<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, 1996
                                       or
[ ]  Transition Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934

                           Commission File No 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:  (562) 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 5, 1997, 5,700,922 common shares were outstanding, and the aggregate
market value of the Common shares (based on the closing price on March 5,1997)
of McFarland Energy, Inc. held by non-affiliates was approximately $35,000,000.

                      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 28, 1997, which portions of registrant's Proxy Statement is
incorporated by reference in Part III.

                                                  Exhibit Index - Page 53
<PAGE>
 
--------------------------------------------------------------------------------
  Safe Harbor for Forward-Looking Statements:  This Annual Report on Form 10-K
contains forward-looking statements.  Such forward-looking statements and the
business prospects of the Company are subject to many risks and uncertainties
which may cause actual future results of the Company to differ materially from
those statements.  Factors that could cause or contribute to such differences
include, but are not limited to, those factors discussed in Item 1.  Business
and elsewhere in this report, as well as the following factors: volatility of
oil and gas prices, product supply and demand, competition, government
regulation or action, litigation, drilling and operations performance, the
company's ability to replace reserves or implement its business plans, access to
capital, uncertainties about estimates of reserves and environmental risks.
--------------------------------------------------------------------------------

                                    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 twenty-two properties
located in California, Texas, and Louisiana, and which consisted of more than
330 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 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 

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

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 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 operated and thirty-three 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 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 fifty years.

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

   In September 1996, the Company closed its second acquisition of a non-
operated working interest in the Rio Vista gas unit located in Sacramento
Valley, California.  This acquisition, combined with an earlier acquisition
closed in January 1996, increased the Company's working interest in California's
most prolific dry gas producing unit to 8%.  The Rio Vista gas unit is presently
producing 16,000 mcf per day.

EXPLORATION ACTIVITIES
----------------------

   The Company maintains an ongoing exploration program focused principally in
California. During the years 1991-1996, the Company actively explored for
natural gas in the Northern San Joaquin Valley.  As a result of low prices,
steep production decline rates and unsatisfactory drilling results, the Company
discontinued exploratory activities in this area in 1996.  In 1997, the Company
plans to continue to explore for oil and gas in other areas of California, such
as the Sacramento Valley.  Thus far, the Company has participated in a 3-D
seismic program in order to help identify drilling prospects in this area.  From
these activities the Company expects to drill at least two exploratory wells
later this year.  While the exploration activities remain focused in California,
the Company is also planning to participate in a limited number of higher risk,
higher potential out-of-state exploration ventures.  In March 1997, the Company
participated in an exploratory dry hole drilled in Nye County, Nevada.

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 62%
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 

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

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
1,700 barrels per day. Since the beginning of 1993, the Company has drilled a
total of twenty-three development wells on the property. An additional nine
wells are budgeted to be drilled during 1997 at a cost of approximately
$700,000.

   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 six months
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.  At
the time of the acquisition, 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 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. During 1995 and 1996, the
Company drilled a total of twenty-six additional development wells, increasing
production to its current level of more than 1,600 gross barrels per day.  The
Company plans to drill sixteen development wells on Star Fee in 1997 at a cost
of approximately $1,400,000.
 
     OAK HILL FIELD -  In September 1994, the Company acquired working interests
     --------------                                                             
in fifteen operated properties ranging from 65% to 96% and lesser interests in
thirty-three non-operated properties located in East Texas.  At the end of 1996,
these interests accounted for approximately 40% 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 fifty 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 well development drilling program in the Oak Hill  field.  The four wells
were drilled and completed and on production by mid-year 1995.

   BARHAM RANCH - The Company closed the acquisition of operated and non-
   ------------                                                         
operated interests ranging from 43% to 60% in this Santa Barbara County,
California property in January 1996. The property is presently producing
approximately 550 gross barrels per day from the Monterey formation.  Consistent
with the Company's strategy of developing its existing assets, in early 

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

March 1997, the Company commenced the drilling of a horizontal well on this
property at a cost of $800,000 to the 100% interest. The Company believes that
this well could significantly increase production and prove up additional
reserves. If this well is successful, it will result in at least one additional
horizontal well being drilled in 1997.

   RIO VISTA GAS UNIT - During 1996, the Company closed two acquisitions for a
   ------------------                                                         
combined 8% non-operated working interest in California's most prolific dry gas
producing unit.  The Rio Vista gas unit is located in the California Sacramento
Valley and is currently producing 16,000 mcf per day.  The natural gas reserves
attributable to the Company's interest in the unit represent 32% of the year end
1996 natural gas reserves.

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 1996, sales to
Huntway Refining Company and Independent Oil Producers' Agency accounted for 34%
and 24%, 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 canceled 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 95% 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.  The law went into effect in April 1996
and, thus far, has contributed to narrowing of the price differential between
California lower gravity crude and the benchmark WTI crude oil.  The Company
believes that these favorable effects on the relationship between WTI and
California crude prices have become permanent.

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

   Throughout 1995 and 1996, the price differential between the Company's
predominate Midway Sunset field crude and WTI ranged between $3.00-$6.50 per
barrel.  This compares favorably with the $7.00-$9.00 per barrel price
differential that had existed since the mid 1980's. The anticipated and
subsequent repeal of the ban on the export of ANS crude, along with rising West
Coast crude oil demand and declining Alaskan North Slope production, have been
the factors behind this narrowed price differential.  These factors have
combined 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 California oil reserves.

   Since 1992, the Company has maintained a hedging arrangement with a local
refiner that covers approximately one-half of the Company's daily crude oil
production.  The purpose of this arrangement 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.  In 1996 and 1995, the hedge program decreased
revenues by $1,381,000 and $482,000, respectively, while in 1994, the hedge
program increased Company revenues by $446,000.  The agreement is renegotiated
annually to reflect current heavy oil market conditions.  The hedge agreement
requires that the Company and the refiner maintain certain minimum levels of
security.  At December 31, 1996 and 1995, the Company had on deposit in an
interest bearing escrow account $328,000 and $280,000, respectively, to meet
such requirements.

   Natural gas prices continue to be very seasonal and highly volatile,
particularly during the peak demand winter months.  During 1996, domestic
natural gas prices were significantly higher than in the prior year, reflecting
the generally colder weather conditions across the country and below normal
natural gas storage levels.  These two fundamental factors helped keep gas
prices at higher levels throughout the year and also created extreme price
volatility during the period of December 1996 through mid-February 1997.  It was
during this two and one-half month period that prices rose throughout many parts
of country to more than $4.00 per mcf, price levels not experienced since the
early 1980's.  However, since that time, gas prices in most regions have fallen
below $2.00 per mcf, as above normal temperatures have  prevailed throughout the
nation and storage levels have risen.

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 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

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

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.  By letter from the
EPA dated March 7, 1997, the Company was advised that it (and six other
companies) is subject to a "Unilateral Administrative Order" requiring that it
"operate the onsite leachate treatment system from May 10, 1997 to December 31,
1999, among other tasks."  The letter from the EPA states that failure to comply
with the Order, without sufficient cause, could subject the Company to penalties
and punitive damages.  As of the date of this report, the Company cannot predict
the effect of this matter on capital expenditures, earnings or its competitive
position; however, management believes that the outcome will not have a material
impact on Company's financial condition.  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 $245,000 for environmental control
facilities and other related projects in 1996 and has budgeted $404,000 for
similar capital projects in 1997.

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 55 full-time employees as of December 31, 1996, 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, Texas and Louisiana.  The Company contracts for the
drilling of all its wells and does not itself own any drilling equipment, bulk
storage facilities or refineries.

   For 1996, the Company contracted with independent petroleum engineering firms
of DeGolyer and MacNaughton and Netherland, Sewell & Associates, Inc. for the
purpose of estimating the Company's net share of proved oil and gas reserves.
The properties evaluated by the outside independent petroleum engineers account
for approximately 85% of the Company's total proved reserves.

   The estimated future net recoverable oil and gas reserves from proved
properties as of December 31, 1996, 1995, 1994, 1993, and 1992 were as follows:
<TABLE>
<CAPTION>
 
                          Crude Oil         Natural Gas
                          ----------        -----------
<S>                   <C>                <C>   
            1996      13,712,000   bbl   19,795,000    mcf
            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
</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 $115,000,000, $60,000,000, $44,000,000, $21,000,000, and $33,000,000
at December 31, 1996, 1995, 1994, 1993, and 1992, 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:

                  (In thousands of bbls and thousands of mcf)
<TABLE>
<CAPTION>

                                                  1996     1995     1994     1993     1992
                                                 ------   ------   ------   ------   ------
<S>                                              <C>      <C>      <C>      <C>      <C>
Crude Oil                                         1,357    1,206      969      795      835
                                                 ------   ------   ------   ------   ------
Natural Gas                                       1,976    2,181    1,456      998    1,306
                                                 ------   ------   ------   ------   ------
</TABLE> 
 
  The Company's average sales prices and production costs per unit for the past
five years were as follows:

<TABLE> 
<CAPTION> 
                                                         1996     1995     1994     1993     1992
                                                       ------   ------   ------   ------   ------
<S>                                                    <C>      <C>      <C>      <C>      <C> 
Sales Price                  
-----------                  
                             
Crude Oil (per bbl)(1)                                 $15.28   $13.56   $12.97   $13.29   $14.44
                                                       ------   ------   ------   ------   ------
                             
Natural Gas (per mcf)                                  $ 1.80   $ 1.24   $ 1.71   $ 2.08   $ 1.89
                                                       ------   ------   ------   ------   ------
                             
Production Costs (per boe)(2)                          $ 4.56   $ 4.63   $ 5.35   $ 6.98   $ 6.76
----------------                                       ------   ------   ------   ------   ------
</TABLE>

 (1)The crude oil sales prices include the effects of the Company's hedging
 activities which reduced the 1996 and 1995 realized sales prices by $1.03 and
 $0.40 per barrel, respectively, and increased the 1994, 1993 and 1992 average
 sales prices by $0.46, $0.59 and $0.02 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, 1996, 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          295       224    42,046    9,538
Natural Gas        182        26    80,650    9,749
                   ---       ---   -------   ------
  Totals           477       250   122,650   19,287
                   ===       ===   =======   ======
</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, 1996, 1995, and 1994, the Company
participated in the drilling of 27, 35, and 27 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> 
1996
----
Exploratory Wells          1     .5       5   2.5       6    3.0
Development Wells         21   20.9      --    --      21   20.9
                         ---   ----     ---   ---     ---   ----
  Totals                  22   21.4       5   2.5      27   23.9
                         ---   ----     ---   ---     ---   ----
 
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
                         ---   ----     ---   ---     ---   ---- 
</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, 1996, the Company held positions in unproven
acreage in the following locations:
<TABLE>
<CAPTION>
 
                             Acres
                             ------
                             Gross     Net
                             ------   -----
<S>                          <C>      <C>
California
----------
   Fresno County              1,489     299
   Kern County                   57      29
   Madera County                671     335
   Merced County              3,803   1,452
   Santa Barbara County         542     542
   Solano County              3,429   1,715
 
Nevada
------
   Nye County                 1,280     576
                             ------   -----
 
   Totals                    11,271   4,948
                             ======   =====
</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 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 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 settled the suit with a payment to the waste haulers
of $5,000.  While there can be no assurance that the Company will be able to
settle any existing and future claims associated with OII, and subject to the
uncertainty arising from the matters raised in the final paragraph of this
subsection, 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 have disputed coverage and have received a summary judgment
ruling in their favor on the issue of insurance coverage of the Company's
claims.  The Company intends to appeal the ruling, however, there is no
assurance that the Company will ultimately prevail.

     By letter from the EPA dated March 7, 1997, the Company was advised that it
(and six other companies) is subject to a "Unilateral Administrative Order"
requiring that it "operate the onsite leachate treatment system from May 10,
1997 to December 31, 1999, among other tasks." 

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

The letter from the EPA states that failure to comply with the Order, without
sufficient cause, could subject the Company to penalties and punitive damages.
As of the date of this report, the Company cannot predict the effect of this
matter on capital expenditures, earnings or its competitive position; however,
management believes that the outcome will not have a material impact on
Company's financial condition.

  (b) As previously reported in 1995, the Company is proceeding as a co-
plaintiff in 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 expected to go to trial in
1997.  This matter pertains to the company's investment in Triumph Natural Gas,
Inc.  The lawsuit alleges that certain conduct of the defendants resulted in
diminishing the value of Triumph Natural Gas, Inc.  The plaintiffs seek to
recover actual and punitive damages.  One defendant has filed a counterclaim
seeking unspecified damages against the non-corporate plaintiffs and has
included 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.  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               50   Chairman of the Board and Chief
                                     Executive Officer
 
Ronald T Yoshihara              42   Vice President and Treasurer
                                     Chief Financial Officer
 
Robert E. Ransom                45   Vice President-Corporate
                                     Development
 
William H. Moodie               44   Vice President-Operations
 
Craig M. Sturtevant             47   Vice President-General Counsel
</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 Mr. L.C. McFarland
in March 1986.  In January 1992, Mr. L.C. McFarland resigned as Chairman of the
Board and Mr. John C. 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.

  Mr. Moodie was elected Vice President in December 1996.  He joined McFarland
Energy, Inc. in 1992 as Manager of Engineering.  Previously, Mr. Moodie was
employed by Santa Fe Energy Resources, Inc. as a Senior Production Engineer.

  Mr. Sturtevant was elected Vice President in December 1996.  He joined
McFarland Energy, Inc. in 1994 as General Counsel.  Previously, Mr. Sturtevant
was employed by Exxon Corporation as an attorney in the Production Department.

                                       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 ("MCFE").
During 1996 and 1995, the quarterly high and low closing prices were as follows:
<TABLE>
<CAPTION>
 
                              1996              1995
                             ------             -----
                          High      Low     High     Low
                         ------   -------   -----   -----
<S>                      <C>      <C>       <C>     <C>
 
     First Quarter        8 3/4     7 1/4       8   5 7/8
     Second Quarter      10 3/8   7 31/32       8   6 1/4
     Third Quarter       10 1/2         9   7 1/2   6 3/4
     Fourth Quarter      12 1/2        10   8 1/4   6 1/4
</TABLE>
  As of March 5, 1997, there were approximately 1,700 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.

                                       15
<PAGE>
 
Item 6.  Selected Financial Data
--------------------------------
<TABLE>
<CAPTION>
 
 
                                               1996      1995(1)     1994       1993(2)     1992
                                             --------   --------   --------   ---------   --------
                                                    (In thousands except per share data)
<S>                                          <C>        <C>        <C>        <C>         <C>
Operations
----------
(Year ended December 31)
Net operating revenue                         $25,721    $19,883    $16,270    $12,862     $15,283
Income (loss) from continuing                 $ 7,126    $13,641    $ 1,508    $(1,566)    $   925
 operations before accounting change
 
  Per Share-Primary                           $  1.26    $  2.61    $  0.29    $ (0.30)    $  0.18
  Per Share-Fully Diluted                     $  1.26    $  2.41    $  0.29    $ (0.30)    $  0.18
Net income (loss)                             $ 7,126    $13,641    $ 1,508    $(1,116)    $   925
 
  Per Share-Primary                           $  1.26    $  2.61    $  0.29    $ (0.21)    $  0.18
  Per Share-Fully Diluted                     $  1.26    $  2.41    $  0.29    $ (0.21)    $  0.18
 
Financial Position
------------------
 (As of December 31)
Working Capital                               $ 8,758    $ 4,793    $ 2,792    $ 2,902     $ 3,678
Total Assets                                  $50,859    $47,693    $43,545    $23,016     $25,117
Convertible Notes (3)                             ---    $ 2,600    $ 2,600    $ 2,600     $ 2,592
Production Payment Notes                      $ 2,558    $ 3,139    $ 3,481        ---         ---
Long-term Debt                                    ---        ---    $12,650        ---         ---
 
</TABLE>


(1)In January 1995, the Company recorded a litigation settlement of $17,158,000,
net of legal fees and other related costs.  See Note 3. of Notes to Consolidated
Financial Statements.

(2)Net loss reflects the $450,000 ($0.09 per share) benefit of the cumulative
effect of the change in accounting for income taxes which resulted from the
Company's adoption of Financial Accounting Standards Board Statement No. 109
"Accounting for Income Taxes".

(3)In January 1996, the Company elected to convert the convertible note into
400,000 shares of McFarland Energy, Inc. common stock.  See Note 6. 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 before the change in current assets
and liabilities in 1996 totaled $12,393,000 as compared to $26,717,000 in 1995.
The 1995 results reflected the settlement of a lawsuit which netted the Company
$17,158,000, after deducting for attorney fees and estimated taxes.  In 1996,
operating cash flow benefitted from higher oil and gas production and prices and
lower per unit lifting costs.

   Crude oil production in 1996 rose 13% above the prior year to 1,357,000
barrels, a new Company record.  Higher crude production in 1996 reflected the
positive results from the Company's ongoing development drilling and steaming
activities in the Midway Sunset field, California.  In 1996, the Company drilled
a total of twenty-one wells at its two core properties in this field.  The
increase in production from these two properties accounted for substantially all
of the increase in company wide oil production.  For 1997, the Company has a
similar development drilling program budgeted, consisting of twenty-five well
drilling program to commence in March 1997.  The Company expects the development
drilling program at the Midway Sunset field, combined with drilling planned at
several of its other California and Texas properties, to raise its 1997 oil
production above the 1996 levels.

   Natural gas production declined 9% in 1996 to 1,976,000 mcf as a result of
lower production from the Company's gas wells in the Northern San Joaquin Valley
and in East Texas.  The decline rates of the Northern San Joaquin Valley wells
have been much steeper than anticipated and prices have averaged well below
$2.00 per mcf.  Consequently, in 1996 the Company discontinued exploration
activities in this area.  As of March 1997, there remain four producing wells
and one shut-in well. In 1997, the Company does not expect a significant
contribution from these remaining wells.  In East Texas, the Company's operation
in the Oak Hill field is expected to account for approximately 32% of 1997 gas
production.  The Company considers the Oak Hill field a core operation and is
seeking opportunities to expand on its holdings in this area. In the California
Sacramento Valley, the Company expects its interest in the Rio Vista gas unit to
account for approximately 24% of its 1997 gas production.  For 1997, without
consideration of possible producing property acquisitions, gas production is
projected to equal or slightly exceed 1996 levels.

   The benchmark West Texas Intermediate ("WTI") crude price continued to
strengthen throughout 1996, closing the year at a twelve month high.  California
crude performed equally as well, averaging $15.78 per barrel during the year,
which was the highest average price since 1990. Equally as important was the
fact that the "basis" differential between California heavy crude and WTI
remained within a historically narrower dollar range.  From the mid 1980's
through 1994, this differential ranged between $7.00 to $9.00 per barrel.  In
1995, and continuing through 1996, the differential narrowed significantly to a
range of $3.00 to $6.50 per barrel.  On the West Coast, demand for crude oil has
been rising at the same time that production of crude 

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

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 crude was shipped by tanker
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 will 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
refiner, whereby a price range based on California Midway Sunset field posted
prices is established.  The purpose of the hedge is to ensure the Company a
minimum level of cash flow to fund its capital commitments.  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.  The current agreement, effective November 1996,
covers approximately one-half of the Company's average daily oil production and
runs through October 1997.

   In 1996, the Company's average natural gas price was $1.80 per mcf, up
sharply from the 1995 average of $1.24 per mcf.  Gas prices in 1996 began the
year higher and remained relatively stable throughout the first nine months of
the year.  This period of relatively higher prices and price stability reflected
the strengthened market fundamentals of colder national weather conditions and
below average gas storage levels.  These factors greatly contributed to the
"spike" in gas prices at the end of 1996, which carried over through mid-
February 1997.  During this period, colder than normal weather conditions caused
gas prices in most regions of the country to rise near or above $4.00 per mcf.
However, since that time, gas prices have fallen precipitously to below $2.00
per mcf in most regions, as the national weather picture has turned to  "warmer
than normal" conditions in most areas of the country.  This recent extreme gas
price volatility confirms the fragile supply/demand equilibrium that now exists
in the natural gas markets.  Consequently, it appears that future gas prices
will continue to be highly seasonal and especially volatile during the peak
demand winter months.

   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 saved the Company
$193,000 of interest expense in 1996.

   The Company presently maintains an unsecured $10,000,000 revolving line of
credit facility which expires on June 1, 1997. The credit facility is to be used
for producing property acquisitions.  As of March 1997, there is no outstanding
borrowing.  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 one or more significant producing property
acquisitions.

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

CAPITAL RESOURCES
-----------------

   Net working capital at December 31, 1996 totaled $8,758,000, up 83% from the
prior year. This sharp increase in year end net working capital reflected the
Company's strong operating performance.  In 1996, the Company achieved record
cash flow from operations, record oil production and reduced per unit lifting
costs.

   In 1996, oil and gas related capital expenditures totaled $7,551,000,
consisting of development activities of $3,179,000, exploration activities of
$2,538,000 and producing property acquisitions of $1,834,000.

   Development activities in 1996 consisted primarily of development drilling in
the Midway Sunset field and capital expenditures for surface facility
enhancements and maintenance projects. In 1996, the Company drilled twenty-one
development wells at Midway Sunset at a cost of $1,855,000.  For 1997, the
Company has budgeted twenty-five wells at Midway Sunset and up to nine wells at
other properties in California and Texas.  The budgeted cost of all 1997
development related activities is approximately $5,700,000.

   The primary focus of the Company's exploration activities in 1996 was in the
California San Joaquin Valley.  In 1996, the Company participated in the
drilling of five exploratory wells in the Northern San Joaquin Valley, one of
which was successfully completed as a producer and four were dry holes.  In
addition, the Company drilled one exploratory dry hole in another area of the
San Joaquin Valley.  Due to the disappointing drilling results and operating
performance of the producing wells in the Northern San Joaquin Valley, the
Company has decided to discontinue its exploratory activities in this area.  For
1997, the Company has budgeted approximately $2,200,000 for exploration
activities primarily focused in California. However, the Company's budget also
includes a limited number of higher risk, higher potential out-of-state
exploratory ventures.

   In 1996, the Company was successful in consummating an acquisition of a non-
operated working interest in the California Rio Vista gas unit for $1,612,000.
This was the second such acquisition in California's most prolific dry gas
producing unit.  In late 1995, the Company made a similar acquisition of a non-
operated working interest for $1,000,000.  The Company now owns an 8% interest
in the gas unit.  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.

   For 1997, the Company's total capital budget is approximately $12,000,000,
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 one or more significant producing property acquisition.

                                       19
<PAGE>
 
Item 7. Management's Discussion and Analysis of Financial Condition and Results
--------------------------------------------------------------------------------
of Operations  (continued)
-------------
 
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 has
elected to continue to follow the intrinsic value-based method of accounting
prescribed by APB No. 25.  See Note 8. of Notes to Consolidated Financial
Statements for pro forma disclosures required by SFAS No. 123.

   In February 1997, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards ("SFAS") No. 128, "Earnings per Share."  SFAS
No. 128 replaces the standards for computing earnings per share previously
established by APB No. 15, "Earnings per Share" by replacing the primary EPS
with a presentation of "basic EPS" and requiring dual presentation of basic and
diluted EPS on the face of the income statement.  SFAS No. 128 requires
companies to adopt its provisions for fiscal years ending after December 15,
1997 and requires restatement of all prior period EPS data, if necessary.  The
Company has not yet determined the impact on the financial statements.

RESULTS OF OPERATIONS 1996 VS. 1995
-----------------------------------

   Oil and gas revenues in 1996 increased 28% to $24,541,000 from $19,204,000 in
1995.  This significant increase reflects higher crude oil production and higher
crude oil and natural gas prices in 1996.

   Crude oil production in 1996 totaled 1,357,000 barrels, or a 13% increase
above the prior year.  Higher crude production was attributable to the Company's
successful development activities in the Midway Sunset field and the Barham
Ranch property which was acquired in late 1995.  Natural gas production
decreased 9% to 1,976,000 mcf in 1996. This decrease was primarily attributable
to declining production from the Company's gas wells in the Northern San Joaquin
Valley and Oak Hill field, which was partially offset by the net production from
the Rio Vista gas unit.  1996 production from the Northern San Joaquin Valley
and Oak Hill field operations declined 29% and 13%, respectively, from 1995.
Production from the Rio Vista gas unit accounted for approximately 12% of the
Company's total gas production in 1996.

                                       20
<PAGE>
 
Item 7. Management's Discussion and Analysis of Financial Condition and Results
--------------------------------------------------------------------------------
of Operations  (continued)
-------------
 
   Crude oil prices in 1996, excluding the effects of the Company's hedge
program, averaged $16.31 per barrel as compared to $13.96 per barrel received in
1995.  In 1996, the hedge program reduced revenues by $1,381,000 or $1.03 per
barrel.  In 1995, the hedge program reduced revenues by $482,000, or $0.40 per
barrel.  Natural gas prices averaged $1.80 per mcf in 1996 as compared to $1.24
per mcf received in 1995.

   Oil and gas production costs rose 6% to $7,691,000 in 1996.  However, on a
barrel of oil equivalent ("BOE") basis, the average lifting cost in 1996
declined slightly to $4.56 per BOE from $4.63 per BOE in 1995.

   Exploration, dry holes and abandonment costs of $1,627,000 in 1996 reflected
five exploratory dry holes drilled in the Northern San Joaquin and Sacramento
Valleys, leasehold write-offs and property abandonment costs.

   General and administrative expense in 1996 increased 23% to $2,816,000, due
primarily to higher overall general corporate expenses, increased consulting
fees for engineering and technical services associated with the Company's
ongoing producing property acquisition efforts and year end bonus accruals.
Interest expense for 1996 declined to $193,000 as a result of the conversion of
the convertible note in January 1996. See Note 6. of Notes to Consolidated
Financial Statements.

   In 1996, the Company's effective tax rate was 21%.  This compares with a net
tax benefit in 1995, which reflected the realization of tax benefits
attributable to operating loss and percentage depletion carryforwards.

   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.  See
Note 1. of Notes to Consolidated Financial Statements. As a result of this
accounting pronouncement, in 1995 the Company recorded impairment losses on
certain oil and gas properties and an investment in a natural gas marketing and
gas gathering company totaling $7,917,000.

   The litigation settlement in 1995 reflected the net proceeds of $17,158,000
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.

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 

                                       21
<PAGE>
 
Item 7. Management's Discussion and Analysis of Financial Condition and Results
--------------------------------------------------------------------------------
of Operations  (continued)
-------------
 
in the prior year.  This significant increase was primarily
attributable to the Company's successful 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 dry holes drilled in the Northern San Joaquin and Sacramento 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 totaling $1,520,000
and also wrote-off its investment in its natural gas storage project at Ten
Section totaling $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.

                                       22
<PAGE>
 
Item 8.  Financial Statements and Supplementary Data
----------------------------------------------------

                                       23
<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 53 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
misstatements. 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 believer 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, 1996 and 1995, and the consolidated
results of their operations and their cash flows for each of the three years in
the period ended December 31, 1996 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 impairment of long-lived assets in 1995,
and the amortization of oil and gas properties in 1994.

/s/ Coopers & Lybrand, L.L.P.

Coopers & Lybrand, L.L.P.
Newport Beach, California
March 7, 1997 

                                      24
<PAGE>
 
                             McFarland Energy, Inc.
                          Consolidated Balance Sheets
<TABLE>
<CAPTION>
                                                         December 31,
                                                         ------------
                                                     1996            1995
                                                 ------------    ------------
<S>                                              <C>             <C>
                          Assets
                          ------
Current Assets
  Cash and cash equivalents                      $  9,289,000    $  6,974,000
  Accounts receivable                               4,208,000       3,797,000
  Tax refund receivable                                   ---         229,000
  Crude oil inventory                                 316,000         259,000
  Materials and supplies inventory                    176,000         131,000
  Prepaid expenses and other current assets           669,000         610,000
  Deferred tax assets                                     ---       1,588,000
                                                 ------------    ------------
    Total current assets                           14,658,000      13,588,000
                                                 ============    ============ 
Property and Equipment
  Oil and gas properties                           85,505,000      85,688,000
  Other equipment                                   3,406,000       3,411,000
                                                 ------------    ------------
                                                   88,911,000      89,099,000
  Less accumulated depletion and depreciation     (53,274,000)    (55,266,000)
                                                 ------------    ------------
                                                   35,637,000      33,833,000
                                                 ------------    ------------
Other Assets                                          155,000         272,000
                                                 ------------    ------------
Deferred Tax Assets                                   409,000             ---
                                                 ------------    ------------
                                                 $ 50,859,000    $ 47,693,000
                                                 ============    ============ 
       Liabilities and Stockholders' Equity
       ------------------------------------
Current Liabilities
  Accounts payable                               $  2,497,000    $  2,170,000
  Royalties and revenue payable                     1,786,000       1,345,000
  Cost advances from joint venture partners           163,000           9,000
  Other taxes payable                                 504,000         283,000
  Other accrued liabilities                           950,000       4,988,000
                                                 ------------    ------------
    Total current liabilities                       5,900,000       8,795,000
                                                 ------------    ------------   
Convertible Note                                          ---       2,600,000
                                                 ------------    ------------
Production Payment Notes                            2,558,000       3,139,000
                                                 ------------    ------------
Deferred Income Taxes                                     ---         764,000
                                                 ------------    ------------
Stockholders' Equity
 Common Stock, $1.00 par value                   
  Authorized  10,000,000 shares, Issued and      
  Outstanding 5,679,484 and 5,239,234            
  in 1996 and 1995                                  5,679,000       5,239,000
 Additional paid-in capital                        21,372,000      18,932,000
 Retained Earnings                                 15,350,000       8,224,000
                                                 ------------    ------------
                                                   42,401,000      32,395,000
                                                 ------------    ------------
                                                 $ 50,859,000    $ 47,693,000
                                                 ============    ============

</TABLE>                                         


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

                                       25
<PAGE>
 
                             McFarland Energy, Inc.
                     Consolidated Statements of Operations



<TABLE>
<CAPTION>
 
 
                                                         Year Ended December 31,
                                                -----------------------------------------  
                                                    1996           1995           1994
                                                -----------   ------------    -----------
<S>                                             <C>           <C>             <C> 
Revenues:
   Oil and gas sales                            $24,541,000   $ 19,204,000    $15,310,000
   Interest and other                               495,000        551,000        171,000
   Gain on sale of assets                           685,000        128,000        789,000
                                                -----------   ------------    ----------- 
                                                 25,721,000     19,883,000     16,270,000
                                                -----------   ------------    ----------- 
Costs and expenses:
   Crude oil and gas production                   7,691,000      7,274,000      6,482,000
   Exploration, dry holes and abandonments        1,627,000      1,595,000        705,000
   Depletion and depreciation                     4,242,000      4,374,000      3,927,000
   General and administrative                     2,816,000      2,294,000      2,314,000
   Litigation settlement                                ---    (17,158,000)           ---
   Property impairments                                 ---      7,917,000            ---
   Interest                                         193,000        548,000        840,000
   Other                                            103,000        440,000        492,000
                                                -----------   ------------    -----------
                                                 16,672,000      7,284,000     14,760,000
                                                -----------   ------------    ----------- 
 
Income before income taxes                        9,049,000     12,599,000      1,510,000
                                                -----------   ------------    -----------
 
Income taxes (benefit):
   Current                                        1,508,000         27,000          2,000
   Deferred                                         415,000     (1,069,000)           ---
                                                -----------   ------------    ----------- 
                                                  1,923,000     (1,042,000)         2,000
                                                -----------   ------------    -----------
 
Net income                                      $ 7,126,000   $ 13,641,000    $ 1,508,000
                                                ===========   ============    ===========  
 
Net income per common share:
   Primary                                            $1.26          $2.61          $0.29 
                                                       ====           ====           ==== 

   Fully diluted                                      $1.26          $2.41          $0.29
                                                       ====           ====           ====

</TABLE> 

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

                                       26
<PAGE>
 
                            McFarland Energy, Inc.
          Consolidated Statements of Changes in Stockholders' Equity

<TABLE>
<CAPTION>
 
                                                               Additional      Retained         Total
                                           Common Stock          Paid-in      Earnings/     Stockholders'
                                       Shares       Amount       Capital      (Deficit)        Equity
                                      ---------   ----------   -----------   ------------   -------------
<S>                                   <C>         <C>          <C>           <C>            <C>
Balances, January 1, 1994             5,199,359   $5,199,000   $18,796,000   $(6,925,000)     $17,070,000
Exercise of stock options                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
Exercise of stock options                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
Conversion of convertible note          400,000      400,000     2,200,000           ---        2,600,000
                                                                                                          
Exercise of stock options,
  including related tax benefits         40,250       40,000       240,000           ---          280,000 
Net income for year                         ---          ---           ---     7,126,000        7,126,000
                                      ---------   ----------   -----------   -----------    ------------- 
Balances, December 31, 1996           5,679,484   $5,679,000   $21,372,000   $15,350,000      $42,401,000
                                      =========   ==========   ===========   ===========    ============= 
 
</TABLE>

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

                                       27
<PAGE>
 
                            McFarland Energy, Inc.
                     Consolidated Statements of Cash Flows
<TABLE>
<CAPTION>
 
 
                                                       Year Ended December 31,
                                               -------------------------------------------- 
                                                   1996            1995            1994         
                                               ------------    ------------    ------------      
<S>                                            <C>             <C>             <C>   
CASH FLOWS FROM OPERATING                                                                       
 ACTIVITIES:                                                                                    
 Net income                                    $  7,126,000    $ 13,641,000    $  1,508,000     
 Adjustments to reconcile                                                                       
  net income to net cash provided by                                                                           
  operating activities:                                                                         
   Depletion and depreciation                     4,242,000       4,374,000       3,927,000     
   Dry holes, abandonments and impairments        1,295,000       9,471,000         571,000      
   Deferred income taxes                            415,000      (1,069,000)            ---     
   Gain from sale of assets                        (685,000)       (128,000)       (789,000)    
   Other                                                ---         428,000             ---     
   Change in assets and liabilities:                                                                                
     Decrease (increase) in:                                                                    
        Receivables                                (411,000)      1,872,000      (2,387,000)    
        Tax refund receivable                       229,000        (200,000)            ---     
        Inventory                                  (102,000)          3,000         (69,000)    
        Prepaids and other current assets           (59,000)         27,000         (58,000)     
     Increase (decrease) in:                                                                    
        Accounts payable                            327,000        (438,000)        684,000     
        Royalties and revenue payable               441,000        (312,000)        664,000       
        Cost advances from joint venture
         partners                                   154,000        (264,000)        273,000
        Taxes payable                               221,000           9,000          78,000
        Other accrued expenses                      341,000         (56,000)        391,000
                                               ------------    ------------    ------------      
 NET CASH PROVIDED BY OPERATING ACTIVITIES       13,534,000      27,358,000       4,793,000 
                                               ------------    ------------    ------------      
CASH FLOWS FROM (USED IN) INVESTING ACTIVITIES:
 Purchase of property and equipment
  (including dry holes)                          (7,551,000)    (13,207,000)   (22,435,000)
 Amounts included in accrued liabilities         (4,379,000)      4,379,000            ---         
 Proceeds from sales of property and equipment      895,000         145,000         10,000                   
 Other                                              117,000          55,000          5,000        
                                               ------------   ------------    ------------                   
 NET CASH USED IN INVESTING ACTIVITIES          (10,918,000)     (8,628,000)   (22,420,000)       
                                               ------------   ------------    ------------                   
CASH FLOWS FROM (USED IN) FINANCING ACTIVITIES: 
 Exercise of stock options                          280,000         123,000         53,000        
 Payments on debt                                  (581,000)    (13,743,000)      (143,000)       
 Issuance of production payment notes                   ---             ---      3,624,000                   
 Proceeds from long-term borrowing                      ---             ---     13,400,000                   
                                               ------------   ------------    ------------                   
 NET CASH (USED IN) FROM FINANCING ACTIVITIES      (301,000)    (13,620,000)    16,934,000                   
                                               ------------   ------------    ------------                    
NET INCREASE/(DECREASE) IN CASH AND                                                                          
  CASH EQUIVALENTS                                2,315,000       5,110,000       (693,000)        
 
Cash and cash equivalents, beginning of the year  6,974,000       1,864,000      2,557,000 
                                               ------------   ------------    ------------                    
CASH AND CASH EQUIVALENTS, END OF THE YEAR     $  9,289,000    $  6,974,000   $  1,864,000
                                               ============    ============   ============
</TABLE>

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

                                       28
<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.  In December 1995, Carl was merged into
McFarland and all of the operational and administrative functions of Carl were
assumed by McFarland.

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 temporarily invests 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, approximates market value.  The average pretax
yield at December 31, 1996 and 1995 was 5.3% and 5.6%, 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, 1996 and 1995 was
$8,475,000 and $6,200,000, respectively.  Also included as cash equivalent at
December 31, 1996 and 1995 was cash held in an interest bearing escrow account
of $328,000 and $280,000, 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. 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.

                                       29
<PAGE>
 
                            McFarland Energy, Inc.
                  Notes to Consolidated Financial Statements

 
  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
-----------------------

  Since 1992, the Company has maintained a crude oil hedging arrangement with a
refiner, whereby a price range based on California Midway Sunset field posted
prices is established.  The purpose of the hedge is to ensure the Company a
minimum level of cash flow to fund its capital commitments.  When the monthly
weighted average Midway Sunset field posted price is above the top of this
range, then 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.  The current agreement, effective November 1,
1996, covers approximately one-half of the Company's average daily oil
production and runs through October 1997.

  Any gain or loss resulting from the hedging arrangement is recognized each
month and included in the results of operations.  In 1996 and 1995, the hedge
program decreased revenues by $1,381,000 and $482,000, respectively.  In 1994,
the hedge program increased revenues by $446,000.  The Hedge Agreement requires
that the Company and the refiner maintain certain minimum levels of security.
At December 31, 1996 and 1995, the Company had on deposit in an interest bearing
escrow account $328,000 and $280,000, 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.

                                       30
<PAGE>
 
                            McFarland Energy, Inc.
                  Notes to Consolidated Financial Statements

 
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 per Common Share
---------------------------

  The computation of primary earnings per share is based on the weighted average
number of 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 weighted average
number of outstanding shares used for primary and fully diluted earnings per
share for 1996 was 5,654,474.  For 1995, the computation of fully diluted
earnings per share 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 was 5,229,338 and 5,755,730,
respectively. The weighted average number of outstanding shares for 1994 was
5,202,630.

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.  The new statement requires the
impairment review be performed on the lowest level of asset grouping for 

                                       31
<PAGE>
 
                            McFarland Energy, Inc.
                  Notes to Consolidated Financial Statements


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 totaling $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 totaling $1,520,000.  In addition, the Company wrote-
off its previously deferred development costs totaling $882,000 related to its
Ten Section gas storage project.  The Company determined that this asset had
been impaired based on the market uncertainties negatively impacting the
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 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

  Rio Vista Property Acquisition - During 1996, the Company closed two
  ------------------------------                                      
acquisitions for a combined 8% non-operated working interest in California's
most prolific dry gas producing unit in Sacramento Valley.  Total consideration
for the interests acquired was $2,612,000 cash and was funded from the Company's
existing cash balances.  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.

  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 producing oil wells in Santa Barbara County,
California for $3,400,000 cash.  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. The Company borrowed $6,000,000 under the term loan 

                                       32
<PAGE>
 
                            McFarland Energy, Inc.
                  Notes to Consolidated Financial Statements
 

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 operated and thirty-three
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.

3.  LITIGATION SETTLEMENT

  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 totaling
$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 totaling $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, 

                                       33
<PAGE>
 
                            McFarland Energy, Inc.
                  Notes to Consolidated Financial Statements

 
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, 1996, there was no outstanding borrowing under this facility.
The Company paid no interest on this facility in 1996.

  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 1996, the Company did not pay any 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 .25% per annum on the unused portion of the
revolving credit facility.  There are no compensating balance requirements.  The
Credit Agreement expires on June 1, 1997.


 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 1996, the Company made interest payments
totaling $144,000 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 

                                       34
<PAGE>
 
                            McFarland Energy, Inc.
                  Notes to Consolidated Financial Statements

 
had 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
totaling $208,000. On January 29, 1996, the Company converted the note 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 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.  Effective January 1, 1997, the
Company increased it's matching contributions to 8% 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 year for the next three
years.

  For the three years ended December 31, 1996, 1995, and 1994, contributions of
$187,000, $172,000, and $171,000, respectively, were made by the Company to the
plan.

                                       35
<PAGE>
 
                            McFarland Energy, Inc.
                  Notes to Consolidated Financial Statements

 
8.  STOCK OPTION PLANS

  Employee Plan
  -------------

  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 were 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 and 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 were reserved for issuance to officers and key employees.

  At the May 30, 1996 Annual Meeting of Shareholders, the shareholders approved
the 1996 Incentive Stock Plan ("1996 Plan") which is identical in all material
respects to the 1986 and 1989 Plans.  Under the 1996 Plan, 260,000 shares of the
Company's common stock are reserved for issuance to officers and key employees.

  A summary of the Company's stock option activity, and related information for
the years ended December 31 follows:
<TABLE>
<CAPTION>
 
                                                1996                     1995
                                      -----------------------   -----------------------
                                                   Wtd. Avg.                 Wtd. Avg.
                                       Options    Exer. Price    Options    Exer. Price
                                      ---------   -----------   ---------   -----------
<S>                                   <C>         <C>           <C>         <C>
Outstanding-beginning of year          317,063          $4.89    295,875          $4.59
Granted                                 86,000          $7.50     69,000          $6.25
Exercised                              (40,250)         $4.51    (25,000)         $4.55
Forfeited                               (2,562)         $5.70    (22,812)         $5.53
                                      --------                  --------
Outstanding-end of year                360,251          $5.58    317,063          $4.89
                                      ========                  ========
Exercisable-end of year                219,781                   199,892
                                      ========                  ========
Weighted average fair value of           
 options granted during the year         $3.33                     $2.73
                                      ========                  ========
 
</TABLE>

   Exercise prices for options outstanding as of December 31, 1996 ranged
from $4.13 to $10.00 per share.  The weighted average contractual life of these
options is 6.9 years.

                                       36
<PAGE>
 
                            McFarland Energy, Inc.
                  Notes to Consolidated Financial Statements

 
8. STOCK OPTION PLANS (continued)

   Director Plan
   -------------

   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.  Effective January 1, 1997, the Director Plan was amended
to increase the annual grant to outside directors to 2,000 shares of common
stock.  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.

   A summary of the Company's stock option activity, and related information for
the years ended December 31 follows:
<TABLE>
<CAPTION>
 
                                              1996                     1995
                                      ---------------------   ----------------------
                                                 Wtd. Avg.                Wtd. Avg.
                                      Options   Exer. Price   Options    Exer. Price
                                      -------   -----------   --------   -----------
<S>                                   <C>       <C>           <C>        <C>
Outstanding-beginning of year          18,000         $5.86    14,000          $5.21
Granted                                 7,000         $9.88     6,000          $7.00
Exercised                                 ---           ---    (2,000)         $4.75
Outstanding-end of year                25,000         $6.99    18,000          $5.86
                                      =======                 =======
Exercisable-end of year                25,000                  18,000
                                      =======                 =======
Weighted average fair value of       
 options granted during the year      $  3.33                 $  2.73
                                      =======                 =======

</TABLE>

   Exercise prices for options outstanding as of December 31, 1996 ranged
from $4.75 to $9.88 per share.  The weighted average contractual life of these
options is 8.3 years.

   The Company has elected to follow Accounting Principles Board Opinion
No. 25, "Accounting for Stock Issued to Employees" ("APB 25")  and related
Interpretations in accounting for its employee stock options because, as
discussed below, the alternative fair value accounting provided for under FASB
Statement No. 123, "Accounting for Stock-Based Compensation," requires use of
option valuation models that were not developed for use in valuing employee
stock options.  Under APB 25, because the exercise price of the Company's
employee stock options equals the market price of the underlying stock on the
date of the grant, no compensation expense is recognized.

                                       37
<PAGE>
 
                            McFarland Energy, Inc.
                  Notes to Consolidated Financial Statements

 
8. STOCK OPTION PLANS (continued)

          Pro forma information regarding net income and earnings per share is
required by SFAS No. 123, and has been determined as if the Company had
accounted for its employee stock options under the fair value method of that
Statement.  The fair value for these options was estimated at the date of the
grant using a Black-Scholes option pricing model with the following weighted-
average assumptions for 1996 and 1995, respectively: risk-free interest rates of
6.5% and 5.4%; volatility factors of the expected market price of the Company's
common stock of .39 and .41; and a weighted-average expected life of the option
of 5 years.

          The Black-Scholes option valuation model was developed for use in
estimating the fair value of traded options which have no vesting restrictions
and are fully transferable.  In addition, option valuation models require the
input of highly subjective assumptions including the expected stock price
volatility.  Because the Company's employee's stock options have characteristics
significantly different from those of traded options, and because changes in the
subjective input assumptions can materially affect the fair value estimate, in
management's opinion, the existing models do not necessarily provide a reliable
single measure of the fair value of its employee stock options.

          For purposes of pro forma disclosures, the estimated fair value of the
options is amortized to expense over the options' vesting period.  The Company's
pro forma information follows:
<TABLE>
<CAPTION>
 
                                           1996         1995
                                        ----------   -----------
<S>                                     <C>          <C>
 
     Pro forma net income               $7,034,000   $13,600,000
                                        ==========   ===========
 
     Pro forma earnings per share:
 
       Primary                          $     1.24   $      2.60
                                        ==========   ===========
 
       Fully diluted                    $     1.24   $      2.41
                                        ==========   ===========
 
</TABLE>

                                       38
<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,
                                                     ---------------------------------------
                                                         1996          1995           1994
                                                     -----------    -----------    --------- 
<S>                                                  <C>            <C>            <C> 
Computed tax at 34%                                  $ 3,077,000    $ 4,284,000    $ 513,000
 
State income taxes, net of federal tax benefit           555,000        773,000       93,000
 
Utilization of net operating loss carryforwards       (1,347,000)    (1,607,000)         ---
 
Utilization of percentage depletion                   (1,177,000)           ---          ---
 
Asset acquisition and sale differences                   736,000            ---          ---
 
Other, net                                                79,000          9,000      204,000
 
Change in valuation allowance                                ---     (4,501,000)    (808,000)
                                                     -----------    -----------    ---------  
                                                      $1,923,000    $(1,042,000)      $2,000
                                                      ==========    ===========    =========  
</TABLE> 

Income taxes have the following components:
<TABLE> 
<S>                                                   <C>           <C>               <C> 

Current tax expense:
  Federal                                             $1,138,000    $       ---    $     ---             
  State                                                  370,000         27,000        2,000           
                                                     -----------    -----------    --------- 
                                                       1,508,000         27,000        2,000           
                                                     -----------    -----------    --------- 
Deferred tax expense (benefit):                                                                        
  Federal                                                261,000     (1,069,000)         ---           
  State                                                  154,000            ---          ---           
                                                     -----------    -----------    --------- 
                                                         415,000     (1,069,000)         ---           
                                                     -----------    -----------    --------- 
                                                                                                       
                                                      $1,923,000    $(1,042,000)      $2,000            
                                                      ==========    ===========    =========  
</TABLE>

                                       39
<PAGE>
 
                            McFarland Energy, Inc.
                  Notes to Consolidated Financial Statements

 
9.      INCOME TAXES (continued)

   The deferred tax assets and liabilities as of December 31, 1996 and 1995 were
as follows:
<TABLE>
<CAPTION>
 
Deferred tax assets (liabilities):

                                             Year Ended December 31,
                                           --------------------------
                                               1996           1995
                                           -----------    -----------
<S>                                        <C>            <C> 
Net operating loss carryforwards           $       ---    $ 1,588,000
Statutory depletion carryforwards            1,449,000      2,414,000
Tax credit carryforwards                     1,757,000        327,000
State taxes, net                                   ---         33,000
Property and equipment                             ---        253,000
Other, net                                     569,000        821,000
Valuation allowance                           (780,000)      (780,000)
                                           -----------    -----------  
 
Total deferred tax assets                    2,995,000      4,656,000
                                           -----------    -----------
 
State taxes, net                              (121,000)           ---
Property and equipment                      (1,115,000)           ---
Other, net                                  (1,350,000)    (3,832,000)
                                           -----------    ----------- 
 
Total deferred tax liabilities              (2,586,000)    (3,832,000)
                                           -----------    ----------- 
 
Net deferred tax assets (liabilities)      $   409,000    $   824,000
                                           ===========    =========== 
</TABLE>

  The Company establishes 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 has approximately $4,300,000 in federal statutory depletion
carryforwards which may be used to offset future taxable income.  These
carryforwards do not expire.  The Company also has approximately $1,757,000 of
various tax credit carryforwards available which can be used to offset future
regular income taxes in excess of future alternative minimum taxes.  If not
fully utilized, certain enhanced oil recovery tax credits of $1,098,000 will
begin to expire in 2009.  Federal alternative minimum tax credits of $659,000
may be carried forward indefinitely.  Federal and state income taxes paid were
$1,230,000, $12,000, and $2,000 in 1996, 1995, and 1994, respectively.

                                       40
<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 1996, two purchasers
accounted for more than 10% of the Company's total oil and gas sales.  Their
purchases in 1996 accounted for 34% and 24%, respectively.

                                       41
<PAGE>
 
                            McFarland Energy, Inc.
                  Notes to Consolidated Financial Statements

 
11.  SUPPLEMENTAL OIL AND GAS RESERVE INFORMATION AND RELATED DATA (UNAUDITED)

   As of December 31, 1996, 1995 and 1994, the detail of capitalized costs
attributable to the Company's oil and gas properties were as follows:
<TABLE>
<CAPTION>
 
                                   1996          1995          1994
                                -----------   -----------   -----------
<S>                             <C>           <C>           <C>
 
     Proved properties          $83,851,000   $85,019,000   $78,942,000
 
     Unproved properties          1,654,000       669,000     2,574,000
                                -----------   -----------   -----------
 
                                $85,505,000   $85,688,000   $81,516,000
                                ===========   ===========   ===========
 
     Accumulated depletion      $50,488,000   $52,351,000   $48,279,000
                                ===========   ===========   =========== 
 
</TABLE>

  During the years ended December 31, 1996, 1995 and 1994, the following amounts
were expended in the activities described:
<TABLE>
<CAPTION>
                                              1996         1995          1994
                                           ----------   -----------   -----------
<S>                                        <C>          <C>           <C>
 
     Acquisition of proved properties      $1,834,000   $ 5,403,000   $17,562,000
 
     Exploration                            2,538,000     1,528,000     1,114,000
 
     Development                            3,179,000     6,276,000     3,838,000
                                           ----------   -----------   -----------
 
                       Total               $7,551,000   $13,207,000   $22,514,000
                                           ==========   ===========   ===========  
</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, 1996, 1995 and 1994.

                                       42
<PAGE>
 
                            McFarland Energy, Inc.
                  Notes to Consolidated Financial Statements

 
11.  SUPPLEMENTAL OIL AND GAS RESERVE INFORMATION AND RELATED DATA (UNAUDITED)
   (continued)

   During 1996, 1995 and 1994, the following changes occurred in the Company's
estimated proved  oil and gas reserves:
<TABLE> 
<CAPTION> 


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

                                      1996      1995      1994     1996      1995      1994
                                     -------   -------   ------   -------   -------   ------- 
<S>                                  <C>       <C>       <C>      <C>       <C>       <C>
Beginning of the year                 9,514     8,299    5,132    12,104    14,723     7,991
Revision of previous estimates:         
    Price changes                       447        54      673     1,735       ---       (30) 
    Quantity estimates                5,225     1,740     (166)    3,075    (1,751)   (2,715)
Purchases of minerals in place          ---       696    3,913     4,547     1,266     9,540
Extensions, discoveries and             
    other additions                     ---       ---      ---       310        47     1,550 
Production                           (1,357)   (1,206)    (969)   (1,976)   (2,181)   (1,456)
Sales of minerals in place             (117)      (69)    (284)      ---       ---      (157)
                                    -------   -------   ------   -------   -------   ------- 
End of the year                      13,712     9,514    8,299    19,795    12,104    14,723
                                    =======   =======   ======   =======   =======   =======  
Proved developed reserves            12,929     8,534    8,299    19,588    12,104     9,374
                                    =======   =======   ======   =======   =======   =======  
 
</TABLE>

The revision of previous estimates of proved reserves is primarily influenced by
two 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.  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.  Product prices were sharply higher at the end of
1996, resulting in upward revisions to oil and gas reserves.  In addition, as a
result of a comprehensive study performed by the Company's independent reservoir
engineers, the Company's Midway Sunset field oil reserves were revised upward in
1996 by 4.8 million barrels.

                                       43
<PAGE>
 
                            McFarland Energy, Inc.
                  Notes to Consolidated Financial Statements
 

11.  SUPPLEMENTAL OIL AND GAS RESERVE INFORMATION AND RELATED DATA (UNAUDITED)
     (continued)

   At December 31, 1996, 1995 and 1994, the Company's Standardized Measure of
Discounted Future Net Cash Flows were as follows:
<TABLE>
<CAPTION>
 
 
                                                  1996            1995            1994
                                             --------------   -------------   -------------
<S>                                          <C>              <C>             <C>
Future gross revenue                         $ 301,000,000    $153,000,000    $129,000,000
Future production and development costs       (115,000,000)    (68,000,000)    (64,000,000)
                                             -------------    ------------    ------------  
Future net revenue                             186,000,000      85,000,000      65,000,000
10% annual discount for estimated                                                           
 timing of net revenue                         (71,000,000)    (25,000,000)    (21,000,000) 
                                             -------------    ------------    ------------ 
Discounted future net revenue                  115,000,000      60,000,000      44,000,000
Discounted future income tax expense           (25,000,000)     (4,000,000)            ---
                                             -------------    ------------    ------------
Standardized measure of discounted                                                         
 future net cash flows                       $  90,000,000    $ 56,000,000    $ 44,000,000 
                                             =============    ============    ============  
 
</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 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.

                                       44
<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.

                                       45
<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,
1996, 1995, and 1994:
<TABLE>
<CAPTION>
                                                   1996            1995            1994
                                               -------------   -------------   ------------
<S>                                            <C>             <C>             <C>
Beginning of year estimate                     $ 56,000,000    $ 44,000,000    $21,000,000
Net change in prices and production costs        24,000,000       7,000,000     10,000,000
Revision to previous quantity estimates          34,000,000      10,000,000     (3,000,000)
Purchase of minerals in place                     8,000,000       6,000,000     22,000,000
Extensions and discoveries                        1,000,000             ---      2,000,000
Net oil and gas sales                           (18,000,000)    (11,000,000)    (9,000,000)
Sales of minerals in place                              ---             ---     (1,000,000)
Accretion of discount                             6,000,000       4,000,000      2,000,000
Net change in income taxes                      (21,000,000)     (4,000,000)           ---
                                               ------------    ------------    -----------  
End of year estimate                           $ 90,000,000    $ 56,000,000    $44,000,000
                                               ============    ============    ===========
 
</TABLE>

                                       46
<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, 1996:
   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.

   Purchase of minerals in place consisted of the acquisition of a working
interest in a gas producing property in Sacramento Valley, California.

   Extensions and discoveries resulted from a successful exploratory gas well
drilled in the Northern San Joaquin Valley.

   "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, 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.

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.

                                       47
<PAGE>
 
12.  UNAUDITED QUARTERLY OPERATING RESULTS

   The following is a tabulation of unaudited quarterly operating results for
1996, 1995 and 1994.


                              (In thousands except per share data)
<TABLE>
<CAPTION>
 
                         FIRST     SECOND     THIRD     FOURTH    
                        QUARTER    QUARTER   QUARTER   QUARTER     TOTAL 
                       ---------   -------   -------   --------   ------- 
<S>                    <C>         <C>       <C>       <C>        <C>
1996
----
Total Revenues          $ 5,822     $6,719    $6,385   $6,795     $25,721
Net Income              $ 1,180     $1,953    $1,486   $2,507/1/  $ 7,126
Per Share               $  0.21     $ 0.35    $ 0.26   $ 0.44     $  1.26
                                                                  
1995                                                              
----                                                              
Total Revenues          $ 4,520     $5,171    $5,109   $5,083     $19,883
Net Income              $10,074/2/  $  840    $1,326   $1,401/3/  $13,641
Per Share               $  1.93     $ 0.16    $ 0.25   $ 0.27     $  2.61
                                                                  
1994                                                              
----                                                              
Total Revenues          $ 2,955     $3,391    $4,406   $5,518     $16,270
Net (Loss) Income         ($349)    $  236    $  658   $  963/4/  $ 1,508
Per Share                ($0.07)    $ 0.05    $ 0.13   $ 0.18     $  0.29
 
</TABLE>


     /1/The fourth quarter of 1996 includes year end tax adjustments and the
     recognition of deferred tax assets totaling $418,000.

     /2/The first quarter of 1995 reflects the net gain from a 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.

     /3/The fourth quarter of 1995 includes the year end income tax adjustments
     and the recognition of deferred tax assets totaling $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 a gas storage
     project.

     /4/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.

                                       48
<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 28, 1997, which Proxy Statement shall be
filed within 120 days of the end of the calendar year 1996, and is hereby
incorporated by reference.

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

                                       49
<PAGE>
 
                                    PART IV
                                    -------
 
Item 14.  Exhibits, Financial Statement Schedules and Reports on Form 8-K
-------------------------------------------------------------------------
<TABLE>
<CAPTION>

                                                                                                                          Page
                                                                                                                          ----
<S>                                                                                                                       <C> 
 (a) 1.  Financial Statements
     The following financial statements of McFarland Energy, Inc. are included in Part II, Item 8:
 
     Report of independent accountants: Coopers & Lybrand L.L.P.                                                           24
     Consolidated Balance Sheets as of December 31, 1996 and 1995                                                          25
     Consolidated Statements of Operations for the years ended
        December 31, 1996, 1995, and 1994                                                                                  26
     Consolidated Statements of Changes in Stockholders' Equity
        for the years ended December 31, 1996, 1995, and 1994                                                              27
     Consolidated Statements of Cash Flows for the
        years ended December 31, 1996, 1995, and 1994                                                                      28
     Notes to Consolidated Financial Statements                                                                            29

    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
</TABLE> 
 
<TABLE> 
<CAPTION> 

Exhibit
Number   Description of Exhibit                                                                          
-------  ----------------------                                                                              
<S>      <C>                                                                                                               <C> 
   2     Agreement for Plan of Reorganization and Business                                                                 (a)
         Combination                                                                                                            
                                                                                                                                
   3     Articles of incorporation and bylaws                                                                              (b)
                                                                                                                                
   4     Instruments defining the rights of security                                                                       (c)
         holders, including indentures                                                                                     
                                                                                                                                
   9     Voting trust agreement                                                                                      not applicable
                                                                                                                     
   10a   Crude Oil Purchase Contract No. 972 between Standard Oil Company of California and 
         McFarland Energy, Inc. dated March 11, 1975                                                                       (d)
 
   10b   Gas Purchase Agreement between Pacific Lighting Gas Supply Co. and McFarland Energy, 
         Inc. dated November 26, 1984.                                                                                     (d)
-----------------------------------------------------------------------------------------------------------------------------------
</TABLE>

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

                                       50
<PAGE>
 
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K 
------------------------------------------------------------------------
(continued)

<TABLE> 
<CAPTION> 
 
Exhibit
Number   Description of Exhibit                                                                 Page
-------  -----------------------------------------------------------------------------------    ----
<C>      <S>                                                                                    <C>   
10c      Business Loan Agreement dated April 20, 1994 and as amended on November 19, 1996        54
 
10e      Operating Agreement dated February 28, 1972 between Standard Oil Company of
         California and Jade Oil & Gas Co.                                                       (e)
 
10f      Operating Agreement-U93 dated February 28, 1972 between Standard Oil Company of
         California and Jade Oil & Gas Co.                                                       (e)
 
10h      Crude Oil Purchase Agreement between Huntway Refining Company and McFarland
         Energy, Inc. dated March 25, 1994 and as amended on February 19, 1996.                  (f)
 
10i      Executive Officer Employment Agreements                                                 (f)
 
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                                               (g)
 
22       Published report re matters submitted to vote of security holders                      none
 
23       Consent of Coopers & Lybrand, L.L.P.                                                    55
 
24       Power of Attorney                                                                      none
 
27       Financial Data Schedule                                                                 (h)
 
28       Information from reports furnished to state insurance regulatory authorities           none
 
99       Additional exhibits                                                                    none
 
---------------- 
</TABLE>
(e)     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.
(f)     Included as Exhibit 10h and 10i in Registrant's Annual Report on Form
        10-K for the year 1995 and herein incorporated by reference.
(g)     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.
(h)     Included in the Registrant's electronic filing on Edgar.
 
                                       51
<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)


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


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


                                             /s/Eileen C. Sugita
                                         ------------------------- 
                                         By: Eileen C. Sugita
Date:     March 12, 1997                 (Chief Accounting Officer)
      ---------------------   


   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:

   /s/J. C. McFarland                        /s/William E. Carl
-------------------------------          -------------------------------
J. C. McFarland, March 12, 1997          William E. Carl, March 12, 1997
   (Director)                                  (Director)

   /s/John C. Capshaw                        /s/Daniel E. Pasquini
-------------------------------          ----------------------------------
John C. Capshaw, March 12, 1997          Daniel E. Pasquini, March 12, 1997
   (Director)                                  (Director)


   /s/John B. Pollara                        /s/Daniel J. Redden
-------------------------------          --------------------------------
John B. Pollara, March 12, 1997          Daniel J. Redden, March 12, 1997
   (Director)                                  (Director)



   /s/Herbert M. Rome
-------------------------------
Herbert M. Rome, March 12, 1997
   (Director)

                                       52
<PAGE>
 
Exhibit Index
-------------
<TABLE>
<CAPTION>
 
Exhibit
Number      Description of Exhibit                                                         Page
-------     ----------------------                                                         ----
<S>         <C>                                                                            <C> 
    3       Articles of incorporation and bylaws                                           (a)
                                                
    4       Instruments defining the rights of security holders, including indentures      (b)
 
    10a     Crude Oil Purchase Contact No. 972 between Standard Oil Company 
            of California and McFarland Energy, Inc. dated March 11, 1975                  (c)
 
    10b     Gas Purchase Agreement between Pacific Lighting Gas Supply Co. 
            and McFarland Energy, Inc. dated November 26, 1984                             (d)
 
    10c     Business Loan Agreement dated April 20, 1994 and as amended on
            November 19, 1996.                                                             54
 
    10e     Operating Agreement dated February 28 1972 between Standard Oil 
            Company of California and Jade Oil & Gas Co.                                   (f)
 
    10f     Operating Agreement-U93 dated February 28, 1972 between Standard 
            Oil Company of California and Jade Oil & Gas Co.                               (f)
 
    10h     Crude Oil Purchase Agreement between Huntway Refining Company and McFarland 
            Energy, Inc. dated March 25, 1994 and as amended on February 19, 1996          (e)
 
    10i     Executive Officer Employment Agreements                                        (e)
 
    18      Letter re change in accounting principles                                      (g)
 
    23      Consent of Coopers & Lybrand L.L.P.                                            55 
 
    27      Financial Data Schedule                                                        (h)
 

---------------------------------------------------------------------------------------------
</TABLE>
    (a) Included as Exhibit 2 in Registrant's Form 8-K for the month of July 15,
        1988 and herein incorporated by reference.
    (b) Included as Exhibit 3 in Registrant's Annual Report on Form 10-K for the
        year 1987 and herein incorporated by reference.
    (c) Included as Exhibits on pages 713 through 770 of the Registration
        Statement No. 2-54844 and herein incorporated by reference.
    (d) Included as Exhibit 10a and 10b in Registrant's Annual Report on Form
        10-K for the year 1987 and herein incorporated by reference.
    (e) 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.
    (f) Included as Exhibit 10c, 10h, and 10i in Registrant's Annual Report on
        Form 10-K for the year 1995 and herein incorporated by reference.
    (g) 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.
    (h) Included in the Registrant's electronic filing on Edgar.
 

                                       53