##### Table of Contents



UNITED STATES SECURITIES AND EXCHANGE COMMISSION
 Washington, D.C. 20549
 FORM 10-Q
 þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13(a) OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
 For the quarterly period ended September 30, 2006
 OR
 o
    
    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. 001-11899
 
 THE HOUSTON EXPLORATION COMPANY
 (Exact name of registrant as specified in its charter)
 Delaware
(State or Other Jurisdiction of 
Incorporation or Organization)
    
    22-2674487
(IRS Employer Identification No.)1100 Louisiana, Suite 2000
Houston, Texas
(Address of Principal Executive Offices)
    
    77002-5215
(Zip Code)
 (713) 830-6800
(Registrants Telephone Number, including Area Code)
 
 þ o
  þ o o
 o þ




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##### 



TABLE OF CONTENTS
 Forward-Looking Statements
    
    
    2Available Information
    
    
    2Part I. Financial Information
    
    
    3Item 1. Condensed Consolidated Financial Statements
    
    
    3Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    22Item 3. Quantitative and Qualitative Disclosures About Market Risk
    
    
    38Item 4. Controls and Procedures
    
    
    40Part II. Other Information
    
    
    40Item 1. Legal Proceedings
    
    
    40Item 1A. Risk Factors
    
    
    40Item 5. Other Information
    
    
    40Item 6. Exhibits
    
    
    41SIGNATURES
    
    
    42Computation of ratio of earnings to fixed chargesCertification of CEO pursuant to Section 302Certification of CFO pursuant to Section 302Certification of CEO pursuant to Section 906Certification of CFO pursuant to Section 906
  -1-




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##### Table of Contents



Forward-Looking Statements
  
 Available Information
 http://www.houstonexploration.com
    -2-




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##### Table of Contents



Part I. Financial Information
 
 Item 1. Condensed Consolidated Financial Statements
 THE HOUSTON EXPLORATION COMPANY
CONSOLIDATED BALANCE SHEETS
 September 30,
    
    
    December 31,2006
    
    
    2005Assets:Cash and cash equivalents
    
    $
    18,435
    
    
    $
    7,979Accounts receivable
    
    
    69,229
    
    
    
    146,020Inventories
    
    
    6,269
    
    
    
    2,726Deferred tax asset
    
    
    83,265
    
    
    
    145,922Prepayments and other
    
    
    27,153
    
    
    
    19,709Total current assets
    
    
    204,351
    
    
    
    322,356Natural gas and oil properties, full cost methodUnevaluated properties
    
    
    45,322
    
    
    
    107,146Properties subject to amortization
    
    
    3,270,984
    
    
    
    3,556,755Other property and equipment
    
    
    14,782
    
    
    
    12,9713,331,088
    
    
    
    3,676,872Less: Accumulated depreciation, depletion and amortization
    
    
    1,852,530
    
    
    
    1,658,5321,478,558
    
    
    
    2,018,340Designated cash
    
    
    314,043
    
    
    
    Other non-current assets
    
    
    16,616
    
    
    
    20,928Total non-current assets
    
    
    330,659
    
    
    
    20,928Total Assets
    
    $
    2,013,568
    
    
    $
    2,361,624Liabilities:Accounts payable and accrued expenses
    
    $
    159,475
    
    
    $
    177,159Derivative financial instruments
    
    
    5,251
    
    
    
    352,457Asset retirement obligation
    
    
    
    
    
    
    7,265Total current liabilities
    
    
    164,726
    
    
    
    536,881Long-term debt and notes
    
    
    362,000
    
    
    
    597,000Derivative financial instruments
    
    
    22,324
    
    
    
    65,201Deferred income taxes
    
    
    456,786
    
    
    
    341,302Asset retirement obligation
    
    
    40,015
    
    
    
    112,406Other non-current liabilities
    
    
    11,008
    
    
    
    15,696Total Liabilities
    
    
    1,056,859
    
    
    
    1,668,486Commitments and Contingencies (see Note 4)Stockholders Equity:Preferred Stock, $0.01 par value, 5,000,000 shares authorized and no shares issued
    
    
    
    
    
    
    Common Stock, $0.01 par value, 100,000,000 shares authorized and 28,024,434 and
28,980,128 shares issued and outstanding at September 30, 2006 and December 31,
2005, respectively
    
    
    280
    
    
    
    289Additional paid-in capital
    
    
    250,380
    
    
    
    297,218Retained earnings
    
    
    750,513
    
    
    
    663,367Accumulated other comprehensive (loss)
    
    
    (44,464
    )
    
    
    (267,736
    )Total Stockholders Equity
    
    
    956,709
    
    
    
    693,138Total Liabilities and Stockholders Equity
    
    $
    2,013,568
    
    
    $
    2,361,624
  -3-




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THE HOUSTON EXPLORATION COMPANY
CONSOLIDATED STATEMENTS OF OPERATIONS
 Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    September 30,2006
    
    
    2005
    
    
    2006
    
    
    2005Revenues:Natural gas and oil revenues
    
    $
    132,673
    
    
    $
    124,997
    
    
    $
    453,505
    
    
    $
    466,011Other
    
    
    (1,336
    )
    
    
    416
    
    
    
    1,350
    
    
    
    939Total revenues
    
    
    131,337
    
    
    
    125,413
    
    
    
    454,855
    
    
    
    466,950Operating expenses:Lease operating
    
    
    12,208
    
    
    
    17,771
    
    
    
    52,052
    
    
    
    52,263Severance tax
    
    
    4,609
    
    
    
    4,165
    
    
    
    15,598
    
    
    
    11,629Transportation expense
    
    
    2,546
    
    
    
    3,000
    
    
    
    8,176
    
    
    
    8,759Asset retirement accretion expense
    
    
    489
    
    
    
    1,313
    
    
    
    2,885
    
    
    
    3,964Depreciation, depletion and amortization
    
    
    52,565
    
    
    
    72,702
    
    
    
    194,184
    
    
    
    215,249General and administrative, net of
amounts capitalized
    
    
    9,392
    
    
    
    10,229
    
    
    
    26,703
    
    
    
    27,552Total operating expenses
    
    
    81,809
    
    
    
    109,180
    
    
    
    299,598
    
    
    
    319,416Income from operations
    
    
    49,528
    
    
    
    16,233
    
    
    
    155,257
    
    
    
    147,534Other (income) expense
    
    
    (8,302
    )
    
    
    (101
    )
    
    
    (10,500
    )
    
    
    286Interest expense, net of amounts capitalized
    
    
    5,180
    
    
    
    3,541
    
    
    
    20,352
    
    
    
    10,171Income before income taxes
    
    
    52,650
    
    
    
    12,793
    
    
    
    145,405
    
    
    
    137,077Provision for income taxes
    
    
    18,647
    
    
    
    4,712
    
    
    
    58,259
    
    
    
    51,728Net income
    
    $
    34,003
    
    
    $
    8,081
    
    
    $
    87,146
    
    
    $
    85,349Earnings per share:Net income per share  basic
    
    $
    1.22
    
    
    $
    0.28
    
    
    $
    3.06
    
    
    $
    2.98Net income per share  diluted
    
    $
    1.22
    
    
    $
    0.28
    
    
    $
    3.06
    
    
    $
    2.95Weighted average shares outstanding  basic
    
    
    27,845
    
    
    
    28,744
    
    
    
    28,458
    
    
    
    28,641Weighted average shares outstanding  diluted
    
    
    27,936
    
    
    
    29,120
    
    
    
    28,492
    
    
    
    28,966
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THE HOUSTON EXPLORATION COMPANY
CONSOLIDATED STATEMENTS OF CASH FLOWS
 Nine Months Ended September 30,2006
    
    
    2005Operating Activities:Net income
    
    $
    87,146
    
    
    $
    85,349Adjustments
to reconcile net income to net cash provided by operating activities:Depreciation, depletion and amortization
    
    
    194,184
    
    
    
    215,249Deferred income tax expense
    
    
    55,792
    
    
    
    39,202Asset retirement accretion expense
    
    
    2,885
    
    
    
    3,964Stock compensation expense
    
    
    7,132
    
    
    
    3,719Tax benefit from non-qualified stock options
    
    
    
    
    
    
    2,909Unrealized (gain) loss on derivative instruments
    
    
    (44,462
    )
    
    
    47,324Debt extinguishment
    
    
    572
    
    
    
    Changes in operating assets and liabilities:Accounts receivable
    
    
    76,791
    
    
    
    (26,192
    )Inventories
    
    
    (3,543
    )
    
    
    (1,353
    )Prepayments and other
    
    
    (7,444
    )
    
    
    (9,665
    )Other non-current assets
    
    
    3,939
    
    
    
    1,817Accounts payable and accrued expenses
    
    
    (29,141
    )
    
    
    16,930Other non-current liabilities
    
    
    (4,688
    )
    
    
    4,728Net cash provided by operating activities
    
    
    339,163
    
    
    
    383,981Investing Activities:Investment in property and equipment
    
    
    (447,093
    )
    
    
    (401,163
    )Cash designated for investment
    
    
    (323,675
    )
    
    
    Withdrawal of designated cash
    
    
    9,632
    
    
    
    Dispositions and other
    
    
    721,607
    
    
    
    165Net cash used in investing activities
    
    
    (39,529
    )
    
    
    (400,998
    )Financing Activities:Proceeds from long-term borrowings
    
    
    495,000
    
    
    
    364,000Repayments of long-term borrowings
    
    
    (730,000
    )
    
    
    (370,000
    )Proceeds from issuance of common stock from exercise of stock options
    
    
    6,879
    
    
    
    13,217Repurchase of common stock
    
    
    (61,638
    )
    
    
    Debt issue costs
    
    
    (199
    )
    
    
    Tax benefit from non-qualified stock options
    
    
    780
    
    
    
    Net cash provided by (used in) financing activities
    
    
    (289,178
    )
    
    
    7,217Increase (decrease) in cash and cash equivalents
    
    
    10,456
    
    
    
    (9,800
    )Cash and cash equivalents, beginning of period
    
    
    7,979
    
    
    
    18,577Cash and cash equivalents, end of period
    
    $
    18,435
    
    
    $
    8,777Supplemental Information:Non-cash transactions:Investments in property and equipment accrued, not paid
    
    $
    (11,457
    )
    
    $
    (19,395
    )Cash paid during period for:Interest
    
    $
    19,424
    
    
    $
    12,664Federal and state income taxes
    
    
    
    
    
    
    19,297
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THE HOUSTON EXPLORATION COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 NOTE 1  Summary of Organization and Significant Accounting Policies
 Our Business
  ).
  Principles of Consolidation
  Interim Financial Statements
   Use of Estimates
  -6-




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THE HOUSTON EXPLORATION COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
  Reclassifications
  Business Segment Information
   Revenue Recognition and Gas Imbalances
    -7-




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THE HOUSTON EXPLORATION COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 Cash and Cash Equivalents
  Designated Cash
 Taxable Gain on Sale of Gulf of Mexico Assets.
  Net Income Per Share
  Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    September 30,2006
    
    
    2005
    
    
    2006
    
    
    2005(in thousands, except per share data)Numerator:Net income
    
    $
    34,003
    
    
    $
    8,081
    
    
    $
    87,146
    
    
    $
    85,349Denominator:Weighted average shares outstanding
    
    
    27,845
    
    
    
    28,744
    
    
    
    28,458
    
    
    
    28,641Add: potentially dilutive securities (1)
    
    
    91
    
    
    
    376
    
    
    
    34
    
    
    
    325Total weighted average shares outstanding and dilutive
securities
    
    
    27,936
    
    
    
    29,120
    
    
    
    28,492
    
    
    
    28,966Net income
per share  basic:
    
    $
    1.22
    
    
    $
    0.28
    
    
    $
    3.06
    
    
    $
    2.98Net income
per share  diluted:
    
    $
    1.22
    
    
    $
    0.28
    
    
    $
    3.06
    
    
    $
    2.95
 
 (1)
    
    Consists of employee stock options and restricted common stock and units.  -8-




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THE HOUSTON EXPLORATION COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 Comprehensive Income (Loss)
  Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    September 30,2006
    
    
    2005
    
    
    2006
    
    
    2005(in thousands)Net income
    
    $
    34,003
    
    
    $
    8,081
    
    
    $
    87,146
    
    
    $
    85,349Other comprehensive income (loss)Derivative contracts settled and reclassified, net of tax
    
    
    19,978
    
    
    
    40,192
    
    
    
    223,272
    
    
    
    65,069Change in fair value of open derivative contracts, net
of tax
    
    
    
    
    
    
    (311,008
    )
    
    
    
    
    
    
    (436,007
    )Change in accumulated other comprehensive income (loss)
    
    
    19,978
    
    
    
    (270,816
    )
    
    
    223,272
    
    
    
    (370,938
    )Comprehensive income (loss)
    
    $
    53,981
    
    
    $
    (262,735
    )
    
    $
    310,418
    
    
    $
    (285,589
    )
 Natural Gas and Oil Properties
 Full Cost Accounting
 §
    
    full cost pool (including assets associated with retirement obligations); plus,§
    
    estimates for future development costs (excluding liabilities associated with retirement obligations); less,§
    
    unevaluated properties and their related costs; less,§
    
    estimates for salvage.
    -9-




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THE HOUSTON EXPLORATION COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
   Unevaluated Properties
  General and Administrative Costs and Expenses
   Capitalization of Interest
  -10-




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THE HOUSTON EXPLORATION COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 Natural Gas and Oil Properties 
Unevaluated Properties
 Asset Retirement Obligations
  Nine Months Ended September 30,2006
    
    
    2005(in thousands)ARO liability at January 1,
    
    $
    119,671
    
    
    $
    91,746Accretion expense
    
    
    2,885
    
    
    
    3,964Liabilities
incurred  drilling
    
    
    5,307
    
    
    
    5,496Liabilities
incurred  assets acquired
    
    
    603
    
    
    
    169Liabilities
settled  assets abandoned
    
    
    
    
    
    
    (32
    )Liabilities
settled  assets sold
    
    
    (88,375
    )
    
    
    (937
    )Changes in estimates
    
    
    (76
    )
    
    
    798ARO liability at September 30,
    
    $
    40,015
    
    
    $
    101,204
 Derivative Instruments and Hedging Activities
    -11-




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THE HOUSTON EXPLORATION COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 Sale
of Texas Gulf of Mexico Assets
   Accounting for Stock Options and Restricted Stock
   -12-




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THE HOUSTON EXPLORATION COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 Three Months
    
    
    Nine MonthsEnded
    
    
    EndedSeptember 30,
    
    
    September 30,2005
    
    
    2005(in thousands, except per share data)Net income
 as reported
    
    $
    8,081
    
    
    $
    85,349Add: Stock-based compensation expense included in net income, net of tax
    
    
    831
    
    
    
    1,705Less: Stock-based compensation expense determined using fair value
method,
net of tax
    
    
    (1,183
    )
    
    
    (2,769
    )Net income
 pro forma
    
    $
    7,729
    
    
    $
    84,285Net income
per share  basic  as reported
    
    $
    0.28
    
    
    $
    2.98Net income
per share  diluted  as reported
    
    
    0.28
    
    
    
    2.95Net income
per share  basic  pro forma
    
    $
    0.27
    
    
    $
    2.94Net income
per share  diluted  pro forma
    
    
    0.27
    
    
    
    2.91
  Nine Months EndedSeptember 30,2006
    
    2005Weighted average fair value of options granted
    
    $
    13.96
    
    
    $
    21.05Assumptions:Risk-free interest rate
    
    
    4.8
    %
    
    
    4.0
    %Expected years until exercise
    
    
    4
    
    
    
    5Expected stock volatility
    
    
    23.4
    %
    
    
    34.0
    %Expected dividends
    
    
    
    
    
    
    
   Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    September 30,2006
    
    
    2005
    
    
    2006
    
    
    2005(in thousands)Options
    
    $
    1,467
    
    
    $
    1,185
    
    
    $
    4,716
    
    
    $
    2,768Restricted stock/units
    
    
    793
    
    
    
    512
    
    
    
    2,416
    
    
    
    951Stock compensation expense, gross
    
    
    2,260
    
    
    
    1,697
    
    
    
    7,132
    
    
    
    3,719Amounts capitalized
    
    
    (811
    )
    
    
    (581
    )
    
    
    (2,559
    )
    
    
    (1,250
    )Stock compensation expense, net of amounts
capitalized
    
    $
    1,449
    
    
    $
    1,116
    
    
    $
    4,573
    
    
    $
    2,469
  -13-




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THE HOUSTON EXPLORATION COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
  Stock Plans.
 Stock Options.
   WeightedAverageShares
    
    Weighted
    
    Remaining
    
    AggregateUnderlying
    
    Average
    
    Contractual
    
    IntrinsicOptions
    
    Exercise Price
    
    Term
    
    Value(1)(shares)
    
    ($/share)
    
    (Years)
    
    ($ in thousands)Options outstanding January 1, 2006
    
    
    1,696,610
    
    
    $
    39.85
    
    
    
    7.8
    
    
    $
    21,971Granted
    
    
    41,920
    
    
    
    53.12
    
    
    
    
    
    
    
    85Exercised
    
    
    (195,199
    )
    
    
    35.23
    
    
    
    
    
    
    
    5,052Forfeited
    
    
    (60,504
    )
    
    
    36.82
    
    
    
    
    
    
    
    Options outstanding September 30, 2006
    
    
    1,482,827
    
    
    $
    40.96
    
    
    
    4.2
    
    
    $
    21,041Options exercisable September 30, 2006
    
    
    607,479
    
    
    $
    32.03
    
    
    
    2.5
    
    
    $
    14,045
 
 (1)
    
    The intrinsic value of an option is the amount by which the current market value of
the underlying stock exceeds the exercise price of the option, or the market price at the end
of the period less the exercise price. At September 30, 2006 and December 31, 2005, the
closing price per share of our common stock on the NYSE was $55.15 and $52.80, respectively.  -14-




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##### Table of Contents



THE HOUSTON EXPLORATION COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
  Restricted Stock
  Restricted
    
    Weighted
    
    AggregateStock and
    
    Average Grant
    
    IntrinsicUnits(1)
    
    Date Fair Value
    
    Value(2)(shares)
    
    ($/share)
    
    ($ in thousands)Unvested restricted stock January 1, 2006
    
    
    171,214
    
    
    $
    56.23
    
    
    $
    9,040Granted
    
    
    25,016
    
    
    
    54.16
    
    
    
    1,380Vested
    
    
    (803
    )
    
    
    58.88
    
    
    
    Forfeited
    
    
    (7,225
    )
    
    
    58.88
    
    
    
    Unvested restricted stock September 30, 2006
    
    
    188,202
    
    
    $
    55.84
    
    
    $
    10,379
 
 (1)
    
    Includes 52,501 units granted in July 2005 pursuant to a retention bonus plan for
certain employees at an average price of $58.76 per unit, of which 50% vest 18 months
following the grant date with the remaining 50% to vest 36 months following the grant date.
Restricted units will convert to shares of common stock at the end of the vesting period. At
September 30, 2006, 45,276 units under the retention bonus plan were unvested and outstanding.(2)
    
    For unvested shares of restricted stock, the intrinsic value is calculated using the
closing price of our common stock at the end of the period. For restricted shares that vested
during the period, the intrinsic value is calculated using the closing price of our common
stock on the vesting date. At September 30, 2006 and December 31, 2005, the closing price per
share of our common stock on the NYSE was $55.15 and $52.80, respectively. Recent Accounting Pronouncements
   -15-




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THE HOUSTON EXPLORATION COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
    NOTE 2  Long-Term Debt and Notes
 September 30, 2006
    
    
    December 31, 2005(in thousands)Senior Debt:Revolving credit facility, due November 30, 2010
    
    $
    187,000
    
    
    $
    422,000Subordinated Debt:7% senior subordinated notes, due June 15, 2013
    
    
    175,000
    
    
    
    175,000Total long-term debt and notes
    
    $
    362,000
    
    
    $
    597,000
  Revolving Credit Facility
 st st
 -16-




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##### Table of Contents



THE HOUSTON EXPLORATION COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
   §
    
    on base rate loans, at a fluctuating rate, or base rate, equal to the sum of (a)
the greater of the Federal funds rate plus 0.5% or Wachovias prime rate plus (b) a variable
margin between 0.00% and 0.50%, depending on the amount of borrowings outstanding under the
credit facility, or§
    
    on fixed rate loans, a fixed rate equal to the sum of (a) a quoted LIBOR rate
divided by one minus the average maximum rate during the interest period set for certain
reserves of member banks of the Federal Reserve System in Dallas, Texas, plus (b) a variable
margin between 1.00% and 1.75%, depending on the amount of borrowings outstanding under the
credit facility.
   §
    
    maintain a ratio of earnings before interest, taxes, depreciation, depletion and
amortization (EBITDA) to cash interest payments of at least 3.00 to 1.00;§
    
    maintain a ratio of total debt to EBITDA of not more than 3.50 to 1.00; and§
    
    hedge no more than 85% of our expected production during any calendar year.
  Senior Subordinated Notes
   §
    
    incurrence of additional indebtedness and issuance of preferred stock;§
    
    repayment of certain other indebtedness;§
    
    payment of dividends or certain other distributions;§
    
    investments and repurchases of equity;§
    
    use of proceeds of assets sales;§
    
    transactions with affiliates;§
    
    creation, incurrence or assumption of liens;§
    
    merger or consolidation and sales or other dispositions of all or substantially all of our assets;§
    
    entering into agreements that restrict the ability of our subsidiaries to make
certain distributions or payments; and§
    
    guarantees by our subsidiaries of certain indebtedness.
 -17-




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##### Table of Contents



THE HOUSTON EXPLORATION COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
   NOTE 3  Stockholders Equity
 Stock Repurchases
  NOTE 4 Commitments and Contingencies
 Taxable Gain on Sale of Gulf of Mexico Assets
  Legal Proceedings
   -18-




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##### Table of Contents



THE HOUSTON EXPLORATION COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 Operating Leases
 th
 Letters of Credit
  Drilling Contracts
  Seismic Contracts
  Supplemental Executive Retirement Plan
  NOTE 5  Related Party Transactions
 Employment Agreements with Executives
  -19-




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##### Table of Contents



THE HOUSTON EXPLORATION COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
      NOTE 6  Acquisitions and Dispositions
 Sale of Texas Gulf of Mexico Assets
  -20-




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##### Table of Contents



THE HOUSTON EXPLORATION COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
  Sale of Louisiana Gulf of Mexico Assets
     East Texas Acquisition
  -21-




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##### Table of Contents



Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
   Overview of Our Business
    Derivative Instruments and Hedging Activities
  Strategic Restructuring Plan
   -22-




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##### Table of Contents



Disposition of Gulf of Mexico Assets.
   .
   Redeployment of Net Sales Proceeds.
 -23-




---



##### Table of Contents



Hedging Strategy.
 Acquisitions
  Critical Accounting Estimates and Significant Accounting Policies
  -24-




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##### Table of Contents



Recent Accounting Pronouncements
     -25-




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##### Table of Contents



Overview of Results for the Third Quarter of 2006
   §
    
    We generated $34.0 million in net income, including $22.6 million ($14.6 million
after tax) of unrealized gains on open derivative contracts in connection with
mark-to-market accounting, compared to $8.1 million in net income during the third quarter
of 2005, including unrealized losses from hedging activities of $45.9 million ($29.7 million
after tax);§
    
    We produced approximately 19 Bcfe and our average total production rate was 204
MMcfe per day, a decrease of approximately 10 Bcfe and 104 MMcfe per day, respectively, from
the third quarter of 2005, which decrease is primarily a result of the sale of
substantially all of our offshore assets, offset in part by an increase in production from
our onshore assets;§
    
    We increased production from our onshore properties by 10%, to 204 MMcfe per
day, from 185 MMcfe per day during the third quarter of 2005;§
    
    We generated $85.8 million in cash flows from operating activities, a decrease
of 32% from the $126.8 million during the third quarter of 2005;§
    
    We invested $142.7 million in natural gas and oil properties;§
    
    We increased net borrowings under our revolving credit facility by $87 million
and used these borrowings to fund our exploration and development activities;§
    
    We drilled 110 wells, of which 100, or 91%, were successful, including 43 in the
Rockies, 28 in South Texas, 20 in Arkoma, and 9 in East Texas;§
    
    We withdrew $9.6 million of the $323.7 million in offshore sales proceeds we had
previously deposited with qualified intermediaries and designated for potential reinvestment
in like-kind exchange transactions under Section 1031 of the Internal Revenue Code, of which
$2.0 million was invested in qualified natural gas and oil assets and the balance, or $7.6
million which remained from the sale of the Texas portion of our offshore assets, was
released from escrow due to the expiration of the 180-day reinvestment period;§
    
    We paid $0.9 million to liquidate and settle derivative contracts covering
20,000 MMBtu per day for each of the months September and October 2006; and§
    
    We continued our review of strategic alternatives that was announced by our
Board of Directors on June 26, 2006.
 -26-




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##### Table of Contents



Operating
and Financial Results for the Three  Month and Nine  Month Periods Ended September 30,
2006 Compared to the Three  Month and Nine  Month Periods Ended September 30, 2005.
  Three Months Ended September 30,
    
    Nine Months Ended September 30,2006
    
    2005
    
    Change
    
    %
    
    2006
    
    2005
    
    Change
    
    %(in thousands, except prices and percentages)Operating revenues
    
    $
    131,337
    
    
    $
    125,413
    
    
    $
    5,924
    
    
    
    5
    %
    
    $
    454,855
    
    
    $
    466,950
    
    
    $
    (12,095
    )
    
    
    -3
    %Operating expenses
    
    
    81,809
    
    
    
    109,180
    
    
    
    (27,371
    )
    
    
    -25
    %
    
    
    299,598
    
    
    
    319,416
    
    
    
    (19,818
    )
    
    
    -6
    %Income from operations
    
    
    49,528
    
    
    
    16,233
    
    
    
    33,295
    
    
    
    205
    %
    
    
    155,257
    
    
    
    147,534
    
    
    
    7,723
    
    
    
    5
    %Net income
    
    
    34,003
    
    
    
    8,081
    
    
    
    25,922
    
    
    
    321
    %
    
    
    87,146
    
    
    
    85,349
    
    
    
    1,797
    
    
    
    2
    %Production:Natural gas (MMcf)
    
    
    18,081
    
    
    
    26,217
    
    
    
    (8,136
    )
    
    
    -31
    %
    
    
    64,348
    
    
    
    81,014
    
    
    
    (16,666
    )
    
    
    -21
    %Oil (MBbls)
    
    
    117
    
    
    
    360
    
    
    
    (243
    )
    
    
    -68
    %
    
    
    722
    
    
    
    1,172
    
    
    
    (450
    )
    
    
    -38
    %Total (MMcfe) (1)
    
    
    18,783
    
    
    
    28,377
    
    
    
    (9,594
    )
    
    
    -34
    %
    
    
    68,680
    
    
    
    88,046
    
    
    
    (19,366
    )
    
    
    -22
    %Average daily production (MMcfe/d)
    
    
    204
    
    
    
    308
    
    
    
    (104
    )
    
    
    -34
    %
    
    
    252
    
    
    
    323
    
    
    
    (71
    )
    
    
    -22
    %Average Sales Prices:Natural Gas (per Mcf) unhedged
    
    $
    5.85
    
    
    $
    8.15
    
    
    $
    (2.30
    )
    
    
    -28
    %
    
    $
    6.75
    
    
    $
    6.90
    
    
    $
    (0.15
    )
    
    
    -2
    %Natural Gas (per Mcf) realized (2)
    
    
    5.70
    
    
    
    5.78
    
    
    
    (0.08
    )
    
    
    -1
    %
    
    
    5.69
    
    
    
    5.65
    
    
    
    0.04
    
    
    
    1
    %Natural Gas (per Mcf) all-in(3)
    
    
    6.95
    
    
    
    4.03
    
    
    
    2.92
    
    
    
    72
    %
    
    
    6.39
    
    
    
    5.07
    
    
    
    1.32
    
    
    
    26
    %Oil (per Bbl) realized
    
    
    59.86
    
    
    
    54.08
    
    
    
    5.78
    
    
    
    11
    %
    
    
    59.04
    
    
    
    47.27
    
    
    
    11.77
    
    
    
    25
    %
 
 (1)
    
    MMcfe is defined as one million cubic feet equivalent of natural gas,
determined using the ratio of six MMcf of natural gas to one MBbl of crude oil, condensate or
natural gas liquids.(2)
    
    Includes gains and losses realized on derivative contracts settled during
the period.(3)
    
    Includes both the effect of gains and losses realized on derivative
contracts settled during the period as well as unrealized gains and losses recognized pursuant
to accounting under SFAS 133. Production Volume
 Three Months Ended September 30,
    
    
    Nine Months Ended September 30,2006
    
    
    2005
    
    
    Change
    
    
    %
    
    
    2006
    
    
    2005
    
    
    Change
    
    
    %(in thousands, except percentages)Natural Gas Production (MMcf):Onshore
    
    
    18,081
    
    
    
    16,879
    
    
    
    1,202
    
    
    
    7
    %
    
    
    53,261
    
    
    
    50,681
    
    
    
    2,580
    
    
    
    5
    %Offshore
    
    
    
    
    
    
    9,338
    
    
    
    (9,338
    )
    
    
    -100
    %
    
    
    11,087
    
    
    
    30,333
    
    
    
    (19,246
    )
    
    
    -63
    %Total natural gas
    
    
    18,081
    
    
    
    26,217
    
    
    
    (8,136
    )
    
    
    -31
    %
    
    
    64,348
    
    
    
    81,014
    
    
    
    (16,666
    )
    
    
    -21
    %Oil (MBbls):Onshore
    
    
    108
    
    
    
    24
    
    
    
    84
    
    
    
    350
    %
    
    
    289
    
    
    
    69
    
    
    
    220
    
    
    
    319
    %Offshore
    
    
    9
    
    
    
    336
    
    
    
    (327
    )
    
    
    -97
    %
    
    
    433
    
    
    
    1,103
    
    
    
    (670
    )
    
    
    -61
    %Total oil
    
    
    117
    
    
    
    360
    
    
    
    (243
    )
    
    
    -68
    %
    
    
    722
    
    
    
    1,172
    
    
    
    (450
    )
    
    
    -38
    %Natural Gas Equivalent (MMcfe):Onshore
    
    
    18,729
    
    
    
    17,023
    
    
    
    1,706
    
    
    
    10
    %
    
    
    54,995
    
    
    
    51,095
    
    
    
    3,900
    
    
    
    8
    %Offshore
    
    
    54
    
    
    
    11,354
    
    
    
    (11,300
    )
    
    
    -100
    %
    
    
    13,685
    
    
    
    36,951
    
    
    
    (23,266
    )
    
    
    -63
    %Total equivalents
    
    
    18,783
    
    
    
    28,377
    
    
    
    (9,594
    )
    
    
    -34
    %
    
    
    68,680
    
    
    
    88,046
    
    
    
    (19,366
    )
    
    
    -22
    %
 -27-




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##### Table of Contents



Three Months Ended September 30,
    
    
    Nine Months Ended September 30,2006
    
    
    2005
    
    
    Change
    
    
    %
    
    
    2006
    
    
    2005
    
    
    Change
    
    
    %(MMcfe per day, except percentages)
    
    
    (MMcfe per day, except percentages)South Texas
    
    
    142
    
    
    
    127
    
    
    
    15
    
    
    
    12
    %
    
    
    143
    
    
    
    134
    
    
    
    9
    
    
    
    7
    %Arkoma
    
    
    40
    
    
    
    46
    
    
    
    (6
    )
    
    
    -13
    %
    
    
    40
    
    
    
    43
    
    
    
    (3
    )
    
    
    -7
    %East Texas
    
    
    12
    
    
    
    7
    
    
    
    5
    
    
    
    71
    %
    
    
    11
    
    
    
    4
    
    
    
    7
    
    
    
    175
    %Rockies
    
    
    9
    
    
    
    4
    
    
    
    5
    
    
    
    125
    %
    
    
    7
    
    
    
    5
    
    
    
    2
    
    
    
    40
    %Other
    
    
    1
    
    
    
    1
    
    
    
    
    
    
    
    
    
    
    
    1
    
    
    
    1
    
    
    
    
    
    
    
    Total onshore
    
    
    204
    
    
    
    185
    
    
    
    19
    
    
    
    10
    %
    
    
    202
    
    
    
    187
    
    
    
    15
    
    
    
    8
    %Offshore
    
    
    
    
    
    
    123
    
    
    
    (123
    )
    
    
    -100
    %
    
    
    50
    
    
    
    136
    
    
    
    (86
    )
    
    
    -63
    %Total (MMcfe/day)
    
    
    204
    
    
    
    308
    
    
    
    (104
    )
    
    
    -34
    %
    
    
    252
    
    
    
    323
    
    
    
    (71
    )
    
    
    -22
    %
   Commodity Prices and Effects of Hedging
 Three Months Ended September 30,
    
    Nine Months Ended September 30,2006
    
    2005
    
    Change
    
    %
    
    2006
    
    2005
    
    Change
    
    %Average Natural Gas Prices ($  per Mcf):Onshore
    
    $
    5.86
    
    
    $
    7.75
    
    
    $
    (1.89
    )
    
    
    -24
    %
    
    $
    6.49
    
    
    $
    6.62
    
    
    $
    (0.13
    )
    
    
    -2
    %Offshore
    
    
    
    
    
    
    8.86
    
    
    
    (8.86
    )
    
    
    -100
    %
    
    
    7.97
    
    
    
    7.35
    
    
    
    0.62
    
    
    
    8
    %Total
Natural Gas  unhedged
    
    
    5.85
    
    
    
    8.15
    
    
    
    (2.30
    )
    
    
    -28
    %
    
    
    6.75
    
    
    
    6.90
    
    
    
    (0.15
    )
    
    
    -2
    %Total
Natural Gas  realized (1)
    
    
    5.70
    
    
    
    5.78
    
    
    
    (0.08
    )
    
    
    -1
    %
    
    
    5.69
    
    
    
    5.65
    
    
    
    0.04
    
    
    
    1
    %Total
Natural Gas  all-in (2)
    
    
    6.95
    
    
    
    4.03
    
    
    
    2.92
    
    
    
    72
    %
    
    
    6.39
    
    
    
    5.07
    
    
    
    1.32
    
    
    
    26
    %Average Oil Prices ($  per Bbl):Onshore
    
    
    61.53
    
    
    
    46.46
    
    
    
    15.07
    
    
    
    32
    %
    
    
    58.87
    
    
    
    51.36
    
    
    
    7.51
    
    
    
    15
    %Offshore
    
    
    39.89
    
    
    
    54.63
    
    
    
    (14.74
    )
    
    
    -27
    %
    
    
    59.15
    
    
    
    47.01
    
    
    
    12.14
    
    
    
    26
    %Total Oil
    
    
    59.86
    
    
    
    54.08
    
    
    
    5.78
    
    
    
    11
    %
    
    
    59.04
    
    
    
    47.27
    
    
    
    11.77
    
    
    
    25
    %
 
 (1)
    
    Includes gains and losses realized on derivative contracts settled during the
period.(2)
    
    Includes gains and losses realized on derivative contracts settled during the
period, as well as unrealized gains and losses recognized pursuant to SFAS 133.  -28-




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##### Table of Contents



Three Months Ended September 30,
    
    
    Nine Months Ended September 30,2006
    
    
    2005
    
    
    Change
    
    
    2006
    
    
    2005
    
    
    Change(in thousands)Gain (Loss) from Hedging ActivitiesCash (loss) realized on contracts settled (1)
    
    $
    (2,715
    )
    
    $
    (62,216
    )
    
    $
    59,501
    
    
    $
    (67,664
    )
    
    $
    (100,726
    )
    
    $
    33,062Non-cash unrealized gain (loss):Ineffectiveness gain (loss)
    
    
    7,070
    
    
    
    (45,900
    )
    
    
    52,970
    
    
    
    38,970
    
    
    
    (47,324
    )
    
    
    86,294Mark-to-market change in fair value gain (loss)
    
    
    15,521
    
    
    
    
    
    
    
    15,521
    
    
    
    84,307
    
    
    
    
    
    
    
    84,307Deferred loss prior quarter production shortfalls
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (20,600
    )
    
    
    
    
    
    
    (20,600
    )Recognition of all deferred losses relating to Gulf of
Mexico production sold during period
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (58,215
    )
    
    
    
    
    
    
    (58,215
    )Total non-cash unrealized gain (loss)
    
    
    22,591
    
    
    
    (45,900
    )
    
    
    68,491
    
    
    
    44,462
    
    
    
    (47,324
    )
    
    
    91,786Total gain (loss) from hedging activities
    
    $
    19,876
    
    
    $
    (108,116
    )
    
    $
    127,992
    
    
    $
    (23,202
    )
    
    $
    (148,050
    )
    
    $
    124,848
 
 (1)
    
    For the three months ended September 30, 2006, also includes $0.9 million to
liquidate and settle contracts covering 20,000 MMBtu per day for each of the months September
and October 2006. For the nine months ended September 30, 2006, includes the aforementioned
$0.9 million paid during the third quarter of 2006 and $14.3 million paid during the second
quarter of 2006 to liquidate and settle contracts covering 60,000 MMBtu per day for each of
the months July through December 2006. This 60,000 MMBtu per day liquidiation was made in
connection with the completion of the sale of our Gulf of Mexico assets on June 1, 2006 and
was required under the terms of our revolving credit facility.   -29-




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##### Table of Contents



Natural Gas and Oil Revenues
 Three Months Ended September 30,
    
    
    Nine Months Ended September 30,2006
    
    
    2005
    
    
    Change
    
    
    %
    
    
    2006
    
    
    2005
    
    
    Change
    
    
    %(in thousands, except percentages)Natural Gas Revenues:Onshore
    
    $
    105,875
    
    
    $
    130,894
    
    
    $
    (25,019
    )
    
    
    -19
    %
    
    $
    345,679
    
    
    $
    335,598
    
    
    $
    10,081
    
    
    
    3
    %Offshore
    
    
    (82
    )
    
    
    82,749
    
    
    
    (82,831
    )
    
    
    -100
    %
    
    
    88,404
    
    
    
    223,068
    
    
    
    (134,664
    )
    
    
    -60
    %Gain (loss) on settled derivatives
    
    
    (2,715
    )
    
    
    (62,216
    )
    
    
    59,501
    
    
    
    -96
    %
    
    
    (67,664
    )
    
    
    (100,726
    )
    
    
    33,062
    
    
    
    -33
    %Unrealized gain (loss) on derivatives
    
    
    22,591
    
    
    
    (45,900
    )
    
    
    68,491
    
    
    
    -149
    %
    
    
    44,462
    
    
    
    (47,324
    )
    
    
    91,786
    
    
    
    -194
    %Total natural gas revenues
    
    
    125,669
    
    
    
    105,527
    
    
    
    20,142
    
    
    
    19
    %
    
    
    410,881
    
    
    
    410,616
    
    
    
    265
    
    
    
    
    %Oil Revenues:Onshore
    
    
    6,645
    
    
    
    1,115
    
    
    
    5,530
    
    
    
    496
    %
    
    
    17,012
    
    
    
    3,544
    
    
    
    13,468
    
    
    
    380
    %Offshore
    
    
    359
    
    
    
    18,355
    
    
    
    (17,996
    )
    
    
    -98
    %
    
    
    25,612
    
    
    
    51,851
    
    
    
    (26,239
    )
    
    
    -51
    %Total oil revenues
    
    
    7,004
    
    
    
    19,470
    
    
    
    (12,466
    )
    
    
    -64
    %
    
    
    42,624
    
    
    
    55,395
    
    
    
    (12,771
    )
    
    
    -23
    %Total natural gas and oil revenues
    
    $
    132,673
    
    
    $
    124,997
    
    
    $
    7,676
    
    
    
    6
    %
    
    $
    453,505
    
    
    $
    466,011
    
    
    $
    (12,506
    )
    
    
    -3
    %
    Operating Expenses
 Three Months Ended September 30,
    
    
    Nine Months Ended September 30,2006
    
    
    2005
    
    
    Change
    
    
    %
    
    
    2006
    
    
    2005
    
    
    Change
    
    
    %($ per MMcfe, except percentages)Lease operating expense
    
    $
    0.65
    
    
    $
    0.63
    
    
    $
    0.02
    
    
    
    3
    %
    
    $
    0.76
    
    
    $
    0.59
    
    
    $
    0.17
    
    
    
    29
    %Severance tax
    
    
    0.25
    
    
    
    0.15
    
    
    
    0.10
    
    
    
    67
    %
    
    
    0.23
    
    
    
    0.13
    
    
    
    0.10
    
    
    
    77
    %Transportation expense
    
    
    0.14
    
    
    
    0.11
    
    
    
    0.03
    
    
    
    27
    %
    
    
    0.12
    
    
    
    0.10
    
    
    
    0.02
    
    
    
    20
    %Asset retirement accretion expense
    
    
    0.03
    
    
    
    0.05
    
    
    
    (0.02
    )
    
    
    -40
    %
    
    
    0.04
    
    
    
    0.05
    
    
    
    (0.01
    )
    
    
    -20
    %Depreciation, depletion and amortization
    
    
    2.80
    
    
    
    2.56
    
    
    
    0.24
    
    
    
    9
    %
    
    
    2.83
    
    
    
    2.44
    
    
    
    0.39
    
    
    
    16
    %General and administrative, net
    
    
    0.50
    
    
    
    0.36
    
    
    
    0.14
    
    
    
    39
    %
    
    
    0.39
    
    
    
    0.31
    
    
    
    0.08
    
    
    
    26
    %Total operating expenses per unit of
production
    
    $
    4.37
    
    
    $
    3.86
    
    
    $
    0.51
    
    
    
    13
    %
    
    $
    4.37
    
    
    $
    3.62
    
    
    $
    0.75
    
    
    
    21
    %
   -30-




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##### Table of Contents



Lease Operating Expense
 Three Months Ended September 30,
    
    
    Nine Months Ended September 30,2006
    
    
    2005
    
    
    Change
    
    
    %
    
    
    2006
    
    
    2005
    
    
    Change
    
    
    %(in thousands, except percentages)Onshore
    
    $
    11,984
    
    
    $
    7,398
    
    
    $
    4,586
    
    
    
    62
    %
    
    $
    35,162
    
    
    $
    20,493
    
    
    $
    14,669
    
    
    
    72
    %Offshore
    
    
    224
    
    
    
    10,373
    
    
    
    (10,149
    )
    
    
    -98
    %
    
    
    16,890
    
    
    
    31,770
    
    
    
    (14,880
    )
    
    
    -47
    %Total
    
    $
    12,208
    
    
    $
    17,771
    
    
    $
    (5,563
    )
    
    
    -31
    %
    
    $
    52,052
    
    
    $
    52,263
    
    
    $
    (211
    )
    
    
    Onshore per Mcfe
    
    $
    0.64
    
    
    $
    0.43
    
    
    $
    0.21
    
    
    
    49
    %
    
    $
    0.64
    
    
    $
    0.40
    
    
    $
    0.24
    
    
    
    60
    %Offshore per Mcfe
    
    
    
    
    
    
    0.91
    
    
    
    (0.91
    )
    
    
    N/A
    
    
    
    1.23
    
    
    
    0.86
    
    
    
    0.37
    
    
    
    43
    %Total
    
    
    0.65
    
    
    
    0.63
    
    
    
    0.02
    
    
    
    3
    %
    
    
    0.76
    
    
    
    0.59
    
    
    
    0.17
    
    
    
    29
    %
  Severance Tax
 Depreciation, Depletion and Amortization
 -31-




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##### Table of Contents



General and Administrative Expenses, Net of Overhead Reimbursements and Capitalized General and
Administrative Expenses.
 Three Months Ended September 30,
    
    
    Nine Months Ended September 30,2006
    
    
    2005
    
    
    Change
    
    
    %
    
    
    2006
    
    
    2005
    
    
    Change
    
    
    %(in thousands, except percentages)Absolute DollarsGross general and administrative expense
    
    $
    14,588
    
    
    $
    14,917
    
    
    $
    (329
    )
    
    
    -2
    %
    
    $
    43,994
    
    
    $
    41,395
    
    
    $
    2,599
    
    
    
    6
    %Operating overhead reimbursements
    
    
    (535
    )
    
    
    (508
    )
    
    
    (27
    )
    
    
    5
    %
    
    
    (1,716
    )
    
    
    (1,583
    )
    
    
    (133
    )
    
    
    8
    %Capitalized amounts (1)
    
    
    (4,661
    )
    
    
    (4,180
    )
    
    
    (481
    )
    
    
    12
    %
    
    
    (15,575
    )
    
    
    (12,260
    )
    
    
    (3,315
    )
    
    
    27
    %General and administrative expense, net
    
    $
    9,392
    
    
    $
    10,229
    
    
    $
    (837
    )
    
    
    -8
    %
    
    $
    26,703
    
    
    $
    27,552
    
    
    $
    (849
    )
    
    
    -3
    %
 Three Months Ended September 30,
    
    
    Nine Months Ended September 30,2006
    
    
    2005
    
    
    Change
    
    
    %
    
    
    2006
    
    
    2005
    
    
    Change
    
    
    %($ per Mcfe, except percentages)Unit of
Production  McfeGross general and administrative expense
    
    $
    0.78
    
    
    $
    0.53
    
    
    $
    0.25
    
    
    
    47
    %
    
    $
    0.64
    
    
    $
    0.47
    
    
    $
    0.17
    
    
    
    36
    %Operating overhead reimbursements
    
    
    (0.03
    )
    
    
    (0.02
    )
    
    
    (0.01
    )
    
    
    50
    %
    
    
    (0.02
    )
    
    
    (0.02
    )
    
    
    
    
    
    
    Capitalized amounts (1)
    
    
    (0.25
    )
    
    
    (0.15
    )
    
    
    (0.10
    )
    
    
    67
    %
    
    
    (0.23
    )
    
    
    (0.14
    )
    
    
    (0.09
    )
    
    
    64
    %General and administrative expense, net
    
    $
    0.50
    
    
    $
    0.36
    
    
    $
    0.14
    
    
    
    39
    %
    
    $
    0.39
    
    
    $
    0.31
    
    
    $
    0.08
    
    
    
    26
    %
 
 (1)
    
    Includes only those internal general and administrative costs that are directly
associated with our acquisition, exploration and development activities, such as salaries,
benefits and incentive compensation for geological and geophysical employees and other
specifically identifiable non-payroll costs. These capitalized general and administrative
costs do not include costs related to production operations, general corporate overhead or
other activities that are not directly attributable to our acquisition, exploration and
development efforts.    -32-




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##### Table of Contents



Other Income and Expense, Interest and Taxes
 Other Income and Expense Designated Cash
  Interest Expense, Net of Amounts Capitalized
 Three Months Ended September 30,
    
    
    Nine Months Ended September 30,Interest and Average Borrowings
    
    2006
    
    
    2005
    
    
    Change
    
    
    2006
    
    
    2005
    
    
    Change(dollars in thousands)Interest Expense, net:Gross interest (1)
    
    $
    6,173
    
    
    $
    5,898
    
    
    $
    275
    
    
    
    5
    %
    
    $
    24,000
    
    
    $
    16,943
    
    
    $
    7,057
    
    
    
    42
    %Capitalized interest
    
    
    (993
    )
    
    
    (2,357
    )
    
    
    1,364
    
    
    
    -58
    %
    
    
    (3,648
    )
    
    
    (6,772
    )
    
    
    3,124
    
    
    
    -46
    %Interest expense, net
    
    $
    5,180
    
    
    $
    3,541
    
    
    $
    1,639
    
    
    
    46
    %
    
    $
    20,352
    
    
    $
    10,171
    
    
    $
    10,181
    
    
    
    100
    %Average Borrowings:Bank credit facility
    
    $
    147,000
    
    
    $
    175,000
    
    
    $
    (28,000
    )
    
    
    -16
    %
    
    $
    261,000
    
    
    $
    172,000
    
    
    $
    89,000
    
    
    
    52
    %Senior subordinated notes
    
    
    175,000
    
    
    
    175,000
    
    
    
    
    
    
    
    
    
    
    
    175,000
    
    
    
    175,000
    
    
    
    
    
    
    
    Total borrowings
    
    $
    322,000
    
    
    $
    350,000
    
    
    $
    (28,000
    )
    
    
    -8
    %
    
    $
    436,000
    
    
    $
    347,000
    
    
    $
    89,000
    
    
    
    26
    %Average Interest Rate:Bank credit facility (2)
    
    
    7.40
    %
    
    
    5.64
    %
    
    
    1.76
    %
    
    
    31
    %
    
    
    6.67
    %
    
    
    5.14
    %
    
    
    1.53
    %
    
    
    30
    %Senior subordinated notes
    
    
    7.00
    %
    
    
    7.00
    %
    
    
    
    
    
    
    
    
    
    
    7.00
    %
    
    
    7.00
    %
    
    
    
    
    
    
    
 
 (1)
    
    Includes commitment fees, letter of credit fees, amortization of deferred
financing costs and other non-loan related charges of $0.3 million for each of the three
months ended September 2006 and 2005, respectively, and $1.6 million and $0.9 million for the
nine months ended September 2006 and 2005, respectively.(2)
    
    Includes letter of credit and commitment fees.  -33-




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##### Table of Contents











Income Tax Provision.


Liquidity and Capital Resources




§
    
    Drilling and completing new natural gas and oil wells;§
    
    Constructing and installing new production infrastructure;§
    
    Acquiring additional reserves and producing properties;§
    
    Acquiring and maintaining our lease acreage position and our seismic resources;§
    
    Maintaining, repairing, and enhancing existing natural gas and oil wells;§
    
    Plugging and abandoning depleted or uneconomic natural gas and oil wells; and§
    
    General and administrative costs directly associated with our acquisition,
exploration and development activities, including payroll and other expenses attributable
to only our geological and geophysical employees.


Drilling
Contracts


-34-




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##### Table of Contents



Sources of Liquidity and Capital Resources
  Available Liquidity and Designated Cash
 September 30,
    
    
    December 31,2006
    
    
    2005(in thousands)Available Liquidity:Revolving
credit facility  borrowing base
    
    $
    500,000
    
    
    $
    600,000Outstanding borrowings
    
    
    (187,000
    )
    
    
    (422,000
    )Letters of credit
    
    
    (300
    )
    
    
    (300
    )Unused borrowing capacity
    
    
    312,700
    
    
    
    177,700Cash and cash equivalents
    
    
    18,435
    
    
    
    7,979Total available liquidity
    
    $
    331,135
    
    
    $
    185,679Available Liquidity and Designated Cash:Total available liquidity
    
    $
    331,135
    
    
    $
    185,679Designated cash
    
    
    314,043
    
    
    
    Total available liquidity and designated cash
    
    $
    645,178
    
    
    $
    185,679
 Designated Cash
 Cash Provided by Operating Activities.
  -35-




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##### Table of Contents



Access to Capital Markets
 Uses of Liquidity and Capital Resources
  Capital Expenditures.
  Natural Gas and Oil Expenditures and DispositionsThree Months Ended September 30,
    
    

Nine
Months Ended September 30,2006
    
    
    2005
    
    
    2006
    
    
    2005(in thousands)Producing property acquisitions (1)
    
    $
    (8,436
    )
    
    $
    57
    
    
    $
    38,809
    
    
    $
    31,691Leasehold and lease acquisition costs (2)
    
    
    10,090
    
    
    
    9,680
    
    
    
    38,055
    
    
    
    45,255Development
    
    
    111,811
    
    
    
    102,732
    
    
    
    304,468
    
    
    
    250,784Exploration
    
    
    29,200
    
    
    
    28,857
    
    
    
    75,220
    
    
    
    91,986Total natural gas and oil capital expenditures
    
    
    142,665
    
    
    
    141,326
    
    
    
    456,552
    
    
    
    419,716Producing property dispositions (3)
    
    
    2,043
    
    
    
    
    
    
    
    (721,606
    )
    
    
    (150
    )Net natural gas and oil capital expenditures
    
    $
    144,708
    
    
    $
    141,326
    
    
    $
    (265,054
    )
    
    $
    419,566
 
 (1)
    
    For the three months ended September 30, 2006, includes an adjustment of
approximately $9.0 million to a $30 million accrual made during the second quarter of 2006 for
an estimated net profits interest payment of $21 million paid in August 2006 to the
predecessor owner of certain offshore properties acquired by us in October 2003 which payment
was accelerated by the sale of certain offshore Louisiana assets completed June 1, 2006. -36-




---



##### Table of Contents



For the nine months ended September 30, 2006, includes the following: (i) the above mentioned
$21.0 million payment for a net profits interest paid in August 2006 to the predecessor owner of
certain offshore properties acquired by us in October 2003; (ii) $21.3 million paid for
producing properties in East Texas in April 2006; and (iii) a final purchase price adjustment
and return of capital of $4.1 million received during the first quarter of 2006, representing a
reduction to the $159.0 net purchase price paid for the South Texas properties acquired on
November 30, 2005 from Kerr-McGee Oil & Gas Onshore LP and Westport Oil and Gas Company, L.P.(2)
    
    For the three months ended September 30, 2006 and 2005, includes
capitalized interest and general and administrative expenses of
$5.7 million and $6.6 million,
respectively. For the nine months ended September 30, 2006 and 2005, includes capitalized
interest and general and administrative expenses of
$19.2 million and $19.1 million,
respectively.(3)
    
    For the three months ended September 30, 2006, a net purchase price
adjustment and additional proceeds of $0.6 million from the sale of the Texas portion of our
offshore assets and a purchase price adjustment and additional payment by us of $2.6 million
in connection with the sale of our offshore Louisiana assets.For the nine months ended September 30, 2006 includes: (i) net proceeds from the sale of our
Louisiana Gulf of Mexico assets of $530.8 million, net of $4.4 million in fees associated with
completion of the transaction and $2.6 million in purchase price adjustments; (ii) net proceeds
from the sale of the Texas portion of our Gulf of Mexico assets of $190.8 million, net of $1.5
million in transaction fees and additional proceeds resulting from the final purchase price
adjustment of $0.6 million; and (iii) $7.9 million in net proceeds for the sale of other assets. Stock Repurchases.
 Debt Repayments
 Future Commitments.
 Future CommitmentsPayments Due by PeriodReference
    
    
    Total
    
    
    1 year or less
    
    
    2  3 years
    
    
    4  5 years
    
    
    after 5 years(in thousands)Contractual Obligations:Revolving credit facility, due November 2010
    
    Note 2
    
    $
    187,000
    
    
    $
    
    
    
    $
    
    
    
    $
    187,000
    
    
    $
    7% senior subordinated notes, due June 2013
    
    Note 2
    
    
    175,000
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    175,000Derivative instruments
    
    Note 1
    
    
    27,575
    
    
    
    5,251
    
    
    
    22,324
    
    
    
    
    
    
    
    Operating leases
    
    Note 4
    
    
    5,382
    
    
    
    1,857
    
    
    
    3,516
    
    
    
    9
    
    
    
    Letters of credit
    
    Note 4
    
    
    300
    
    
    
    300
    
    
    
    
    
    
    
    
    
    
    
    Drilling contracts
    
    Note 4
    
    
    11,640
    
    
    
    9,644
    
    
    
    1,996
    
    
    
    
    
    
    
    Seismic contracts
    
    Note 4
    
    
    3,014
    
    
    
    3,014
    
    
    
    
    
    
    
    
    
    
    
    409,911
    
    
    
    20,066
    
    
    
    27,836
    
    
    
    187,009
    
    
    
    175,000Other Long-Term Obligations:Asset retirement obligations
    
    Note 1
    
    
    40,015
    
    
    
    
    
    
    
    92
    
    
    
    
    
    
    
    39,923Supplemental Executive Retirement Plan
    
    Note 4
    
    
    2,229
    
    
    
    100
    
    
    
    265
    
    
    
    261
    
    
    
    1,60342,244
    
    
    
    100
    
    
    
    357
    
    
    
    261
    
    
    
    41,526Total Contractual Obligations and
Commitments:
    
    
    
    
    
    $
    452,155
    
    
    $
    20,166
    
    
    $
    28,193
    
    
    $
    187,270
    
    
    $
    216,526
  -37-




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##### Table of Contents



Off-Balance Sheet Arrangements
  
 Item 3. Quantitative and Qualitative Disclosures About Market Risk
 Market Risk
  Interest Rate Risk
  Commodity Price Risk
 Derivative Instruments and Hedging Activities)
  -38-




---



##### Table of Contents



Changes in Fair Value of Derivative Instruments
  Nine Months Ended September 30,2006
    
    
    2005Change in Fair Value of Derivative Instruments:
    
    Before Tax(in thousands)Fair value of contracts at January 1
    
    $
    (417,658
    )
    
    $
    (75,149
    )Realized loss on contracts settled during period (1)
    
    
    67,664
    
    
    
    100,726(Decrease) increase in fair value of all open contracts
    
    
    322,419
    
    
    
    (722,256
    )Net change during period
    
    
    390,083
    
    
    
    (621,530
    )Fair value of contracts outstanding at September 30
    
    $
    (27,575
    )
    
    $
    (696,679
    )
 
 (1)
    
    Includes $15.2 million paid during the first nine months of 2006 to
liquidate and settle contracts. In June 2006, we paid $14.3 million to liquidate
and settle contracts covering 60,000 MMBtu per day for each of the months July
through December 2006. This liquidation and settlement was made in connection with
the completion of the sale of our Gulf of Mexico assets on June 1, 2006 and was
required under the terms of our revolving credit facility. In August 2006, we
elected to liquidate and settle open derivative contracts representing 20,000 MMBtu
per day of hedged production for each of the months September and October 2006. The
cost to liquidate and settle these contracts was approximately $0.9 million. Summary of Derivative Contracts
  NYMEXPeriod
    
    
    
    
    
    Daily Volume
    
    Price
    
    Floor Price
    
    Ceiling PriceYear
    
    (Months)
    
    Transaction Type
    
    (MMBtu/day)
    
    ($/MMBtu)
    
    ($/MMBtu)
    
    ($/MMBtu)2006
    
    Oct  Dec
    
    Swap
    
    
    20,000
    
    
    $
    5.87
    
    
    
    
    
    
    
    2006
    
    Oct  Dec
    
    Swap
    
    
    10,000
    
    
    
    5.94
    
    
    
    
    
    
    
    2006
    
    Oct  Dec
    
    Costless collar
    
    
    10,000
    
    
    
    
    
    
    $
    5.50
    
    
    $
    7.202006
    
    Oct  Dec
    
    Costless collar
    
    
    20,000
    
    
    
    
    
    
    
    5.50
    
    
    
    7.262006
    
    Oct  Dec
    
    Costless collar
    
    
    20,000
    
    
    
    
    
    
    
    5.75
    
    
    
    7.202006
    
    Oct  Dec
    
    Costless collar
    
    
    50,000
    
    
    
    
    
    
    
    5.82
    
    
    
    7.002006
    
    Oct
    
    Costless collar
    
    
    10,000
    
    
    
    
    
    
    
    6.00
    
    
    
    7.002006
    
    Nov  Dec
    
    Costless collar
    
    
    30,000
    
    
    
    
    
    
    
    6.00
    
    
    
    7.002006
    
    Oct  Dec
    
    Costless collar
    
    
    20,000
    
    
    
    
    
    
    
    6.00
    
    
    
    7.022006
    
    Oct  Dec
    
    Costless collar
    
    
    10,000
    
    
    
    
    
    
    
    6.00
    
    
    
    7.052007
    
    Jan  Dec
    
    Costless collar
    
    
    20,000
    
    
    
    
    
    
    $
    5.00
    
    
    $
    6.502007
    
    Jan  Dec
    
    Costless collar
    
    
    10,000
    
    
    
    
    
    
    
    5.00
    
    
    
    6.792008
    
    Jan  Dec
    
    Costless collar
    
    
    20,000
    
    
    
    
    
    
    $
    5.00
    
    
    $
    5.72
   -39-




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##### Table of Contents










Item 4. Controls and Procedures


Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures




Changes in Internal Control Over Financial Reporting







Part II. Other Information





Item 1. Legal Proceedings


Legal Proceedings





Item 1A. Risk Factors




Our hedging activities have resulted in financial losses and reduced our income and may continue to
do so in the future.




We
could lose certain leasehold rights if we do not drill all the wells that are necessary to hold our
acreage, especially in the Rocky Mountains, before the initial lease terms expire.







Item 5. Other Information


-40-




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##### Table of Contents



Item 6. Exhibits
 EXHIBITS
    
    
    
    DESCRIPTION10.1(1)(2)
    
    
    
    Amendment No. 1, dated October 24, 2006, to the Amended and Restated Employment
Agreement dated February 8, 2005 between The Houston Exploration Company and William G.
Hargett (filed as Exhibit 10.1 to Current Report on Form 8-K dated October 27, 2006
(File No. 001-11899) and incorporated by reference).10.2(1)(2)
    
    
    
    Amendment No. 1, dated October 24, 2006, to the Amended and Restated Employment
Agreement dated February 8, 2005 between The Houston Exploration Company and Steven L.
Mueller (filed as Exhibit 10.2 to Current Report on Form 8-K dated October 27, 2006
(File No. 001-11899) and incorporated by reference).10.3(1)(2)
    
    
    
    Amendment No. 1, dated October 24, 2006, to the Employment Agreement dated January 8,
2006 between The Houston Exploration Company and Robert T. Ray (filed as Exhibit 10.3 to
Current Report on Form 8-K dated October 27, 2006 (File No. 001-11899) and incorporated
by reference).10.4(1)(2)
    
    
    
    Amendment No. 1, dated October 24, 2006, to the Employment Agreement dated March 27,
2006, between The Houston Exploration Company and Carolyn M. Campbell (filed as Exhibit
10.4 to Current Report on Form 8-K dated October 27, 2006 (File No. 001-11899) and
incorporated by reference).10.5(1)(2)
    
    
    
    Amendment No. 1, dated October 24, 2006, to the Amended and Restated Employment
Agreement dated February 8, 2005 between The Houston Exploration Company and Roger B.
Rice (filed as Exhibit 10.5 to Current Report on Form 8-K dated October 27, 2006 (File
No. 001-11899) and incorporated by reference).10.6(1)(2)
    
    
    
    Amendment No. 1, dated October 24, 2006, to the Employment Agreement dated April 13,
2005, between The Houston Exploration Company and Jeffrey B. Sherrick (filed as Exhibit
10.6 to Current Report on Form 8-K dated October 27, 2006 (File No. 001-11899) and
incorporated by reference).10.7(1)(2)
    
    
    
    Amendment No. 1, dated October 24, 2006, to the Amended and Restated Employment
Agreement dated February 8, 2005 between The Houston Exploration Company and James F.
Westmoreland (filed as Exhibit 10.7 to Current Report on Form 8-K dated October 27, 2006
(File No. 001-11899) and incorporated by reference).10.8(1)(2)
    
    
    
    Amendment No. 1, dated October 24, 2006, to the Employment Agreement dated February 10,
2005, between The Houston Exploration Company and Joanne C. Hresko (filed as Exhibit
10.8 to Current Report on Form 8-K dated October 27, 2006 (File No. 001-11899) and
incorporated by reference).10.9(1)(2)
    
    
    
    Amendment No. 1, dated October 24, 2006, to the Employment Agreement dated March 10,
2005, between The Houston Exploration Company and John E. Bergeron, Jr. (filed as
Exhibit 10.9 to Current Report on Form 8-K dated October 27, 2006 (File No. 001-11899)
and incorporated by reference)12.1
    
    
    
    Computation of ratio of earnings to fixed charges.31.1
    
    
    
    Certification of William G. Hargett, Chief Executive Officer, as required pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.31.2
    
    
    
    Certification of Robert T. Ray, Chief Financial Officer, as required pursuant to Section
302 of the Sarbanes-Oxley Act of 2002.32.1
    
    
    
    Certification of William G. Hargett, Chief Executive Officer, as required pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.32.2
    
    
    
    Certification of Robert T. Ray, Chief Financial Officer, as required pursuant to Section
906 of the Sarbanes-Oxley Act of 2002.
 
 (1)
    
    Previously filed.(2)
    
    Identified as a management contract or compensation plan or arrangement -41-




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##### Table of Contents



SIGNATURES
  THE HOUSTON EXPLORATION COMPANYBy:
    /s/ William G. HargettWilliam G. HargettDate: November 8, 2006
    
    Chairman, President and Chief Executive Officer By:
    /s/ Robert T. RayRobert T. RayDate: November 8, 2006
    
    Senior Vice President and Chief Financial Officer By:
    /s/ James F. WestmorelandJames F. WestmorelandDate:  November 8, 2006
    
    Vice President and Chief Accounting Officer -42-




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##### Table of Contents



EXHIBITS
    
    
    
    DESCRIPTION10.1(1)(2)
    
    
    
    Amendment No. 1, dated October 24, 2006, to the Amended and Restated Employment
Agreement dated February 8, 2005 between The Houston Exploration Company and William G.
Hargett (filed as Exhibit 10.1 to Current Report on Form 8-K dated October 27, 2006
(File No. 001-11899) and incorporated by reference).10.2(1)(2)
    
    
    
    Amendment No. 1, dated October 24, 2006, to the Amended and Restated Employment
Agreement dated February 8, 2005 between The Houston Exploration Company and Steven L.
Mueller (filed as Exhibit 10.2 to Current Report on Form 8-K dated October 27, 2006
(File No. 001-11899) and incorporated by reference).10.3(1)(2)
    
    
    
    Amendment No. 1, dated October 24, 2006, to the Employment Agreement dated January 8,
2006 between The Houston Exploration Company and Robert T. Ray (filed as Exhibit 10.3 to
Current Report on Form 8-K dated October 27, 2006 (File No. 001-11899) and incorporated
by reference).10.4(1)(2)
    
    
    
    Amendment No. 1, dated October 24, 2006, to the Employment Agreement dated March 27,
2006, between The Houston Exploration Company and Carolyn M. Campbell (filed as Exhibit
10.4 to Current Report on Form 8-K dated October 27, 2006 (File No. 001-11899) and
incorporated by reference).10.5(1)(2)
    
    
    
    Amendment No. 1, dated October 24, 2006, to the Amended and Restated Employment
Agreement dated February 8, 2005 between The Houston Exploration Company and Roger B.
Rice (filed as Exhibit 10.5 to Current Report on Form 8-K dated October 27, 2006 (File
No. 001-11899) and incorporated by reference).10.6(1)(2)
    
    
    
    Amendment No. 1, dated October 24, 2006, to the Employment Agreement dated April 13,
2005, between The Houston Exploration Company and Jeffrey B. Sherrick (filed as Exhibit
10.6 to Current Report on Form 8-K dated October 27, 2006 (File No. 001-11899) and
incorporated by reference).10.7(1)(2)
    
    
    
    Amendment No. 1, dated October 24, 2006, to the Amended and Restated Employment
Agreement dated February 8, 2005 between The Houston Exploration Company and James F.
Westmoreland (filed as Exhibit 10.7 to Current Report on Form 8-K dated October 27, 2006
(File No. 001-11899) and incorporated by reference).10.8(1)(2)
    
    
    
    Amendment No. 1, dated October 24, 2006, to the Employment Agreement dated February 10,
2005, between The Houston Exploration Company and Joanne C. Hresko (filed as Exhibit
10.8 to Current Report on Form 8-K dated October 27, 2006 (File No. 001-11899) and
incorporated by reference).10.9(1)(2)
    
    
    
    Amendment No. 1, dated October 24, 2006, to the Employment Agreement dated March 10,
2005, between The Houston Exploration Company and John E. Bergeron, Jr. (filed as
Exhibit 10.9 to Current Report on Form 8-K dated October 27, 2006 (File No. 001-11899)
and incorporated by reference)12.1
    
    
    
    Computation of ratio of earnings to fixed charges.31.1
    
    
    
    Certification of William G. Hargett, Chief Executive Officer, as required pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.31.2
    
    
    
    Certification of Robert T. Ray, Chief Financial Officer, as required pursuant to Section
302 of the Sarbanes-Oxley Act of 2002.32.1
    
    
    
    Certification of William G. Hargett, Chief Executive Officer, as required pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.32.2
    
    
    
    Certification of Robert T. Ray, Chief Financial Officer, as required pursuant to Section
906 of the Sarbanes-Oxley Act of 2002.
 
 (1)
    
    Previously filed.(2)
    
    Identified as a management contract or compensation plan or arrangement -43-