<PAGE>
 
                      SECURITIES AND EXCHANGE COMMISSION
                            WASHINGTON, D.C. 20549
                      ----------------------------------
                                   FORM 10-K

[X]  Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934

     For the fiscal year ended               December 31, 1995
                              ------------------------------------------------
                                                    OR

[ ] Transition Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934

                        Commission file number    0-8232
                                              --------------

                            McFARLAND ENERGY, INC.
--------------------------------------------------------------------------------
            (Exact name of registrant as specified in its charter)

       Delaware                                           95-2756635
 ----------------------                      ----------------------------------
(State of incorporation)                    (I.R.S. Employer Identification No.)
 
10425 South Painter Avenue, Santa Fe Springs, California          90670
--------------------------------------------------------     ---------------
     (Address of principal executive offices)                   (Zip Code)
 
Registrant's telephone number, including area code     (310) 944-0181
                                                   ----------------------------

      Securities registered pursuant to Section 12(b) of the Act:   None

          Securities registered pursuant to Section 12(g) of the Act:
                         Common Stock $1.00 Par Value
--------------------------------------------------------------------------------
                               (Title of Class)

     Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.  YES  X  NO
                                               ---    ---
     Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K.   [X]

     As of March 4, 1996, 5,644,359 Common shares were outstanding, and
aggregate market value of the Common shares (based on the closing price) of
McFarland Energy, Inc. held by non-affiliates was approximately $26,000,000.

                      DOCUMENTS INCORPORATED BY REFERENCE

     The information required for part of Part III of Form 10-K is contained in
the Company's Proxy Statement for its Annual Meeting of Shareholders proposed to
be held on May 30, 1996, which portions of registrant's Proxy Statement is
incorporated by reference in Part III.

                                              EXHIBIT INDEX - PAGE 56

                                       1
<PAGE>
 
                                    PART I
                                    ------

Item 1.  Business
-----------------

General
-------

     McFarland Energy, Inc., hereinafter referred to as "Company, Registrant, or
McFarland," is principally engaged in the production and sale of crude oil and
natural gas, oil and gas exploration and development, and proven oil and gas
property acquisition and development, all within the Continental United States.

     McFarland was reincorporated under the laws of Delaware on October 7, 1987.
It was previously incorporated under the laws of California on February 7, 1972.
McFarland had a wholly-owned subsidiary, Carl Oil & Gas Co. ("Carl"), which was
incorporated in July 1988 as a result of a merger and maintained its
headquarters in Corpus Christi, Texas.  Through this subsidiary, the Company
operated its properties in the Gulf Coast region.  In December 1995, Carl was
merged into McFarland and all of the operational and administrative functions of
Carl were assumed by McFarland.

Property Acquisitions and Dispositions
--------------------------------------

     In 1992, the Company implemented an asset divestiture program to sell its
economically marginal and non-strategic oil and gas properties.  Since the
program's implementation, the Company has sold a total of sixteen (16)
properties located in California, Texas, and Louisiana, and which consisted of
more than 300 wells.  The success of this ongoing program has allowed the
Company to focus more effectively on its core operations and has resulted in
significantly higher profit margins and a reduced cost structure.

     In April 1994, the Company acquired a significant crude oil producing
property located one-eighth mile west of its other principal Midway Sunset
field, California property.  This property, known as the Star Fee, was purchased
for approximately $7,300,000 cash plus the issuance of $3,624,000 seven-year
convertible production notes bearing interest at 5% per annum.  The Company
borrowed $6,000,000 under its bank term loan facility to finance the
acquisition.  The acquisition of the Star Fee allowed the Company to
strategically add significant long-lived oil reserves in an area where the
Company already had substantial technical and operational experience.

     In September 1994, the Company closed an acquisition of working interests
in fifteen (15) operated and thirty-three (33) non-operated natural gas
producing wells located in the Oak Hill field, Rusk County, Texas.  The Company
paid $6,280,000 for the interests acquired and utilized its bank revolving line
of credit facility to finance $6,000,000 of the transaction.  This acquisition
allowed the Company to significantly add to its natural gas reserves and provide
future natural gas development potential.  The Oak Hill field reserves are very
long-lived, with reserve lives of up to thirty years.

     In January 1996, the Company closed an acquisition of both operated and
non-operated working interests in nineteen (19) producing oil wells located in
Santa Barbara County, California

                                       2
<PAGE>
 
Item 1.  Business (continued)
-----------------------------

for $3,400,000 cash.  This acquisition provides the Company with additional high
gravity and long-lived reserves with future development potential.  In addition,
the properties are strategically located such that no additional personnel will
be required.

Exploration Activities
----------------------

     Northern San Joaquin Valley - Since 1991, the Company has maintained an
     ---------------------------                                            
active exploration program in the Northern San Joaquin Valley of California.
These exploration activities consist of geological and geophysical evaluation of
exploratory prospects, the acquisition of oil and gas leases, the acquisition of
non-leasehold interests in exploration prospects and the drilling of exploratory
wells using contract drillers.  The Company conducts its activities through
joint ventures in which its working interests range from 20% to 50%.  The
Company acts as the operator on approximately half of the properties.

     A total of twenty-two (22) natural gas wells have been drilled, of which,
eleven (11) have been successful.  The results of the discovery wells have added
approximately 2.5 billion cubic feet ("bcf") of natural gas to the Company's
year-end proved reserves.  The Company and its co-venturers have developed
additional prospects in this same geographic area and have plans to drill
exploratory wells on some of these prospects in 1996.   In 1996, approximately
$1,100,000 of the Company's capital expenditure budget has been allocated to
this drilling program.

     While the results achieved thus far have been somewhat moderate, the
program's economics have been severely impacted by the low California natural
gas prices which have prevailed since 1993.  In 1995, the average natural gas
price received for this production was a net $0.87 per thousand cubic feet
("mcf"), and in 1996, prices have remained near this level.  These soft market
conditions caused the Company to shut-in one well and curtail production by more
than 50% on two other wells for all of 1995.  Currently, net production is down
to approximately one (1) million cubic feet per day.  As a result of these
market conditions, the Company will carefully evaluate its commitment to this
exploration program during 1996.

Development Activities
----------------------

     Midway Sunset Field - The Company is continuing its cyclic steaming
     -------------------                                                
activities at its McDonald and Star Fee properties in the Midway Sunset field,
Kern County, California.  These two properties now account for approximately 72%
of the Company's total proved crude oil reserves.  The cyclic steam injection
process consists of the injection of steam into the reservoir to raise the
temperature and reduce the viscosity of the heavy oil, facilitating the flow of
the oil into the producing well bore.  As a result of intensified steam
injection and development drilling, production on the McDonald property has
increased from an average of 750 gross barrels per day in 1992, to its present
level of more than 1,600 barrels per day.  Since the beginning of 1993, the
Company has drilled a total of fifteen (15) new development wells on the
property.  An additional eight (8) wells  are budgeted to be drilled during 1996
at a cost of approximately $800,000.

                                       3
<PAGE>
 
Item 1.  Business (continued)
-----------------            

     In connection with its cyclic steaming program at the McDonald property, in
July of 1992, the Company entered into an agreement to buy up to 2,000 barrels
of steam per day from a third party. Previously, the Company had created its own
steam with its steam generators fueled by lease crude or purchased natural gas.
While the Company continues to have the ability to generate its own steam, this
arrangement to buy third party steam is both economically and environmentally
desirable. It reduces the Company's operating expenses and eliminates the need
to meet strict environmental regulations applicable to the operation of steam
generators. The agreement runs month to month and requires 30 day termination
notice by either party. A similar agreement to buy up to 2,000 barrels of steam
per day was entered into with this same third party for the Star Fee property.

     On April 22, 1994, the Company completed its acquisition of the property,
known as the Star Fee.  The Star Fee is located one-eighth mile west of the
Company's McDonald property and possesses similar reservoir characteristics.
The acquisition of the Star Fee added an estimated 3.7 million barrels of proved
producing crude oil reserves and increased the Company's proved developed oil
reserves by more than 70%.  Immediately after closing the acquisition, the
Company implemented an intensified steam injection program and commenced a
twelve (12) well development drilling program.  The results of both programs
were highly successful, as production quickly increased from 550 gross barrels
per day to in excess of 1,200 barrels per day. In 1995, the Company drilled
thirteen (13) additional development wells, increasing production to its current
level of more than 1,600 gross barrels per day.  The Company expects to drill
thirteen (13) new development wells in 1996 at a cost of approximately
$1,300,000.

     Ten Section Field - The Company owns a 60% interest in an oil and gas
     -----------------                                                    
producing property located in the Ten Section field, Kern County, California.
This property contains a potential gas storage reservoir in addition to the
separate crude oil reservoir.  In 1993, the Company retained the services of
outside consultants to study and help evaluate the potential of the gas storage
reservoir and to determine the market demand for a facility of this nature.  In
March 1994, the Company announced a preliminary agreement with Alberta Energy
Company, Ltd. ("AEC") of Calgary, Alberta to join the Company and its joint
venture partners in their efforts to develop the potential of the gas storage
project.  AEC was to become the project operator and share in the cost of the
testing, facility design and market development.  In October 1994, the Company
announced that the relationship with AEC had been terminated due to the parties
inability to agree on the terms of a definitive commercial agreement.  In the
fourth quarter of 1995, the Company expensed previously deferred gas storage
development costs totalling $882,000 due to the project's future uncertainty.

       Oak Hill Field -  In September 1994, the Company acquired working
       --------------                                                   
interests in fifteen (15) operated properties ranging from 65% to 96% and lesser
interests in thirty-three (33) non-operated properties.  At the end of 1995,
these interests accounted for approximately 53% of the Company's proved natural
gas reserves.  Production comes from the 10,000-11,000 feet lower Cotton Valley
formation which has reserve lives of up to thirty years.  This is a very "tight"
formation requiring some type of hydraulic fracturing before a new well is put
on production. The cost to drill a new well typically ranges from $800,000 -
$1,000,000.  In the fourth quarter of 1994, the Company commenced a four (4)
well development drilling program in the Oak Hill

                                       4
<PAGE>
 
Item 1.  Business (continued)
-----------------            

field. The four (4) wells were drilled and completed and on production by mid-
year 1995. Current net production from the Oak Hill field is approximately three
(3) million cubic feet per day.

Marketing of Oil and Gas
------------------------

   Major Customers
   ---------------

     The Company markets its crude oil to a number of refiners and marketing
agencies, including several major oil companies.  Most of the oil is transported
to the refineries by pipeline and the balance by truck.  In 1995, sales to
Huntway Refining Company and Independent Oil Producers' Agency accounted for 33%
and 30%, respectively, of total oil and gas sales.  Most of the oil sold to
these purchasers is under contracts which provide for prices indexed to posted
field prices and which can be cancelled by the buyer or seller upon six months
to one year's written notice.

     The Company markets its natural gas to utilities and pipeline companies
under both long-term contracts and spot market pricing arrangements.  No one
purchaser of natural gas accounted for more than 10% of  total oil and gas
sales.

   Oil and Gas Prices
   ------------------

     The Company's crude oil production comes predominately from its California
operations, accounting for approximately 90% of the Company's total oil
production.  Most California crude is of lower gravity and must be heated or
blended to transport.  These characteristics make this type of crude more costly
to refine and also result in lower light product yields, such as gasoline and
kerosene.  Consequently, California crude prices have been historically lower
than other types of higher gravity domestic crudes, such as West Texas
Intermediate ("WTI").  In addition to these qualitative differences,  California
crude prices, until recently, were negatively impacted by the existence of the
Federal law which prohibited the export of Alaskan North Slope ("ANS") crude. As
a consequence of this law, most of the ANS crude was shipped to California
markets, thereby creating an excess supply of crude on the West Coast.

     In November 1995, President Clinton signed legislation that repealed the
Federal ban on the export of ANS crude.  While the new law does not go into
effect until April 1996, lifting the ban may result in a "permanent" narrowing
of the price differential between California lower gravity crude and the
benchmark WTI crude oil.

     Throughout 1995 and continuing into 1996, the price differential between
the Company's predominate Midway Sunset field crude and WTI has ranged between
$3.00-$5.00 per barrel. This compares favorably with the $7.00-$9.00 per barrel
price differential that had existed since the mid 1980's. During 1995, the
anticipated repeal of the ban on the export of ANS crude was one of the factors
behind this narrowed price differential. Two other contributing factors are
rising West Coast crude oil demand and declining Alaskan North Slope production.
All of these factors combine to represent a fundamental change in the California
crude market, which should have a very positive impact on the Company's future
operating cash flows and the value of its

                                       5
<PAGE>
 
Item 1.  Business (continued)
-----------------            

 California oil reserves.

     In December 1992, the Company entered into a 1,000 barrel per day crude oil
hedging arrangement with a local refiner based on a minimum posted price of
$12.50 per barrel and a maximum of $14.00 per barrel of Midway Sunset field
crude.  The purpose of the Company's hedging activities is to ensure a
relatively stable crude price for a portion of the Company's daily production.
This, in turn, enables the Company to more accurately forecast its cash flow and
budget for future capital commitments.  The original agreement was revised and
extended through October 1996 and now covers 2,000 barrels per day.  Under the
revised agreement, during the period of November 1994 through October 1995, when
the Midway Sunset field monthly weighted average posted price was below $11.25
per barrel, the Company received an amount up to a maximum of $2.75 per barrel,
equal to the difference between $11.25 and the monthly average posted price,
times 2,000 barrels per day.  When the monthly average posted price was above
$13.00 per barrel, the Company paid an amount up to $2.75 per barrel, equal to
the difference between the average posted price and $13.00 per barrel, times
2,000 barrels per day.  During the period of November 1995 through October 1996,
the maximum amount received or paid by the Company increases to $3.00 per barrel
on 2,000 barrels per day, and the benchmark posted prices increase to $11.50 and
$13.25 per barrel. While there can be no guarantees that the Company will be
able to extend the hedge at its expiration in November 1996, the Company has
every intention of doing so, and at price levels which it deems acceptable given
the new California market conditions.  In 1995, the hedge program decreased
revenues by $482,000, while in 1994 and 1993, the hedge program increased
Company revenues by $446,000 and $467,000, respectively. The hedge agreement
requires that the Company and the refiner maintain certain minimum levels of
security.  At December 31, 1995 and 1994, the Company had on deposit in an
interest bearing escrow account $280,000 and $273,000, respectively, to meet
such requirements.

     The weakness in natural gas prices, which began in the second half of 1994,
continued on into 1995.  Domestic natural gas prices in 1995 were at
historically low levels for most of the year. The companywide average price
received during the year was $1.24 per mcf.  Mild domestic weather conditions
combined with increased imports of low-priced Canadian gas were the principal
factors behind the weak gas markets.  Gas prices in California were particularly
low, with the Company selling its Northern San Joaquin Valley gas production in
1995 for less than $1.00 per mcf, net of transportation costs.  Prices in 1996
for this production have remained near the $1.00 per mcf level.

     Beginning in December 1995 and continuing into 1996, domestic natural gas
prices in the Midwest and East have risen sharply and become highly volatile.
Extremely cold winter weather conditions, particularly in the East, and
seasonally low natural gas storage levels caused gas prices to "spike" upward in
December and create record setting price differentials between the various
natural gas delivery points.  The sharp increase in demand caused significant
operational and pipeline capacity problems which resulted in significantly
higher spot prices for natural gas in many parts of the country.  While the
Company has benefitted from these increased prices at its Louisiana properties,
85% of the Company's natural gas production comes from its Texas and California
properties, where gas prices have been lower and less volatile.  As such, the
effect of the current market conditions on the Company's operating results has
not been significant.

                                       6
<PAGE>
 
Item 1.  Business (continued)
-----------------            

Environmental and Other Regulations
-----------------------------------

     The Company's operations are subject to various federal, state and local
laws and regulations governing the discharge of materials into the environment
or otherwise relating to environmental protection. Such laws and regulations
have significantly increased the cost of well operations and exploration and
development activities, particularly in the areas of disposal of produced waste
water and drilling fluids and activities in connection with treating, processing
and storage of hydrocarbons.

     The Company has been identified as a potentially responsible party ("PRP"),
along with many other industrial firms, in connection with a waste disposal
facility and which is now subject to a cleanup order by the United States
Environmental Protection Agency ("EPA").  In 1989 and 1991, a group of PRPs (the
"settling PRPs") settled with the EPA for the entire cost of the first two
phases of work.  In September 1993, the Company resolved the first two phases of
work with the settling PRPs without waiving its defenses by paying $70,000 in
exchange for a release from all contribution or related claims the settling PRPs
may have against the Company regarding the first two phases of work.  Not
included in this settlement with the settling PRPs are costs associated with
additional phases of work or remedial efforts, certain resource damage claims or
environmental tort claims.  Also, the settlement does not directly protect the
Company from actions from the EPA for the matters settled.  See Item 3. Legal
Proceedings for a detailed discussion.

     In general, compliance with environmental laws could have a potentially
significant effect on the Company's capital spending.  Given the continually
changing environmental rules and regulations, it is impossible at this time to
estimate the magnitude of the required future expenditures.  Despite the fact
that all of McFarland's competitors are having to comply with these regulations,
many are much larger and have greater resources with which to deal with these
regulations.  The Company spent approximately $555,000 for environmental control
facilities and other related projects in 1995 and has budgeted $337,000 for
similar capital projects in 1996.

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

     The oil and gas industry is highly competitive.  Major oil and gas
companies, independent concerns, drilling and production purchase programs and
individual producers and operators are active bidders for desirable oil and gas
properties, as well as for the equipment and labor required to operate and
develop such properties.  Many of those competitors have financial resources
substantially greater than those of the Company.

Employees
---------

     The Company had 59 full-time employees as of December 31, 1995, none of
whom are covered by a collective bargaining agreement.  The Company believes
that its relations with its employees are good.

                                       7
<PAGE>
 
Item 2.  Properties
-------------------

     The Company's principal executive offices are located in a 10,900 square
foot building in Santa Fe Springs, California, which is owned by the Company.

     The principal properties of the Company consist of proven and unproven oil
and gas reserves, certain real estate and equipment related to proven
properties, maps and geologic records related to prospective oil and gas
properties and automotive, office and other equipment.  The oil and gas
properties cover lands located exclusively in the Continental United States,
primarily in California, Louisiana and Texas.  The Company contracts for the
drilling of all its wells and does not itself own any drilling equipment, bulk
storage facilities or refineries.

     For 1995 and 1994, the Company contracted with an independent petroleum
engineering firm for the purpose of estimating the Company's net share of proved
oil and gas reserves.  In prior years, the Company's reserves had been evaluated
by the firm of Babson and Sheppard, Santa Fe Springs, California.  The
properties evaluated by the outside independent petroleum engineers account for
approximately 86% of the Company's total proved reserves.

     The estimated future net recoverable oil and gas reserves from proved
properties as of December 31, 1995, 1994, 1993, 1992, and 1991 were as follows:
<TABLE>
<CAPTION>
 
                    Crude Oil                 Natural  Gas
                    ---------                 ------------
<S>               <C>                        <C>
                               
  1995            9,514,000 bbl              12,104,000 mcf
  1994            8,299,000 bbl              14,723,000 mcf
  1993            5,132,000 bbl               7,991,000 mcf
  1992            5,804,000 bbl               8,610,000 mcf
  1991            5,976,000 bbl               6,170,000 mcf
</TABLE>

          The process of estimating oil and gas quantities is inherently
imprecise.  Ascribing monetary values to those reserves, therefore, yields
imprecise estimates at best.  Proved reserve quantities are merely estimates of
future production from known reservoirs based on year-end economic factors,
which estimates may differ materially from actual recovery as production occurs
and market prices and production costs change.

          Using year-end oil and gas prices and current levels of lease
operating expenses, the estimated present value of the future net revenue,
before income taxes, to be derived from the Company's proved oil and gas
reserves, discounted at 10%, was $60,000,000, $44,000,000, $21,000,000,
$33,000,000, and $26,000,000 at December 31, 1995, 1994, 1993, 1992,  and 1991,
respectively. See Note 11 of Notes to Consolidated Financial Statements for
further information on oil and gas reserves and estimated values.

  The Company is continually participating in the drilling of oil and gas
exploratory and development wells, no single one of which would cause a
significant change in the Company's net reserve position.  The Company must file
the Annual Survey of Domestic Oil and Gas Reserves annually with U.S. Department
of Energy (DOE).  There were no material differences between the reserves
reported to the DOE and the reserves reported in this report.

                                       8
<PAGE>
 
Item 2.  Properties (continued)
-------------------            

     The Company's consolidated net oil and gas production for the past five
years were as follows:

<TABLE> 
<CAPTION> 
                         (In thousands of bbls and thousands of mcf)
                        1995       1994      1993       1992      1991
                        ----       ----      ----       ----      ---- 
<S>                     <C>        <C>       <C>        <C>       <C> 
Crude Oil               1,206        969       795        835       858
                        -----      -----     -----      -----     -----
Natural Gas             2,181      1,456       998      1,306     1,767
                        -----      -----     -----      -----     -----
</TABLE> 

   The Company's average sales prices and production costs per unit for the past
five years were as follows:

<TABLE> 
<CAPTION> 
                      1995        1994        1993        1992        1991 
                      ----        ----        ----        ----        ---- 
Sales Price:                                                       
<S>                   <C>         <C>         <C>         <C>         <C> 
  Crude Oil (1)       $13.56/bbl  $12.97/bbl  $13.29/bbl  $14.44/bbl  $14.43/bbl
                      ----------  ----------  ----------  ----------  ----------
  Natural Gas         $ 1.24/mcf  $ 1.71/mcf  $ 2.08/mcf  $ 1.89/mcf  $ 1.78/mcf
                      ----------  ----------  ----------  ----------  ----------
Production Costs: (2) $ 4.63/bbl  $ 5.35/bbl  $ 6.98/bbl  $ 6.76/bbl  $ 7.68/bbl
                      ----------  ----------  ----------  ----------  ----------
</TABLE> 

        (1)  The crude oil sales prices include the effects of the Company's
hedging activities which increased the 1994, 1993 and 1992 average sales prices
by $0.46, $0.59 and $0.02 per barrel, respectively, and reduced the 1995 and
1991 realized sales prices by $0.40 and $0.14 per barrel, respectively.  See
Note 1 of Notes to Consolidated Financial Statements for a detailed discussion
of the Company's Crude Oil Hedge Program.

        (2)  Natural gas production is converted to its oil barrel equivalent
based on the relative energy content of each (6 mcf is equivalent to 1 bbl).

        As of December 31, 1995,  the Company had the following gross and net
position in producing wells and productive acreage:

<TABLE>
<CAPTION>
                                Wells (1)                       Acres (2)
                          --------------------            ------------------
                          Gross         Net               Gross       Net
<S>                       <C>           <C>               <C>         <C>
Crude Oil                    310           229            42,174       9,594
Natural Gas                  121            22            52,984      10,098
                          ------        ------            ------      ------
       Totals                431           251            95,158      19,692
                          ======        ======            ======      ======
</TABLE>

(1)  "Gross Wells" represents the total number of producing wells in which the
Company has a working interest; "Net Wells" represents the number of gross wells
multiplied by the Company's working interests in each well.

(2)  "Gross Acres" represents all productive acreage in which the Company has a
working interest; "Net Acres" represents the number of gross acres multiplied by
the Company's working interests in each property.

                                       9
<PAGE>
 
Item 2.  Properties (continued)
-------------------            

     During the years ended December 31, 1995, 1994 and 1993 the Company
participated in the drilling of 35, 27, and 11 wells, respectively.  Results and
classification of those activities were as follows:

<TABLE> 
<CAPTION> 
                                             Number of Wells
                       ---------------------------------------------------------
                         Completed as  
                         a Producer             Abandoned              Total
                         ------------         -------------        -------------
                         Gross    Net         Gross     Net        Gross    Net
                         -----    ---         -----     ---        -----    ---
<S>                      <C>      <C>         <C>       <C>        <C>      <C>
1995 Exploratory Wells     --       --           5       2.5          5      2.5
     Development Wells     30     28.6          --        --         30     28.6
                         ----     ----        ----      ----       ----     ----
         Totals            30     28.6           5       2.5         35     31.1
                         ----     ----        ----      ----       ----     ----
 
1994 Exploratory Wells      2      0.6           4       1.7          6      2.3
     Development Wells     20     16.8           1       0.3         21     17.1
                         ----     ----        ----      ----       ----     ----
         Totals            22     17.4           5       2.0         27     19.4
                         ----     ----        ----      ----       ----     ----
 
1993 Exploratory Wells      1      0.4           4       1.5          5      1.9
     Development Wells      5      4.0           1       0.2          6      4.2
                         ----     ----        ----      ----       ----     ----
         Totals             6      4.4           5       1.7         11      6.1
                         ----     ----        ----      ----       ----     ----
</TABLE>


  Unproven oil and gas properties are those on which the presence of
economically recoverable reserves of crude oil or natural gas has not been
established.  As of December 31, 1995, the Company held positions in unproven
acreage in the following locations:

<TABLE>
<CAPTION>
                                             Acres
                                             -----
                                     Gross             Net
                                     -----            -----
California
----------
<S>                                  <C>              <C>
Fresno County                        2,488               798
Los Angeles County                     409               205
Madera County                        3,552             1,389
Merced County                        5,729             2,210
Solano County                          210               210
                                    ------             ----- 
 TOTALS                             12,388             4,812
                                    ======             =====
</TABLE>

                                       10
<PAGE>
 
Item 3.   Legal Proceedings
---------------------------

  (a) In 1987 it was originally reported that the Company received a
notification letter and request for information from the United States
Environmental Protection Agency ("EPA") concerning a disposal site in Monterey
Park, California, operated by Operating Industries, Inc. ("OII").  The OII site
is on the National Priorities list of "superfund" sites under existing
environmental laws and the EPA is taking steps to clean up the site and assess
costs.  Costs are potentially assessable to those who disposed of hazardous
substances at the site.  EPA has notified McFarland and Seaboard Oil and Gas
Co., one of McFarland's corporate predecessors through merger, that each is a
potentially responsible party ("PRP"), along with many other industrial firms,
for the cleanup costs at the site.

  On two separate occasions, EPA has proposed a settlement of costs and
liabilities associated with the first two phases (with two more phases
anticipated) of cleanup work at the site.  On each occasion, the Company
declined to participate in the proposed settlement because it believes that its
waste material was either exempt or not hazardous as such term is defined in
applicable laws. Thereafter, the entire cost of the first two phases of work
were paid for by a group of PRPs (the "settling PRPs").  The settling PRPs, in
turn gave the Company notice that they intended to file a contribution action
against the Company to recover the portion of the remediation costs allegedly
attributable to the Company.  In September 1993, the Company resolved the first
two phases of work with the settling PRPs without waiving its defenses by paying
$70,000 in exchange for a release from all contribution or related claims the
settling PRPs may have against McFarland and Seaboard regarding the first two
phases of work.  Not included in this settlement with the settling PRPs are
costs associated with additional phases of work or remedial efforts, certain
resource damage claims or environmental tort claims.  Also, the settlement does
not directly protect the Company from actions from the EPA for the matters
settled.

  In 1995 the Company received a settlement offer from the EPA proposing
settlement of the first three "operating units" at OII for the amount of
$1,700,000.  Consistent with its responses to past settlement proposals, the
Company rejected the proposed settlement based on its defenses to liability
associated with the OII site.  Furthermore, litigation was initiated by PRP
waste haulers, which had previously settled with the EPA, seeking contribution
and indemnification from other PRPs, including the Company, on the grounds, in
part, that the defendant PRPs had directed that the waste haulers deposit the
waste at OII.  The Company denies any liability and has filed a counterclaim
against the plaintiff waste haulers.  While there can be no assurance that the
Company will be able to settle any claims associated with either of these
matters, management believes that any settlement or other resolution, will not
have a material adverse impact on its financial condition.  The Company has
placed its insurance companies on notice of these potential claims, however, the
insurance companies dispute coverage and there is no assurance that any claims
will ultimately be approved by the insurance companies.

  (b) The Company has engaged outside counsel on a contingency fee basis to
prosecute the Company's interest as a co-plaintiff in the case of Friemark-Blair
& Co., et al., v. NIPSCO Energy Services, Inc., et al, Cause No. 95-36553 in the
129th Judicial District Court of Harris County, Texas. The case is pending in
Houston, Texas, and is in the very early stages of discovery. This matter
pertains to the Company's investment in Triumph Natural Gas, Inc. The lawsuit
alleges, in part, that certain conduct of the defendants resulted in diminishing
the value

                                       11
<PAGE>
 
Item 3.   Legal Proceedings (continued)
---------------------------            

of Triumph Natural Gas, Inc.  The plaintiffs seek to recover actual damages in
the range of twenty to thirty million dollars.  The defendant has filed a
counterclaim seeking unspecified damages against the non-corporate plaintiffs
and is attempting to bring into the counterclaim a member of the Board of
Directors of the Company for his alleged role in damaging the defendants in his
prior capacity as a Director of Triumph Natural Gas, Inc.  The counterclaim
seeks damages for the defendant's inability to consummate a transaction for the
sale of its shares in Triumph Natural Gas, Inc., due to the actions of those
non-corporate plaintiffs who sat on the Board of Directors of Triumph Natural
Gas, Inc.  The Company is vigorously prosecuting the lawsuit and believes the
counterclaim to be without merit.  The financial impact of the counterclaim the
defendant has filed cannot presently be ascertained, but it is the opinion of
management that it is more likely than not that it will not have a material
effect on the Company's financial condition.

                                       12
<PAGE>
 
Item 4.   Submission of Matters to a Vote of Security Holders
-------------------------------------------------------------

 None.

                                       13
<PAGE>
 
                     Executive Officers of the Registrant
                     ------------------------------------
<TABLE>
<CAPTION>
 
     Name                      Age          Office Held
     ----                      ---          -----------
<S>                            <C>          <C>
John C. McFarland              49           Chairman of the Board and Chief
                                            Executive Officer
                                           
Ronald T Yoshihara             41           Vice President-Treasurer and Chief
                                            Financial Officer
                                           
Robert E. Ransom               44           Vice President-Corporate Development
 
</TABLE>

     For the past five years, the principal occupations of the Company's
executive officers were as follows:

     Mr. John C. McFarland joined the Company as Treasurer in February 1977. He
was appointed Vice President and Secretary in January 1979 and was elected
President and Chief Operating Officer in January 1982. He became a director in
March 1982 and Chief Executive Officer upon the retirement of L.C. McFarland in
March 1986. In January 1992, Mr. L.C. McFarland resigned as Chairman of the
Board and John McFarland was elected to that position.

     Mr. Yoshihara was elected Vice President in June 1987. He joined McFarland
Energy, Inc. in 1984 as Controller. In March 1992, Mr. Yoshihara was named
Treasurer and Chief Financial Officer of the Company.

     Mr. Ransom was elected Vice President in May 1986. He became Treasurer in
March 1982, having previously served the Company as Controller since July 1980.
In March 1992, Mr. Ransom was named to the newly created position of Vice
President-Corporate Development.

                                       14
<PAGE>
 
                                    PART II
                                    -------

Item 5.   Market for the Registrant's Common Equity and Related Stockholder
---------------------------------------------------------------------------
Matters
-------

     The Company's common stock is traded on the NASDAQ National Market System
("MCFE"). During 1995 and 1994, the quarterly high and low closing prices were
as follows:
<TABLE>
<CAPTION>
 
                                     1995                      1994
                                     ----                      ----
                               High        Low           High        Low
<S>                            <C>         <C>           <C>         <C>
                                                
   First Quarter               8           5-7/8         5-5/8       4-1/4
   Second Quarter              8           6-1/4         5-3/8       4
   Third Quarter               7-1/2       6-3/4         8           4
   Fourth Quarter              8-1/4       6-1/4         8-3/4       5-1/2
</TABLE>

     As of March 4, 1996, there were approximately 1,900 holders of record of
McFarland Energy, Inc. common stock.

     The Company has never paid cash dividends on its common stock and does not
intend to pay cash dividends on its common stock in the foreseeable future. The
terms of the Company's present credit agreement restrict the payment of cash
dividends when there exists outstanding borrowing under the facility (See Note 4
of Notes to Consolidated Financial Statements). In addition, the convertible
note restricts the payment of cash dividends when there exists any unpaid
accrued interest on the convertible note (See Note 6 of Notes to Consolidated
Financial Statements).

                                       15
<PAGE>
 
Item 6.   Selected Financial Data
---------------------------------

<TABLE>
<CAPTION>
                                 1995     1994     1993(1)   1992     1991
                                 ----     ----     ----      ----     ----
                                   (In thousands except per share data)
Operations                                                 
----------                                                 
    (Year ended December 31)                                
<S>                              <C>      <C>      <C>       <C>      <C>
                                                           
Net operating revenue            $19,883  $16,270  $12,862   $15,283  $15,584
                                                             
Income (loss) from continuing                                
 operations before accounting                                 
 change                          $13,641  $ 1,508  $(1,566)  $   925  $(7,987)
                                                             
    Per Share-Primary            $  2.61  $  0.29  $ (0.30)  $  0.18  $ (1.54)
    Per Share-Fully Diluted      $  2.41  $  0.29  $ (0.30)  $  0.18  $ (1.54)
                                                             
Net income (loss)                $13,641  $ 1,508  $(1,116)  $   925  $(7,987)
                                                             
    Per Share-Primary            $  2.61  $  0.29  $ (0.21)  $  0.18  $ (1.54)
    Per Share-Fully Diluted      $  2.41  $  0.29  $ (0.21)  $  0.18  $ (1.54)
                                                             
Financial Position                                           
------------------                                           
    (As of December 31)                                      
                                                             
Working capital                  $ 4,793  $ 2,792  $ 2,902   $ 3,678  $ 1,176
                                                             
Total assets                     $47,693  $43,545  $23,016   $25,117  $25,343
                                                             
Convertible notes (2)            $ 2,600  $ 2,600  $ 2,600   $ 2,592  $ 2,592
                                                             
Production payment notes         $ 3,139  $ 3,481  $   ---   $   ---  $   ---
                                                             
Long-term debt                   $   ---  $12,650  $   ---   $   ---  $   ---
 
</TABLE>

(1)  Net loss reflects the $450,000 ($0.09 per share) benefit of the cumulative
effect of the change in accounting for income taxes.  See Note 1 of Notes to
Consolidated Financial Statements.

(2)  In January 1996, the Company elected to convert the convertible note into
400,000 shares of McFarland Energy, Inc. common stock. See Note 13 of Notes to
Consolidated Financial Statements.

                                       16
<PAGE>
 
Item 7.   Management's Discussion and Analysis of Financial Condition and
-------------------------------------------------------------------------
Results of Operations
---------------------

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

Liquidity
---------

     Net cash provided by operating activities, excluding the change in current
assets and liabilities, totalled $26,717,000 in 1995 as compared to $5,217,000
in 1994. This four-fold increase reflected the Company's litigation settlement
in the first quarter of 1995 and its substantially improved operating
fundamentals. In 1995, the Company produced record levels of crude oil and
natural gas and reduced its companywide per unit lifting cost to its lowest
level in the past fifteen years. These improved fundamentals resulted in 1995
cash flow from recurring operations increasing 65% from a year ago to
approximately $9,700,000.

     In the first quarter of 1995, the Company settled its lawsuit with Chevron
U.S.A., Inc. for the sum of $25,673,000. The Company's net share after deducting
for attorney fees and estimated taxes was $17,158,000. The Company immediately
used the proceeds to pay off all of its outstanding bank debt and invested the
remainder of the funds in A1 or P1 rated commercial paper.

     In 1995, crude oil production rose 24% to 1,206,000 barrels, a new Company
record. Higher crude production in 1995 reflected the positive results from the
Company's ongoing development drilling and steaming activities in the Midway
Sunset field, California. In 1995, the Company drilled a total of twenty-one
(21) wells and recompleted five (5) wells at its two core properties in this
field. Higher production from these two properties accounted for substantially
all of the increase in companywide oil production. For 1996, the Company has a
similar development drilling program budgeted, consisting of another twenty-one
(21) development wells being drilled beginning in mid-March 1996. The Company
expects the 1996 development drilling program to increase gross oil production
by 400-500 barrels per day, and with the acquisition discussed below, should
result in record crude production in 1996.

     In January 1996, the Company closed the acquisition of both operated and
non-operated working interests in nineteen (19) producing oil wells located in
Santa Barbara County, California for $3,400,000 cash. These properties produce
high gravity crude and are long-lived reserves with future development
potential. Net production from these properties is currently 250 barrels per
day.

     Natural gas production increased 50% in 1995 to a Company record 2,181,000
mcf. Higher natural gas production reflected increased production from the
Company's Oak Hill field properties in East Texas and its Northern San Joaquin
Valley gas wells in California. In 1995, these properties accounted for 68% of
companywide natural gas production. The increase in production at the Oak Hill
field reflected the drilling of four (4) new development wells which were on
production by mid-year 1995. In the Northern San Joaquin Valley, only one of six
wells drilled in 1995 was a discovery well and that well is presently awaiting
hook-up. In addition, due to the extremely low California gas prices, production
from two other wells was curtailed by more than 50% throughout 1995 and remain
curtailed in 1996, indefinitely. For 1996, the Company is committed to drilling
up to six (6) exploratory wells in the Northern San Joaquin Valley and,

                                       17
<PAGE>
 
Item 7.   Management's Discussion and Analysis of Financial Condition and
-------------------------------------------------------------------------
Results of Operations (continued)
---------------------


presently, has no immediate plans for further development drilling at its Oak
Hill field properties.

     Crude oil prices were relatively strong in 1995. The companywide average
price in 1995 was $13.96 per barrel, which was 12% higher than the price
received in 1994. California heavy crude prices were especially strong
throughout the year, and, more importantly, the "basis" differential between
California heavy crude and West Texas Intermediate crude narrowed significantly.
Previously, this differential had ranged between $7.00 to $9.00 per barrel since
the mid 1980's. In 1995 and continuing into 1996, the differential has ranged
between $3.00 to $5.00 per barrel. This marked change in pricing appears to be
the result of fundamental economic and political factors. On the West Coast,
demand for crude oil has been rising at the same time that production of crude
in both California and Alaska has been declining. In addition, in November 1995,
President Clinton signed legislation that repealed the ban on the export of
Alaskan North Slope crude. Previously, most of this oil was delivered into the
California crude markets, thereby suppressing prices. The repeal of the ban and
the improved California crude oil market fundamentals appear to represent
permanent changes that could have long-term positive effects on the Company's
future operating results and cash flows.

     Since 1992, the Company has maintained a crude oil hedging arrangement with
a local refiner, whereby a price range based on California Midway Sunset field
posted prices is established. When the monthly weighted average Midway Sunset
field posted price is above the top of this range, the Company pays the refiner
the difference up to a maximum dollar amount per barrel. When the Midway Sunset
field posted price is below the bottom of the range, then the refiner pays the
Company the difference up to a maximum dollar amount per barrel. Currently, the
established price range is $11.50 per barrel to $13.25 per barrel and the
quantity of barrels affected is 2,000 barrels per day. The maximum dollar amount
paid by either party is $3.00 per barrel. Therefore, under the current
agreement, when the monthly weighted average Midway Sunset field posted price is
above $13.25, the Company pays the refiner the difference between the monthly
average and $13.25 up to a maximum of $3.00 per barrel, or $6,000 per day. When
the average price is below $11.50 per barrel, then the refiner pays the Company
the difference up to a maximum of $3.00 per barrel, or $6,000 per day. In 1995,
the Company paid the refiner $482,000 as a result of the hedging arrangement. At
the current Midway Sunset field posted price of $17.25 per day, the Company
would have to pay the refiner the maximum amount of $6,000 per day. The
agreement runs through October 1996. While there can be no guarantees that the
Company will be able to extend the hedge at its expiration, it has every
intention of doing so, and at price levels which it deems acceptable given the
new California market conditions.

     Natural gas prices were at relatively low levels throughout most of 1995.
However, in December 1995, prices rose sharply as a result of extremely cold
domestic weather conditions, particularly in the East. During the months of
December and January 1996, the surge in demand in certain parts of the country
created record setting price differentials between the various natural gas
delivery points. While natural gas prices in the East, Midwest and parts of the
Gulf Coast regions currently remain at higher levels, prices in California
remain low. Throughout 1995, the Company's average price for its gas production
in the Northern San Joaquin Valley was below

                                       18
<PAGE>
 
Item 7.   Management's Discussion and Analysis of Financial Condition and
-------------------------------------------------------------------------
Results of Operations
---------------------
(continued)

$1.00 per mcf, and, in 1996, prices are not much higher.  The weak California
gas market is primarily the result of an abundance of inexpensive natural gas
being delivered into the state through the various interstate natural gas
pipelines.  Imports of  natural gas from Canada, in particular, have increased
significantly over the past year.  At this time, it is uncertain how long this
market condition will persist.  At these low price levels, the economics of the
Company's Northern San Joaquin Valley exploration program are significantly
impacted.

     In January 1996, the Company elected to convert its $2,600,000 8%
convertible note, which was held by a large public company, into 400,000 shares
of McFarland Energy, Inc. common stock. The conversion of the note will save the
Company $208,000 of interest expense annually.

     The Company presently maintains an unsecured $10,000,000 revolving line of
credit facility which expires on March 31, 1996. The credit facility is to be
used for producing property acquisitions. The Company plans to renew the
facility at its expiration. The Company believes that it has substantially
greater borrowing capacity, should the need arise, in order to make a
significant producing property acquisition.

Capital Resources
-----------------

     Net working capital at December 31, 1995 totalled $4,793,000, up 72% from
the prior year. This sharp increase in year end net working capital reflected
the Company's strong operating performance in 1995 combined with the net cash
proceeds resulting from the settlement of the Chevron lawsuit in the first
quarter of the year.

     In 1995, capital expenditures totalled $13,200,000, consisting of property
acquisitions of $5,400,000, exploration activities of $1,500,000 and development
activities of $6,300,000. Capital expenditures in 1995 were below the
$22,500,000 spent in 1994. In 1994, the Company was successful in consummating
the Star Fee and Oak Hill field property acquisitions, which totalled
$17,600,000.

     The largest property acquisition in 1995 was the $3,400,000 acquisition of
oil producing properties in Santa Barbara County, California at the end of the
year. The Company also made several smaller working interest acquisitions during
the year which totalled $2,000,000. While the Company does not budget amounts
for future producing property acquisitions, it remains committed to its pursuit
of acquiring high quality assets which meet its economic and operational
criteria.

     In 1995, exploration related activities totalled $1,500,000, which was
comparable to the $1,700,000 spent in the prior year. The primary focus of the
Company's exploration activities in 1995 was in the California Northern San
Joaquin Valley. In 1995, the Company participated in the drilling of six (6)
wells, five (5) of which were dry holes. The Company is committed to participate
in the drilling of six (6) additional wells in this area in 1996. The results of
these upcoming wells, along with the outlook for the California natural gas
market will help determine the level of the Company's long-term commitment to
this exploration program. For 1996, the

                                       19
<PAGE>
 
Item 7.   Management's Discussion and Analysis of Financial Condition and
-------------------------------------------------------------------------
Results of Operations
---------------------
(continued)

Company has budgeted approximately $2,000,000 for exploration activities, all
within California.

     Development activities in 1995 totalled $6,300,000 and consisted primarily
of development drilling in the Midway Sunset field of California and in the Oak
Hill field of East Texas. In 1995, the Company drilled twenty-one (21)
development wells and recompleted five (5) wells in the Midway Sunset field at a
cost of $2,400,000. Four development wells were drilled during the year in the
Oak Hill field at a cost of $2,400,000. The remainder of the amounts spent in
1995 were related to surface facility and maintenance type capital projects. In
1996, the Company plans to drill a total of twenty-one (21) development wells in
the Midway Sunset field at a cost of approximately $2,100,000.

     For 1996, the Company's total capital budget is $5,100,000, which will be
funded with its existing cash balances and internally generated cash flow.
Presently, the Company has a $10,000,000 unused line of credit facility and is
highly confident that it could increase the amount significantly, if it desired.
In addition, the Company believes that it could obtain financing from other
financial institutions or access the equity markets if funds were needed to
consummate a significant producing property acquisition.

Impact of Inflation
-------------------

     The impact of inflation on the Company's capital costs and operations has
not been significant in recent years due to the relatively low rates of
inflation experienced in the United States.

New Accounting Standards
------------------------

     In October 1995, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards ("SFAS") No. 123, "Accounting for Stock-Based
Compensation." SFAS No. 123 requires companies to adopt its provisions for
fiscal years beginning after December 15, 1995. SFAS No. 123 encourages a fair
value-based method of accounting for an employee stock option or similar equity
instrument, but allows continued use of the intrinsic value-based method of
accounting prescribed by Accounting Principles Board ("APB") No. 25,
"Accounting for Stock Issued to Employees." Companies electing to continue to
use APB No. 25 must make pro forma disclosures of net income and earnings per
share as if the fair value-based method of accounting had been applied. The
Company is evaluating the provisions of SFAS No. 123, but has not yet determined
whether it will continue to follow the provisions of APB No. 25 or change to the
fair value-based method of SFAS No. 123.

Results of Operations 1995 vs. 1994
-----------------------------------

     Oil and gas sales increased 25% in 1995 to $19,204,000. This increase was
due to the combination of record setting crude oil and natural gas production
and higher crude oil prices.

     Crude oil production rose 24% in 1995 to 1,206,000 barrels, as compared to
969,000 barrels in the prior year. This significant increase was primarily
attributable to the Company's successful

                                       20
<PAGE>
 
Item 7.   Management's Discussion and Analysis of Financial Condition and
-------------------------------------------------------------------------
Results of Operations
---------------------
(continued)

development drilling program at its two core properties in the Midway Sunset
field. Production from the McDonald property increased 17% in 1995 to more than
1,500 gross barrels per day, while at the Star Fee property, production rose 15%
to 1,400 gross barrels per day.

     Natural gas production increased 50% in 1995 to 2,181,000 mcf, reflecting
higher production from the Oak Hill field properties and from the gas wells in
the Northern San Joaquin Valley.

     Crude oil prices, excluding the effects of the Company's hedge program,
averaged $13.96 per barrel in 1995 as compared to $12.51 per barrel received in
1994. In 1995, the hedge program reduced revenues by $482,000, or $0.40 per
barrel. In 1994, the hedge program increased revenues by $446,000, or $0.46 per
barrel. Natural gas prices averaged $1.24 per mcf in 1995 compared to $1.71 per
mcf received in 1994.

     In 1995, crude oil and gas production costs increased to $7,274,000, up 12%
from 1994. On a barrel of equivalent ("BOE") basis, the average lifting cost in
1995 was $4.63 per BOE compared to $5.35 per BOE in 1994, or a 13% decline. This
decrease in the BOE lifting costs reflects higher oil and gas production volumes
and increased operating efficiencies.

     Exploration, dry holes and abandonment costs of $1,595,000 in 1995
represent five (5) dry holes drilled in the Sacramento and Northern San Joaquin
Valleys, leasehold write-offs and property abandonment costs.

     Depletion and depreciation expense increased 11% in 1995 to $4,374,000,
primarily as a result of the incremental depletion related to the Star Fee and
Oak Hill properties.

     Litigation settlement reflects the net proceeds received from the
settlement of the Company's lawsuit with Chevron U.S.A., Inc. in January 1995.
See Note 3 of Notes to Consolidated Financial Statements.

     In the first quarter of 1995, the Company adopted the Statement of
Financial Accounting Standards No. 121, "Accounting for the Impairment of Long-
Lived Assets and for Long-Lived Assets to be Disposed of," which requires that
long-lived assets be reviewed for impairment on a property by property basis. As
a result, the Company recorded an impairment loss of $4,765,000 on certain oil
and gas properties and a write-down of $750,000 on its investment in a natural
gas marketing and gas gathering company. In the fourth quarter of 1995, the
Company recorded an additional impairment on certain gas properties totalling
$1,520,000 and also wrote-off its investment in its natural gas storage project
at Ten Section totalling $882,000. See Note 1 of Notes to Consolidated Financial
Statements.

     General and administrative expense in 1995 was down slightly from the prior
year. Interest expense for 1995 decreased 35% to $548,000 as a result of the
lower outstanding borrowing during the year. In the first quarter of 1995, the
Company paid-off all of its outstanding bank borrowing. Other expense of
$440,000 consisted of the write-down of tubular inventories and an accrual for
estimated future environmental costs.

                                       21
<PAGE>
 
Item 7.   Management's Discussion and Analysis of Financial Condition and
-------------------------------------------------------------------------
Results of Operations
---------------------
(continued)

Results of Operations 1994 vs. 1993
-----------------------------------

     Revenues increased 26% in 1994 to $16,270,000. This increase reflected
higher 1994 oil and gas sales and a significant gain on the sale of a non-
operated interest in a California oil and gas producing property. Higher oil and
gas sales in 1994 were due primarily to a 22% increase in crude oil production
and a 46% increase in natural gas production.

     Crude oil production in 1994 rose 22% to 969,000 barrels. This sharp
increase in oil production reflected the acquisition of the Star Fee property in
April 1994 which accounted for 220,000 net barrels. Natural gas production
increased 46% in 1994 to 1,456,000 mcf. The acquisition of the Oak Hill Field,
Rusk County, Texas working interests in June 1994 and sales from the new gas
wells put on production in the second half of 1994 in the Northern San Joaquin
Valley of California were principally responsible for the increase in gas
production.

     In 1994, the Company received an average crude price, excluding hedging
effects, of $12.51 per barrel. This compares with the $12.70 per barrel received
on average in 1993. In 1994, the Company's hedge program added $0.46 per barrel
to the crude price and increased revenues by $446,000. In 1993, the Company's
hedging activities added $0.59 per barrel to the crude price and increased
revenues by $467,000. Including the effects of the hedge, the effective crude
price realized by the Company in 1994 and 1993 was $12.97 per barrel and $13.29
per barrel, respectively.

     Natural gas prices in 1994 averaged $1.71 per mcf, or an 18% decline from
the $2.08 per mcf received in 1993. Natural gas prices were especially weak in
the second half of 1994, reflecting mild weather conditions and excess domestic
supply.
 
     In 1994, the Company sold its interest in a Los Angeles Basin, California
oil and gas producing property to a third party. This sale was part of an 
out-of-court settlement reached with one of the defendants in the Company's
lawsuit entitled McFarland Energy, Inc. v. Chevron U.S.A. Inc., et al. The
                 ----------------------------------------------------- 
settlement agreement included the sale of the Company's interest in the property
for $905,000. The Company recognized a gain on the sale in 1994 of $773,000.

     Crude oil and gas production costs declined 3% in 1994 to $6,482,000. On a
barrel of oil equivalent ("BOE") basis, lifting costs declined 23% to $5.35 per
barrel from $6.98 per barrel in 1993. This significant reduction in BOE lifting
costs reflected overall higher oil and gas production volumes combined with the
positive effects resulting from the sale of higher cost marginal properties at
the end of 1993.

     Exploration costs were 42% lower in 1994 at $705,000. Lower exploration
expenses in 1994 were primarily the result of a higher success rate on wells
drilled and lower leasehold impairments.

                                       22
<PAGE>
 
Item 7.   Management's Discussion and Analysis of Financial Condition and
-------------------------------------------------------------------------
Results of Operations (continued) 
---------------------


     Depletion expense increased 16% in 1994 to $3,927,000. This significant
increase in depletion expense was principally attributable to the addition of
the Star Fee and Oak Hill field properties in 1994. These two acquisitions added
$19,405,000 to the Company's depletable costs.

     General and administrative expenses in 1994 declined 7% reflecting lower
legal fees paid. Interest expense rose 203% reflecting increased outstanding
long-term debt in 1994. In 1994, the Company borrowed a total of $13,400,000 in
conjunction with two significant producing property acquisitions and issued a
total of $3,624,000 of interest bearing production notes in conjunction with one
of the transactions. Other expenses in 1994 totalled $492,000 and consisted of
employee severance pay and various legal settlements.

                                       23
<PAGE>
 
Item 8.   Financial Statements and Supplementary Data
-----------------------------------------------------

                                       24
<PAGE>

[LETTERHEAD OF COOPERS & LYBRAND]



To the Board of Directors and Stockholders
  of McFarland Energy, Inc.


We have audited the consolidated financial statements of McFarland Energy, Inc.
and subsidiary listed in the index on page 52 of this Form 10-K. These financial
statements are the responsibility of the Company's management. Our 
responsibility is to express an opinion on these financial statements based on 
our audits.

We conducted our audits in accordance with generally accepted auditing 
standards. Those standards require that we plan and perform the audit to obtain 
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting 
the amounts and disclosures in the financial statements. An audit also includes 
assessing the accounting principles used and significant estimates made by 
management, as well as evaluating the overall financial statement presentation. 
We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in 
all material respects, the consolidated financial position of McFarland Energy, 
Inc. and subsidiary as of December 31, 1995 and 1994, and the consolidated 
results of their operations and their cash flows for each of the three years in 
the period ended December 31, 1995 in conformity with generally accepted 
accounting principles.

As discussed in Note 1 to the consolidated financial statements, the Company  
changed its methods of accounting for the amortization of oil and gas properties
in 1994 and accounting for income taxes in 1993.


                                         /s/ COOPERS & LYBRAND L.L.P.

Newport Beach, California
March 8, 1996


                                       25
<PAGE>
 
                             McFARLAND ENERGY, INC.
                          CONSOLIDATED BALANCE SHEETS
<TABLE> 
<CAPTION> 
                           ASSETS                                               LIABILITIES AND STOCKHOLDERS' EQUITY
                           ------                                               ------------------------------------
                                            December 31,                                                     December 31,
                                       ---------------------                                            --------------------- 
                                        1995           1994                                              1995           1994
                                        ----           ----                                              ----           ----
<S>                                     <C>            <C>          <C>                                  <C>            <C>
Current Assets:                                                     Current Liabilities:                             
  Cash and cash equivalents             $ 6,974,000    $ 1,864,000     Accounts payable                  $ 2,170,000    $ 2,359,000
  Accounts receivable                     3,797,000      5,669,000     Royalties and revenue payable       1,345,000      1,657,000
  Tax refunds receivable                    229,000         29,000     Cost advances from joint                       
  Crude oil inventory                       259,000        280,000      venture partners                       9,000        273,000
  Materials and supplies inventory          131,000        290,000     Other taxes payable                   283,000        274,000
  Prepaid expenses and                                                                                               
   other current assets                     610,000        638,000     Other accrued liabilities           4,988,000        665,000
  Deferred tax assets                     1,588,000            ---     Current portion of long-term debt         ---        750,000
                                        -----------    -----------                                       -----------    ----------- 

Total current assets                     13,588,000      8,770,000     Total current liabilities           8,795,000      5,978,000
                                        -----------    -----------                                       -----------    ----------- 


                                                                    Convertible Notes                      2,600,000      2,600,000
                                                                                                         -----------    ----------- 

Property and Equipment:
  Oil and gas properties                 85,688,000     81,516,000  Production Payment Notes               3,139,000      3,481,000
  Other equipment                         3,411,000      3,313,000
                                        -----------    -----------  
                                         89,099,000     84,829,000  Long-term Debt                               ---     12,650,000
                                                                                                         -----------    ----------- 

  Less accumulated depletion
     and depreciation                    55,266,000     51,090,000  Deferred Income Taxes                    764,000        205,000
                                        -----------    -----------                                       -----------    ----------- 

 
                                         33,833,000     33,739,000  Stockholders' Equity:
                                        -----------    -----------  
                                                                    Common stock, $1.00 par value
Other Assets                                272,000      1,036,000    Authorized - 10,000,000 shares
                                        -----------    -----------    
                                                                      Issued and outstanding 5,239,234
                                                                      and 5,212,234 in 1995 and 1994       5,239,000      5,212,000
                                                                    Additional paid-in capital            18,932,000     18,836,000
                                                                    Retained Earnings (Deficit)            8,224,000     (5,417,000)

                                                                                                         -----------    -----------
                                                                                                          32,395,000     18,631,000
                                                                                                         -----------    -----------
                                        $47,693,000    $43,545,000                                       $47,693,000    $43,545,000
                                        ===========    ===========                                       ===========    ===========
</TABLE>
   The accompanying notes are an integral part of the financial statements.

                                       26
<PAGE>
 
                            McFARLAND ENERGY, INC.
                     CONSOLIDATED STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
 
                                                Year Ended December 31,
                                        ----------------------------------------
                                        1995           1994         1993
                                        ----           ----         ----
<S>                                     <C>            <C>          <C>
Revenues:
 Oil and gas sales                      $ 19,204,000   $15,310,000  $12,695,000
 Interest and other                          551,000       171,000      246,000
 Gain (loss) on sale of assets               128,000       789,000      (79,000)
                                          ----------    ----------   ----------
                                          19,883,000    16,270,000   12,862,000
                                          ----------    ----------   ----------
Costs and expenses:
 Crude oil and gas production              7,274,000     6,482,000    6,713,000
 Exploration, dry holes and
  abandonments                             1,595,000       705,000    1,214,000
 Depletion and depreciation                4,374,000     3,927,000    3,391,000
 General and administrative                2,294,000     2,314,000    2,488,000
 Litigation settlement                   (17,158,000)          ---          ---
 Property impairments                      7,917,000           ---          ---
 Interest                                    548,000       840,000      277,000
 Other                                       440,000       492,000      331,000
                                          ----------    ----------   ----------
                                           7,284,000    14,760,000   14,414,000
                                          ----------    ----------   ----------
 
Income (loss) before income taxes         12,599,000     1,510,000   (1,552,000)
                                          ----------    ----------   ----------
 
Income taxes (benefit):
 Current                                      27,000         2,000       14,000
 Deferred                                 (1,069,000)          ---          ---
                                          ----------    ----------   ----------
                                          (1,042,000)        2,000       14,000
                                          ----------    ----------   ----------
Income (loss) from continuing operations
 before cumulative effect of change in
 accounting principle                     13,641,000     1,508,000   (1,566,000)
 
Cumulative effect on prior years of
 change in accounting for income taxes           ---           ---      450,000
                                          ----------    ----------   ----------
 
Net income (loss)                       $ 13,641,000   $ 1,508,000  $(1,116,000)
                                          ==========    ==========   ========== 
Per common share:
-----------------
 
Primary:
 Income (loss) per share before cumulative
  effect of change in accounting principle     $2.61         $0.29       $(0.30)
                                                ====          ====        =====
 Net income (loss)                             $2.61         $0.29       $(0.21)
                                                ====          ====        =====
                                                                   
Fully Diluted:                                                     
 Income (loss) per share before cumulative                         
  effect of change in accounting principle     $2.41         $0.29       $(0.30)
                                                ====          ====        =====
 Net income (loss)                             $2.41         $0.29       $(0.21)
                                                ====          ====        =====
 
</TABLE>

   The accompanying notes are an integral part of the financial statements.

                                       27
<PAGE>
 
                            McFARLAND ENERGY, INC.
          CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY

<TABLE>
<CAPTION>
 
                                                                  
                                      Common Stock                     Additional              Retained              Total     
                                 ----------------------                 Paid-in                Earnings/          Stockholders' 
                                 Shares          Amount                 Capital                (Deficit)             Equity
                                 ------          ------                 -------                ---------             ------
<S>                              <C>             <C>                    <C>                    <C>                   <C>
Balances,
  January 1, 1993                5,199,359       $5,199,000             $18,796,000            $(5,809,000)          $18,186,000
                                                                                                            
Net loss for year                      ---              ---                     ---             (1,116,000)           (1,116,000)
                                 ---------       ----------             -----------            -----------           -----------

Balances,                                                                                                   
  December 31, 1993              5,199,359        5,199,000              18,796,000             (6,925,000)          $17,070,000
                                                                                                            
Stock option exercises              12,875           13,000                  40,000                    ---                53,000
                                                                                                            
Net income for year                    ---              ---                     ---              1,508,000             1,508,000
                                 ---------       ----------             -----------            -----------           -----------
                                                                                                            
Balances,                                                                                                   
  December 31, 1994              5,212,234        5,212,000              18,836,000             (5,417,000)           18,631,000
                                                                                                            
Stock option exercises              27,000           27,000                  96,000                    ---               123,000
                                                                                                            
Net income for year                    ---              ---                     ---             13,641,000            13,641,000
                                 ---------       ----------             -----------            -----------           -----------
                                                                                                            
Balances,                                                                                                   
  December 31, 1995              5,239,234       $5,239,000             $18,932,000            $ 8,224,000           $32,395,000
                                 =========       ==========             ===========            ===========           ===========
</TABLE>

   The accompanying notes are an integral part of the financial statements.

                                       28
<PAGE>
 
                            McFARLAND ENERGY, INC.
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
                                                                               Year Ended December 31,
                                                                 1995                   1994                   1993
                                                                 ----                   ----                   ----
<S>                                                              <C>                    <C>                    <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
 Net income (loss)                                               $13,641,000            $ 1,508,000            $(1,116,000)
 Adjustments to reconcile net income (loss) to
 net cash provided by operating activities:
   Cumulative effect of accounting change                                ---                    ---               (450,000)
   Depletion and depreciation                                      4,374,000              3,927,000              3,391,000
   Dry holes, abandonments and impairments                         9,471,000                571,000              1,020,000
   Deferred income taxes                                          (1,069,000)                   ---                    ---
   (Gain) loss from sale of assets                                  (128,000)              (789,000)                79,000
   Other                                                             428,000                    ---                236,000
   Change in assets and liabilities:
     Decrease (increase) in:
        Receivables                                                1,872,000             (2,387,000)             1,990,000
        Tax refund receivable                                       (200,000)                   ---                    ---
        Inventory                                                      3,000                (69,000)               107,000
        Prepaids and other current assets                             27,000                (58,000)              (190,000)
     Increase (decrease) in:                                                                           
        Accounts payable                                            (438,000)               684,000                153,000
        Royalties and revenue payable                               (312,000)               664,000               (480,000)
        Cost advances from joint venture partners                   (264,000)               273,000               (126,000)
        Taxes payable                                                  9,000                 78,000                 19,000
        Other accrued expenses                                       (56,000)               391,000               (150,000)
                                                                 -----------            -----------            -----------
 
 NET CASH PROVIDED BY OPERATING ACTIVITIES                        27,358,000              4,793,000              4,483,000
                                                                 -----------            -----------            -----------
CASH FLOWS FROM (USED IN) INVESTING ACTIVITIES:
 Purchase of property and equipment (including dry holes)        (13,207,000)           (22,435,000)            (3,573,000)
 Amounts included in accrued liabilities                           4,379,000                    ---                    ---
 Proceeds from sales of property and equipment                       145,000                 10,000                 57,000
 Other                                                                55,000                  5,000               (152,000)
                                                                 -----------            -----------            -----------
 
 NET CASH USED IN INVESTING ACTIVITIES                            (8,628,000)           (22,420,000)            (3,668,000)
                                                                 -----------            -----------            -----------
CASH FLOWS  FROM (USED IN) FINANCING ACTIVITIES:
 Exercise of stock options                                           123,000                 53,000                    ---
 Issuance of production payment notes                                    ---              3,624,000                    --- 
 Proceeds from long-term borrowing                                       ---             13,400,000                    ---    
 Payments on debt                                                (13,743,000)              (143,000)                   ---  
 Other                                                                   ---                    ---                  8,000
                                                                 -----------            -----------            -----------
 
 NET CASH (USED IN) FROM FINANCING ACTIVITIES                    (13,620,000)            16,934,000                  8,000
                                                                 -----------            -----------            -----------
NET INCREASE (DECREASE) IN CASH AND CASH
   EQUIVALENTS                                                     5,110,000               (693,000)               823,000

 Cash and cash equivalents, beginning of the year                  1,864,000              2,557,000              1,734,000
                                                                 -----------            -----------            -----------

CASH AND CASH EQUIVALENTS, END OF THE YEAR                       $ 6,974,000            $ 1,864,000            $ 2,557,000
                                                                 ===========            ===========            ===========
</TABLE> 

   The accompanying notes are an integral part of the financial statements.

                                       29
<PAGE>
 
                             McFARLAND ENERGY, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


1.  Summary of Significant Accounting Policies

    This summary of significant accounting policies of McFarland Energy, Inc. is
presented to assist in understanding the Company's financial statements. These
accounting policies conform to generally accepted accounting principles and have
been consistently applied in the preparation of the financial statements.

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

    The consolidated financial statements include the accounts of McFarland
Energy, Inc. and its wholly-owned subsidiary, Carl Oil and Gas Co.
(collectively, the "Company"). All intercompany accounts and transactions have
been eliminated in consolidation.

Business Activity
-----------------

    The Company is engaged in the exploration for and the production of crude
oil and natural gas in the Continental United States.

Cash and Cash Equivalents
-------------------------

    The Company invests temporarily surplus cash in top rated commercial paper
and money market asset funds. These investments are carried at cost, which,
because of the proximity of maturity, approximate market value. The average
pretax yield at December 31, 1995 and 1994 was 5.6% and 3.3%, respectively. The
Company considers all highly liquid investments with a maturity of three months
or less when purchased to be cash equivalents. The total of short term
investments included as cash equivalents at December 31, 1995 and 1994 was
$6,200,000 and $1,026,000, respectively. Also included as cash equivalent at
December 31, 1995 and 1994 was cash held in an interest bearing escrow account
of $280,000 and $273,000, respectively. See Crude Oil Hedge Program.

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

    The Company accounts for its oil and gas operations using the successful
efforts method. Under the successful efforts method, costs of productive wells,
development dry holes and productive leases are capitalized and amortized on a
unit-of-production basis over the life of the related remaining proven reserves.
Cost centers for amortization purposes are determined on a property by property
basis. See Changes in Accounting Principles. The Company provides for future
abandonment and site restoration costs with respect to certain of its oil and
gas properties. The costs are accrued over the expected life of the properties
and are taken into account in determining depletion and depreciation expense.
Oil and gas leasehold costs are capitalized when incurred. Significant unproved
properties are assessed periodically and any impairments in value are charged to
expense.

                                       30
<PAGE>
 
                             McFARLAND ENERGY, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


Oil and Gas Properties (continued)
----------------------            

Exploratory costs including geological and geophysical costs, dry holes and
delay rentals are expensed as incurred.  Exploratory drilling costs are
initially capitalized, but charged to expense if and when a well is determined
to be unsuccessful.

    Proved properties are assessed periodically for impairments by comparing the
future net cash flows with the net book carrying amount of the asset. The
impairment loss on an oil and gas property is calculated as the difference
between the carrying amount of the asset and its fair value, giving
consideration to recent prices, pricing trends and discount rates. These
projections represent the Company's best estimate of fair value based on the
information available. Any impairment loss is recorded in the current period in
which the recognition criteria are first applied and met. See Changes in
Accounting Principles.

Other Equipment
---------------

    Depreciation of other equipment has been provided using the straight-line
method over estimated useful lives ranging from three to thirty years.

    Costs and accumulated depreciation of automobiles, trucks, and office
equipment are removed from their respective accounts when retired, and the
related gain or loss is recognized.

Inventories
-----------

    Crude oil inventories are stated at market and removed at the prevailing
market price, which is essentially the actual selling price. Inventory of
materials and supplies is stated at the lower of market or weighted average
cost.

Crude Oil Hedge Program
-----------------------

    In December 1992, the Company entered into a 1,000 barrel per day crude oil
hedging arrangement ("Hedge Agreement") with a local refiner which was based on
a minimum posted price of $12.50 per barrel and a maximum of $14.00 per barrel
of Midway Sunset field crude oil.

    In November 1993, the Hedge Agreement was extended through November 1994 and
expanded to 2,000 barrels per day. Under the revised terms, when the prevailing
posted price for Midway Sunset field crude was between $9.50-$11.49 per barrel,
the Company received an amount equal to the difference between $11.50 and the
prevailing price, times 2,000 barrels per day. When the prevailing Midway Sunset
field posted price was below $9.50 per barrel, the effect of the hedge was to
add $2.00-$2.50 per barrel to the actual crude price received by the Company on
2,000 barrels per day. Conversely, when the Midway Sunset field posted price was
between $13.10-$15.10, the Company paid to the refiner an amount equal to the
difference between the prevailing price and $13.10, up to a maximum of $2.00 per
barrel, times 2,000 barrels per day. At prices above $15.10, the maximum amount
paid to the refiner was $2.50 per

                                       31
<PAGE>
 
                             McFARLAND ENERGY, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


Crude Oil Hedge Program (Continued)
-----------------------            

barrel on 2,000 barrels per day.

    In October 1994, the Company extended the Hedge Agreement to November 1,
1996. The extended agreement continues to cover 2,000 barrels per day and is
only slightly modified with respect to some of the other terms of the previous
agreement. During the period of November 1994 through October 1995, the Company
received up to $2.75 per barrel when the Midway Sunset field monthly weighted
average posted price was below $11.25 per barrel and paid up to $2.75 per barrel
when the average price was above $13.00 per barrel. During the period of
November 1995 through October 1996, the Company receives up to $3.00 per barrel
when the average posted price is below $11.50 per barrel and pays up to $3.00
per barrel when the average price is above $13.25 per barrel.

    Any gain or loss resulting from the Hedge Agreement is recognized each month
and included in the results of operations. In 1995, the hedge program decreased
revenues by $482,000. In 1994 and 1993, the hedge program increased revenues by
$446,000 and $467,000, respectively. The Hedge Agreement requires that the
Company and the refiner maintain certain minimum levels of security. At December
31, 1995 and 1994, the Company had on deposit in an interest bearing escrow
account $280,000 and $273,000, respectively, to meet such requirements.

    The hedging arrangement exposes the Company to minimal counterparty credit
risk, since to the extent that the refiner is unable to meet a monthly
settlement obligation, the Company can call upon the security posted by the
refiner.

Environmental Expenditures
--------------------------

    Environmental expenditures relating to current operations are expensed or
capitalized, as appropriate, depending on whether such expenditures provide
future economic benefits. Liabilities are recognized when the expenditures are
considered probable and can be reasonably estimated. Measurement of liabilities
is based on currently enacted laws and regulations, existing technology and
undiscounted site-specific costs.

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

    The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.

Net Income (Loss) per Common Share
----------------------------------

    The computation of primary earnings per share is based on the weighted
average number of

                                       32
<PAGE>
 
                             McFARLAND ENERGY, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


Net Income (Loss) per Common Share (continued)
----------------------------------            

outstanding shares during each period.  Shares of common stock issuable under
stock options were excluded from the computation because they did not have a
material effect on primary earnings per share.  The computation of fully diluted
earnings per share for 1995 includes the conversion of the 8% convertible note
and the assumed exercise of the dilutive stock options. Net income used in the
computation of fully diluted earnings per share was adjusted for the interest
expense applicable to the convertible note. The assumed conversion of the
production payment notes was not included in the computation of fully diluted
earnings per share since the effect would be anti-dilutive. The weighted average
number of outstanding shares used in the calculations for primary and fully
diluted per share amounts for 1995 were 5,229,338 and 5,755,730, respectively.
The weighted average number of outstanding shares for 1994 and 1993 were
5,202,630 and 5,199,359, respectively. Net loss per share for 1993 reflects the
$450,000 ($0.09 per share) benefit of the cumulative effect of the change in
accounting for income taxes.

Changes in Accounting Principles
--------------------------------

    Accounting for Impairment of Long-Lived Assets - In March 1995, the
    ----------------------------------------------                     
Financial Accounting Standards Board issued Statement of Financial Accounting
Standards ("SFAS") No. 121, "Accounting for the Impairment of Long-Lived Assets
and for Long-Lived Assets to Be Disposed Of."  This statement requires that
long-lived assets be reviewed for impairment whenever events or changes in
circumstances indicate that the carrying amount of an asset may not be
recoverable. It establishes guidelines for determining recoverability based on
future net cash flows from the use of the asset and for the measurement of the
impairment loss.  Impairment loss under SFAS No. 121 is calculated as the
difference  between the carrying amount of the asset and its fair value. Any
impairment loss is recorded in the current period in which the recognition
criteria are first applied and met.

    Under the successful efforts method of accounting for oil and gas
operations, the Company periodically assessed its proved properties for
impairments by comparing the aggregate net book carrying amount of all proved
properties with their aggregate future net cash flows. At December 31, 1994, the
future cash flows of these proved properties was $65,000,000 as compared to the
net book carrying amount of $33,000,000. The new statement requires the
impairment review be performed on the lowest level of asset grouping for which
there are identifiable cash flows. In the case of the Company, this results in a
property by property impairment review. The Company adopted SFAS No. 121 in the
first quarter of 1995 and primarily as a result of significantly lower natural
gas prices, recorded an impairment loss on certain oil and gas properties
totalling $4,765,000. In addition, the Company wrote-off its investment in a
natural gas marketing and gas gathering company in the amount of $750,000.

    In the fourth quarter of 1995, the Company recorded an additional impairment
on certain gas properties totalling $1,520,000. In addition, the Company wrote-
off its previously deferred development costs totalling $882,000 related to its
Ten Section gas storage project. The Company determined that this asset had been
impaired based on the present market uncertainties negatively

                                       33
<PAGE>
 
                             McFARLAND ENERGY, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



Changes in Accounting Principles (continued)
---------------------------------           

impacting this project.

    Amortization of Oil and Gas Properties - Effective January 1, 1994, the
    --------------------------------------                             
Company changed its method of accounting for amortization of its oil and gas
properties. As a result of this change, the capitalized costs of the Company's
oil and gas properties which were previously amortized on a field-by-field basis
are now amortized on a property-by-property basis. The Company believes that
this change permits a more precise calculation of amortization and association
of a property's cost with related revenues. For the year ended December 31,
1994, the effect of the change increased net income by $95,000 or $0.02 per
share of common stock. The cumulative effect of this accounting change for years
prior to 1994 was not material.

    Accounting for Income Taxes - The Financial Accounting Standards Board
    ---------------------------                                           
issued SFAS No. 109, "Accounting for Income Taxes," which requires a change from
the deferred method to the asset and liability method of accounting for income
taxes.  Under the asset and liability method, deferred income taxes are
recognized for the tax consequences of "temporary differences" by applying
enacted statutory tax rates applicable to future years to differences between
the financial statement carrying amounts and the tax bases of existing assets
and liabilities.  Under SFAS No. 109, the effect on deferred taxes of a change
in tax rates is recognized in income in the period that includes the enactment
date.  Under the deferred method, deferred taxes were recognized using the tax
rate applicable to the year of the calculation and were not adjusted for
subsequent changes in tax rates. Valuation allowances are established, when
necessary, to reduce deferred tax assets to the amount expected to be realized.

    The Company adopted SFAS No. 109 in the first quarter of 1993 and reported
the cumulative effect of the change in the method of accounting for income taxes
as of the beginning of 1993 in the consolidated statement of operations. The
cumulative effect on prior years of this change in accounting principle
increased 1993 net income by $450,000, or $0.09 per share, and is reported
separately in the consolidated statement of operations for the year ended
December 31, 1993. The adoption of SFAS No. 109 did not have any effect on the
1993 net income from continuing operations before cumulative effect of change in
accounting principle. Prior years' financial statements have not been restated
to apply the provisions of SFAS No. 109.

    Accounting for Investments - On January 1, 1994, the Company adopted the
    --------------------------                                          
provisions of SFAS No. 115, "Accounting for Certain Investments in Debt and
Equity Securities." The adoption of SFAS No. 115 did not have any effect on the
1994 net income.

2.  Property Acquisitions

    Barham Ranch Property Acquisition - On December 7, 1995, the Company
    ---------------------------------                                   
announced it had reached a definitive agreement to acquire the operated and non-
operated working interests in nineteen (19) producing oil wells in Santa Barbara
County, California for $3,400,000 cash.

                                       34
<PAGE>
 
                             McFARLAND ENERGY, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


2.  Property Acquisitions (continued)

The transaction closed on January 31, 1996 and was funded from the Company's
existing cash balances.  The transaction was accounted for as a purchase as of
December 31, 1995, and accordingly, the purchase price was allocated to the
assets acquired on the basis of their fair values.

    Star Fee Property Acquisition - On April 22, 1994, the Company announced the
    -----------------------------                                 
closing of its acquisition of a significant oil producing property located in
the Midway Sunset field, Kern County, California. The property, known as the
Star Fee, is located one-eighth mile west of the Company's other principal
Midway Sunset field property and possesses several similar reservoir
characteristics. Final consideration consisted of approximately $7,300,000 cash,
issuance of $3,624,000 seven-year convertible production payment notes and
retention of a sliding scale royalty by the seller in exchange for 100% working
interest. At closing, the Company acquired approximately 91% of the ownership
interests and has since acquired substantially all of the remaining interests.
The Company borrowed $6,000,000 under the term loan facility provided by its
credit agreement. See Note 4 of Notes to Consolidated Financial Statements. The
Company's financial statements include the results of the Star Fee property from
the closing date. The acquisition was accounted for as a purchase, and
accordingly, the purchase price was allocated to the assets acquired on the
basis of their fair values.

    Oak Hill Field Property Acquisition - On September 26, 1994, the Company
    -----------------------------------
closed the acquisition of working interests in fifteen (15) operated and thirty-
three (33) non-operated natural gas producing properties located in the Oak Hill
field, Rusk County, Texas. Total consideration was $6,280,000 cash, of which the
Company borrowed $6,000,000 under its amended revolving line of credit facility.
Most of the reserves and value are concentrated in the operated properties in
which the working interests acquired range from 65% to 96%. The transaction was
accounted for as a purchase and reflected as of June 1, 1994, the effective
date. In accordance with the purchase method of accounting, the purchase price
was allocated to the assets acquired on the basis of their fair values.

    The following table presents unaudited proforma operating results as if the
acquisition of the Star Fee and Oak Hill field properties had occurred on
January 1, 1994 and 1993:

<TABLE>
<CAPTION>
                                Year Ended December 31,
                               -------------------------
                                  1994           1993   
                               -----------  ------------
<S>                            <C>          <C>
Revenues                       $17,268,000   $16,409,000
Net Income (Loss)               $1,354,000   ($1,171,000)
Net Income (Loss) Per Share    $      0.26        ($0.23)
</TABLE>

    The proforma results are based upon certain assumptions and estimates which
the Company believes are reasonable. The proforma results do not purport to be
indicative of results that actually would have been obtained had the
acquisitions occurred on January 1 of the periods presented, nor are they
intended to be a projection of future results.

                                       35
<PAGE>
 
                             McFARLAND ENERGY, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


3.  Settlement of Chevron Lawsuit

    On January 16, 1995, the Company announced it had settled with Chevron the
lawsuit of McFarland Energy, Inc. v. Chevron U.S.A., Inc. (Case No. BC023747)
           ----------------------------------------------          
for the sum of $25,673,000. In September 1994, a Los Angeles Superior Court jury
trial awarded the Company compensatory and punitive damages totalling
$47,300,000. On January 13, 1995, the Company and Chevron entered into a final
settlement agreement and funds in the amount of $25,673,000 were wired to the
Company on January 17, 1995. Of the total settlement amount, $8,292,000 was paid
to the Company's outside attorneys and the Company incurred various other costs
totalling $223,000. The net settlement amount of $17,158,000 was recognized as a
gain in the first quarter of 1995.

4.  Credit Agreement

    On April 20, 1994, the Company entered into a credit agreement with its bank
("Credit Agreement") which consisted of a $5,000,000 unsecured revolving line of
credit facility and a $6,000,000 seven-year term loan facility. On September 20,
1994, the Company amended the Credit Agreement in order to finance its
acquisition of the Oak Hill field, Rusk County, Texas properties. The amendment
increased the revolving line of credit facility to $10,000,000 and replaced the
bank's offshore interest rate option with a LIBOR plus 1.5% optional rate. At
the option of the Company, the interest rate on borrowed funds is either the
reference rate, a rate of interest publicly announced by the bank; the fixed
rate, the rate agreed upon between the Company and the bank; or LIBOR plus 1.5%.
In January 1995, the Company repaid all of the outstanding borrowing on the
revolving line of credit. At December 31, 1995, there was no outstanding
borrowing under this facility. The Company paid a total of $23,000 of interest
on this facility in 1995.

    The term loan credit facility consisted of a $6,000,000 seven-year term loan
repayable over twenty-four successive quarterly equal installments commencing on
June 1, 1995. The interest rate on borrowed funds was either the bank's
reference rate plus .5%, a negotiated fixed rate or LIBOR plus 2%. In
conjunction with the acquisition of the Star Fee property, the Company borrowed
$6,000,000 under the term loan facility. The term loan was collateralized by two
of the Company's principal crude oil producing properties. In March 1995, the
Company repaid all the outstanding borrowing under the term loan facility. In
1995, the Company paid a total of $75,000 of interest on the term loan facility.

    The Credit Agreement contains certain covenants which require maintenance of
minimum levels of net worth and working capital, maintenance of minimum or
maximum financial ratios, and certain limitations on the incurrence of liens or
encumbrances on the Company's assets. The Company is required to pay a quarterly
commitment fee of .375% per annum on the unused portion of the revolving credit
facility. There are no compensating balance requirements.

                                       36
<PAGE>
 
                             McFARLAND ENERGY, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


5.  Production Payment Notes

    On April 22, 1994, the Company issued $3,624,000 of 5% seven-year production
payment notes ("Notes") in conjunction with the Star Fee property acquisition.
Interest payments are due quarterly, while monthly principal payments occur when
the average monthly crude oil selling price of the property's production exceeds
$12.00 per barrel. When the monthly average selling price is between $12.00 and
$15.01 per barrel, the sum of the principal payments will be equal to $1.00 per
each net revenue barrel produced from the property in that month. When the
monthly average selling price exceeds $15.00 per barrel, the sum of the
principal payments will be equal to $2.00 per each net revenue barrel produced
from the property in that month.

    The Notes are due February 1, 2001. The Company has the option to make the
final payment of the outstanding balance in either cash, Company common stock,
or a combination of both. The market value per share of common stock delivered
will be based on the average quoted closing price on the National Association of
Securities Dealers Stock Market System for the twenty trading days prior to
January 20, 2001. The Notes are collateralized by one of the Company's principal
crude oil properties. In 1995, the Company made interest payments totalling
$166,000 on the production payment notes.

6.  Convertible Notes

    On January 4, 1993, the Company refinanced its previously issued convertible
notes with the issuance of a single $2,600,000 convertible note to its largest
institutional shareholder. The note bore interest at 8% per annum and was due
January 4, 2003. The terms of the note called for quarterly interest payments
through January 4, 2003, or up to the date of conversion. The Company has the
option to convert the note to its common stock at any time after January 4, 1996
provided that the Company's common stock had been quoted by the National
Association of Securities Dealers at a weighted average price of $6.50 per
share, or higher, for at least nineteen out of twenty consecutive business days.
This note was also convertible at the option of the note holder at any time
after January 4, 1994 at the rate of one share of the Company's common stock
for each $6.50 principal amount.  In 1995, the Company made interest payments
totalling $208,000.  On January 29, 1996, the Company converted the note into
400,000 shares of the Company's common stock.  See Note 13 of Notes to
Consolidated Financial Statements for details.  The note was subordinate to any
senior indebtedness incurred by the Company and restricted the payment of
dividends on common stock if there existed any unpaid accrued interest.

7.  Employees Savings and Stock Ownership Plan

    The Company maintains a defined contribution and contributory savings plan
covering all full-time employees who have been employed at least six months. The
plan qualifies under Section 401(k) of the Internal Revenue Code. The Company
contributes to the plan an amount equal to 1% of each eligible employee's annual
earnings. In addition, the Company matches employee voluntary contributions up
to 6% of annual compensation. Employees vest in the Company's contribution at
the rate of 10% each year for the first four years of credited service and 20%
each

                                       37
<PAGE>
 
                             McFARLAND ENERGY, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


7.  Employees Savings and Stock Ownership Plan (continued)

year for the next three years.

    For the three years ended December 31, 1995, 1994, and 1993, contributions
of $172,000, $171,000, and $173,000, respectively, were made by the Company to
the plan.

8.  Stock Option Plans

    On March 6, 1986, the Company's Board of Directors unanimously approved the
1986 Stock Option Plan ("1986 Plan"), under which 225,000 shares of the
Company's common stock are reserved for issuance to officers and key employees.
The 1986 Plan was adopted by the shareholders at the May 29, 1986 Annual Meeting
of Shareholders. Options vest 25% annually. Options are exercisable beginning
one year after the date granted.

    At the May 24, 1989 Annual Meeting of Shareholders, the shareholders
approved the 1989 Stock Option Plan ("1989 Plan") which is identical in all
material respects to the 1986 Plan. Under the 1989 Plan, 250,000 shares of the
Company's common stock are reserved for issuance to officers and key employees.
A summary of the stock option activity related to the Company's 1986 and 1989
Plans is as follows:

<TABLE> 
<CAPTION> 
                                       Number          Exercise        Shares   
                                      of Shares         Price        Exercisable
                                      ---------       ----------     -----------
<S>                                   <C>           <C>              <C>
Outstanding at January 1, 1994          270,000     $4.13 - $10.00        90,125
Granted                                  67,750      $5.25 - $7.75
Exercised                               (12,875)         $4.13
Cancelled or Expired                    (29,000)     $4.13 - $5.25
 
Outstanding at December 31, 1994        295,875     $4.13 - $10.00       154,875
Granted                                  66,000          $6.25  
Exercised                               (25,000)     $4.13 - $5.25
Cancelled or Expired                    (22,812)     $4.13 - $4.75
 
Outstanding at December 31, 1995        314,063     $4.13 - $10.00       199,892
 
</TABLE>

                                       38
<PAGE>
 
                             McFARLAND ENERGY, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


8.  Stock Option Plans (continued)

    At the June 7, 1994 Annual Meeting of Shareholders, the shareholders
approved the Non-Employee Director Stock Option Plan (the "Director Plan").
Under the Director Plan, 50,000 shares of the Company's common stock are
reserved for issuance to the outside directors of the Company. Each outside
director receives an initial option to purchase 2,000 shares of common stock.
Annually, thereafter, options to purchase 1,000 shares of common stock will be
granted to each outside director. The option exercise price is equal to the fair
market value of the Company's common stock on the date of grant and the options
are exercisable immediately.

<TABLE>
<CAPTION>

                                       Number         Exercise      Shares 
                                     of Shares         Price     Exercisable
                                     ---------       ----------  -----------
<S>                                  <C>           <C>           <C>        
Granted in 1994                         14,000     $4.75 - $8.00
 
Outstanding at December 31, 1994        14,000     $4.75 - $8.00      14,000
Granted                                  6,000         $7.00
Exercised                               (2,000)        $4.75
 
Outstanding at December 31, 1995        18,000     $4.75 - $8.00      18,000
</TABLE>

                                       39
<PAGE>
 
                             McFARLAND ENERGY, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


9.  Income Taxes

    Income tax expense provided in the Company's financial statements differs
substantially from the actual income tax liability to federal and state
governments. The following reconciliations are provided to enhance the reader's
understanding of this relationship.

Reconciliation of income tax expense (benefit) with tax at statutory rate:

<TABLE>
<CAPTION>
 
                                                    Year Ended December 31,
                                                -------------------------------
                                                 1995        1994        1993
                                                ------      ------      ------
<S>                                         <C>           <C>         <C> 
Computed tax (benefit) at 34%               $ 4,284,000   $ 513,000   $(528,000)
                                         
Net operating losses with no carryback              ---         ---     528,000
                                         
State income taxes, net of federal tax   
 benefit                                        773,000      93,000      14,000
                                         
Utilization of net operating loss        
 carryovers                                  (1,607,000)        ---         ---
                                         
Change in valuation allowance                (4,501,000)   (808,000)        ---
                                         
Other, net                                        9,000     204,000         ---
                                              ---------    --------    -------- 
                                            $(1,042,000)  $   2,000   $  14,000
                                              =========    ========    ========
<CAPTION> 

Income taxes have the following components:
<S>                                         <C>           <C>         <C> 
Current tax expense: 
   Federal                                  $       ---   $     ---   $     ---
   State                                         27,000       2,000      14,000
                                              ---------    --------    --------
                                                 27,000       2,000      14,000
                                              ---------    --------    -------- 

Deferred tax (benefit) expense:
   Federal                                   (1,069,000)        ---         ---
   State                                            ---         ---         ---
                                              ---------    --------    --------
                                             (1,069,000)        ---         ---
                                              ---------    --------    --------

                                            $(1,042,000)  $   2,000   $  14,000
                                              =========    ========    ========
</TABLE> 

                                       40
<PAGE>
 
                             McFARLAND ENERGY, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


9.  Income Taxes (continued)

    The deferred tax assets and liabilities as of December 31, 1995 and 1994
were as follows:
 
Deferred tax assets (liabilities):

<TABLE> 
<CAPTION> 
                                                     Year Ended December 31,
                                                  -----------------------------
                                                        1995           1994
                                                        ----           ---- 
<S>                                                <C>            <C>   
 Net operating loss carryforwards                  $ 1,588,000    $ 3,126,000
 Statutory depletion carryforwards                   2,414,000      2,245,000
 Tax credit carryforwards                              327,000        143,000
 State taxes, net                                       33,000        371,000
 Property and equipment                                253,000            ---
 Other, net                                            821,000            ---
 Valuation allowance                                  (780,000)    (5,281,000)
                                                    ----------     ---------- 
 Total deferred tax assets                           4,656,000        604,000
                                                    ----------     ----------

 Property and equipment                                    ---       (428,000)
 Other, net                                         (3,832,000)      (381,000)
                                                    ----------     ----------

 Total deferred tax liabilities                     (3,832,000)      (809,000)
                                                    ----------     ----------

 Net deferred tax assets (liabilities)             $   824,000    $  (205,000)
                                                    ==========     ==========
</TABLE>

    The Company has net operating loss carryovers into 1996 of approximately
$4,700,000 for federal purposes and approximately $1,900,000 for State of
California purposes.  The federal losses may be carried over for fifteen years
from the year in which they were incurred.  The oldest carryforwards will begin
to expire in 2003.  The State of California net operating losses may be carried
over for five years. The oldest carryforwards will begin to expire in 1995.  The
Company established valuation allowances for deferred tax assets where it is
more likely than not that some portion or all of the deferred tax assets will
not be realized.

    The Company also has approximately $7,100,000 in federal statutory depletion
carryovers which may be used to offset future taxable income.  These carryovers
do not expire.  Federal alternative minimum tax credits which can be used to
offset regular income taxes in excess of alternative minimum tax total
approximately $143,000.  Income taxes paid were $12,000, $2,000 and $47,000 in
1995, 1994 and 1993, respectively.

                                       41
<PAGE>
 
                             McFARLAND ENERGY, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


10.   Commitments and Contingencies

    The Company has certain contingent liabilities with respect to litigation,
claims, taxes, government regulations and contractual agreements arising from
the ordinary course of business.  While there are always risks inherent in the
resolution of any contingency, it is the opinion of management that such
contingent liabilities will not result in any loss which would have an adverse
material effect on the Company's financial position.

    The Company is subject to other possible loss contingencies pursuant to
federal, state and local environmental laws and regulations.  These include
existing and potential obligations to investigate the effects of the release of
certain hydrocarbons or other substances at various sites; to remediate or
restore these sites; and to compensate others for damages and to make other
payments as required by law or regulation.  These obligations relate to sites
owned by the Company or others, and are associated with past and present oil and
gas operations.  The amount of such obligations is indeterminate and will depend
on such factors as the unknown nature and extent of contamination, the unknown
timing, extent and method of remedial actions which may be required, the
determination of the Company's liability in proportion to other responsible
parties, and the state of the law.

    The Company has entered into employment agreements with certain key
employees. The initial term of each agreement expires on December 31, 1999, or
after twenty-four months following a change in control. The agreements provide
if the individual's employment is terminated after a change in control (as
described in the agreements), the individual is entitled to a lump sum payment
equal to an amount ranging from one to two times his base salary, including
bonus.

    The Company markets its crude oil under long-term contracts to a number of
refiners and marketing agencies, including several major oil companies, and its
natural gas to utilities and pipeline companies. In 1995, two purchasers
accounted for more than 10% of the Company's total oil and gas sales.  Their
purchases in 1995 accounted for 33% and 30%, respectively.

                                       42
<PAGE>
 
                             McFARLAND ENERGY, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


11.  Supplemental Oil and Gas Reserve Information and Related Data (Unaudited)

     As of December 31, 1995, 1994 and 1993, the detail of capitalized costs
attributable to the Company's oil and gas properties were as follows:

<TABLE>
<CAPTION>
 
                          1995         1994         1993
                          ----         ----         ----   
<S>                    <C>          <C>          <C>
 
Proved properties      $85,019,000  $78,942,000  $64,306,000
 
Unproved properties        669,000    2,574,000    2,295,000
                        ----------   ----------   ----------
 
                       $85,688,000  $81,516,000  $66,601,000
                        ==========   ==========   ==========

Accumulated depletion  $58,611,000  $48,279,000  $51,254,000
                        ==========   ==========   ==========
</TABLE> 

     During the years ended December 31, 1995, 1994 and 1993, the following 
amounts were expended in the activities described:

<TABLE>
<CAPTION>
                                         1995          1994         1993  
                                         ----          ----         ----  
<S>                                <C>           <C>           <C>        
                                                                          
Acquisition of proved properties   $  5,403,000  $ 17,562,000  $   273,000
                                                                          
Exploration                           1,528,000     1,114,000    1,779,000
                                                                          
Development                           6,276,000     3,838,000    1,624,000
                                      ---------    ----------    ---------
                    TOTAL          $ 13,207,000  $ 22,514,000  $ 3,676,000 
                                     ==========    ==========    =========
</TABLE>

     The Company operates in only one line of business, oil and gas exploration
and production, and conducts those operations solely in one major geographic
area, the Continental United States. Accordingly, the consolidated statements of
operations shown in these financial statements reflect the results of operations
from oil and gas producing activities for the years ended December 31, 1995,
1994 and 1993. 

                                       43
<PAGE>
 
                             McFARLAND ENERGY, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


11.  Supplemental Oil and Gas Reserve Information and Related Data (Unaudited)
     (continued)

     During 1995, 1994 and 1993, the following changes occurred in the Company's
estimated proved oil and gas reserves:

<TABLE>
<CAPTION>

                                        (In thousand of bbls and mcf)
                                         Oil                      Gas
                               ---------------------    ----------------------

                               1995     1994    1993    1995     1994     1993
                               ----     ----    ----    ----     ----     ---- 
<S>                          <C>      <C>     <C>    <C>       <C>      <C>
 
Beginning of year             8,299    5,132   5,804  14,723    7,991    8,610
 
Revision of previous
 estimates:
   Price changes                 54      673    (564)    ---      (30)     (81)
 
   Quantity estimates         1,740     (166)    640  (1,751)  (2,715)    (236)
 
Purchases of minerals in
 place                          696    3,913      70   1,266    9,540      125
 
Extensions, discoveries
 and other additions            ---      ---     ---      47    1,550      571
 
Production                   (1,206)    (969)   (795) (2,181)  (1,456)    (998)
 
Sales of minerals in place      (69)    (284)    (23)    ---     (157)     ---
                             ------   ------  ------  ------   ------   ------ 

End of year                   9,514    8,299   5,132  12,104   14,723    7,991
                             ======   ======  ======  ======   ======   ====== 

Proved developed reserves:    8,534    8,299   5,132  12,104    9,374    7,991
                             ======   ======  ======  ======   ======   ====== 
</TABLE>

The revision of previous estimates of proved reserves is primarily influenced by
factors: the estimate of remaining hydrocarbons in the reservoir and the
economics of extraction and sale.  When sales prices fluctuate dramatically, the
estimate of economically recoverable reserves is significantly impacted.   Crude
prices in 1993 closed the year nearly $4.00 per barrel below the 1992 closing
price levels.  The sharply lower crude prices significantly reduced the
economically recoverable reserves at the Company's price-sensitive oil producing
properties.  However, offsetting most of this decline was a significant increase
in the recoverable reserves at the Company's core Midway Sunset field property.
This upward revision reflected better than projected production and lower
operating costs in 1993.  At the end of 1994, California crude prices were more
than $4.00 per barrel higher than at the end of 1993.  These higher prices
increased the Company's economically recoverable reserves in 1994 at several oil
producing properties.  In 1995, better than projected operating results at the
Company's two core Midway Sunset field properties accounted for most of the
upward quantity estimate revisions.  1994 and 1995 gas reserves were revised
downward principally due to disappointing production results at some of the
Company's gas wells in the Northern San Joaquin Valley of California and in East
Texas.

                                       44
<PAGE>
 
                             McFARLAND ENERGY, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


11.  Supplemental Oil and Gas Reserve Information and Related Data (Unaudited)
     (continued)

     At December 31, 1995, 1994 and 1993, the Company's Standardized Measure of
Discounted Future Net Cash Flows were as follows:

<TABLE> 
<CAPTION> 
                                         1995          1994          1993
                                         ----          ----          ----
<S>                                 <C>           <C>           <C> 

Future gross revenue                $153,000,000  $129,000,000  $ 62,000,000

Future production and
 development costs                   (68,000,000)  (64,000,000)  (33,000,000)

Future net revenue                    85,000,000    65,000,000    29,000,000

10% annual discount for estimated
 timing of net revenue               (25,000,000)  (21,000,000)   (8,000,000)

Discounted future net revenue         60,000,000    44,000,000    21,000,000

Discounted future income tax
 expense                              (4,000,000)          ---           ---
                                      ----------   -----------   -----------
Standardized measure of discounted
 future net cash flows              $ 56,000,000  $ 44,000,000  $ 21,000,000
                                      ==========   ===========   ===========
</TABLE> 

     The process of estimating oil and gas quantities is inherently imprecise.
Ascribing monetary values to those reserves, therefore, yields imprecise
estimates at best. Proved reserve quantities are merely estimates of future
production from known reservoirs based on year-end economic factors, which
estimates may differ materially from actual recovery as production occurs and
market prices and production costs change. The Company's Hedge Program is not
considered in the evaluation of the year-end reserves.

                                       45
<PAGE>
 
                             McFARLAND ENERGY, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


11.  Supplemental Oil and Gas Reserve Information and Related Data (Unaudited)
     (continued)

     THE FOREGOING RESERVE ESTIMATES AND RESULTING FUTURE NET CASH FLOWS WERE
DEVELOPED IN ACCORDANCE WITH SEC PROCEDURES, USING SELLING PRICES IN EFFECT AT
THE END OF THE YEARS INDICATED. AS ILLUSTRATED ABOVE, BOTH THE QUANTITY
ESTIMATES AND "CASH FLOWS" OF RESERVES ARE SENSITIVE TO SALES PRICES IN EFFECT
AT THE YEAR-END QUANTIFICATION DATE. DURING PERIODS OF RAPIDLY CHANGING PRICES,
RESERVE INFORMATION MUST BE EXAMINED WITH THIS UNDERSTANDING.

Statement of Valuation Policies
-------------------------------

     The following accounting policies have been followed in preparing the above
presentation. The estimates of proved reserves and related valuations were
developed in accordance with rules of the Securities and Exchange Commission
(SEC). The other policies described below are based principally on rules
developed by the SEC and the Financial Accounting Standards Board (FASB).

The dollar valuation of proved reserves is developed as follows:

     (1) Estimates are made of quantities of proved reserves and the future
         periods during which they are expected to be produced, based on year-
         end economic conditions.

     (2) The estimated future production of proved reserves is priced on the
         basis of year-end prices.

     (3) The estimated future expense of developing and producing the reserve
         quantities and of abandonment and site restoration are costed at year-
         end costs.

     (4) The resulting future net revenue streams are reduced to present value
         amount by applying a 10 percent discount factor.

     (5) The Discounted Future Net Revenue amount is further reduced by the
         estimated amount of discounted future income tax expense attributable
         to the future income based on year-end tax rates. Anticipated future
         permanent differences, such as allowable statutory percentage depletion
         in excess of basis, are taken into account. The effects of any future
         timing differences, such as intangible drilling costs, are not
         recognized.

                                       46
<PAGE>
 
                             McFARLAND ENERGY, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


11.  Supplemental Oil and Gas Reserve Information and Related Data (Unaudited)
     (continued)

     AS ACKNOWLEDGED BY THE SEC, THIS VALUATION PROCEDURE IS NOT INTENDED TO
YIELD THE BEST ESTIMATE OF THE FAIR MARKET VALUE OF A COMPANY'S OIL AND GAS
PROPERTIES. AN ESTIMATE OF FAIR MARKET VALUE SHOULD ALSO TAKE INTO ACCOUNT,
AMONG OTHER FACTORS, THE LIKELIHOOD OF FUTURE RECOVERIES OF OIL AND GAS IN
EXCESS OF PROVED RESERVES, ANTICIPATED FUTURE PRICES OF OIL AND GAS AND RELATED
DEVELOPMENT AND PRODUCTION COSTS, A DISCOUNT RATE WHICH REFLECTS ACTUAL ECONOMIC
CONDITIONS, AND AN INCOME TAX PROVISION WHICH RECOGNIZES BOTH PERMANENT AND
TEMPORARY DIFFERENCES.


     The following are the principal sources of changes in the standardized
measure of discounted future net cash flows during the years ended December 31,
1995, 1994 and 1993:

<TABLE>
<CAPTION>
 
                                          1995           1994          1993     
                                          ----           ----          ----     
<S>                                   <C>            <C>           <C>          
                                                                                
Beginning of year estimate             $44,000,000   $21,000,000    $30,000,000 
                                                                                
Net change in prices and production                                             
 costs                                   7,000,000    10,000,000    (12,000,000)
                                                                                
Revision to previous quantity                                                   
 estimates                              10,000,000    (3,000,000)     2,000,000 
                                                                                
Purchases of minerals in place           6,000,000    22,000,000            --- 
                                                                                
Extensions and discoveries                     ---     2,000,000      1,000,000 
                                                                                
Net oil and gas sales                  (11,000,000)   (9,000,000)    (6,000,000)
                                                                                
Sales of minerals in place                     ---    (1,000,000)           --- 
                                                                                
Accretion of discount                    4,000,000     2,000,000      3,000,000 
                                                                                
Net change in income taxes              (4,000,000)          ---      3,000,000 
                                        ----------    ----------     ----------
                                                                                
End of year estimate                   $56,000,000   $44,000,000    $21,000,000 
                                        ==========    ==========     ========== 
 
</TABLE>

                                       47
<PAGE>
 
                             McFARLAND ENERGY, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


11.  Supplemental Oil and Gas Reserve Information and Related Data (Unaudited)
     (continued)

Analysis of Changes:
------------------- 

Year ended December 31, 1995:

     Net change in prices and production costs represents the present value of
changes in prices and production costs multiplied by proved reserves as of the
beginning of the year.

     The revision to previous quantity estimates reflects upward estimate
revisions at the Company's two core Midway Sunset field properties, partially
offset by downward revisions at some of the Company's gas properties in the
California Northern San Joaquin Valley and in East Texas.

     Purchases of minerals in place consisted principally of the acquisition of
oil producing properties in Santa Barbara County, California and the purchase of
additional working interests in a property already operated by the Company.

     "Accretion of Discount" was computed by applying 10 percent to the
discounted future net revenue before taxes as of the beginning of the year in
recognition of the increase resulting from the impact of the passage of time on
the discounted cash flow approach to the valuation of the proved reserves.

Year ended December 31, 1994:

     The revision to previous quantity estimates reflects the downward revision
to some of the Company's natural gas reserves in the Northern San Joaquin Valley
of California.

     Purchases of minerals in place consisted principally of the acquisition of
the Star Fee property in April 1994 and the Oak Hill field properties in
September 1994.

     Extensions and discoveries resulted from the drilling of five successful
natural gas wells in the Northern San Joaquin Valley of California.

     Sales of minerals in place principally reflects the sale of a Los Angeles
Basin, California property to a third party pursuant to an out-of-court
settlement reached in August 1994.


Year ended December 31, 1993:

     The revision of previous quantity estimates resulted primarily from
improved operating results at the Company's McDonald property.

     Natural gas reserve extensions and discoveries resulted from the drilling
of one successful exploratory well in the Northern San Joaquin Valley of
California.

                                       48
<PAGE>
 
                             McFARLAND ENERGY, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


12.  Unaudited Quarterly Operating Results

     The following is a tabulation of unaudited quarterly operating results for
1995, 1994 and 1993.

<TABLE>
<CAPTION>
 
                                        (In thousands except per share data)
                                                 Income (Loss) From
                                   Total        Continuing Operations                                          
                                  Revenues    Before Accounting Change      Net Income (Loss)                
                                  --------    ------------------------      -----------------                
                                   Amount        Amount      Per Share     Amount     Per Share                
                                   ------        ------      ---------     ------     ---------                
<S>                               <C>           <C>          <C>          <C>         <C>       
                                                                                                
1995                                                                                            
----                                                                                            
        First Quarter             $ 4,520       $10,074 (1)      $1.93    $10,074 (1)     $1.93  
        Second Quarter              5,171           840           0.16        840          0.16                      
        Third Quarter               5,109         1,326           0.25      1,326          0.25                      
        Fourth Quarter              5,083         1,401 (2)       0.27      1,401 (2)      0.27   
                                   ------        ------           ----     ------          ----  
                                  $19,883       $13,641          $2.61    $13,641         $2.61 
                                   ======        ======           ====     ======          ==== 
1994                                                                                            
----                                                                                            
        First Quarter             $ 2,955       $  (349)        $(0.07)   $  (349)       $(0.07)
        Second Quarter              3,391           236           0.05        236          0.05 
        Third Quarter               4,406           658           0.13        658          0.13 
        Fourth Quarter              5,518           963 (3)       0.18        963 (3)      0.18                           
                                   ------        ------           ----     ------          ----   
                                  $16,270       $ 1,508         $ 0.29    $ 1,508        $ 0.29 
                                   ======        ======           ====     ======          ====  
                                                                                                
1993                                                                                            
----                                                                                            
        First Quarter             $ 3,271       $    78         $ 0.01    $   528        $ 0.10                                    
        Second Quarter              3,482            40           0.01         40          0.01                                    
        Third Quarter               3,185          (177)         (0.03)      (177)        (0.03)                                    
        Fourth Quarter              2,924        (1,507)(4)      (0.29)    (1,507)(4)     (0.29)    
                                   ------        ------           ----     ------          ----   
                                  $12,862       $(1,566)        $(0.30)   $(1,116)       $(0.21) 
                                   ======        ======           ====     ======          ====  
</TABLE>

(1) The first quarter of 1995 reflects the gain on the Chevron lawsuit
settlement of $17,158,000 and the $5,515,000 impairment on certain oil and gas
properties and a write-off of an investment in a natural gas marketing company.

(2) The fourth quarter of 1995 includes the year-end income tax adjustments and
the recognition of deferred tax assets totalling $3,050,000, which were
partially offset by an additional impairment of $2,402,000 on certain gas
properties and the write-off of development costs relating to the gas storage
project.

(3) The fourth quarter of 1994 reflects the gain on the sale of an oil and gas
property and other nonrecurring items, the net of which increased operating
income by approximately $437,000.

(4) In the fourth quarter of 1993, year-end adjustments relating to depletion,
write-downs of tubular inventories and impairments of unproved properties
reduced operating income by approximately $1,000,000.

                                       49
<PAGE>
 
                             McFARLAND ENERGY, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


13.  Subsequent Event

     Conversion of Convertible Subordinated Note
     -------------------------------------------

     On January 29, 1996, the Company converted its $2.6 million 8% convertible
subordinated note held by Fund American Enterprises, Inc. into 400,000 shares of
the Company's common stock. Following the conversion, the Company had a total of
5,639,234 common shares outstanding. The conversion will eliminate $208,000 of
annual interest expense.

                                       50
<PAGE>
 
Item  9.  Changes in and Disagreements with Accountants on Accounting and
-------------------------------------------------------------------------
Financial Disclosure
--------------------
          None.

                                    PART III
                                    --------


Item 10.  Directors and Executive Officers of the Registrant
------------------------------------------------------------

Item 11.  Executive Compensation
--------------------------------

Item 12.  Security Ownership of Certain Beneficial Owners and Management
------------------------------------------------------------------------

          The information required by Items 10, 11, and 12 are contained under
the headings "Election of Directors", "Executive Compensation", and "Voting
Securities" in the Company's Proxy Statement for its Annual Meeting of
Shareholders proposed to be held on May 30, 1996, which Proxy Statement shall be
filed within 120 days of the end of the calendar year 1995, and is hereby
incorporated by reference.

Item 13.  Certain Relationships and Related Transactions
--------------------------------------------------------
          None.

                                       51
<PAGE>
 
                                    PART IV
                                    -------

Item 14.  Exhibits, Financial Statement Schedules and Reports on Form 8-K
-------------------------------------------------------------------------

 
 (a)  1.  Financial Statements
      The following financial statements of McFarland Energy, Inc. are included
      in Part II, Item 8:
                                                                            Page
                                                                            ----

           Report of independent accountants: Coopers & Lybrand L.L.P.        25
           Consolidated Balance Sheets as of December 31, 1995
            and 1994                                                          26
           Consolidated Statements of Operations for the years ended
            December 31, 1995, 1994, and 1993                                 27
           Consolidated Statements of Changes in Stockholders' Equity
            for the years ended December 31, 1995, 1994 and 1993              28
           Consolidated Statements of Cash Flows for the years ended
            December 31, 1995, 1994 and 1993                                  29
           Notes to Consolidated Financial Statements                         30

      2.  Financial Statement Schedules
                Schedules have been omitted since they are either not
                  required, are not applicable, or the required information
                  is shown in the financial statements or related notes.

 (b)  Reports on Form 8-K:
                None

 (c)  Exhibits

Exhibit Number     Description of Exhibit

   2               Agreement for Plan of Reorganization and
                   Business Combination                                   *

   3               Articles of incorporation and bylaws                  **

   4               Instruments defining the rights of security 
                   holders, including indentures                        ***

   9               Voting trust agreement                         NOT APPLICABLE

--------------------------------------------------------------------------------
  *  Included as Exhibit 2 in Registrant's Form 8-K for the month of July 15,
     1988 and herein incorporated by reference.
 **  Included as Exhibit 3 in Registrant's Annual Report on Form 10-K for the
     year 1987 and herein incorporated by reference.
***  Included as Exhibits on pages 713 through 770 of the Registrant's 
     Registration Statement No. 2-54844 and herein incorporated by reference.

                                       52
<PAGE>
 
Item 14.  Exhibits, Financial Statement Schedules and Reports on Form 8-K
-------------------------------------------------------------------------
(continued)

Exhibit Number   Description of Exhibit

                                                                        Page
                                                                        ----
  10a            Crude Oil Purchase Contact No. 972 between 
                 Standard Oil Company of California and McFarland 
                 Energy, Inc. dated March 11, 1975                      ****

  10b            Gas Purchase Agreement between Pacific Lighting 
                 Gas Supply Co. and McFarland Energy, Inc. dated 
                 November 26, 1984                                      ****

  10c            Business Loan Agreement dated April 20, 1994 and 
                 as amended on August 25, 1995                           57
 
  10e            Operating Agreement dated February 28, 1972 
                 between Standard Oil Company of California and 
                 Jade Oil & Gas Co.                                    *****
 
  10f            Operating Agreement-U93 dated February 28, 1972
                 between Standard Oil Company of California and
                 Jade Oil & Gas Co.                                    *****
 
  10h            Crude Oil Purchase Agreement between Huntway
                 Refining Company and McFarland Energy, Inc. 
                 dated March 25, 1994 and as amended on 
                 February 19, 1996                                       58
 
  10i            Executive Officer Employment Agreements                 66

 
  11             Statement re computation of per share earnings     NOT REQUIRED
                                      
  
  12             Statement re computation of ratios                 NOT REQUIRED
                                          
 
  13             Annual report to security holders, Form 10-Q 
                 or quarterly report to security holders            NOT REQUIRED
 
  18             Letter re change in accounting principles            ******

  22             Published report re matters submitted to vote 
                 of security holders                                   NONE

--------------------------------------------------------------------------------
   ****  Included as Exhibit 10A and 10B in Registrant's Annual Report on Form
         10-K for the year 1987 and herein incorporated by reference.
  *****  Included as Exhibit 10D, 10E, 10F, and 10G in Registrant's Annual
         Report on Form 10-K for the year 1992 and herein incorporated by
         reference.
 ******  Included as Exhibit 18 in Registrant's Quarterly Report on Form 10-Q
         for the quarter ended June 30, 1994 and herein incorporated by
         reference.

                                       53
<PAGE>
 
Item 14.  Exhibits, Financial Statement Schedules and Reports on Form 8-K
-------------------------------------------------------------------------
(continued)

Exhibit Number   Description of Exhibit
 
                                                                        Page
                                                                        ----
 
   23            Consent of Coopers & Lybrand L.L.P.                     108
 
   24            Power of Attorney                                      NONE
 
   27            Financial Data Schedule                                 109
 
   28            Information from reports furnished to state 
                 insurance regulatory authorities                       NONE
 
   99            Additional exhibits                                    NONE

                                       54
<PAGE>
 
     Pursuant to the requirements of Section 13 or 15 (d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.


                                     McFARLAND ENERGY, INC.
                                     (REGISTRANT)


                                         J. C. McFarland
                                     -----------------------
                                     By:  J. C. McFarland
                                     (Chief Executive Officer)



                                       Ronald T Yoshihara
                                     -----------------------
                                     By:  Ronald T Yoshihara
                                     (Vice President and Treasurer)
                                     (Chief Financial Officer)


DATE:     March 13, 1996
     -------------------------     


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

      J. C. McFarland                     William E. Carl
--------------------------------     ----------------------------------  
J. C. McFarland, March 13, 1996      William E. Carl, March 13, 1996
      (Director)                             (Director)

 
      John C. Capshaw                     Daniel E. Pasquini
--------------------------------     ---------------------------------- 
John C. Capshaw, March 13, 1996      Daniel E. Pasquini, March 13, 1996
      (Director)                             (Director)
 
      Daniel J. Redden                    Herbert Rome
--------------------------------     ----------------------------------
Daniel J. Redden, March 13, 1996     Herbert Rome, March 13, 1996
      (Director)                             (Director)

      Barclay Simpson
--------------------------------
Barclay Simpson, March 13, 1996
      (Director)

                                       55
<PAGE>
 
EXHIBIT INDEX

Exhibit Number     Description of Exhibit                            Page Number
--------------     ----------------------                            -----------

   3               Articles of incorporation and bylaws                   **
      
   4               Instruments defining the rights of security 
                   holders, including indentures                         ***
      
   10a             Crude Oil Purchase Contact No. 972 between 
                   Standard Oil Company of California and 
                   McFarland Energy, Inc. dated March 11, 1975           ****

   10b             Gas Purchase Agreement between Pacific Lighting 
                   Gas Supply Co. and McFarland Energy, Inc. dated 
                   November 26, 1984                                     ****
 
   10c             Business Loan Agreement dated April 20, 1994 and 
                   as amended on August 25, 1995                          57
 
   10e             Operating Agreement dated February 28 1972 between
                   Standard Oil Company of California and Jade Oil & 
                   Gas Co.                                              *****
 
   10f             Operating Agreement-U93 dated February 28, 1972
                   between Standard Oil Company of California and 
                   Jade Oil & Gas Co.                                   *****
 
   10h             Crude Oil Purchase Agreement between Huntway
                   Refining Company and McFarland Energy, Inc. dated 
                   March 25, 1994 and as amended on February 19, 1996     58
 
   10i             Executive Officer Employment Agreements                66

      
   18              Letter re change in accounting principles            ******
                                         
      
   23              Consent of Coopers & Lybrand L.L.P.                   108
                                   
      
   27              Financial Data Schedule                               109
 

--------------------------------------------------------------------------------
     **  Included as Exhibit 3 in Registrant's Annual Report on Form 10-K for
         the year 1987 and herein incorporated by reference.
    ***  Included as Exhibits on pages 713 through 770 of the Registrant's
         Registration Statement No. 2-54844 and herein incorporated by
         reference.
   ****  Included as Exhibit 10A and 10B in Registrant's Annual Report on Form
         10-K for the year 1987 and herein incorporated by reference.
  *****  Included as Exhibit 10D, 10E, 10F, and 10G in Registrant's Annual
         Report on Form 10-K for the year 1992 and herein incorporated by 
         reference.
 ******  Included as Exhibit 18 in Registrant's Quarterly Report on Form 10-Q
         for the quarter ended June 30, 1994 and herein incorporated by 
         reference.

                                       56