<PAGE>   1



================================================================================


                                  UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549

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

                                    FORM 10-Q


        [x]       Quarterly Report Pursuant to Section 13 or 15(d)
                     of the Securities Exchange Act of 1934
                  FOR THE QUARTERLY PERIOD ENDED JUNE 30, 1998

                                       or

        [ ]     Transition Report Pursuant to Section 13 or 15(d)
                     of the Securities Exchange Act of 1934
                For the transition period from _______ to _______

                           COMMISSION FILE NO. 0-21411

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

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

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

         DELAWARE                                         75-2658940
(State or other jurisdiction of                        (I.R.S. Employer
  incorporation or organization)                        Identification No.)

    400 WEST ILLINOIS, SUITE 1000
         MIDLAND, TEXAS                                       79701
(Address of principal executive offices)                   (Zip code)

                                 (915) 683-3092
              (Registrant's telephone number, including area code)

                                 Not applicable
              (Former name, former address and former fiscal year,
                         if changed since last report)

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

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

<TABLE>
<S>                                                                                              <C>      
NUMBER OF SHARES OF COMMON STOCK OUTSTANDING AS OF AUGUST 10, 1998 . . . . . . . . . . . . . . . 9,855,600
</TABLE>



================================================================================

<PAGE>   2




                              COSTILLA ENERGY, INC.

                                    FORM 10-Q

                                TABLE OF CONTENTS




<TABLE>
<CAPTION>
                                                                                                 Page
                                                                                                 ----
                                                   PART I - FINANCIAL INFORMATION

<S>                                                                                               <C>
Item 1.           Financial Statements

                  Consolidated Balance Sheets as of June 30, 1998 (unaudited) and
                    December 31, 1997........................................................     3

                  Consolidated Statements of Operations for the three and six months
                    ended June 30, 1998 and 1997 (unaudited).................................     4

                  Consolidated Statements of Cash Flows for the three and six months
                    ended June 30, 1998 and 1997 (unaudited).................................     5

                  Notes to Consolidated Financial Statements (unaudited).....................     6

Item 2.           Management's Discussion and Analysis of Financial
                    Condition and Results of Operations......................................    10


                                                     PART II - OTHER INFORMATION


Item 6.           Exhibits and Reports on Form 8-K...........................................    18

Signatures...................................................................................    19
</TABLE>


                                       2
<PAGE>   3



                         PART I - FINANCIAL INFORMATION

ITEM 1.  FINANCIAL STATEMENTS

                              COSTILLA ENERGY, INC.


                           CONSOLIDATED BALANCE SHEETS
                                 (IN THOUSANDS)

<TABLE>
<CAPTION>
                                                                               JUNE 30,     DECEMBER 31,
                                                                                 1998          1997
                                                                               ---------     ---------
                                        ASSETS                                (UNAUDITED)
<S>                                                                            <C>           <C>      
CURRENT ASSETS:
   Cash and cash equivalents                                                   $  17,089     $   3,615
   Accounts receivable:
       Trade, net                                                                  3,081         5,241
       Oil and gas sales                                                           7,954         9,312
   Prepaid and other current assets                                                1,439           912
                                                                               ---------     ---------
           Total current assets                                                   29,563        19,080
                                                                               ---------     ---------

PROPERTY, PLANT AND EQUIPMENT, AT COST:
   Oil and gas properties, using the successful efforts
     method of accounting:
       Proved properties                                                         233,420       199,355
       Unproved properties                                                        47,076        35,971
   Accumulated depletion, depreciation and amortization                          (84,658)      (71,152)
                                                                               ---------     ---------
                                                                                 195,838       164,174
   Other property and equipment, net                                               3,628         3,766
                                                                               ---------     ---------
           Total property, plant and equipment                                   199,466       167,940
                                                                               ---------     ---------

OTHER ASSETS:
   Deferred charges                                                                6,829         4,212
   Other                                                                           2,400         2,856
                                                                               ---------     ---------
           Total other assets                                                      9,229         7,068
                                                                               ---------     ---------
                                                                               $ 238,258     $ 194,088
                                                                               =========     =========

       LIABILITIES AND STOCKHOLDERS' EQUITY

CURRENT LIABILITIES:
   Current maturities of long-term debt                                        $      98     $      98
   Trade accounts payable                                                         16,299        22,490
   Undistributed revenue                                                           3,312         4,566
   Other current liabilities                                                       5,577         3,437
                                                                               ---------     ---------
           Total current liabilities                                              25,286        30,591
                                                                               ---------     ---------
LONG-TERM DEBT, LESS CURRENT MATURITIES                                          182,441       163,087
                                                                               ---------     ---------
OTHER NONCURRENT LIABILITIES                                                         313          --
                                                                               ---------     ---------


STOCKHOLDERS' EQUITY :
   Preferred stock, $.10 par value (3,000,000 shares authorized; 50,000
     shares outstanding at June 30, 1998 and
     no shares outstanding at December 31, 1997)                                       5          --
   Common stock, $.10 par value (20,000,000 shares authorized;
     9,981,000 shares outstanding at June 30, 1998 and
     10,150,500 shares outstanding at December 31, 1997)                             998         1,015
   Additional paid-in capital                                                     83,552        37,425
   Retained deficit                                                              (54,337)      (38,030)
                                                                               ---------     ---------
           Total stockholders' equity                                             30,218           410
                                                                               ---------     ---------
COMMITMENTS AND CONTINGENCIES                                                       --            --
                                                                               ---------     ---------
                                                                               $ 238,258     $ 194,088
                                                                               =========     =========
</TABLE>


See accompanying notes to consolidated financial statements.






                                       3
<PAGE>   4



                              COSTILLA ENERGY, INC.

                      CONSOLIDATED STATEMENTS OF OPERATIONS
                      (IN THOUSANDS, EXCEPT PER SHARE DATA)
                                   (UNAUDITED)

<TABLE>
<CAPTION>
                                                       THREE MONTHS ENDED         SIX MONTHS ENDED
                                                            JUNE 30,                  JUNE 30,
                                                      ---------------------     ---------------------
                                                        1998         1997         1998         1997
                                                      --------     --------     --------     --------
<S>                                                   <C>          <C>          <C>          <C>     
REVENUES:
  Oil and gas sales                                   $ 16,670     $ 15,279     $ 32,015     $ 34,892
  Interest and other                                       155          154          360          920
  Gain on sale of assets                                  --           --            337         --
                                                      --------     --------     --------     --------

                                                        16,825       15,433       32,712       35,812
                                                      --------     --------     --------     --------

EXPENSES:

  Oil and gas production                                 7,441        6,794       14,226       14,163
  General and administrative                             2,577        1,856        5,070        3,370
  Exploration and abandonments                           2,078        1,774        5,228        3,115
  Depreciation, depletion and amortization               8,305        4,806       14,364        9,720
  Interest                                               5,094        2,809        9,833        5,516

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

                                                        25,495       18,039       48,721       35,884
                                                      --------     --------     --------     --------

    Loss before federal income taxes and
        extraordinary item                              (8,670)      (2,606)     (16,009)         (72)
PROVISION FOR FEDERAL INCOME TAXES
  Current                                                 --           --           --             62
  Deferred                                                --           (191)        --           --
                                                      --------     --------     --------     --------

    Loss before extraordinary item                      (8,670)      (2,415)     (16,009)        (134)

    Extraordinary loss resulting from early
        extinguishment of debt                            --           --           (299)        --
                                                      --------     --------     --------     --------


NET LOSS                                              $ (8,670)    $ (2,415)    $(16,308)    $   (134)
                                                      ========     ========     ========     ========

CUMULATIVE PREFERRED STOCK DIVIDEND                   $    307     $   --       $    307     $   --
                                                      ========     ========     ========     ========

LOSS BEFORE EXTRAORDINARY ITEM
  APPLICABLE TO COMMON EQUITY                         $ (8,977)    $ (2,415)    $(16,316)    $   (134)
                                                      ========     ========     ========     ========

NET LOSS APPLICABLE TO COMMON EQUITY                  $ (8,977)    $ (2,415)    $(16,615)    $   (134)
                                                      ========     ========     ========     ========

LOSS PER SHARE:
  Loss before extraordinary item                      $  (0.90)    $  (0.23)    $  (1.63)    $  (0.01)


  Extraordinary loss resulting from early
    extinguishment of debt                                --           --          (0.03)        --
                                                      --------     --------     --------     --------

  NET LOSS                                            $  (0.90)    $  (0.23)    $  (1.66)    $  (0.01)
                                                      ========     ========     ========     ========


WEIGHTED AVERAGE SHARES OUTSTANDING                      9,981       10,459       10,027       10,468
                                                      ========     ========     ========     ========
</TABLE>


See accompanying notes to consolidated financial statements.




                                       4
<PAGE>   5





                              COSTILLA ENERGY, INC.

                      CONSOLIDATED STATEMENTS OF CASH FLOWS
                                 (IN THOUSANDS)
                                   (UNAUDITED)

<TABLE>
<CAPTION>
                                                                                  THREE MONTHS ENDED          SIX MONTHS ENDED
                                                                                       JUNE 30,                    JUNE 30,
                                                                               -----------------------     -----------------------
                                                                                 1998          1997           1998          1997
                                                                               ---------     ---------     ---------     ---------
<S>                                                                            <C>           <C>           <C>           <C>       
CASH FLOWS FROM OPERATING ACTIVITIES:

   NET LOSS                                                                    $  (8,670)    $  (2,415)    $ (16,308)    $    (134)

   ADJUSTMENTS TO RECONCILE NET LOSS TO NET
   CASH PROVIDED BY OPERATING ACTIVITIES:

      Depreciation, depletion and amortization                                     8,305         4,806        14,364         9,720
      Exploration and abandonments                                                   165            11           262            58
      Amortization of deferred charges                                               287           459           481           610
      Deferred income tax expense                                                   --            (191)         --            --
      Allowance for doubtful accounts                                               --             208          --             208
      Gain on sale of oil and gas properties                                        --            --            (337)           30
      Extraordinary loss resulting from early  extinguishment of debt               --            --             299          --
      Gain on investment transactions                                                 (1)         (224)           (5)         (981)
                                                                               ---------     ---------     ---------     ---------

                                                                                      86         2,654        (1,244)        9,511

      Changes in operating assets and liabilities:
        Decrease (increase) in accounts receivable                                 3,606         2,485         3,518         1,864
        Decrease (increase) in other assets                                          276           (21)           54          (429)
        Increase (decrease) in accounts payable                                   (5,662)       (1,580)       (7,445)        3,435
        Increase (decrease) in other liabilities                                  (2,158)       (2,425)        2,141           191
                                                                               ---------     ---------     ---------     ---------

            Net cash provided by (used in) operating activities                   (3,852)        1,113        (2,976)       14,572
                                                                               ---------     ---------     ---------     ---------

CASH FLOWS FROM INVESTING ACTIVITIES:

   Additions to oil and gas properties                                           (17,706)      (20,672)      (48,474)      (35,878)
   Proceeds from sale of oil and gas properties                                      658         1,842         3,158         2,709
   Additions to other property and equipment                                        (298)         (613)         (497)       (1,284)

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

            Net cash used in investing activities                                (17,346)      (19,443)      (45,813)      (34,453)
                                                                               ---------     ---------     ---------     ---------

CASH FLOWS FROM FINANCING ACTIVITIES:

   Borrowings under long-term debt                                                16,000        14,600       111,000        14,600
   Payments of long-term debt                                                    (29,021)          (19)      (91,541)          (37)
   Proceeds from issuance of preferred stock, net                                 47,957          --          47,957          --
   Proceeds from issuance of common stock, net                                      --            --            --              14
   Purchase of common stock                                                         --          (1,248)       (1,841)       (1,248)
   Deferred loan and financing costs                                                (123)         --          (3,313)          (61)
                                                                               ---------     ---------     ---------     ---------

            Net cash provided by (used in) financing activities                   34,813        13,333        62,262        13,268
                                                                               ---------     ---------     ---------     ---------

NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS                              13,615        (4,997)       13,473        (6,613)

CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD                                     3,473        11,002         3,615        12,618
                                                                               ---------     ---------     ---------     ---------

CASH AND CASH EQUIVALENTS, END OF PERIOD                                       $  17,088     $   6,005     $  17,088     $   6,005
                                                                               =========     =========     =========     =========
</TABLE>


See accompanying notes to consolidated financial statements.





                                       5
<PAGE>   6





                              COSTILLA ENERGY, INC.


                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  JUNE 30, 1998
                                   (UNAUDITED)



1.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

         The interim financial information as of June 30, 1998, and for the six
months ended June 30, 1998 and 1997, is unaudited. Certain information and
footnote disclosures normally included in financial statements prepared in
accordance with generally accepted accounting principles have been condensed or
omitted in this form 10-Q pursuant to the rules and regulations of the
Securities and Exchange Commission. However, in the opinion of management, these
interim financial statements include all the necessary adjustments to fairly
present the results of the interim periods and all such adjustments are of a
normal recurring nature. The interim consolidated financial statements should be
read in conjunction with the audited financial statements for the year ended
December 31, 1997.

         Costilla Energy, Inc. ("Costilla" or the "Company") was incorporated in
Delaware in June 1996 to consolidate and continue the activities previously
conducted by Costilla Energy, L.L.C., a Texas limited liability company (the
"LLC"), and its wholly owned subsidiaries, to acquire the assets of CSL
Management Corporation (which owned certain office equipment used by the
Company), and to acquire the stock of Valley Gathering Company. Costilla was
formed for the purpose of conducting a $60 million initial public offering of
common stock and a $100 million senior notes offering (the "Offerings"), which
Offerings were completed in early October 1996.

         The Company is an oil and gas exploration and production concern with
properties located principally in South and East Texas, the Rocky Mountains and
the Permian Basin regions of the United States.


2.  DERIVATIVE FINANCIAL INSTRUMENTS

         The Company utilizes derivative financial instruments to manage
well-defined commodity price and interest rate risks. The Company is exposed to
credit losses in the event of nonperformance by the counterparties to its
commodity hedges and its interest rate swap agreements. The Company only deals
with reputable financial institutions as counterparties and anticipates that
such counterparties will be able to fully satisfy their obligations under the
contracts. The Company does not obtain collateral or other security to support
financial instruments subject to credit risk but monitors the credit standing of
the counterparties.


         Commodity Hedges. The Company utilizes put option contracts and
costless collars to hedge the effect of price changes on a portion of its future
oil and gas production. Premiums paid and amounts receivable under the put
option contracts are amortized and accrued to oil and gas sales, respectively.
If market prices of oil and gas exceed the strike price of put options, the
options will expire unexercised, therefore, reducing the effective price
received for oil and gas sales by the cost of the related option. Conversely, if
market prices of oil and gas decline below the strike price of put options, the
options will be exercised, therefore, increasing the effective price received
for oil and gas sales by the proceeds received from the related option.

         A costless collar establishes both a floor price and a ceiling for the
commodity through the simultaneous purchase of a put option contract and the
sale of a call option contract. Since the value of the put option and the call
option offset at the time of their purchase, the collar is costless, therefore
there are no premiums to amortize. If market prices of oil and gas decline below
the strike price of put options, the options will be exercised, therefore,
increasing the effective price received for oil and gas sales by the proceeds
received from the related option. Conversely, if market prices of oil and gas
exceed the strike price of call options, the Company is obligated to pay the
contracting counterparty an amount equal to the contracted volumes times the
difference between the market 


                                       6
<PAGE>   7

price and the strike price, therefore, reducing the effective price received 
for oil and gas sales by the amount paid to the counterparty.

         The Company has established a costless collar for oil by purchasing put
options in August 1997 on 6,500 Bbls of oil per day which establish a floor
price of $18.50 per Bbl and selling call options on 6,500 Bbls of oil per day at
$22.55 per Bbl. These oil option contracts continue through August 1998. The
referenced oil prices are based upon the price at which West Texas Intermediate
crude oil ("WTI") trades on the New York Mercantile Exchange ("NYMEX"). The
Company has established a costless collar for gas by purchasing put options on
40,000 Mmbtu of gas per day which establish a floor price of $2.40 per Mmbtu and
selling call options on 40,000 Mmbtu of gas per day at $2.55 per Mmbtu. These
gas option contracts continue through October 1998. The referenced gas prices
are based upon the index price for Houston Ship Channel gas sales. As of June
30, 1998 the Company had sold a put option on 40,000 Mmbtu of gas per day at
$2.00 per Mmbtu based upon the index price for Houston Ship Channel gas sales
during the months of September and October 1998. 

         Interest Rate Swap Agreements. The Company had an interest rate swap
agreement in place as of June 30, 1998 with a notional amount of $24 million, a
fixed rate of 7.5% and which will expire in January, 1999. Since the Company had
no material amount of floating rate debt outstanding at June 30, 1998, the
interest swap agreement did not qualify as a hedge and was marked to market with
the carrying value being a liability of approximately $313,000.


3.  ACQUISITIONS

         On August 28, 1997, the Company consummated the purchase from Ballard
Petroleum LLC ("Ballard") of certain oil and gas properties for an estimated
adjusted purchase price of approximately $41.2 million (the "Ballard
Acquisition"). The properties are located primarily in the Rocky Mountain region
of the United States. The transaction was accounted for using the purchase
method. The results of operations of the acquired properties are included in the
Consolidated Statements of Operations as of the acquisition closing date, August
28, 1997. In addition, the Company and Ballard have entered into an Acquisition
and Exploration Agreement that establishes an area of mutual interest in the
Rocky Mountain Region in which the parties will jointly own, acquire, explore
and develop properties.





                                       7
<PAGE>   8





         Pro Forma Results of Operations

         The following table reflects the pro forma results of operations for
the six months ended June 30, 1997, as though the Ballard Acquisition occurred
as of January 1, 1997. The pro forma amounts are not necessarily indicative of
results that may be reported in the future.

<TABLE>
<CAPTION>
                                                          SIX MONTHS ENDED
                                                           JUNE 30, 1997
                                                          ----------------
                                                           (IN THOUSANDS)

<S>                                                        <C>     
Revenues                                                   $ 41,936
Net income before extraordinary items                          (163)
Net income per share before extraordinary items               (0.02)
</TABLE>



4.  LONG TERM DEBT

         In August 1997, the Company entered into a credit agreement (the
"Revolving Credit Facility") with Bankers Trust Company, as agent, to refinance
its existing bank indebtedness and to finance a portion of the Ballard
Acquisition purchase price. The Revolving Credit Facility provides for a maximum
availability of $75.0 million, $0.5 million of which was borrowed at June 30,
1998 against an available borrowing base of $40.0 million at such date.
Borrowings under the Revolving Credit Facility bear interest, at the Company's
option, at a floating rate which is at or above the Lender's prime rate or above
the applicable Eurodollar rate, depending on the percentage of committed funds
which have been borrowed. Interest is payable quarterly as to base rate loans,
and at the end of the applicable interest period as to Eurodollar loans. The
borrowing base of the Revolving Credit Facility is automatically reduced by 5%
each quarter beginning in August 1999, and payments of principal are required in
each quarter in which the outstanding principal balance is greater than the
reduced borrowing base. The remaining balance is payable on August 28, 2002, the
maturity date of the Revolving Credit Facility. Under the Revolving Credit
Facility, the Company is obligated to pay certain fees to the lender, including
a commitment fee based on the unused portion of the commitment. The Revolving
Credit Facility contains customary restrictive covenants (including restrictions
on the payment of dividends and the incurrence of additional indebtedness) and
requires the Company to maintain (i) a current ratio of not less than 1.0 to
1.0, including amounts available under the Revolving Credit Facility and
excluding current maturities under the Revolving Credit Facility and the
Acquisition Credit Facility, (ii) a ratio of EBITDA to interest expense, for the
last twelve months as of the end of each quarter, of not less than 1.75 to 1
through December 31, 1998, 2.3 to 1 through December 31, 1999 and 2.5 to 1
thereafter and (iii) a minimum tangible net worth. Borrowings under the
Revolving Credit Facility are secured by substantially all of the assets of the
Company.

         Contemporaneous with entering into the Revolving Credit Facility, the
Company also entered into a second credit agreement (the "Acquisition Credit
Facility") to provide the remaining financing for the Ballard Acquisition. The
Acquisition Credit Facility was a term loan in the amount of $30.0 million which
was repaid in full in connection with the sale of the 1998 Notes.

         In October 1996, the Company issued $100 million aggregate principal
amount of 10.25% Senior Notes due October 1, 2006 (the "Notes"). The Notes were
sold at par and interest is payable April 1 and October 1, commencing April 1,
1997. The Notes may not be redeemed prior to October 1, 2001, and thereafter at
a premium reducing to par, plus interest, by maturity. There is no mandatory
redemption of the Notes required prior to maturity. The Notes are general
unsecured senior obligations of the Company and rank equally in right of payment
with all other senior indebtedness of the Company and senior in right of payment
of all existing future subordinated indebtedness of the Company. The Notes are
subject to an Indenture between the Company and a trustee. The Indenture
restricts, among other things, the Company's ability to incur additional
indebtedness, pay dividends or make certain other restricted payments, incur
liens, engage in any sale and leaseback transaction, sell stock of subsidiaries,
apply net proceeds from certain assets sales, merge or consolidate with any
other person, sell, assign, transfer, lease, convey or otherwise dispose of
substantially all of the assets of the company, or enter into 


                                       8
<PAGE>   9

certain transactions with affiliates. Net proceeds from the sale of the Notes 
of approximately $96.1 million were used to repay existing indebtedness.

         In January 1998, the Company issued an additional $80 million aggregate
principal amount of 10.25% Senior Notes due October 1, 2006 (the " 1998 Notes").
The notes were sold at a premium (102.5%) and interest is payable April 1 and
October 1, commencing April 1, 1998. The 1998 Notes may not be redeemed prior to
October 1, 2001, and thereafter at a premium reducing to par, plus interest, by
maturity. The 1998 Notes are subject to the same terms and conditions as the
Notes. Net proceeds from the sale of the 1998 Notes of approximately $78.8
million were used to repay the Acquisition Credit Facility in full, all but
$500,000 of the Revolving Credit Facility and the remainder was used for general
corporate working capital needs.


5.  CONVERTIBLE PREFERRED STOCK

         On June 3, 1998 the Company closed a private placement of 50,000 shares
of its 7% (8% Paid in Kind) Series A Cumulative Convertible Preferred Stock (the
"Preferred Stock") to Enron Capital & Trade Resources Corp. and Joint Energy
Development Investments II Limited Partnership for a purchase price of $50.0
million (the "Convertible Preferred Stock Offering"). Dividends accrue and are
payable quarterly, commencing September 15, 1998, in cash, or in certain
instances in shares of the Company's Common Stock. The dividend rate is 7% for
dividends paid in cash and 8% for dividends paid in shares of Common Stock. The
holders of the Preferred Stock may, at any time, convert shares of Preferred
Stock into shares of the Company's Common Stock at a conversion price of $12.39
which, subject to certain adjustments, would result in the issuance of 4,035,513
shares of Common Stock upon conversion of the Preferred Stock. The Registrant
may, at its option, redeem the shares of Preferred Stock after June 15, 2001,
subject to certain limitations, for a premium reducing to par on June 15, 2004
and thereafter. Net proceeds from the Convertible Preferred Stock Offering were
$48.0 million, of which $29.0 million was used to repay all but $0.5 million of
the Revolving Credit Facility and the remainder for general corporate purposes.


6.  REPORTING COMPREHENSIVE INCOME

         In June 1997, the FASB issued Statement of Accounting Standards No. 130
"Reporting Comprehensive Income" ("FAS 130") which establishes standards for
reporting and display of comprehensive income and its components in a full set
of general-purpose financial statements. Specifically, FAS 130 requires that an
enterprise (i) classify items of other comprehensive income by their nature in a
financial statement and (ii) display the accumulated balance of other
comprehensive income separately from retained earnings and additional paid-in
capital in the equity section of a statement of financial position. This
statement is effective for fiscal years beginning after December 15, 1997. The
Company has adopted the provisions of FAS 130 in its consolidated financial
statements for periods ending after December 31, 1997. The Company had no
financial instruments giving rise to comprehensive income during the three and
six month periods ended June 30, 1998.

         Comprehensive income consists of the change in equity of a business
enterprise during a period from transactions and other events and circumstances
from nonowner sources. Specifically, this includes net income and other
comprehensive income, which is made up of certain changes in assets and
liabilities that are not reported in a statement of operations but are included
in the balances within a separate component of equity in a statement of
financial position. Such changes include, but are not limited to, unrealized
gains for marketable securities and future contracts, foreign currency
translation adjustments and minimum pension liability adjustments.





                                       9
<PAGE>   10



                              COSTILLA ENERGY, INC.


                SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS


         Certain statements in this Form 10-Q constitute "forward-looking
statements" within the meaning of the Private Securities Litigation Reform Act
of 1995 (the "Reform Act"). Such forward-looking statements involve known and
unknown risks, uncertainties, and other factors which may cause the actual
results, performance, or achievements of Costilla to be materially different
from any future results, performance, or achievements expressed or implied by
such forward-looking statements. Such factors include, among others, the
following: the volatility of oil and gas prices, the Company's drilling results
and ability to replace oil and gas reserves, the availability of capital
resources, the reliance upon estimates of proved reserves, operating hazards and
uninsured risks, competition, government regulation, and the ability of the
Company to implement its business strategy, and other factors referenced in the
Company's public filings with the Securities and Exchange Commission.




ITEM 2.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
         AND RESULTS OF OPERATIONS

GENERAL

         Costilla is an independent energy company engaged in the exploration,
acquisition and development of oil and gas properties. The Company's predecessor
began operating in 1988 and through mid-1995 had grown primarily through a
series of small acquisitions of oil and gas properties and the exploitation of
those properties. In June 1995, Costilla consummated the acquisition of certain
oil and gas properties for a purchase price of approximately $46.6 million (the
"1995 Acquisition"), in June 1996, Costilla consummated the acquisition of
certain oil and gas properties for a purchase price of approximately $38.7
million (the "1996 Acquisition") and in August 1997, Costilla consummated the
Ballard Acquisition for a purchase price of approximately $41.2 million .

         The Company's strategy is to utilize its technical staff and
technological advances to increase its oil and gas reserves, production and cash
flow from operations through an active exploration program and the acquisition
and development of proved reserves. In addition, Costilla continues to evaluate
the acquisition of undeveloped acreage for its exploration efforts. Costilla has
in-house exploration expertise using 3-D seismic technology to identify new
drilling opportunities as well as for the development of acquired properties.

         The Company has grown primarily through acquisitions which impacted its
reported financial results in a number of ways. Properties sold by others
frequently have not received focused attention prior to sale. After acquisition,
certain of these properties are in need of maintenance, workovers, recompletions
and other remedial activity not constituting capital expenditures, which
substantially increase lease operating expenses. The increased production and
revenue resulting from these expenditures is predominately realized in periods
subsequent to the period of expense. In addition, the rapid growth of the
Company has required it to develop operating, accounting and administrative
personnel compatible with its increased size. The Company believes it has now
achieved a sufficient size to expand its reserve base without a corresponding
increase in its general and administrative expense. The Company also believes it
now has a sufficient inventory of prospects and the professional staff necessary
to follow a more balanced program of exploration and development activities to
complement its acquisition efforts.





                                       10
<PAGE>   11





         The following table sets forth certain operating data of Costilla for
the periods presented:

<TABLE>
<CAPTION>
                                                                Three Months Ended               Six Months Ended
                                                                    June 30,                         June 30,
                                                           ------------------------         -------------------------
                                                            1998             1997            1998              1997
                                                           -------          -------         -------           -------
<S>                                                        <C>              <C>             <C>               <C>    
   OIL AND GAS PRODUCTION:
       Oil (Mbbls)                                             505              489           1,049             1,037
       Gas (Mmcf)                                            4,130            3,437           7,562             6,721
       MMCFE  (1)                                            7,160            6,371          13,856            12,943

   AVERAGE SALES PRICES (2):
       Oil (per Bbbl)                                      $ 15.42          $ 17.46         $ 15.39           $ 18.71
       Gas (per Mcf)                                          2.15             1.96            2.10              2.30

   COSTS PER MCFE (1):
       Production cost                                      $ 1.04           $ 1.07          $ 1.03            $ 1.09
       Depreciation, depletion and amortization               1.16             0.75            1.04              0.75
       General and administrative expenses                    0.36             0.29            0.37              0.26
</TABLE>

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

   (1) MCFE represents equivalent Mcf of gas. In reference to oil, natural gas
       equivalents are determined using the ratio of one barrel of crude oil ,
       condensate or natural gas liquids to six Mcf of natural gas.
       MMCFE represents one thousand Mcf of gas equivalent.

   (2) Before deduction of production taxes and net of any hedging results.



         Costilla uses the successful efforts method of accounting for its oil
and gas activities. Costs to acquire mineral interests in oil and gas
properties, to drill and equip exploratory wells that result in proved reserves,
and to drill and equip development wells are capitalized. Costs to drill
exploratory wells that do not result in proved reserves, geological, geophysical
and seismic costs, and costs of carrying and retaining unproved properties are
expensed. Capitalized costs of producing oil and gas properties, after
considering estimated dismantlement and abandonment costs and estimated salvage
values, are depreciated and depleted using the unit-of-production method.
Unproved oil and gas properties that are individually significant are
periodically reviewed for impairment of value, and a loss is recognized at the
time of impairment by providing an impairment allowance. Other unproved
properties are amortized based on the Company's experience of successful
drilling and average holding period.


         The Company utilizes put option contracts and costless collars to hedge
the effect of price changes on a portion of its future oil and gas production.
Premiums paid and amounts receivable under the put option contracts are
amortized and accrued to oil and gas sales, respectively. If market prices of
oil and gas exceed the strike price of put options, the options will expire
unexercised, therefore, reducing the effective price received for oil and gas
sales by the cost of the related option. Conversely, if market prices of oil and
gas decline below the strike price of put options, the options will be
exercised, therefore, increasing the effective price received for oil and gas
sales by the proceeds received from the related option.

         A costless collar establishes both a floor price and a ceiling for the
commodity through the simultaneous purchase of a put option contract and the
sale of a call option contract. Since the value of the put option and the call
option offset at the time of their purchase, the collar is costless, therefore
there are no premiums to amortize. If market prices of oil and gas decline below
the strike price of put options, the options will be exercised, therefore,
increasing the effective price received for oil and gas sales by the proceeds
received from the related option. Conversely, if market prices of oil and gas
exceed the strike price of call options, the Company is obligated to pay the
contracting counterparty an amount equal to the contracted volumes times the
difference between the market price and the strike price, therefore, reducing
the effective price received for oil and gas sales by the amount paid to the
counterparty.

                                       11
<PAGE>   12

         The net effect of the Company's commodity hedging activities increased
oil and gas revenues by $2,700,000 and $4,137,000 for the three and six month
periods ended June 30, 1998 and reduced oil and gas revenues by $236,000 and
$746,000 for the comparable periods in 1997. The Company has established a
costless collar for oil by purchasing put options on 6,500 Bbls of oil per day
which establish a floor price of $18.50 per Bbl and selling call options on
6,500 Bbls of oil per day at $22.55 per Bbl. These oil option contracts continue
through August 1998. The referenced oil prices are based upon the price at which
West Texas Intermediate crude oil ("WTI") trades on the New York Mercantile
Exchange ("NYMEX"). For the three months and six months ended June 30, 1998, the
Company has received a gross wellhead sales price for oil of approximately 74%
and 77%, respectively, of the NYMEX price. The Company has established a
costless collar for gas by purchasing put options on 40,000 Mmbtu of gas per day
which establish a floor price of $2.40 per Mmbtu and selling call options on
40,000 Mmbtu of gas per day at $2.55 per Mmbtu. These gas option contracts
continue through October 1998. The referenced gas prices are based upon the
index price for Houston Ship Channel gas sales, which is approximately 100% of
NYMEX. For the three months and six months ended June 30, 1998, the Company has
received a gross wellhead sales price for gas of approximately 93% of NYMEX. As
of June 30, 1998 the Company had sold a put option on 40,000 Mmbtu of gas per
day at $2.00 per Mmbtu based upon the index price for Houston Ship Channel gas
sales during the months of September and October 1998. 

         The Company utilizes interest rate swap agreements to reduce the
potential impact of increases in interest rates on floating-rate, long term
debt. If market rates of interest experienced during the applicable swap term
are below the rate of interest effectively fixed by the swap agreement, the rate
of interest incurred by the Company will exceed the rate that would have been
experienced under its then outstanding floating-rate indebtedness. The Company
had an interest rate swap agreement in place as of June 30, 1998 with a notional
amount of $24 million, a fixed rate of 7.5% and which will expire in January,
1999. Since the Company had no material amount of floating rate debt outstanding
at June 30, 1998, the interest swap agreement did not qualify as a hedge and was
marked to market with the carrying value being a liability of approximately
$313,000.


RESULTS OF OPERATIONS


  Three Months Ended June 30, 1998 Compared to Three Months Ended June 30, 1997

         The Company's oil and gas revenues for the three months ended June 30,
1998 were $16,670,000, representing an increase of $1,391,000 (9%) from revenues
of $15,279,000 in 1997. Lower oil prices offset in part by higher gas prices
combined to account for an overall decrease in revenues of $349,000 which was
more than offset by an increase in revenues due to a combination of successful
drilling activities and revenues related to properties purchased or sold. The
average net oil price per barrel received in 1998 was $15.42 compared to $17.46
in 1997, a 12% decrease, and the average net gas price received in 1998 was
$2.15 per Mcf compared to $1.96 in 1997, a 10% increase. Revenues received from
oil and gas hedges accounted for $4.46 per barrel and $0.11 per Mcf for the
three months ended June 30, 1998. Oil and gas hedges cost $0.24 per barrel and
$0.03 per Mcf for the comparable period in 1997.

         Oil and gas production was 7,160 MMCFE in 1998 compared to 6,371 MMCFE
in 1997, a 12% increase. Additional production from a combination of successful
drilling activities and acquired properties was partially offset by production
related to properties sold.

         Interest and other revenues were $155,000 for the three months ended
June 30, 1998, representing a $1,000 increase (1%) compared to $154,000 in 1997.
Interest income increased $26,000 to $90,000 for 1998 as compared with $64,000
in 1997 due to increased funds earning interest. Losses on investment
transactions of $39,000 and net gains of $63,000 were recorded for the three
months ended June 30, 1998 and 1997, respectively. These amounts related to an
interest rate swap contract which was marked-to-market. During the three months
ended June 30, 1998, the Company realized a gain of $100,000 from the release of
stock warrants it held in connection with a note receivable. No similar
transaction occurred in 1997.

         Oil and gas production costs for the three month period ended June 30,
1998 were $7,441,000 ($1.04 per MCFE), compared to $6,794,000 in 1997 ($1.07 per
MCFE), representing a decrease of $647,000 (10%), due 


                                       12
<PAGE>   13

principally to a combination of lower production costs on both newly completed 
wells and acquired properties and the sale of certain oil and gas properties.

         General and administrative expenses for the three months ended June 30,
1998 were $2,577,000, representing an increase of $721,000 (39%) from 1997 of
$1,856,000. The increase is primarily due to an increase in personnel and
related costs necessary to accommodate the increase in the Company's oil and gas
activities, including the Acquisition and Exploration Agreement with Ballard
Petroleum.

         Exploration and abandonment expense increased to $2,078,000 for the
three months ended June 30, 1998 compared to $1,774,000 in 1997. Dry hole and
abandonment costs increased to $1,301,000 in 1998 from $793,000 in 1997. The
Company incurred $334,000 of seismic costs for the three months ended June 30,
1998, compared to $812,000 in the comparable period in 1997. The Company
incurred $442,000 of other geological and geophysical costs during the three
month period ended June 30, 1998 compared to $169,000 for the same period in
1997. The increase in exploration and abandonments expense was primarily related
to the Company's increased exploratory drilling activities in 1998 compared to
1997.

         Depreciation, depletion and amortization ("D D & A") expense for the
three month period ended June 30, 1998 was $8,305,000 compared to $4,806,000 for
1997, representing an increase of $3,499,000 (73%). During the 1998 period, D D
& A on oil and gas production was provided at an average rate of $1.16 per MCFE
compared to $0.75 per MCFE for 1997. Of the $3,449,000 increase, $2,612,000 was
due to the $0.41 per MCFE increase in D D & A rate necessitated by lower oil
prices at June 30, 1998 than those experienced at June 30, 1997.

         Interest expense was $5,094,000 for the three months ended June 30,
1998, compared to $2,809,000 for the comparable period in 1997. The $2,285,000
(81%) increase was attributable to a combination of higher levels of average
outstanding indebtedness and the issuance in January 1998 of an additional $80
million of 10.25% senior notes due in 2006. The average amounts of applicable
interest-bearing debt in 1998 and 1997 were $197,615,000 and $104,300,000,
respectively. The effective annualized interest rate in 1998 was 10.3%, as
compared to 10.8% in 1997.


  Six months Ended June 30, 1998 Compared to Six months Ended June 30, 1997

         The Company's oil and gas revenues for the six months ended June 30,
1998 were $32,015,000, representing a decrease of $2,877,000 (8%) from revenues
of $34,892,000 in 1997. Lower commodity prices accounted for a decrease in
revenues of $4,818,000 which was partially offset by a combination of successful
drilling activities and revenues related to properties purchased or sold. The
average net oil price per barrel received in 1998 was $15.39 compared to $18.71
in 1997, an 18% decrease, and the average net gas price received in 1998 was
$2.10 compared to $2.30 in 1997, a 9% decrease. Revenues received from oil and
gas hedges accounted for $3.57 per barrel and $0.05 per Mcf for the six months
ended June 30, 1998. Oil and gas hedges cost $0.58 per barrel and $0.03 per Mcf
for the comparable period in 1997.

         Oil and gas production was 13,856 MMCFE in 1998 compared to 12,943
MMCFE in 1997, a 7% increase. Additional production from a combination of
successful drilling activities and acquired properties was largely offset by
production related to properties sold.

         Interest and other revenues were $360,000 for the six months ended June
30, 1998, representing a $560,000 decrease (61%) compared to $920,000 in 1997.
Interest income decreased $117,000 to $136,000 for 1998 as compared with
$253,000 in 1997 due to decreased funds earning interest. Losses on investment
transactions of $35,000 and gains on investment transactions of $604,000 were
recorded for the six months ended June 30, 1998 and 1997, respectively. These
gains related to an interest rate swap contract which was marked-to-market.
During the six months ended June 30, 1998, the Company realized a gain of
$100,000 from the release of stock warrants it held in connection with a note
receivable. No similar transaction occurred in 1997.

         Gain on sale of assets was $337,000 for the six months ended June 30,
1998 compared to a loss of $30,000 for 1997, representing an increase of
$367,000 (1,213%). Gains from the sale of certain oil and gas properties
increased by approximately $367,000.

                                       13
<PAGE>   14

         Oil and gas production costs for the six month period ended June 30,
1998 were $14,226,000 ($1.03 per MCFE), compared to $14,163,000 in 1997 ($1.09
per MCFE), representing a decrease of $63,000. The 6% decrease in the oil and
gas production cost per MCFE is due principally to a combination of lower
production costs on both newly completed wells and acquired properties and the
sale of certain oil and gas properties.

         General and administrative expenses for the six months ended June 30,
1998 were $5,070,000, representing an increase of $1,700,000 (50%) from 1997 of
$3,370,000. The increase is primarily due to an increase in personnel and
related costs necessary to accommodate the increase in the Company's oil and gas
activities, including the Acquisition and Exploration Agreement with Ballard
Petroleum.

         Exploration and abandonment expense increased to $5,228,000 for the six
months ended June 30, 1998 compared to $3,115,000 in 1997. Dry hole and
abandonment costs increased to $3,994,000 in 1998 from $1,913,000 in 1997. The
Company incurred $624,000 of seismic costs for the six months ended June 30,
1998, compared to $892,000 in the comparable period in 1997. The Company
incurred $610,000 of other geological and geophysical costs during the six month
period ended June 30, 1998 compared to $309,000 for the same period in 1997. The
increase in exploration and abandonments expense was primarily related to the
Company's increased exploratory drilling activities in 1998 compared to 1997.

         Depreciation, depletion and amortization ("D D & A") expense for the
six month period ended June 30, 1998 was $14,364,000 compared to $9,720,000 for
1997, representing an increase of $4,644,000 (48%). During the 1998 period, D D
& A on oil and gas production was provided at an average rate of $1.04 per MCF
compared to $0.75 per MCFE for 1997. Of the $4,644,000 increase, $3,753,000 was
due to the $0.29 per BOE increase in D D & A rate necessitated by lower oil and
gas prices at June 30, 1998 than those experienced at June 30, 1997.

         Interest expense was $9,833,000 for the six months ended June 30, 1998,
compared to $5,516,000 for the comparable period in 1997. The $4,317,000 (78%)
increase was attributable to a combination of higher levels of average
outstanding indebtedness and the issuance in January 1998 of an additional $80
million of 10.25% senior notes due in 2006. The average amounts of applicable
interest-bearing debt in 1998 and 1997 were $189,583,000 and $102,263,000,
respectively. The effective annualized interest rate in 1998 was 10.4%, as
compared to 10.8% in 1997.

         Results of operations for the six months ended June 30, 1998 include an
extraordinary charge of $299,000. There were no extraordinary charges for the
comparable period in 1997. These extraordinary charges related to the early
extinguishment of the Acquisition Credit Facility and consisted of previously
capitalized debt issuance costs. A portion of the proceeds from the 1998 Notes
was used to repay the Acquisition Credit Facility.


LIQUIDITY AND CAPITAL RESOURCES

Net Cash Provided By Operating Activities

         For the six months ended June 30, 1998, net cash provided by operating
activities decreased to a negative $3.0 million from $14.6 million for 1997.
Cash provided by operations, before changes in operating assets and liabilities,
decreased to a negative $1.2 million from $9.5 million for the comparable period
in 1997 due primarily to lower oil and gas prices and exploratory dry holes.
With respect to the effect of lower commodity prices, oil and gas revenues
decreased by $4.8 million for the six months ended June 30, 1998 as compared to
the same period in 1997 because of lower oil and gas prices. Oil and gas
revenues attributable to commodity hedges amounted to $4.1 million for the six
months ended June 30, 1998, $3.7 million of which related to the oil hedge.

Net Cash Used in Investing Activities

         Net cash used in investing activities for the six months ended June 30,
1998 was $45.8 million. Approximately $11.8 million was used for the
acquisition of oil and gas properties, with $10.2 million going to Manti
Resources ("Manti Acquisition"), $34.5 million was used for exploration and
development activities, $2.2 was used to acquire the remaining membership
interest in the limited liability company through which its Moldovan oil and gas
venture is conducted and $0.5 million for other property and equipment. Proceeds
from the sale of various oil and gas assets resulted in net cash provided from
investing activities of approximately $3.2 million. For 


                                       14
<PAGE>   15

the six months ended June 30, 1997, net cash used in investing activities was 
$34.5 million. Approximately $35.9 million was used for exploration and 
development activities, $1.3 million was used for other property and $2.7 
million was provided by sales of oil and gas properties.

Financing Activities

         For the six months ended June 30, 1998, the Company incurred $111.0
million of debt, of which approximately $91.5 million was used to repay certain
prior bank debt, $10.2 million was used for the Manti Acquisition and the
remainder was used in connection with its exploration and development
activities. In addition, the Company used approximately $1.8 million for the
purchase of 169,500 shares of its common stock. Finally, in June 1998, the
Company raised a net of approximately $48.0 million when it issued $50.0 million
of its 7% Series A Cumulative Convertible Preferred Stock. During the six months
ended June 30, 1997, the Company incurred $14.6 million of new debt which was
used in connection with its exploration and development activities and used
approximately $1.3 million , primarily for the purchase of 98,000 shares of its
common stock.

         The Company entered into the Revolving Credit Facility in August 1997.
Approximately $19.9 million of the funds initially borrowed were used for the
extension and refinancing of a prior senior credit facility and $11.2 million
was used as a portion of the purchase price in the Ballard Acquisition. The
Revolving Credit Facility provides for a maximum availability of $75.0 million,
with an current borrowing base of $40.0 million, $0.5 million of which was
borrowed at June 30, 1998. Borrowings under the Revolving Credit Facility bear
interest, at the Company's option, at a floating rate which is at or above the
lender's prime rate or above the applicable Eurodollar rate, depending on the
percentage of committed funds which have been borrowed. Interest is payable
quarterly as to base rate loans, and at the end of the applicable interest
period as to Eurodollar rate loans. The borrowing base of the Revolving Credit
Facility is automatically reduced by 5% each quarter beginning in August 1999,
and payments of principal are required in each such quarter in which the
outstanding principal balance is greater than the reduced borrowing base. The
remaining balance is payable on August 31, 2002, the maturity date of the
Revolving Credit Facility.

         Contemporaneous with entering into the Revolving Credit Facility, the
Company also entered into the Acquisition Credit Facility to provide the
remaining financing for the Ballard Acquisition. The Acquisition Credit Facility
was a term loan in the amount of $30.0 million which was repaid in full in
connection with the sale of notes by the Company described in the following
paragraph.

         In January 1998 the Company issued $80 million of 10.25% Senior Notes
due 2006 (the "Supplemental Notes Offering"). The net proceeds of the
Supplemental Notes Offering were approximately $78.8 million. The Company used
$30.0 million to repay the Acquisition Credit Facility and $32.5 million to
repay all but $0.5 million of the Revolving Credit Facility. In mid-January 1998
approximately $10.0 million of the remaining proceeds were used to fund the
Manti Acquisition.

         On June 3, 1998 the Company closed a private placement of 50,000 shares
of its 7% (8% Paid in Kind) Series A Cumulative Convertible Preferred Stock (the
"Preferred Stock") to Enron Capital & Trade Resources Corp. and Joint Energy
Development Investments II Limited Partnership for a purchase price of $50.0
million (the "Convertible Preferred Stock Offering"). Dividends accrue and are
payable quarterly, commencing September 15, 1998, in cash, or in certain
instances in shares of the Company's Common Stock. The dividend rate is 7% for
dividends paid in cash and 8% for dividends paid in shares of Common Stock. The
holders of the Preferred Stock may, at any time, convert shares of Preferred
Stock into shares of the Company's Common Stock at a conversion price of $12.39
which , subject to certain adjustments, would result in the issuance of
4,035,513 shares of Common Stock upon conversion of the Preferred Stock. The
Registrant may, at its option, redeem the shares of Preferred Stock after June
15, 2001, subject to certain limitations, for a premium reducing to par on June
15, 2004 and thereafter. Net proceeds from the Convertible Preferred Stock
Offering were $48.0 million, of which $29.0 million was used to repay all but
$0.5 million of the Revolving Credit Facility and the remainder for general
corporate purposes.


                                       15
<PAGE>   16

Capital Resources

         Funding for the Company's business activities has historically been
provided by bank financings, cash flow from operations, equity sales, property
divestitures and joint ventures with industry participants. The 1995
Acquisition, 1996 Acquisition and Ballard Acquisition were substantially funded
by bank financings. The Company plans to execute its business strategy with cash
flow from operations, net proceeds from the Supplemental Notes Offering, net
proceeds from the Convertible Preferred Stock Offering and borrowings available
under the Revolving Credit Facility.

         While the Company regularly engages in discussions relating to
potential acquisitions, the Company has no present agreement, commitment or
understanding with respect to any such acquisition, other than the acquisition
of undeveloped acreage and various mineral interests in its normal course of
business. Any future acquisition may require additional financing and will be
dependent upon financing arrangements available at the time.

         The Company believes that the increased availability under the
Revolving Credit Facility resulting from the application of net proceeds of the
Supplemental Notes Offering and the Convertible Preferred Stock Offering and
cash flow from operations will be sufficient for its 1998 capital expenditures.
However, because the Company's ultimate 1998 capital expenditures, future cash
flows and the availability of financing are subject to a number of variables,
there can be no assurance that the Company's capital resources will be
sufficient to maintain its capital expenditures. In addition, if the Company is
unable to generate sufficient cash flow from operations to service its debt, it
may be required to refinance all or a portion of its debt or to obtain
additional financing. There can be no assurance that any such refinancing would
be possible or that any additional financing could be obtained.

         Although certain of the Company's costs and expenses may be affected by
inflation, inflationary costs have not had a significant effect on the Company's
results of operations.

         The Company's oil hedge expires on August 31, 1998. As a result, the
Company expects that its cash flow for the four month period September through
December 1998 will be reduced by approximately $3.6 million when compared to
prior periods which included the oil hedge. The Company's estimate assumes that
oil prices are approximately the same as they were for July 1998. The Company
intends to monitor oil prices and follow its historic policy of hedging its oil
production if it believes it advantageous to do so.


Capital Expenditures

         During the six months ended June 30, 1998 the Company had oil and gas
expenditures of approximately $39.7 million, exclusive of the $14.0 million
spent on the acquisition of existing oil and gas properties. The $39.7 million
of oil and gas expenditures consisted of $16.3 million of exploration costs,
$15.9 million of development costs, $4.4 million of undeveloped acreage and $5.3
million on wells in progress at June 30, 1998. The Company anticipates that its
capital expenditures for the third quarter of 1998 will be comparable to an
average of the levels for the first two quarters of 1998. The Company intends
to evaluate its fourth quarter capital expenditures based upon various factors,
including oil and gas prices and the results of its drilling activities, which
during 1998 have been almost entirely devoted to the drilling of gas wells.


Recent Accounting Pronouncements

         INFORMATION SYSTEMS FOR THE YEAR 2000 - The Company will be required to
modify its information systems in order to accurately process data referencing
the year 2000. Because of the importance of occurrence dates in the oil and gas
industry, the consequences of not pursuing these modifications could be very
significant to the Company's ability to manage and report operating activities.
The Company's third-party software vendor for its integrated oil and gas
information system is currently modifying the system to accurately handle the
Year 2000 issue. All necessary programming modifications are scheduled to be
completed by December 31, 1998. From a cost viewpoint, these modifications will
be part of the routine updates the Company receives from its third-party
software vendor as part of its systems support contract already in place. Thus,
the Company believes it will not incur any marginal costs with respect to the
Year 2000 issue.

                                       16
<PAGE>   17

         SEGMENT REPORTING - In June 1997, the FASB issued Statement of
Accounting Standards No. 131 "Disclosures about Segments of an Enterprise and
Related Information" ("FAS 131") which establishes standards for public business
enterprises for reporting information about operating segments in annual
financial statements and requires that such enterprises report selected
information about operating segments in interim financial reports issued to
shareholders. This statement also established standards for related disclosures
about products and services, geographic areas, and major customers. FAS 131 is
effective for financial statements for years beginning after December 15, 1997.

         The Company operates in the one product line of oil and gas production
in limited geographic areas. This information and information about major
customers historically has been disclosed in the Company's annual financial
statements.

         DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES - In June 1998, The FASB
issued Statement of Financial Accounting Standards No. 133 "Accounting for
Derivative Instruments and Hedging Activities" which establishes accounting and
reporting standards for derivative instruments, including certain derivative
instruments embedded in other contracts, (collectively referred to as
derivatives) and for hedging activities. It requires that an entity recognize
all derivatives as either assets or liabilities in the statement of financial
position and measure those instruments at fair value. If certain conditions are
met, a derivative may be specifically designated as (a) a hedge of the exposure
to changes in the fair value of a recognized asset or liability or an
unrecognized firm commitment, (b) a hedge of the exposure to variable cash flows
of a forecasted transaction, or (c) a hedge of the foreign currency exposure of
a net investment in a foreign operation, an unrecognized firm commitment, an
available-for-sale security, or a foreign-currency-denominated forecasted
transaction.

Under this Statement, an entity that elects to apply hedge accounting is
required to establish at the inception of the hedge the method it will use for
assessing the effectiveness of the hedging derivative and the measurement
approach for determining the ineffective aspect of the hedge. Those methods must
be consistent with the entity's approach to managing risk.

This Statement applies to all entities and is effective for all fiscal quarters
of fiscal years beginning after June 15, 1999. Initial application of this
Statement should be as of the beginning of an entity's fiscal quarter; on that
date, hedging relationships must be designated anew and documented pursuant to
the provisions of this Statement. Earlier application of all of the provisions
of this Statement is encouraged, but it is permitted only as of the beginning of
any fiscal quarter that begins after issuance of this Statement. This Statement
should not be applied retroactively to financial statements of prior periods.






                                       17
<PAGE>   18





                           PART II - OTHER INFORMATION


ITEM 6.           EXHIBITS AND REPORTS ON FORM 8-K

EXHIBITS

<TABLE>
<CAPTION>
              Exhibit
              Number           Description of Exhibit
              ------           ----------------------

<S>                            <C> 
              *10.28            Securities Purchase Agreement dated as of June 3, 1998 between
                                Enron Capital & Trade Resources Corp. and Joint Energy
                                Development Investments II Limited Partnership, as purchasers,
                                and the Company

              *10.29            Registration Rights Agreement dated as of June 3, 1998 between
                                Enron Capital & Trade Resources Corp. and Joint Energy
                                Development Investments II Limited Partnership, as purchasers,
                                and the Company

              +10.30            Certificate of Designations of 7% (8% Paid in Kind) Series A
                                Cumulative Convertible Preferred Stock of Costilla Energy, Inc.

              *10.31            Fifth Amendment to Amended and Restated Credit Agreement dated
                                as of June 30, 1998 between Bankers Trust Company, as Agent and
                                Union Bank of California, N.A., as Co-Agent and the Company

              *27.1             Financial Data Schedule
</TABLE>



     *        Filed herewith
     +        Incorporated by reference to the Company's Current Report on Form 
              8-K filed on June 5, 1998


REPORTS ON FORM 8-K

                  The Company filed a report on Form 8-K on June 5, 1998
         reporting the private placement of 50,000 shares of its 7% (8% Paid in
         Kind) Series A Cumulative Convertible Preferred Stock to Enron Capital
         & Trade Resources Corp. and Joint Energy Development Investments II
         Limited partnership for a purchase price of $50.0 million.

                  Also, the Company filed a report on Form 8-K on June 15, 1998
         reporting the exchange offer of registered 10 1/4% Senior Notes due
         2006 for $80.0 million of outstanding unregistered 10 1/4% Senior Notes
         due 2006.




                                       18
<PAGE>   19



                               S I G N A T U R E S


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


                                       COSTILLA ENERGY, INC.




Date:    August 12, 1998               By:  /s/ BOBBY W. PAGE
                                            -----------------------------------
                                            Bobby W. Page
                                            Senior Vice President
                                            and Chief Financial Officer




                                       19
<PAGE>   20


                               INDEX TO EXHIBITS


<TABLE>
<CAPTION>
              Exhibit
              Number           Description of Exhibit
              ------           ----------------------

<S>                            <C> 
              *10.28            Securities Purchase Agreement dated as of June 3, 1998 between
                                Enron Capital & Trade Resources Corp. and Joint Energy
                                Development Investments II Limited Partnership, as purchasers,
                                and the Company

              *10.29            Registration Rights Agreement dated as of June 3, 1998 between
                                Enron Capital & Trade Resources Corp. and Joint Energy
                                Development Investments II Limited Partnership, as purchasers,
                                and the Company

              +10.30            Certificate of Designations of 7% (8% Paid in Kind) Series A
                                Cumulative Convertible Preferred Stock of Costilla Energy, Inc.

              *10.31            Fifth Amendment to Amended and Restated Credit Agreement dated
                                as of June 30, 1998 between Bankers Trust Company, as Agent and
                                Union Bank of California, N.A., as Co-Agent and the Company

              *27.1             Financial Data Schedule
</TABLE>



     *        Filed herewith
     +        Incorporated by reference to the Company's Current Report on Form 
              8-K filed on June 5, 1998