires that rental costs associated with ground or buildingoperating leases that are incurred during a construction period be recognizedas rental expense. We do not expect the adoption of FSP No. 13-1 to havean impact on our financial statements. 

**13.**   GUARANTORFINANCIAL INFORMATION

In connection with the issuance of the notes in December 2004,three of the Company’s wholly-owned subsidiaries, BMC, Ltd., Whittier PipelineCorp. and 217 State Street, Inc. (“Guarantors”), fully and unconditionallyguaranteed, on a joint and several basis, the Company’s obligations under the notes(the “Guarantees”). On March 31, 2005, Marquez Energy became a Guarantorof the notes. Each Guarantee is a general unsecured obligation of the Guarantor,senior in right of payment to all existing and future subordinated indebtednessof that Guarantor, pari passu in right of payment with any existing and futuresenior unsecured indebtedness of that Guarantor and effectively junior in rightof payment to that Guarantor’s existing and future secured indebtedness,including its guarantee of indebtedness under the restated Credit Agreement, tothe extent of the value of the collateral securing that facility. AllGuarantors are 100% owned by the Company. The Company has two subsidiaries, 6267 CarpinteriaAvenue, LLC and Ellwood Pipeline, Inc., that are not guarantors of the notes(the “Non-Guarantor Subsidiaries”).

The following is condensed consolidating financialinformation for the three and nine months ended September 30, 2005 and2004 and as of September 30, 2005 and December 31, 2004.

15

----

**CONDENSEDCONSOLIDATING STATEMENT OF OPERATIONS INFORMATIONTHREE MONTHS ENDED SEPTEMBER 30, 2005(Successor)(in thousands)**

| ** **                                              | ** ** | **Venoco, Inc.** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|---------------------------------------------------------|------------|-----------------------|------------|-----------------------------|------------|---------------------------------|------------|------------------|------------|------------------|------------|
| REVENUES:                                               |       |                  |       |                        |       |                            |       |             |       |             |       |   |   |   |   |   |   |   |   |   |   |
| Oil and natural gas sales                               |       |                  | $          | 45,203                      |       |                            |       | $                | 2,075      |             |       |   | $ | — |   |   |   | $ | — |   |   |   | 47,278 |   |   |
| Commodity derivative losses (realized)                  |       |                  | (8,287     | )                           |       |                            | —     |             |       |             | —     |   |   |   | — |   |   |   | (8,287 | ) |   |
| Commodity derivative losses (unrealized)                |       |                  | (16,242    | )                           |       |                            | —     |             |       |             | —     |   |   |   | — |   |   |   | (16,242 | ) |   |
| Other                                                   |       |                  | 653        |                        |       |                            | 4          |             |       |             | 1,622      |   |   |   | (1,503 | ) |   |   | 776 |   |   |
| Total revenues                                          |       |                  | 21,327     |                        |       |                            | 2,079      |             |       |             | 1,622      |   |   |   | (1,503 | ) |   |   | 23,525 |   |   |
| EXPENSES:                                               |       |                  |       |                        |       |                            |       |             |       |             |       |   |   |   |   |   |   |   |   |   |   |
| Oil and natural gas production                          |       |                  | 13,092     |                        |       |                            | 322        |             |       |             | 334        |   |   |   | — |   |   |   | 13,748 |   |   |
| Transportation expense                                  |       |                  | 1,401      |                        |       |                            | 141        |             |       |             | —     |   |   |   | (1,078 | ) |   |   | 464 |   |   |
| Depletion, depreciation, amortization and impairment    |       |                  | 5,192      |                        |       |                            | 380        |             |       |             | 62         |   |   |   | — |   |   |   | 5,634 |   |   |
| Accretion of abandonment liability                      |       |                  | 263        |                        |       |                            | 25         |             |       |             | 5          |   |   |   | — |   |   |   | 293 |   |   |
| General and administrative, net of amounts  capitalized |       |                  | 2,986      |                        |       |                            | 262        |             |       |             | 132        |   |   |   | (425 | ) |   |   | 2,955 |   |   |
| Amortization of deferred loan costs                     |       |                  | 320        |                        |       |                            | —     |             |       |             | —     |   |   |   | — |   |   |   | 320 |   |   |
| Interest, net                                           |       |                  | 4,357      |                        |       |                            | (664       | )                |       |             | (332       | ) |   |   | — |   |   |   | 3,361 |   |   |
| Total expenses                                          |       |                  | 27,611     |                        |       |                            | 466        |             |       |             | 201        |   |   |   | (1,503 | ) |   |   | 26,775 |   |   |
| Equity in  subsidiary income                            |       |                  | 1,027      |                        |       |                            | —     |             |       |             | —     |   |   |   | (1,027 | ) |   |   | — |   |   |
| Income (loss)  before income taxes                      |       |                  | (5,257     | )                           |       |                            | 1,613      |             |       |             | 1,421      |   |   |   | (1,027 | ) |   |   | (3,250 | ) |   |
| Income tax  provision (benefit)                         |       |                  | (3,424     | )                           |       |                            | 61         |             |       |             | 531        |   |   |   | 1,415 |   |   |   | (1,417 | ) |   |
| Income (loss)  before minority interest                 |       |                  | (1,833     | )                           |       |                            | 1,552      |             |       |             | 890        |   |   |   | (2,442 | ) |   |   | (1,833 | ) |   |
| Minority interest  in consolidated subsidiary           |       |                  | —     |                        |       |                            | —     |             |       |             | —     |   |   |   | — |   |   |   | — |   |   |
| Net income (loss)                                       |       |                  | $          | (1,833                      | )          |                            |       | $                | 1,552      |             |       |   | $ | 890 |   |   |   | $ | (2,442 | ) |   |   | $ | (1,833 | ) |   |
|                                                         |            |                       |            |                             |            |                                 |            |                  |            |                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

16

----

**CONDENSEDCONSOLIDATING STATEMENT OF OPERATIONS INFORMATIONTHREE MONTHS ENDED SEPTEMBER 30, 2004(Predecessor)(in thousands)**

| ** **                                                 | ** ** | **Venoco, Inc.** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|------------------------------------------------------------|------------|-----------------------|------------|-----------------------------|------------|---------------------------------|------------|------------------|------------|------------------|------------|
| REVENUES:                                                  |       |                  |       |                        |       |                            |       |             |       |             |       |   |   |   |   |   |   |   |   |   |   |
| Oil and natural gas sales                                  |       |                  | $          | 33,912                      |       |                            |       | $                | 2,932      |             |       |   | $ | — |   |   |   | $ | — |   |   |   | $ | 36,844 |   |   |
| Commodity derivative losses (realized)                     |       |                  | (4,968     | )                           |       |                            | —     |             |       |             | —     |   |   |   | — |   |   |   | (4,968 | ) |   |
| Commodity derivative losses (unrealized)                   |       |                  | (851       | )                           |       |                            | —     |             |       |             | —     |   |   |   | — |   |   |   | (851 | ) |   |
| Other                                                      |       |                  | 1,404      |                        |       |                            | 247        |             |       |             | 1,106      |   |   |   | (804 | ) |   |   | 1,953 |   |   |
| Total revenues                                             |       |                  | 29,497     |                        |       |                            | 3,179      |             |       |             | 1,106      |   |   |   | (804 | ) |   |   | 32,978 |   |   |
| EXPENSES:                                                  |       |                  |       |                        |       |                            |       |             |       |             |       |   |   |   |   |   |   |   |   |   |   |
| Oil and natural gas production                             |       |                  | 11,563     |                        |       |                            | 651        |             |       |             | 369        |   |   |   | — |   |   |   | 12,583 |   |   |
| Transportation expense                                     |       |                  | 1,525      |                        |       |                            | 2          |             |       |             | —     |   |   |   | (744 | ) |   |   | 783 |   |   |
| Depletion, depreciation, amortization and  impairment |       |                  | 3,379      |                        |       |                            | 211        |             |       |             | 21         |   |   |   | — |   |   |   | 3,611 |   |   |
| Accretion of abandonment liability                         |       |                  | 344        |                        |       |                            | 24         |             |       |             | 5          |   |   |   | — |   |   |   | 373 |   |   |
| General and administrative, net of amounts capitalized     |       |                  | 2,532      |                        |       |                            | 425        |             |       |             | 60         |   |   |   | (60 | ) |   |   | 2,957 |   |   |
| Amortization of deferred loan costs                        |       |                  | 103        |                        |       |                            | —     |             |       |             | —     |   |   |   | — |   |   |   | 103 |   |   |
| Interest, net                                              |       |                  | 768        |                        |       |                            | 49         |             |       |             | (374       | ) |   |   | — |   |   |   | 443 |   |   |
| Total expenses                                             |       |                  | 20,214     |                        |       |                            | 1,362      |             |       |             | 81         |   |   |   | (804 | ) |   |   | 20,853 |   |   |
| Equity in subsidiary  income                               |       |                  | 1,598      |                        |       |                            | —     |             |       |             | —     |   |   |   | (1,598 | ) |   |   | — |   |   |
| Income (loss)  before income taxes                         |       |                  | 10,881     |                        |       |                            | 1,817      |             |       |             | 1,025      |   |   |   | (1,598 | ) |   |   | 12,125 |   |   |
| Income tax  provision                                      |       |                  | 3,935      |                        |       |                            | 768        |             |       |             | 440        |   |   |   | — |   |   |   | 5,143 |   |   |
| Income (loss)  before minority interest                    |       |                  | 6,946      |                        |       |                            | 1,049      |             |       |             | 585        |   |   |   | (1,598 | ) |   |   | 6,982 |   |   |
| Minority interest  in consolidated subsidiary              |       |                  | —     |                        |       |                            | 36         |             |       |             | —     |   |   |   | — |   |   |   | 36 |   |   |
| Net income (loss)                                          |       |                  | $          | 6,946                       |       |                            |       | $                | 1,013      |             |       |   | $ | 585 |   |   |   | $ | (1,598 | ) |   |   | $ | 6,946 |   |   |

 

17

----

**CONDENSEDCONSOLIDATING STATEMENT OF OPERATIONS INFORMATIONNINE MONTHS ENDED SEPTEMBER 30, 2005(Successor)(in thousands)**

| ** **                                                        | ** ** | **Venoco, Inc.** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|-------------------------------------------------------------------|------------|-----------------------|------------|-----------------------------|------------|---------------------------------|------------|------------------|------------|------------------|------------|
| REVENUES:                                                         |       |                  |       |                        |       |                            |       |             |       |             |       |   |   |   |   |   |   |   |   |   |   |
| Oil and natural gas sales                                         |       |                  | $          | 126,967                     |       |                            |       | $                | 7,701      |             |       |   | $ | — |   |   |   | $ | — |   |   |   | $ | 134,668 |   |   |
| Commodity derivative losses (realized)                       |       |                  | (15,442    | )                           |       |                            | —     |             |       |             | —     |   |   |   | — |   |   |   | (15,442 | ) |   |
| Commodity derivative losses (unrealized)                          |       |                  | (44,241    | )                           |       |                            | —     |             |       |             | —     |   |   |   | — |   |   |   | (44,241 | ) |   |
| Other                                                             |       |                  | 2,337      |                        |       |                            | 21,682     |             |       |             | 5,364      |   |   |   | (26,516 | ) |   |   | 2,867 |   |   |
| Total revenues                                                    |       |                  | 69,621     |                        |       |                            | 29,383     |             |       |             | 5,364      |   |   |   | (26,516 | ) |   |   | 77,852 |   |   |
| EXPENSES:                                                         |       |                  |       |                        |       |                            |       |             |       |             |       |   |   |   |   |   |   |   |   |   |   |
| Oil and natural gas production                                    |       |                  | 35,492     |                        |       |                            | 1,537      |             |       |             | 1,001      |   |   |   | — |   |   |   | 38,030 |   |   |
| Transportation expense                                            |       |                  | 5,196      |                        |       |                            | 38         |             |       |             | —     |   |   |   | (3,554 | ) |   |   | 1,680 |   |   |
| Depletion, depreciation, amortization and impairment         |       |                  | 14,210     |                        |       |                            | 699        |             |       |             | 218        |   |   |   | — |   |   |   | 15,127 |   |   |
| Accretion of abandonment liability                                |       |                  | 1,212      |                        |       |                            | 83         |             |       |             | 16         |   |   |   | — |   |   |   | 1,311 |   |   |
| General and administrative, net of amounts  capitalized |       |                  | 10,790     |                        |       |                            | 1,009      |             |       |             | 419        |   |   |   | (1,564 | ) |   |   | 10,654 |   |   |
| Amortization of deferred loan costs                               |       |                  | 1,337      |                        |       |                            | 4          |             |       |             | —     |   |   |   | — |   |   |   | 1,341 |   |   |
| Interest, net                                                     |       |                  | 11,712     |                        |       |                            | (616       | )                |       |             | (915       | ) |   |   | — |   |   |   | 10,181 |   |   |
| Total expenses                                                    |       |                  | 79,949     |                        |       |                            | 2,754      |             |       |             | 739        |   |   |   | (5,118 | ) |   |   | 78,324 |   |   |
| Equity in  subsidiary income                                      |       |                  | 5,907      |                        |       |                            | —     |             |       |             | —     |   |   |   | (5,907 | ) |   |   | — |   |   |
| Income (loss)  before income taxes                                |       |                  | (4,421     | )                           |       |                            | 26,629     |             |       |             | 4,625      |   |   |   | (27,305 | ) |   |   | (472 | ) |   |
| Income tax provision  (benefit)                                   |       |                  | (4,550     | )                           |       |                            | 10,555     |             |       |             | 1,834      |   |   |   | (8,482 | ) |   |   | (643 | ) |   |
| Income (loss)  before minority interest                           |       |                  | 129        |                        |       |                            | 16,074     |             |       |             | 2,791      |   |   |   | (18,823 | ) |   |   | 171 |   |   |
| Minority interest  in consolidated subsidiary                     |       |                  | —     |                        |       |                            | 42         |             |       |             | —     |   |   |   | — |   |   |   | 42 |   |   |
| Net income (loss)                                                 |       |                  | $          | 129                         |       |                            |       | $                | 16,032     |             |       |   | $ | 2,791 |   |   |   | $ | (18,823 | ) |   |   | $ | 129 |   |   |

 

18

----

**CONDENSEDCONSOLIDATING STATEMENT OF OPERATIONS INFORMATIONNINE MONTHS ENDED SEPTEMBER 30, 2004(Predecessor)(in thousands)**

| ** **                                              | ** ** | **Venoco, Inc.** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|---------------------------------------------------------|------------|-----------------------|------------|-----------------------------|------------|---------------------------------|------------|------------------|------------|------------------|------------|
| REVENUES:                                               |       |                  |       |                        |       |                            |       |             |       |             |       |   |   |   |   |   |   |   |   |   |   |
| Oil and natural gas sales                               |       |                  | $          | 92,745                      |       |                            |       | $                | 7,016      |             |       |   | $ | — |   |   |   | $ | — |   |   |   | $ | 99,761 |   |   |
| Commodity derivative losses (realized)                  |       |                  | (11,076    | )                           |       |                            | —     |             |       |             | —     |   |   |   | — |   |   |   | (11,076 | ) |   |
| Commodity derivative losses (unrealized)                |       |                  | (1,692     | )                           |       |                            | —     |             |       |             | —     |   |   |   | — |   |   |   | (1,692 | ) |   |
| Other                                                   |       |                  | 2,840      |                        |       |                            | 277        |             |       |             | 4,533      |   |   |   | (3,516 | ) |   |   | 4,134 |   |   |
| Total revenues                                          |       |                  | 82,817     |                        |       |                            | 7,293      |             |       |             | 4,533      |   |   |   | (3,516 | ) |   |   | 91,127 |   |   |
| EXPENSES:                                               |       |                  |       |                        |       |                            |       |             |       |             |       |   |   |   |   |   |   |   |   |   |   |
| Oil and natural gas production                          |       |                  | 32,644     |                        |       |                            | 1,692      |             |       |             | 962        |   |   |   | — |   |   |   | 35,298 |   |   |
| Transportation expense                                  |       |                  | 5,544      |                        |       |                            | 2          |             |       |             | —     |   |   |   | (3,324 | ) |   |   | 2,222 |   |   |
| Depletion, depreciation, amortization and impairment    |       |                  | 10,255     |                        |       |                            | 584        |             |       |             | 153        |   |   |   | — |   |   |   | 10,992 |   |   |
| Accretion of abandonment liability                      |       |                  | 1,018      |                        |       |                            | 59         |             |       |             | 16         |   |   |   | — |   |   |   | 1,093 |   |   |
| General and administrative, net of amounts  capitalized |       |                  | 7,922      |                        |       |                            | 765        |             |       |             | 202        |   |   |   | (192 | ) |   |   | 8,697 |   |   |
| Amortization of deferred loan costs                     |       |                  | 233        |                        |       |                            | —     |             |       |             | —     |   |   |   | — |   |   |   | 233 |   |   |
| Interest, net                                           |       |                  | 2,062      |                        |       |                            | 49         |             |       |             | (1,035     | ) |   |   | — |   |   |   | 1,076 |   |   |
| Total expenses                                          |       |                  | 59,678     |                        |       |                            | 3,151      |             |       |             | 298        |   |   |   | (3,516 | ) |   |   | 59,611 |   |   |
| Equity in  subsidiary income                            |       |                  | 4,825      |                        |       |                            | —     |             |       |             | —     |   |   |   | (4,825 | ) |   |   | — |   |   |
| Income (loss)  before income taxes                      |       |                  | 27,964     |                        |       |                            | 4,142      |             |       |             | 4,235      |   |   |   | (4,825 | ) |   |   | 31,516 |   |   |
| Income tax  provision (benefit)                         |       |                  | 9,711      |                        |       |                            | 1,738      |             |       |             | 1,778      |   |   |   | — |   |   |   | 13,227 |   |   |
| Net income (loss)  before minority interest             |       |                  | 18,253     |                        |       |                            | 2,404      |             |       |             | 2,457      |   |   |   | (4,825 | ) |   |   | 18,289 |   |   |
| Minority interest  in consolidated subsidiary           |       |                  | —     |                        |       |                            | 36         |             |       |             | —     |   |   |   | — |   |   |   | 36 |   |   |
| Net income (loss)                                       |       |                  | $          | 18,253                      |       |                            |       | $                | 2,368      |             |       |   | $ | 2,457 |   |   |   | $ | (4,825 | ) |   |   | $ | 18,253 |   |   |

 

19

----

**CONDENSEDCONSOLIDATING BALANCE SHEET INFORMATIONAT SEPTEMBER 30, 2005(Successor)(in thousands)**

| ** **                                                 | ** ** | **Venoco, Inc.** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|------------------------------------------------------------|------------|-----------------------|------------|-----------------------------|------------|---------------------------------|------------|------------------|------------|------------------|------------|
| **ASSETS**                                                 |       |                  |       |                        |       |                            |       |             |       |             |       |   |   |   |   |   |   |   |   |   |   |
| CURRENT ASSETS:                                            |       |                  |       |                        |       |                            |       |             |       |             |       |   |   |   |   |   |   |   |   |   |   |
| Cash and cash equivalents                                  |       |                  | $          | 10,011                      |       |                            |       | $                | 2,699      |             |       |   | $ | 313 |   |   |   | $ | — |   |   |   | $ | 13,023 |   |   |
| Accounts receivable                                        |       |                  | 26,261     |                        |       |                            | 630        |             |       |             | 112        |   |   |   | (554 | ) |   |   | 26,449 |   |   |
| Inventories                                                |       |                  | 1,784      |                        |       |                            | —     |             |       |             | —     |   |   |   | — |   |   |   | 1,784 |   |   |
| Commodity derivatives                                      |       |                  | 3,680      |                        |       |                            | —     |             |       |             | —     |   |   |   | — |   |   |   | 3,680 |   |   |
| Prepaid expenses and other current assets                  |       |                  | 6,255      |                        |       |                            | 279        |             |       |             | 491        |   |   |   | — |   |   |   | 7,025 |   |   |
| TOTAL CURRENT  ASSETS                                      |       |                  | 47,991     |                        |       |                            | 3,608      |             |       |             | 916        |   |   |   | (554 | ) |   |   | 51,961 |   |   |
| PROPERTY, PLANT & EQUIPMENT, NET                  |       |                  | 194,683    |                        |       |                            | 21,294     |             |       |             | 14,938     |   |   |   | (21,664 | ) |   |   | 209,251 |   |   |
| COMMODITY DERIVATIVES                                      |       |                  | 950        |                        |       |                            | —     |             |       |             | —     |   |   |   | — |   |   |   | 950 |   |   |
| INVESTMENTS IN AFFILIATES                                  |       |                  | 83,098     |                        |       |                            | —     |             |       |             | —     |   |   |   | (83,098 | ) |   |   | — |   |   |
| OTHER                                                      |       |                  | 6,999      |                        |       |                            | 46         |             |       |             | —     |   |   |   | — |   |   |   | 7,045 |   |   |
| TOTAL ASSETS                                               |       |                  | $          | 333,721                     |       |                            |       | $                | 24,948     |             |       |   | $ | 15,854 |   |   |   | $ | (105,316 | ) |   |   | $ | 269,207 |   |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY (DEFICIT)**   |       |                  |       |                        |       |                            |       |             |       |             |       |   |   |   |   |   |   |   |   |   |   |
| CURRENT LIABILITIES:                                       |       |                  |       |                        |       |                            |       |             |       |             |       |   |   |   |   |   |   |   |   |   |   |
| Accounts payable and accrued liabilities                   |       |                  | $          | 33,109                      |       |                            |       | $                | 816        |             |       |   | $ | 59 |   |   |   | $ | (820 | ) |   |   | $ | 33,164 |   |   |
| Undistributed revenue payable                              |       |                  | 4,422      |                        |       |                            | 70         |             |       |             | —     |   |   |   | — |   |   |   | 4,492 |   |   |
| Income taxes payable                                       |       |                  | 4,853      |                        |       |                            | —     |             |       |             | —     |   |   |   | — |   |   |   | 4,853 |   |   |
| Current maturities of long-term debt                       |       |                  | —     |                        |       |                            | —     |             |       |             | 124        |   |   |   | — |   |   |   | 124 |   |   |
| Commodity derivatives                                      |       |                  | 39,603     |                        |       |                            | —     |             |       |             | —     |   |   |   | — |   |   |   | 39,603 |   |   |
| Repurchase common stock                                    |       |                  | —     |                        |       |                            | —     |             |       |             | —     |   |   |   | — |   |   |   | — |   |   |
| TOTAL CURRENT  LIABILITIES                                 |       |                  | 81,987     |                        |       |                            | 886        |             |       |             | 183        |   |   |   | (820 | ) |   |   | 82,236 |   |   |
| LONG-TERM  DEBT                                            |       |                  | 149,146    |                        |       |                            | —     |             |       |             | 9,796      |   |   |   | — |   |   |   | 158,942 |   |   |
| DEFERRED INCOME  TAXES                                     |       |                  | 4,604      |                        |       |                            | (3604      | )                |       |             | —     |   |   |   | — |   |   |   | 1,000 |   |   |
| ASSET RETIREMENT  OBLIGATIONS                              |       |                  | 22,553     |                        |       |                            | 1,548      |             |       |             | 439        |   |   |   | — |   |   |   | 24,540 |   |   |
| INTERCOMPANY  PAYABLES (RECEIVABLES)                       |       |                  | 72,942     |                        |       |                            | (54,996    | )                |       |             | (17,946    | ) |   |   | — |   |   |   | — |   |   |
| OTHER LIABILITIES                                          |       |                  | 21,874     |                        |       |                            | —     |             |       |             | —     |   |   |   | — |   |   |   | 21,874 |   |   |
| TOTAL LIABILITIES                                          |       |                  | 353,106    |                        |       |                            | (56,166    | )                |       |             | (7,528     | ) |   |   | (820 | ) |   |   | 288,592 |   |   |
| TOTAL  STOCKHOLDERS’ EQUITY (DEFICIT)                 |       |                  | (19,385    | )                           |       |                            | 81,114     |             |       |             | 23,382     |   |   |   | (104,496 | ) |   |   | (19,385 | ) |   |
| TOTAL LIABILITIES AND  STOCKHOLDERS’ EQUITY (DEFICIT) |       |                  | $          | 333,721                     |       |                            |       | $                | 24,948     |             |       |   | $ | 15,854 |   |   |   | $ | (105,316 | ) |   |   | $ | 269,207 |   |   |

 

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**CONDENSEDCONSOLIDATING BALANCE SHEET INFORMATIONAT DECEMBER 31, 2004(Successor)(in thousands)**

| ** **                                                    | ** ** | **Venoco, Inc.** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|---------------------------------------------------------------|------------|-----------------------|------------|-----------------------------|------------|---------------------------------|------------|------------------|------------|------------------|------------|
| **ASSETS**                                                    |       |                  |       |                        |       |                            |       |             |       |             |       |   |   |   |   |   |   |   |   |   |   |
| CURRENT ASSETS:                                               |       |                  |       |                        |       |                            |       |             |       |             |       |   |   |   |   |   |   |   |   |   |   |
| Cash and cash equivalents                                     |       |                  | $          | 53,075                      |       |                            |       | $                | 1,590      |             |       |   | $ | 50 |   |   |   | $ | — |   |   |   | $ | 54,715 |   |   |
| Accounts receivable                                           |       |                  | 16,306     |                        |       |                            | 904        |             |       |             | 545        |   |   |   | — |   |   |   | 17,755 |   |   |
| Inventories                                                   |       |                  | 1,079      |                        |       |                            | —     |             |       |             | —     |   |   |   | — |   |   |   | 1,079 |   |   |
| Commodity derivatives                                         |       |                  | 5,300      |                        |       |                            | —     |             |       |             | —     |   |   |   | — |   |   |   | 5,300 |   |   |
| Notes receivable—officer                                 |       |                  | —     |                        |       |                            | 1,420      |             |       |             | —     |   |   |   | — |   |   |   | 1,420 |   |   |
| Prepaid expenses and other current assets                     |       |                  | 7,249      |                        |       |                            | 110        |             |       |             | 187        |   |   |   | — |   |   |   | 7,546 |   |   |
| TOTAL CURRENT  ASSETS                                         |       |                  | 83,009     |                        |       |                            | 4,024      |             |       |             | 782        |   |   |   | — |   |   |   | 87,815 |   |   |
| PROPERTY, PLANT & EQUIPMENT, NET                     |       |                  | 151,242    |                        |       |                            | 32,166     |             |       |             | 15,155     |   |   |   | — |   |   |   | 198,563 |   |   |
| COMMODITY DERIVATIVES                                         |       |                  | 4,855      |                        |       |                            | —     |             |       |             | —     |   |   |   | — |   |   |   | 4,855 |   |   |
| INVESTMENTS IN AFFILIATES                                     |       |                  | 63,449     |                        |       |                            | —     |             |       |             | —     |   |   |   | (63,449 | ) |   |   | — |   |   |
| OTHER                                                         |       |                  | 7,613      |                        |       |                            | 36         |             |       |             | —     |   |   |   | — |   |   |   | 7,649 |   |   |
| TOTAL ASSETS                                                  |       |                  | $          | 310,168                     |       |                            |       | $                | 36,226     |             |       |   | $ | 15,937 |   |   |   | $ | (63,449 | ) |   |   | $ | 298,882 |   |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY (DEFICIT)** |       |                  |       |                        |       |                            |       |             |       |             |       |   |   |   |   |   |   |   |   |   |   |
| CURRENT LIABILITIES:                                          |       |                  |       |                        |       |                            |       |             |       |             |       |   |   |   |   |   |   |   |   |   |   |
| Accounts payable and accrued liabilities                      |       |                  | $          | 18,326                      |       |                            |       | $                | 712        |             |       |   | $ | 347 |   |   |   | $ | — |   |   |   | $ | 19,385 |   |   |
| Undistributed revenue payable                                 |       |                  | 4,053      |                        |       |                            | 721        |             |       |             | —     |   |   |   | — |   |   |   | 4,774 |   |   |
| Current maturities of long-term debt                          |       |                  | —     |                        |       |                            | —     |             |       |             | 127        |   |   |   | — |   |   |   | 127 |   |   |
| Commodity derivatives                                         |       |                  | 1,520      |                        |       |                            | —     |             |       |             | —     |   |   |   | — |   |   |   | 1,520 |   |   |
| Repurchase common stock                                       |       |                  | 5,316      |                        |       |                            | —     |             |       |             | —     |   |   |   | — |   |   |   | 5,316 |   |   |
| TOTAL CURRENT  LIABILITIES                                    |       |                  | 29,215     |                        |       |                            | 1,433      |             |       |             | 474        |   |   |   | — |   |   |   | 31,122 |   |   |
| LONG-TERM  DEBT                                               |       |                  | 149,043    |                        |       |                            | 4,684      |             |       |             | 9,815      |   |   |   | — |   |   |   | 163,542 |   |   |
| DEFERRED INCOME  TAXES                                        |       |                  | 32,208     |                        |       |                            | —     |             |       |             | —     |   |   |   | — |   |   |   | 32,208 |   |   |
| ASSET RETIREMENT  OBLIGATIONS                                 |       |                  | 20,750     |                        |       |                            | 2,012      |             |       |             | 422        |   |   |   | — |   |   |   | 23,184 |   |   |
| INTERCOMPANY  PAYABLES (RECEIVABLES)                          |       |                  | 30,513     |                        |       |                            | (16,982    | )                |       |             | (13,531    | ) |   |   | — |   |   |   | — |   |   |
| TOTAL LIABILITIES                                             |       |                  | 261,729    |                        |       |                            | (8,853     | )                |       |             | (2,820     | ) |   |   | — |   |   |   | 250,056 |   |   |
| MINORITY INTEREST                                             |       |                  | —     |                        |       |                            | 387        |             |       |             | —     |   |   |   | — |   |   |   | 387 |   |   |
| TOTAL  STOCKHOLDERS’ EQUITY (DEFICIT)               |       |                  | 48,439     |                        |       |                            | 44,692     |             |       |             | 18,757     |   |   |   | (63,449 | ) |   |   | 48,439 |   |   |
| TOTAL LIABILITIES AND  STOCKHOLDERS’ EQUITY (DEFICIT)    |       |                  | $          | 310,168                     |       |                            |       | $                | 36,226     |             |       |   | $ | 15,937 |   |   |   | $ | (63,449 | ) |   |   | $ | 298,882 |   |   |

 

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**CONDENSEDCONSOLIDATING STATEMENT OF CASH FLOWS INFORMATIONFOR THE NINE MONTHS ENDED SEPTEMBER 30, 2005(Successor)(in thousands)**

| ** **                                                 | ** ** | **Venoco, Inc.** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|------------------------------------------------------------|------------|-----------------------|------------|-----------------------------|------------|---------------------------------|------------|------------------|------------|------------------|------------|
| OPERATING ACTIVITIES                                       |       |                  |       |                        |       |                            |       |             |       |             |       |   |   |   |   |   |   |   |   |   |   |
| Net cash provided by operating activities             |       |                  | $          | 22,242                      |       |                            |       | $                | 6,945      |             |       |   | $ | 4,688 |   |   |   | $ | — |   |   |   | $ | 33,875 |   |   |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                     |       |                  |       |                        |       |                            |       |             |       |             |       |   |   |   |   |   |   |   |   |   |   |
| Expenditures for oil and gas properties                    |       |                  | (49,826    | )                           |       |                            | (9,349     | )                |       |             | (8         | ) |   |   | — |   |   |   | (59,183 | ) |   |
| Acquisition of Marquez Energy, LLC               |       |                  | (14,628    | )                           |       |                            | —     |             |       |             | —     |   |   |   | — |   |   |   | (14,628 | ) |   |
| Proceeds from sale of oil and gas properties               |       |                  | —     |                        |       |                            | 44,619     |             |       |             | —     |   |   |   | — |   |   |   | 44,619 |   |   |
| Notes receivable—officers and employees               |       |                  | (50        | )                           |       |                            | 1,420      |             |       |             | —     |   |   |   | — |   |   |   | 1,370 |   |   |
| Expenditures for property and equipment and other          |       |                  | (1,352     | )                           |       |                            | (15        | )                |       |             | —     |   |   |   | — |   |   |   | (1,367 | ) |   |
| Net cash (used in) provided by investing activities        |       |                  | (65,856    | )                           |       |                            | 36,675     |             |       |             | (8         | ) |   |   | — |   |   |   | (29,189 | ) |   |
| Net proceeds from (repayments of) intercompany  borrowings |       |                  | 3,978      |                        |       |                            | (974       | )                |       |             | (3,004     | ) |   |   | — |   |   |   | — |   |   |
| Proceeds from long-term debt                               |       |                  | 39,000     |                        |       |                            | —     |             |       |             | —     |   |   |   | — |   |   |   | 39,000 |   |   |
| Principal payments on long-term debt                       |       |                  | (39,000    | )                           |       |                            | (4,684     | )                |       |             | (22        | ) |   |   | — |   |   |   | (43,706 | ) |   |
| Distribution payments to Marquez Energy member             |       |                  | —     |                        |       |                            | (707       | )                |       |             | —     |   |   |   | — |   |   |   | (707 | ) |   |
| Payments of dividends                                      |       |                  | (35,000    | )                           |       |                            | —     |             |       |             | —     |   |   |   | — |   |   |   | (35,000 | ) |   |
| Repurchase common stock                                    |       |                  | (5,301     | )                           |       |                            | —     |             |       |             | —     |   |   |   | — |   |   |   | (5,301 | ) |   |
| Increase in deferred loan costs                            |       |                  | (664       | )                           |       |                            | —     |             |       |             | —     |   |   |   | — |   |   |   | (664 | ) |   |
| Net cash used in financing activities                      |       |                  | (36,987    | )                           |       |                            | (6,365     | )                |       |             | (3,026     | ) |   |   | — |   |   |   | (46,378 | ) |   |
| Net (decrease) increase in cash and cash equivalents       |       |                  | (80,601    | )                           |       |                            | 37,255     |             |       |             | 1,654      |   |   |   | — |   |   |   | (41,692 | ) |   |
| Cash and cash  equivalents, beginning of period       |       |                  | 53,075     |                        |       |                            | 1,590      |             |       |             | 50         |   |   |   | — |   |   |   | 54,715 |   |   |
| Cash and cash  equivalents, end of period                  |       |                  | $          | (27,526                     | )          |                            |       | $                | 38,845     |             |       |   | $ | 1,704 |   |   |   | $ | — |   |   |   | $ | 13,023 |   |   |

 

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**CONDENSEDCONSOLIDATING STATEMENT OF CASH FLOWS INFORMATIONFOR THE NINE MONTHS ENDED SEPTEMBER 30, 2004(Predecessor)(in thousands)**

| ** **                                                 | ** ** | **Venoco, Inc.** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-Guarantor  Subsidiaries** | ** **         | **Eliminations** | ** ** | **Consolidated** | ** ** |
|------------------------------------------------------------|------------|-----------------------|------------|-----------------------------|------------|---------------------------------|--------------------|------------------|------------|------------------|------------|
| OPERATING ACTIVITIES                                       |       |                  |       |                        |       |                            |               |             |       |             |       |   |   |   |   |   |   |   |   |   |   |
| Net cash provided by operating activities                  |       |                  | $          | 25,090                      |       |                            |               | $                | 4,830      |             |       |   | $ | 3,500 |   |   |   | $ | — |   |   |   | $ | 33,420 |   |   |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                     |       |                  |       |                        |       |                            |               |             |       |             |       |   |   |   |   |   |   |   |   |   |   |
| Expenditures for oil and gas properties                    |       |                  | (9,073     | )                           |       |                            | (2,734             | )                |       |             | (200       | ) |   |   | — |   |   |   | (12,007 | ) |   |
| Acquisition of Marquez Energy                              |       |                  |       |                        |       |                            | 1,328              |             |       |             |       |   |   |   |   |   |   |   | 1,328 |   |   |
| Proceeds from sale of oil and gas properties               |       |                  | 1,526      |                        |       |                            | —             |             |       |             | —     |   |   |   | — |   |   |   | 1,526 |   |   |
| Proceeds from sale of other property and equipment         |       |                  | —     |                        |       |                            | 2,248              |             |       |             | 228        |   |   |   | — |   |   |   | 2,476 |   |   |
| Notes receivable—officers and employees               |       |                  | 3,530      |                        |       |                            | —             |             |       |             | —     |   |   |   | — |   |   |   | 3,530 |   |   |
| Expenditures for property and equipment and other          |       |                  | (257       | )                           |       |                            | (1                 | )                |       |             | —     |   |   |   | — |   |   |   | (258 | ) |   |
| Net cash (used in) provided by investing activities        |       |                  | (4,274     | )                           |       |                            | 841                |             |       |             | 28         |   |   |   | — |   |   |   | (3,405 | ) |   |
| CASH FLOWS FROM  FINANCING ACTIVITIES:                     |       |                  |       |                        |       |                            |               |             |       |             |       |   |   |   |   |   |   |   |   |   |   |
| Net proceeds from (repayments of) intercompany  borrowings |       |                  | 7,513      |                        |       |                            | (3,940             | )                |       |             | (3,573     | ) |   |   | — |   |   |   | — |   |   |
| Proceeds from long-term debt                               |       |                  | —     |                        |       |                            | 4,685              |             |       |             | —     |   |   |   | — |   |   |   | 4,685 |   |   |
| Principal payments on long-term debt                       |       |                  | (19,000    | )                           |       |                            | (4,625             | )                |       |             | —     |   |   |   | — |   |   |   | (23,625 | ) |   |
| Distribution payments to Marquez Energy members            |       |                  | —     |                        |       |                            | (10                | )                |       |             | —     |   |   |   | — |   |   |   | (10 | ) |   |
| Increase in deferred loan costs                            |       |                  | (60        | )                           |       |                            | —             |             |       |             | —     |   |   |   | — |   |   |   | (60 | ) |   |
| Net cash used in financing activities                      |       |                  | (11,547    | )                           |       |                            | (3,890             | )                |       |             | (3,573     | ) |   |   | — |   |   |   | (19,010 | ) |   |
| Net (decrease)  increase in cash and cash equivalents      |       |                  | 9,269      |                        |       |                            | 1,781              |             |       |             | (45        | ) |   |   | — |   |   |   | 11,005 |   |   |
| Cash and cash  equivalents, beginning of period            |       |                  | 8,372      |                        |       |                            | —   |             |       |             | 45         |   |   |   | — |   |   |   | 8,417 |   |   |
| Cash and cash  equivalents, end of period                  |       |                  | $          | 17,641                      |       |                            |               | $                | 1,781      |             |       |   | $ | — |   |   |   | $ | — |   |   |   | $ | 19,422 |   |   |

 

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**Item 2.**                        Management’sDiscussion and Analysis of Financial Condition and Results of Operations

The following discussionand analysis should be read in conjunction with management’s discussion andanalysis contained in our Registration Statement on Form S-4/A(Registration No. 333-123711) as filed with the Securities andExchange Commission on April 20, 2005, as well as with the financialstatements and related notes and the other information appearing elsewhere inthis quarterly report. As used in this quarterly report, unless the contextotherwise indicates, references to “we,” “our,” “ours,” and “us” refer toVenoco, Inc. and its subsidiaries collectively.

***Overview***

We are an independent energy companyprimarily engaged in the acquisition, exploration, exploitation and developmentof oil and natural gas properties. Since the change in our senior managementthat occurred in June 2004, we have returned to our historical strategy ofdevoting substantial resources to exploration, exploitation and development projectson our properties. Pursuit of this strategy has led to increases in our oil andnatural gas production. Average net production rose from 10,898 barrels of oilequivalent per day (“BOE/d”) in the first nine months of 2004 to 11,565 BOE/din the same period in 2005. Due to delays in implementing severalprojects,  mechanical problems at a wellin the South Ellwood field, and some periods of limited production capacity dueto platform equipment repair and well maintenance, average net production inthe third quarter declined to 10,444 BOE/d in the third quarter of 2005 from11,201 BOE/d in the third quarter of 2004. We believe that these operationalissues have been resolved. We currently project that average net productionwill be 11,000-12,000 BOE/d for both the fourth quarter of 2005 and for2005 as a whole and will increase in 2006. Because of the anticipated overallincreases in production and the effect of our hedging program, we expect ourrevenue, not including the effect of non-cash, unrealized derivative gains andlosses, to increase in both 2005 and 2006 compared to the previous year even ifoil and natural gas prices decline moderately. Our disciplined hedgingstrategy, which includes the use of collars, swaps and purchased floors, hasallowed us to lock in minimum future floor prices we consider attractive onsubstantial production volumes through June 2009, while often allowingupside participation. See “—Qualitative and Quantitative Disclosures AboutMarket Risk.” We believe that continued pursuit of our strategy will also allowus to increase our proved reserves in 2006 and subsequent years. Risingoil and natural gas prices have, however, created substantial unrealizedcommodity derivative losses in the first nine months of 2005 which have servedto suppress earnings reported in the period. In the first nine months of 2005these unrealized losses resulting from mark-to-market valuations for non-highlyeffective or ineffective portions of our derivative positions included incommodity derivative losses in the income statement totaled $44.2 million, ofwhich amount $16.2 million was incurred in the third quarter. Any paymentsactually due to counterparties in the future on these derivatives willultimately be funded by higher prices received from the sale of our production.

***Capital Expenditures***

We have developed an active capital expenditure program to take advantageof our extensive inventory of drilling prospects. Our exploration, exploitationand development capital expenditure budget for 2005, not including acquisitions,is currently anticipated to total between $70 and $80 million, more than triplecapital expenditures of $23.2 million in 2004. We spent $57.1 million ofthis amount in the first nine months of the year, consisting of $41.6 millionfor drilling and rework activities, $12.9 million for facilities and $2.6 millionfor exploration projects. We drilled sixteen new onshore wells to total depthin the period and recompleted 35 additional onshore wells. Offshore, we drilledfour wells to total depth and recompleted three wells. In addition, we spent anet of $24.7 million on acquisitions in the first nine months of 2005.(see “*Acquisitions and Divestitures*” below.)

We also pursued a number of other projects, including an expansion of ourfield work relating to the possible return to production of platform Grace inthe Santa Clara field. In March 2003, we granted an 

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option to Crystal EnergyLLC to lease or purchase platform Grace for use in accepting, vaporizing,transporting and selling liquid natural gas delivered to the platform bytanker. On April 18, 2005, Crystal Energy informed us that it intendsto exercise the option to purchase the platform for $10 million. It ispossible that the purchase could delay or prevent the return of the platform toproduction. The purchase is contingent upon, among other things, the executionof a mutually acceptable purchase agreement and the receipt of regulatoryapprovals. We expect to achieve a resolution of these issues this year.

Additional projects being implemented in the fourth quarter of 2005 includethe drilling of an exploration well to the Monterey formation in the SouthEllwood field and multiple new wells in the Sacramento Basin.

Our preliminary estimate of our exploration, exploitation and developmentcapital expenditure budget for 2006 is $125 million. Projects we expect topursue in 2006 include the drilling of over 50 wells in the Sacramento Basinand the redrilling of approximately six wells in the Santa Clara field. We alsoexpect to pursue a number of projects in the Sockeye field, including thedrilling of a new exploration well, the drilling of a dual completion well tothe Upper and Lower Topanga formations, the recompletion of a well drilled tothe Upper Topanga formation and the installation of an electric submersiblepump.

The aggregate levels of capital expenditures for thebalance of 2005 and for 2006, and the allocation of such expenditures, aredependent on a variety of factors, including the availability of servicecontractors and equipment, permitting issues, weather and limits on the numberof activities that can be conducted at any one time on our offshore platforms.Accordingly, the actual levels of capital expenditures and the allocation ofsuch expenditures may vary materially from the above estimates.

***Acquisitions and Divestitures***

We completed our acquisition of Marquez Energy, a Colorado limitedliability company majority owned and controlled by Timothy Marquez, on March 21,2005. According to a reserve report prepared by NSAI, Marquez Energy had provedreserves of approximately 2.0 MMBOE as of December 31, 2004. The purchaseprice for the membership interests in Marquez Energy was $16.6 million. Thepurchase price was based on the members’ equity on Marquez Energy’s unaudited December 31,2004 balance sheet as adjusted to reflect the value of its oil and natural gasproperties 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/Mcfefor its proved developed non-producing reserves and (iii) $0.75/Mcfe forits proved undeveloped reserves. Quantities of proven reserves were asset forth by NSAI in the December 31, 2004 reserve report. NSAI oranother nationally recognized engineering firm will conduct supplementalevaluations of the Marquez Energy properties as of year-end 2005 and 2006. Inthe event those evaluations attribute proved reserves to the Marquez Energyproperties as of December 31, 2004 in excess of those reflected in NSAI’sinitial report, additional payments will be made to the former holders ofinterests in Marquez Energy pursuant to the same formula, subject to a maximumaggregate price of $25.0 million, including assumption of debt.

By purchasing Marquez Energy, we acquired natural gas properties in theSacramento Basin in California that we believe possess significantexploitation, development and exploration potential. These properties, whichMarquez Energy acquired beginning in January 2004, are complementary toour other properties in the Sacramento Basin. Marquez Energy’s average net productionin the first quarter of 2005 was approximately 500 BOE/d. BecauseMarquez Energy was a company under common control since July 12, 2004, ourfinancial statements and production information for the first nine months of2005 and for the third and fourth quarters of 2004 include Marquez Energy. Forthe same reason, the acquisition was accounted for in a manner similar to apooling of interests whereby the historical results of Marquez 

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Energy have been combinedwith Venoco’s financial results since July 1, 2004. See Notes 1 and 2 toour interim condensed consolidated financial statements.

In September 2005, we acquired a 100% workinginterest in the Willows-Beehive Bend Gas Field, a 100% working interest in theBounde Creek Gas Field and a 65% working interest in the Arbuckle Field for anaggregate net price of $10.1 in cash. We operate all of the acquired fields, whichare located in the Sacramento Basin in California.

On March 31, 2005, we completed the sale of our Big Mineral Creekfield, located in Grayson County, Texas, to BlackWell Energy Group, LLC for$44.6 million. The transaction was given economic effect as of February 1,2005. As of December 31, 2004, the field had proved reserves ofapproximately 3.4 MMBOE, according to a report by NSAI. Average net productionat the field was approximately 547 BOE/d in the first quarter of 2005. Pursuantto Section 1031 of the Internal Revenue Code, we effected a like-kindexchange of a portion of the Big Mineral Creek field representing approximately$15.0 million of the total sale price for certain Marquez Energy properties andproperties acquired from third parties. The like-kind exchange provisionsresulted in the deferral of a portion of income taxes related to the gain onsale. We did not recognize a gain on sale for financial reporting purposes, butapplied the net sales proceeds to reduce the capitalized costs of our oil andnatural gas properties in accordance with our full-cost accounting method.

During 2004, our CEO, Tim Marquez, increased his beneficialownership in our company from 41% to 100%. As a result of a transaction thatclosed on July 12, 2004, Mr. Marquez purchased 53% of our commonshares (18,510,000 common shares) from two of our former officers and theirrespective affiliates. On December 22, 2004, we merged with a corporationthe sole stockholder of which was a trust controlled by Mr. Marquez and hiswife. As a result of this merger, Mr. Marquez acquired beneficial ownership ofthe remaining 6% of our common stock.

As a result of Mr. Marquezobtaining control of over 95% of the common stock of our company on December 22,2004, SEC Staff Accounting Bulletin No. 54 requires the acquisition by Mr. Marquezto be “pushed-down”, meaning the post-transaction condensed consolidatedbalance sheet and the condensed consolidated statements of operations and cashflows of our company reflect a new basis of accounting (“successor basis”). Thepre-transaction condensed consolidated statements of operations and cash flowsare presented on the historical basis (“predecessor basis”).

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

Oil and natural gas prices have increased significantly since the beginningof 2004. Rising prices contributed to an increase in our oil and natural gassales and revenues in both 2004 and 2005 compared to 2003. Prices continued torise in the first nine months of 2005, leading, together with an increase inproduction volumes, to a 35% increase in oil and natural gas sales compared tothe same period in 2004, although unrealized commodity derivative losses led toa decline in total revenues compared to the first nine months of 2004.Unrealized commodity derivative losses result from mark-to-market valuations ofsome of our derivative positions due to rising oil and natural gas prices. Anypayments due to counterparties in the future on these derivatives willultimately be funded by higher oil and natural gas prices received from thesale of production. See note 4 to our interim condensed consolidated financialstatements.

Our production of oil and natural gas hasincreased since the change in our senior management that occurred in June 2004.Average net production has risen from 10,898 BOE/d in the first nine months of2004 to  11,565 BOE/d in the same periodin 2005. Average net production in the third quarter of 2005 of 10,444 BOE/dwas, however, down from 11,201 BOE/d in the third quarter of 2004. We believethat this third quarter reduction is temporary in that it relates to delays inimplementing several projects, mechanical problems at a well in the SouthEllwood field and some periods of limited production capacity 

26

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due to platform equipmentrepair and well maintenance, and we believe that all of these issues wereremedied in late October 2005. We expect our average net production to beapproximately 11,000 to 12,000 BOE/d in the fourth quarter. We also expect production volumes in 2006to exceed 2005 levels. As a result of the expansion of our exploration,exploitation and development activities, our total general and administrativecosts have risen. We expect that increasing production volumes will result inlower general and administrative costs and lower lease operating costs on aunit of production basis in 2006.

***Oil and GasProduction and Prices***

| ** **                                           | ** ** | **Three Months Ended September 30,(1)** | ** ** | **Nine Months Ended September 30,(1)** | ** ** |
|------------------------------------------------------|------------|-------------------------------------------------------------|------------|------------------------------------------------------------|------------|
| ** **                                           | ** ** | **2005**                                                    | ** ** | **2004**                                                   | ** ** | **Increase  (Decrease)** | ** ** | **2005** | ** ** | **2004** | ** ** | **Increase  (Decrease)** | ** ** |
| **Production Volume**                                |       |                                                        |       |                                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Natural Gas  (Mcf/d)                                 |       | 1,920,544                                                   |       | 1,507,948                                                  |       |   | 27 | % |   | 5,652,442 |   | 4,080,963 |   |   | 39 | % |   |
| Oil (Bbls/d)                                         |       | 640,711                                                     |       | 779,243                                                    |       |   | (18 | )% |   | 2,215,192 |   | 2,305,960 |   |   | (4 | )% |   |
| BOE                                                  |       | 960,802                                                     |       | 1,030,567                                                  |       |   | (7 | )% |   | 3,157,266 |   | 2,986,121 |   |   | 6 | % |   |
| **Daily Average Production Volume**                  |       |                                                        |       |                                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Natural Gas  (Mcf/d)                                 |       | 20,875                                                      |       | 16,391                                                     |       |   | 27 | % |   | 20,705 |   | 14,894 |   |   | 39 | % |   |
| Oil (Bbls/d)                                         |       | 6,964                                                       |       | 8,470                                                      |       |   | (18 | )% |   | 8,114 |   | 8,416 |   |   | (4 | )% |   |
| BOE/d                                                |       | 10,444                                                      |       | 11,201                                                     |       |   | (7 | )% |   | 11,565 |   | 10,898 |   |   | 6 | % |   |
| **Oil Price per Barrel Produced  (in dollars)** |       |                                                        |       |                                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Realized price  before hedging loss             |       | $                                                           | 52.50      |                                                       | $          | 36.78 |   |   | 43 | % |   | $ | 44.09 |   | $ | 33.32 |   |   | 32 | % |   |
| Realized hedging  loss                               |       | (13.13                                                      | )          | (6.27                                                      | )          |   | 109 | % |   | (6.85 | ) | (4.53 | ) |   | 51 | % |   |
| Net realized                                         |       | $                                                           | 39.37      |                                                       | $          | 30.51 |   |   | 29 | % |   | $ | 37.24 |   | $ | 28.79 |   |   | 29 | % |   |
| **Natural Gas Price per Mcf (in dollars)**      |       |                                                        |       |                                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Realized price  before hedging gain (loss)           |       | $                                                           | 7.27       |                                                       | $          | 5.52 |   |   | 32 | % |   | $ | 6.58 |   | $ | 5.56 |   |   | 18 | % |   |
| Realized hedging gain  (loss)                        |       | .07                                                         |       | (.06                                                       | )          |   | 217 | % |   | (.04 | ) | (.16 | ) |   | 75 | % |   |
| Net realized                                         |       | $                                                           | 7.34       |                                                       | $          | 5.46 |   |   | 32 | % |   | $ | 6.54 |   | $ | 5.40 |   |   | 21 | % |   |
| Average Sales Price per  BOE                         |       | $                                                           | 40.42      |                                                       | $          | 30.49 |   |   | 33 | % |   | $ | 37.34 |   | $ | 29.83 |   |   | 27 | % |   |

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(1)          Productionin the first nine months of 2005 includes Marquez Energy, which was acquired inMarch 2005. Production for the first nine months of 2004 includes MarquezEnergy’s production only for the third quarter. Inclusion of Marquez Energy’sproduction in the first quarter of 2005 and the third quarter of 2004 is due tothe application of requirements for reporting combined statements for companiesunder common control.

Bbl—Barrel

Mcf—Thousand cubic feet

BOE—Barrel of oil equivalent (computed on an energyequivalent basis of six MCF equals one Bbl)

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Oil and gas production increased in the first ninemonths of 2005 over the comparable period of 2004 primarily because of ourresumed focus on project exploitation and development activities. Average dailyproduction net to our interest increased from 10,898 BOE/d in the first ninemonths of 2004 to 11,565 BOE/D in the first nine months of 2005. Third quarter2005 production of 10,444 BOE/d was down from 11,201 BOE/d in 2004 due to thepreviously described delays in project implementation, mechanical problems at awell in the South Ellwood field and periods of limited production capacity dueto platform equipment repair and well maintenance. We believe that all of theseissues were resolved in October, 2005.

We use price hedging arrangements to reduce price riskon a portion of our oil and gas production. We have hedged a portion of ourexposure to variability in future cash flows from natural gas and oil salesthrough June 2009; see Note 4 to our interim condensed consolidatedfinancial statements. During the third quarter of 2005, our realized net losseson hedging activities decreased oil revenue by $8.4 million, or $13.13 perBbl., and increased gas revenue by $0.1 million, or $.07 per Mcf. During thethird quarter 2004, our realized net losses on hedging activities decreased oilrevenue by $4.9 million, or $6.27 per Bbl., and gas revenue by $0.1 million, or$ 0.06 per Mcf. During the nine months ended September 30, 2005, ourrealized net losses on hedging activities decreased oil revenue by $15.2million, or $6.85 per Bbl., and decreased gas revenue by $0.2 million, or $.04per Mcf. During the nine months ended September 30, 2004, our realized netlosses on hedging activities decreased oil revenue by $10.4 million, or $4.53per Bbl., and gas revenue by $0.6 million, or $ 0.16 per Mcf.

Prices to be realized for hedged production are likelyto be less than NYMEX or hedged prices. The price we receive for our gasproduction is generally less than the NYMEX price because of adjustments fordelivery location (“basis”), relative quality and other factors. Prices to berealized for our hedged oil production are expected to be significantly lessthan the NYMEX price because of location, quality and other adjustments. 

Thefollowing table sets forth our costs and expenses on a barrel of oil equivalentbasis for the three and nine months ended September 30, 2005 and 2004.

| ** **                                            | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                            | ** ** | **2005**                                             | ** ** | **2004**                                            | ** ** | **Increase/  Decrease** | ** ** | **2005** | ** ** | **2004** | ** ** | **Increase/  Decrease** | ** ** |
| ** **                                            | ** ** | **(Successor)**                                      | ** ** | **(Predecessor)**                                   | ** ** | ** ** | ** ** | **(Successor)** | ** ** | **(Predecessor)** | ** ** | ** ** | ** ** |
| **Expense per BOE**                                   |       |                                                 |       |                                                |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Production  expenses(1)                               |       |                                                 | $          | 14.31                                               |       |   |   | $ | 12.21 |   |   |   | 17 | % |   |   | $ | 12.05 |   |   |   | $ | 11.82 |   |   |   | 2 | % |   |
| Transportation  expenses                              |       |                                                 | .48        |                                                |       |   | .76 |   |   |   | (37 | )% |   |   | .53 |   |   |   | .74 |   |   |   | (28 | )% |   |
| Depreciation,  depletion, amortization and impairment |       |                                                 | 5.86       |                                                |       |   | 3.50 |   |   |   | 67 | % |   |   | 4.79 |   |   |   | 3.68 |   |   |   | 30 | % |   |
| General and  administrative expense(2)                |       |                                                 | 3.07       |                                                |       |   | 2.87 |   |   |   | 7 | % |   |   | 3.37 |   |   |   | 2.91 |   |   |   | 16 | % |   |
| Interest expense, net                                 |       |                                                 | 3.50       |                                                |       |   | .43 |   |   |   | 714 | % |   |   | 3.22 |   |   |   | .36 |   |   |   | 794 | % |   |
|                                                       |            |                                                      |            |                                                     |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)          Production expenses aredefined as oil and natural gas production expenses and production taxes.

(2)          Netof amounts capitalized.

***Results of Operations***

***Quarter Ended September 30, 2005 Compared withQuarter Ended September 30, 2004***

Net loss for the third quarter 2005 was $1.8 millioncompared to net income of $6.9 million for the third quarter of 2004. The thirdquarter 2005 net loss includes a $24.5 million commodity derivative loss ($8.3million realized) versus a $5.8 million commodity derivative loss ($5.0 millionrealized) in the third 

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quarter of 2004. Increaseddebt levels in 2005 resulted in net interest expense increasing $2.9 millionto $3.3 million in the third quarter of 2005 from $0.4 million in thethird quarter of 2004.

Oil and gas sales were $47.3 million, a 28% increasefrom the third quarter of 2004 oil and gas sales of $36.8 million. Oil salesincreased $4.8 million (17%) because of a 43% increase in realized oil pricespartially offset by the effect of a decrease in oil production volumes. Naturalgas sales increased $5.7 million (68%) because of an increase in salesquantities of 27% as well as an increase in prices received for gas sales of 32%.Revenues were reduced by both the realized and unrealized components ofcommodity derivative losses as described above. Other revenues decreased $1.2million.

Expenses for the thirdquarter of 2005 increased $5.9 million, or 28%, to $26.8 million compared to$20.9 million in the third quarter of 2004. Interest expense increased$2.9 million, or 659%, due to increased debt levels resulting from the issuanceof our $150 million senior notes in December 2004. Oil and natural gas productionexpenses increased $1.2 million (9%) due to increased field activities comparedto the third quarter of 2004. General and administrative expenses remainedconstant at $3.0 million. General and administrative expenses in the quarter endedSeptember 30, 2004 included non-recurring severance payments paid as aresult of changes of several personnel positions during the quarter. Ongoinggeneral and administrative expenses were higher during the quarter ended September 31,2005 due to increases in technical staff and higher professional fees relatedto accounting and information technology system conversions and enhancementcosts incurred in the quarter. Depletion, depreciation, amortization andimpairment expenses increased 56%. The primary reason for the increase was anincrease in the rate per unit due to an increase in estimated futuredevelopment costs reflected in a new reserve report as of September 1,2005 and a decrease in reserves at December 31, 2004. This increased thedepletion rate per unit, a factor that was partially offset by a decrease inproduction volumes. Amortization of deferred loan costs increased $0.2 milliondue to amortization of costs associated with the senior notes (see Note 5 toour interim condensed consolidated financial statements). Transportationexpense and accretion of abandonment liability changes were the result ofordinary business fluctuations and timing.

***Nine Months Ended September 30, 2005 Comparedwith Nine Months Ended September 30, 2004***

Net income for the nine months ended September 30,2005 was $0.1 million, compared to net income of $18.3 million for the ninemonths ended September 30, 2004. The three largest factors causing thechange were the substantial increase in unrealized derivative losses in 2005and the increased interest expense as a result of an increase in debt,partially offset by an increase in oil and gas revenues. Earnings for the firstnine months of 2005 include a $59.7 million commodity derivative loss ($15.4million realized) compared to a $12.8 million commodity derivative loss ($11.1million realized) for the nine months ended September 30, 2004. Netinterest expense totaled $10.2 million for the first nine months of 2005compared to $1.1 million for the first nine months of 2004.

Oil and gas sales for the nine months ended September 30,2005 were $134.7 million, a 35% increase from oil and gas sales for the firstnine months of 2004 of $99.8 million. Oil sales increased $20.4 million (26%)because of a 32% increase in realized oil prices, partially offset by a 4%decrease in production volumes due to operational issues in the third quarter. Naturalgas sales increased $14.5 million (64%) because of an increase in salesquantities of 39% as well as an increase in prices received for gas sales of 18%.Commodity derivative losses increased $46.9 million in first nine months of2005 due to a $42.5 million increase in unrealized commodity derivative lossesas compared to the same period in 2004. Other revenues decreased $1.3 million.

Expenses for the firstnine months of 2005 increased $18.7 million, or 31%, to $78.3 million comparedto $59.6 million in the first nine months of 2004. Interest expense, whichaccounted for $9.1 million of the total increase in expenses, increased 846%due to increased debt levels resulting from the issuance of $150 million of oursenior notes in December 2004. Oil and natural gas production expensesincreased $2.7 

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million(8%) due to the increased field activity in 2005. General and administrativeexpenses increased $2.0 million (23%) due to increases in technical staff, higherprofessional fees related to accounting and information technology systemsconversions and enhancements and the fact that only three months of expenses ofMarquez Energy were included in the period in 2004. Depletion, depreciation,amortization and impairment expenses increased $4.1 million due to anincrease in estimated future development costs, increased production volumesand a decrease in reserves at December 31, 2004. These factors increasedthe depletion rate per unit. Amortization of deferred loan costs increased $1.1million due to amortization of costs associated with the senior notes (see Note5 to our interim condensed consolidated financial statements) and a write-offof deferred loan costs related to a reduction in the available borrowing baseon the revolving credit facility from $50 million to $40 million. The borrowingbase was increased to $80 million effective September 30, 2005.

**Liquidity and Capital Resources**

***Cash Flows***

| ** **                             | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                             | ** ** | **2005**                                            | ** ** | **2004** | ** ** |
| ** **                             | ** ** | **(in thousands)**                                  | ** ** |
| Cash provided by  operating activities |       | 33,875                                              |       | $ | 33,420 |   |
| Cash used in  investing activities     |       | (29,189                                             | )          | (3,405 | ) |
| Cash used in financing  activities     |       | (46,378                                             | )          | (19,010 | ) |
|                                        |            |                                                     |            |  |  |  |

 

Net cash provided by operating activities was $33.9million for the first nine months of 2005, compared with $33.4 million in thefirst nine months of 2004. Cash flows from operating activities as compared tothe prior year’s first nine months were favorably impacted primarily by a$10.4 million increase in revenues from oil and natural gas sales. Oil andnatural gas sales increased due to increased production from developmentactivity, the acquisition of Marquez Energy and increased commodity prices. Increasesin production were partially offset in the second and third quarters by theloss of production from the Big Mineral Creek field which was sold on March 31,2005. Cash flows from operating activities as compared to the prior year’sfirst nine months were negatively impacted primarily by the previouslydescribed increases in realized commodity derivative losses and otherpreviously described expenses, and by payments of net premiums paid onderivative contracts of $18.4 million.

Net cash used in investing activities was $29.2million in the first nine months of 2005 and consisted primarily of $14.6million in expenditures to acquire Marquez Energy and $59.2 million inexpenditures for oil and gas properties including drilling, completion,development costs and acquisitions. The $59.2 million total reported cashexpended for oil and gas properties is derived from $67.1 million in costsincurred reduced by $7.9 million in accrued amounts payable atSeptember 30, 2005. These uses were offset primarily by $44.6 million innet proceeds from the sale of oil and gas properties.

Net cash used in financingactivities was $46.4 million and $19.0 million in the first nine months of 2005and 2004, respectively. Net cash used in the first nine months of 2005 resultedprimarily from the payment of a $35 million dividend to our sole stockholder, $5.3million paid to purchase the interests of minority shareholders and principalrepayments on long-term debt of $43.7 million, partially offset by $39.0million in new borrowings under our credit agreement.

***Capital Resources and Requirements***

We plan to make substantial capital expenditures inthe future for the acquisition, exploitation, development and exploration ofoil and natural gas properties. For the year 2005 we expect to make aggregatecapital expenditures of approximately $70-$80 million not includingproperty acquisitions. We 

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spent approximately $54.5million through September 30, 2005 on drilling and rework activity andfacilities offshore on platforms Holly and Gail and onshore in the SacramentoBasin area. In addition we  spent $24.7on property acquisitions, including the acquisition of Marquez Energy in March 2005and other producing properties that were acquired in September. The timing ofapproximately $8.6 million of originally budgeted 2005 expenditures regardingthe return to production of platform Grace is being reviewed. Success innegotiating and closing significant new acquisitions would result in increasesin our aggregate 2005 capital expenditures.

Additional cash was utilized in the first quarter forpayment of a dividend of $35 million to the Company’s sole stockholder, a trustcontrolled by Timothy Marquez, our chief executive officer and chairman, andhis wife. Additional cash dividends are not currently anticipated to be paid in2005.

Our credit agreement currently has a borrowing base of$80 million. The credit agreement will mature on November 4, 2007.Revolving loans made under the credit agreement are designated, at our option,as either “Base Rate Loans” or “LIBO Rate Loans”. Base Rate Loans bear interestat a floating rate equal to (i) the greater of Bank of Montreal’sannounced base rate and the overnight federal funds rate plus one-half of 1.00%plus (ii) an applicable margin ranging from 0.25% to 1.00%, based uponamounts borrowed under the credit agreement. LIBO Rate Loans bear interest at (i) LIBORplus (ii) an applicable margin ranging from 1.75% to 2.50%, based alsoupon amounts borrowed. At November 14, 2005, there were no loansoutstanding under the credit agreement. A commitment fee ranging from .35% to0.50% per annum is payable with respect to unused borrowing availability underthe credit agreement. The credit agreement contains a number of restrictivecovenants with regard to leverage and current ratios and other terms customaryin a credit facility secured by oil and natural gas properties. As of September 30,2005, we were in compliance with all of our debt covenants.

In December 2004, we sold $150.0 million inaggregate principal amount of our 8.75% senior notes due 2011 in a privateplacement. In connection with the issuance of the notes, we entered into aregistration rights agreement with the initial purchasers of the notes pursuantto which we agreed to file and to use our reasonable best efforts to cause tobe declared effective by the SEC a registration statement with respect to theexchange of the originally issued notes for new notes that were registeredunder the Securities Act of 1933. We did so and our Registration Statement on Form S-4became effective on April 20, 2005. The exchange offer commenced on April 25,2005 and expired on May 27, 2005. We did not receive any proceeds from theexchange offer, which we made to fulfill our obligations under the registrationrights agreement. Pursuant to the exchange offer, we issued the new notes inexchange for the previously outstanding notes. The terms of the new notes areidentical in all material respects to those of the old notes, except that thenew notes (i) have been registered under the Securities Act and thereforeare not subject to certain restrictions on transfer applicable to the old notesand (ii) do not have registration rights or provide for any additionalinterest related to the obligation to register. All of the old notes wereexchanged for new notes.

To date, we have financed our 2005 capitalexpenditures with a portion of the proceeds of the offering of our notes, cashon hand and short-term borrowings under the credit agreement. We anticipatefunding the remainder of our capital program and meeting our other needs forliquidity primarily with cash flow from operations and from cash on hand. Our creditagreement has undrawn funds availability of $80 million but we do not currentlyexpect to use those funds to finance our capital expenditures except withrespect to short term working capital needs.

If cash flow fromoperations does not meet our expectations, we may reduce the expected level ofcapital expenditures and/or fund a larger than expected portion of theexpenditures using borrowings under the credit agreement. We may also makeacquisitions that will require additional capital resources. We may seek suchadditional capital through a combination of funding sources that may includetraditional reserve base borrowings, joint venture partnerships, productionpayment financings, asset sales and 

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offeringsof debt and equity securities and other sources. We cannot assure you that neededcapital will be available on acceptable terms or at all. If we are unable toobtain funds when needed or on acceptable terms, we may not be able to completeacquisitions that may be favorable to us or finance the capital expendituresnecessary to replace our reserves.

***Forward-LookingStatements***

Certain informationincluded in this quarterly report and other materials filed or to be filed bythe company with the Securities and Exchange Commission, as well as informationincluded in oral statements or other written statements made or to be made bythe company, contain projections and forward-looking statements within themeaning of Section 21E of the Securities Exchange Act of 1934, as amended,and Section 27A of the Securities Act of 1933, as amended, relating to thecompany and the oil and gas industry. Such forward-looking statements mayconcern, among other things, capital expenditures, cash flow, drillingactivity, drilling locations, acquisition and development activities andfunding thereof, pricing differentials, production and reserve growth, reservepotential, operating costs, operating margins, production activities, oil, gasand natural gas liquids reserves and prices, hedging activities and the resultsthereof, liquidity, debt repayment, regulatory matters and competition. Suchforward-looking statements are based on management’s current plans,expectations, assumptions, projections and estimates and are frequently identifiedby words such as “expects,” “intends,” “plans,” “projects,” “predicts,” “anticipates,”“believes,” “estimates,” “goal,” “should,” “could,” “assume,” and similar wordsthat convey the uncertainty of future events. These statements are notguarantees of future performance and involve certain risks, uncertainties andassumptions that are difficult to predict. In particular, the factors discussedin our Registration Statement on Form S-4 filed on April 20,2004 could affect our actual results and cause our actual results to differmaterially from expectations, estimates, or assumptions expressed in,forecasted in, or implied in such forward-looking statements. The cautionarystatements contained in our Registration Statement on Form S-4 filedon April 20, 2004 are incorporated herein by reference.

**Item 3.**                        Qualitativeand Quantitative Disclosures About Market Risk

The discussion in this section provides informationabout derivative financial instruments we use to manage commodity pricevolatility. To the extent we borrow amounts under our credit agreement, we aresubject to interest rate risk because such amounts bear interest at variablerates. At November 14, 2005, there were no loans outstanding under thecredit agreement.

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 optionsand fixed price swaps for hedging commodity prices. All contracts are settledwith cash and do not require the delivery of a physical quantity to satisfysettlement. While this hedging strategy may result in us having lower revenuesthan we would have if we were unhedged in times of higher oil and natural gasprices, management believes that the stabilization of prices and protectionafforded us by providing a revenue floor is beneficial. We had hedgingcontracts (excluding floors) in place for 79% of our oil production and 19% ofour natural gas production during the quarter ended September 30, 2005.

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As of September 30,2005, we had entered into option, swap and collar agreements to receive averageminimum and maximum New York Mercantile Exchange (NYMEX) West TexasIntermediate (WTI) prices as summarized below. Location and quality differentialsattributable to our 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  September 30, 2005 for production: |       |            |       |                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| October 1 – December 31, 2005                 |       |            | 9,471      |                 |       |   | $ | 37.73 |   |   |   | 5,471 |   |   |   | $ | 47.17 |   |   |
| January 1 – December 31, 2006                 |       |            | 8,500      |                 |       |   | $ | 45.34 |   |   |   | 5,000 |   |   |   | $ | 53.56 |   |   |
| January 1 – December 31, 2007                 |       |            | 4,313      |                 |       |   | $ | 43.96 |   |   |   | 4,313 |   |   |   | $ | 68.99 |   |   |
| January 1 – December 31, 2008                 |       |            | 2,946      |                 |       |   | $ | 52.00 |   |   |   | 2,946 |   |   |   | $ | 75.00 |   |   |
| January 1 – June 30,  2009                    |       |            | 2,170      |                 |       |   | $ | 50.00 |   |   |   | 2,170 |   |   |   | $ | 75.00 |   |   |

 

As of September 30,2005, we had entered into option, swap and collar agreements to receive averageminimum and maximum PG&E Citygate prices as follows: 

| ** **                                                     | ** ** | **Minimum**   | ** ** | **Maximum**          | ** ** |
|----------------------------------------------------------------|------------|---------------|------------|----------------------|------------|
| ** **                                                     | ** ** | **MMBtu/Day** | ** ** | **Avg. Prices** | ** ** | **MMBtu/Day** | ** ** | **Avg. Prices** | ** ** |
| Natural gas  hedges at September 30, 2005 for production: |       |          |       |                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| October 1 – December 31, 2005                   |       |          | 14,000     |                 |       |   | $ | 6.09 |   |   |   | 4,000 |   |   |   | $ | 6.77 |   |   |
| January 1 – December 31, 2006                   |       |          | 21,000     |                 |       |   | $ | 7.06 |   |   |   | 15,000 |   |   |   | $ | 11.04 |   |   |
| January 1 – December 31,  2007                  |       |          | 6,000      |                 |       |   | $ | 6.00 |   |   |   | 6,000 |   |   |   | $ | 8.40 |   |   |

 

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Ourportfolio of commodity derivative transactions as of September 30, 2005 issummarized below:

**Crude Oil**

| **Type of Contract** | ** ** | ** ** | ** ** | **Basis** | ** ** | **Quantity  (Bbl/d)** | ** ** | **Strike Price  ($/Bbl)**    | ** ** | **Term** |
|----------------------|------------|------------|------------|-----------|------------|-----------------------|------------|------------------------------|------------|----------|
| Collar               |       | NYMEX      |       | 4,471     |       | $38.00 – $47.10  |       | Jan 1, 05 – Dec 31, 05  |
| Collar               |       | NYMEX      |       | 1,000     |       | $38.00 – $47.50  |       | Jan 1, 05 – Dec  31, 05 |
| Put                  |       | NYMEX      |       | 2,000     |       | $36.00 Floor          |       | Jan 1, 05 – Dec  31, 05 |
| Put                  |       | NYMEX      |       | 2,000     |       | $38.70 Floor          |       | Jan 1, 05 – Dec  31, 05 |
| Swap                 |       | NYMEX      |       | 1,000     |       | $57.00 Fixed          |       | Jan 1, 06 – Dec  31, 06 |
| Collar               |       | NYMEX      |       | 2,000     |       | $40.00 – $51.00  |       | Jan 1, 06 – Dec  31, 06 |
| Collar               |       | NYMEX      |       | 1,000     |       | $40.00 – $51.05  |       | Jan 1, 06 – Dec  31, 06 |
| Collar               |       | NYMEX      |       | 1,000     |       | $40.00 – $57.75  |       | Jan 1, 06 – Dec  31, 06 |
| Put                  |       | NYMEX      |       | 1,000     |       | $40.00 Floor          |       | Jan 1, 06 – Dec  31, 06 |
| Put                  |       | NYMEX      |       | 1,000     |       | $42.90 Floor          |       | Jan 1, 06 – Dec  31, 06 |
| Put                  |       | NYMEX      |       | 1,500     |       | $57.00 Floor          |       | Jan 1, 06 – Dec  31, 06 |
| Collar               |       | NYMEX      |       | 2,000     |       | $40.00 – $65.80  |       | Jan 1, 07 – Dec  31, 07 |
| Collar               |       | NYMEX      |       | 1,000     |       | $40.00 – $67.50  |       | Jan 1, 07 – Dec  31, 07 |
| Collar               |       | NYMEX      |       | 1,600     |       | $53.00 – $75.00  |       | Jan 1, 07 – Jun  30, 07 |
| Collar               |       | NYMEX      |       | 1,030     |       | $53.00 – $75.00  |       | Jul 1, 07 – Dec  31, 07 |
| Collar               |       | NYMEX      |       | 3,450     |       | $52.00 – $75.00  |       | Jan 1, 08 – Jun  30, 08 |
| Collar               |       | NYMEX      |       | 2,450     |       | $52.00 – $75.00  |       | Jul 1, 08 – Dec  31, 08 |
| Collar               |       | NYMEX      |       | 2,170     |       | $50.00 – $75.00  |       | Jan 1, 09 – Jun 30, 09  |

 

**NaturalGas**

| **Type of Contract** | ** ** | ** **        | ** ** | **Basis** | ** ** | **Quantity  (MMBtu/d)** | ** ** | **Strike Price  ($/Mcf)**    | ** ** | **Term** |
|----------------------|------------|-------------------|------------|-----------|------------|-------------------------|------------|------------------------------|------------|----------|
| Physical Sale        |       | SoCal             |       | 2,000     |       | $4.85 Floor(1)          |       | Apr 1, 05 – Sep 30, 06  |
| Put                  |       | NYMEX             |       | 5,000     |       | $5.80 Floor             |       | Jan 1, 05 – Dec  31, 05 |
| Basis Swap           |       | PG&E Citygate |       | 5,000     |       | $(0.150)(2)             |       | Jan 1, 05 – Dec  31, 05 |
| Put                  |       | PG&E Citygate |       | 5,000     |       | $6.00 Floor             |       | Jan 1, 05 – Dec  31, 05 |
| Swap                 |       | PG&E Citygate |       | 4,000     |       | $6.765 Fixed            |       | Apr 1, 05 – Dec  31, 05 |
| Swap                 |       | NYMEX             |       | 2,000     |       | $6.71 Fixed             |       | Jan 1, 06 – Dec  31, 06 |
| Collar               |       | NYMEX             |       | 4,000     |       | $6.00 – $8.50      |       | Jan 1, 06 – Dec  31, 06 |
| Basis Swap           |       | PG&E Citygate |       | 6,000     |       | $(0.035)(3)             |       | Jan 1, 06 – Dec  31, 06 |
| Put                  |       | PG&E Citygate |       | 6,000     |       | $6.00 Floor             |       | Jan 1, 06 – Dec  31, 06 |
| Collar               |       | PG&E Citygate |       | 3,000     |       | $7.00 – $9.45      |       | Jan 1, 06 – Dec  31, 06 |
| Collar               |       | NYMEX             |       | 6,000     |       | $9.00 – $15.00     |       | Jan 1, 06 – Dec  31, 06 |
| Collar               |       | NYMEX             |       | 6,000     |       | $6.00 – $8.40      |       | Jan 1, 07 – Dec 31, 07  |

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(1)          The price of thiscontract is the monthly NGI SoCal Border Index less $0.10 per MMBtu, with afloor of $4.85.

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(2)          This basis swap locksthe $5.80 NYMEX put into a $5.65 floor with a PG&E Citygate location for2005.

(3)          This basis swap locksthe $6.71 NYMEX swap into a $6.675 PG&E Citygate location swap and the $6.00-$8.50collar into a $5.965-$8.465 collar with a PG&E Citygate location for2006.

Since September 30,2005 and through November 14, 2005 we have not entered into any additionalcommodity price hedging contracts. We did extend the above referenced physicalsale through December 31, 2006 at a price of $5.899 after November 1,2005.

*Changesin Fair Value*

Thefair value of outstanding crude oil and natural gas commodity derivativeinstruments and the change in fair value that would be expected from a $5.00per barrel increase in the price of oil and a $1.00 per MMBtu increase in the price of natural gas are shown in thetable below (in millions):

| ** **                                                                                                                    | ** ** | **September 30, 2005** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                                                    | ** ** | **Fair  Value**                  | ** ** | **Effect of  $5.00/Bbl and  $1.00/MMbtu  Price  Increases** | ** ** |
| Effective portion  of derivatives designated as cash flow hedges                                                              |       | $                                | (29.6      | ) |   | $ | (13.4 | ) |   |
| Derivatives not  designated as hedging instruments and the ineffective portion of derivatives  designated as cash flow hedges |       | (29.7                            | )          |   | (21.5 | ) |   |
|                                                                                                                               |            |                                  |            |  |  |  |  |  |  |

 

The fair value of the swaps and option contracts areestimated based on quoted prices from independent reporting services comparedto the contract price of the agreement, and approximate the cash gain or lossthat would have been realized if the contracts had been closed out at periodend. All hedge positions offset physical positions exposed to the cash market.None of these offsetting physical positions are included in the above table.Price risk sensitivities were calculated by assuming across-the-board increasesin price of $5.00 per barrel for oil and $1.00 per MMBtu for natural gasregardless of term or historical relationships between the contractual price ofthe instruments and the underlying commodity price. In the event of actualchanges in prompt month prices equal to the assumptions, the fair value of ourderivative portfolio would typically change less than that shown in the tabledue to lower volatility in out-month prices. In the event of actual changes inall months equal to the assumptions, the fair value of our derivative portfoliowould typically change less then that shown in the table due to the fact thatmany of such changes would be within the range of our derivative collars wherethe movement in fair value would typically be less then the changes incommodity prices.

We have NYMEX put options with a weighted averagestrike price of $37.35 per barrel on 4,000 barrels of oil per day in 2005 and$48.11 per barrel on 3,500 barrels of oil per day in 2006. We also have putoptions with a weighted average strike price of $5.91 per MMBtu on 11,000 MMBtusof natural gas per day in 2005 and $6.00 per MMBtul on 6,000 MMBtus of naturalgas per day in 2006. These put options cost an average of $1.33 per barrel and$0.28 per MMBtu for 2005 and $2.83 per barrel and $0.46 per MMBtu for 2006(a total of $7.7 million), which was paid when the  put options were contracted. Such amount isnot included in the fair value of derivatives in the foregoing table.

See Note 5 to our interim condensed consolidatedfinancial statements for discussion of our long-term debt as of September 30,2005, all of which is at a fixed rate.

**CriticalAccounting Policies and Estimates**

We refer you to thecorresponding section in Management’s Discussion and Analysis of FinancialCondition and Results of Operations included in our Registration Statement onForm S-4/A (Registration 

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no.333-1237111)as filed with the Securities and Exchange Commission on April 20, 2005 (the“Registration Statement”) and Note 2, Summary of Significant AccountingPolicies, included in the notes to the financial statements in the RegistrationStatement, and in the notes to the financial statements included in Item 1 ofthis Form 10-Q for a description of critical accounting policies and estimates.

**Item 4.**                        Controlsand Procedures

**Disclosure Controls and Procedures**

Timothy Marquez,our chief executive officer, and David Christofferson, our chief financialofficer, evaluated the effectiveness of our disclosure controls and proceduresas of September 30, 2005. Based on the evaluation, they believe that:

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

·       our disclosure controls andprocedures were effective to ensure that information required to be disclosedby us in the reports we file or submit under the Securities Exchange Act of1934 was accumulated and communicated to our management, including our chiefexecutive officer and chief financial officer, as appropriate to allow timelydecisions regarding required disclosure.

As reported in our CurrentReport on Form 8-K filed on November 7, 2005, we have determined that thecondensed consolidated financial statements included in our Quarterly Reportson Form 10-Q for the first two quarters of fiscal 2005 should be restatedin order to correct our accounting for an acquisition completed in the firstquarter of 2005. Following that determination, we commenced, and are currentlyengaged in, a review of the adequacy of our current levels of accounting staffwith a view towards enhancing our disclosure controls and procedures,particularly with respect to GAAP accounting and financial reporting, potentiallyby adding additional staff.

**InternalControl Over Financial Reporting**

There has not been any change in our internal controlover financial reporting that occurred during the quarterly period ended September 30,2005 that has materially affected, or is reasonably likely to materiallyaffect, our internal control over financial reporting.

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**PART II—OTHER INFORMATION**

**Item 1.**                        LegalProceedings

See Note 7 to our interimcondensed consolidated financial statements.

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

As reported in our CurrentReports on Form 8-K filed on August 31, 2005 and August 18, 2005, wegranted options to purchase shares of our common stock to Mark DePuy, our VicePresident, Northern Assets, and to each of our non-employee directors. Eachgrant of the options was exempt from the registration requirements of theSecurities Act pursuant to Section 4(2) of that act. The persons to whomoptions were granted represented their intention to acquire the options andunderlying shares of common stock for investment only and not with a view to orfor sale in connection with any unregistered distribution thereof. The grantsof the options were made without general solicitation or advertising. Inaddition, the persons to whom options were granted had access to informationconcerning our company, including through our public filings with the SEC, comparableto the information that would have been provided in a registration statementhad the grants been registered.

**Item 3.**                        DefaultsUpon Senior Securities

Not Applicable

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

Not Applicable

**Item 5.**                        OtherInformation

See Item 2 above.

**Item6.**                        Exhibits

| Exhibit  Number | ** ** | ** **                                                                                                                                | ** ** | **Exhibit** |
|-----------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------|
| 3.1             |       | Restated Certificate of  Incorporation of Venoco, Inc.                                                                                    |
| 3.2             |       | Restated Bylaws  of Venoco, Inc.                                                                                                          |
| 10.1            |       | Employment  Agreement, dated as of August 15, 2005, by and between Venoco, Inc. and Mark  DePuy.                                          |
| 10.2            |       | Non-Qualified  Stock Option Agreement, dated as of August 15, 2005, by and between  Venoco, Inc. and Mark DePuy.                     |
| 10.3            |       | Form of  Non-Qualified Stock Option Agreement for Non-Employee Directors.                                                                 |
| 10.4            |       | Form of  Non-Qualified Stock Option Agreement for Non-Executive Officer Employees.                                                        |
| 31.1            |       | Certification of  the Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act  of 2002.                                 |
| 31.2            |       | Certification of  the Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002.                                 |
| 32              |       | Certification of the  Chief Executive Officer and the Chief Financial Officer Pursuant to Section  906 of the Sarbanes-Oxley Act of 2002. |

 

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**SIGNATURES**

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

| November 21, 2005 | 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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