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Clayton Williams Energy 10-Q 2008

Documents found in this filing:

  1. 10-Q
  2. Ex-31.1
  3. Ex-31.2
  4. Ex-32.1
  5. Ex-32.1

Washington, D.C.  20549


(Mark One)
For the quarterly period ended September 30, 2008

For the transition period from                 to                
Commission File Number 001-10924

(Exact name of registrant as specified in its charter)

(State or other jurisdiction of incorporation or organization)
(I.R.S. Employer Identification No.)
Six Desta Drive - Suite 6500
Midland, Texas
(Address of principal executive offices)
(Zip code)
Registrant’s telephone number, including area code:
(432) 682-6324

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.
x Yes
¨ No

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer  ¨
Accelerated filer  x
Non-accelerated filer  ¨
Smaller reporting company ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
¨ Yes
x No

There were 12,113,898 shares of Common Stock, $.10 par value, of the registrant outstanding as of November 4, 2008.




Item 1.
Financial Statements
and December 31, 2007                                                                                                
ended September 30, 2008 and 2007                                                                                                
ended September 30, 2008                                                                                                
ended September 30, 2008 and 2007                                                                                                
Condition and Results of Operations                                                                                                



(Dollars in thousands)

September 30,
December 31,
Cash and cash equivalents                                                                                     
  $ 34,532     $ 12,344  
Accounts receivable:
Oil and gas sales, net                                                                                
    40,617       36,698  
Joint interest and other, net                                                                                
    17,507       16,666  
    549       308  
    24,908       14,348  
Deferred income taxes                                                                                     
    3,581       3,581  
Fair value of derivatives                                                                                     
    3,461       7,191  
Assets held for sale                                                                                     
    -       17,281  
Prepaids and other                                                                                     
    2,642       3,962  
      127,797       112,379  
Oil and gas properties, successful efforts method                                                                                     
    1,486,443       1,374,090  
Natural gas gathering and processing systems                                                                                     
    17,946       18,404  
Contract drilling equipment                                                                                     
    91,639       89,956  
    14,757       14,505  
      1,610,785       1,496,955  
Less accumulated depreciation, depletion and amortization
    (798,732 )     (765,877 )
Property and equipment, net                                                                                
    812,053       731,078  
Debt issue costs, net                                                                                     
    6,533       6,963  
Fair value of derivatives                                                                                     
    626       -  
    1,795       10,676  
      8,954       17,639  
    $ 948,804     $ 861,096  

The accompanying notes are an integral part of these consolidated financial statements.



(Dollars in thousands)

September 30,
December 31,
Accounts payable:
  $ 105,913     $ 72,477  
Oil and gas sales                                                                                
    26,514       24,806  
    2,574       1,747  
Current maturities of long-term debt                                                                                     
    18,750       22,500  
Fair value of derivatives                                                                                     
    21,378       56,929  
Accrued liabilities and other                                                                                     
    6,874       10,308  
      182,003       188,767  
Long-term debt                                                                                     
    379,113       430,175  
Deferred income taxes                                                                                     
    87,719       44,302  
Fair value of derivatives                                                                                     
    8,517       -  
    36,720       37,046  
      512,069       511,523  
Preferred stock, par value $.10 per share, authorized – 3,000,000
 shares; none issued                                                                                     
    -       -  
Common stock, par value $.10 per share, authorized – 30,000,000
 shares; issued and outstanding –  12,113,898 shares in 2008
 and 11,354,051 shares in 2007                                                                                     
    1,211       1,135  
Additional paid-in capital                                                                                     
    136,994       121,063  
Retained earnings                                                                                     
    116,527       35,890  
Accumulated other comprehensive income, net of tax
    -       2,718  
      254,732       160,806  
    $ 948,804     $ 861,096  

The accompanying notes are an integral part of these consolidated financial statements.



(Dollars in thousands, except per share)

Three Months Ended
Nine Months Ended
September 30,
September 30,
Oil and gas sales                                                   
  $ 128,335     $ 84,639     $ 381,545     $ 220,712  
Natural gas services                                                   
    2,978       2,268       9,069       7,831  
Drilling rig services                                                   
    12,515       14,806       40,050       37,451  
Gain on sales of property and equipment
    3,157       126       44,447       910  
Total revenues                                             
    146,985       101,839       475,111       266,904  
    22,861       20,851       65,365       55,969  
Abandonments and impairments
    43,036       18,802       45,266       53,426  
Seismic and other                                             
    5,993       1,236       11,230       3,706  
Natural gas services                                                   
    2,706       2,121       8,465       7,438  
Drilling rig services                                                   
    9,763       9,075       30,803       22,514  
Depreciation, depletion and amortization
    27,226       23,018       82,473       56,736  
Impairment of property and equipment
    9,985       7,979       9,985       9,023  
Accretion of abandonment obligations
    654       627       1,669       1,864  
General and administrative                                                   
    6,501       4,289       17,893       13,124  
Loss on sales of property and equipment
    134       92       420       9,415  
Total costs and expenses                                             
    128,859       88,090       273,569       233,215  
Operating income                                             
    18,126       13,749       201,542       33,689  
Interest expense                                                   
    (5,406 )     (8,448 )     (18,929 )     (24,063 )
Gain (loss) on derivatives                                                   
    132,710       (2,284 )     (61,986 )     (13,023 )
    2,030       366       5,699       4,693  
Total other income (expense)
    129,334       (10,366 )     (75,216 )     (32,393 )
Income before income taxes                                                        
    147,460       3,383       126,326       1,296  
Income tax expense                                                        
    (52,829 )     (1,173 )     (45,409 )     (450 )
Minority interest, net of tax                                                        
    (2 )     (1,224 )     (280 )     (3,360 )
NET INCOME (LOSS)                                                        
  $ 94,629     $ 986     $ 80,637     $ (2,514 )
Net income (loss) per common share:
  $ 7.81     $ 0.09     $ 6.79     $ (0.22 )
  $ 7.79     $ 0.09     $ 6.72     $ (0.22 )
Weighted average common shares outstanding:
    12,114       11,352       11,874       11,286  
    12,141       11,521       12,008       11,286  

The accompanying notes are an integral part of these consolidated financial statements.



(Dollars in thousands)

Common Stock
No. of
December 31, 2007                                         
    11,354     $ 1,135     $ 121,063     $ 35,890     $ 2,718  
Net income                                      
    -       -       -       80,637       -  
Sale of marketable securities
    -       -       -       -       (2,718 )
Issuance of stock through
  compensation plans                                      
    760       76       15,931       -       -  
September 30, 2008                                         
    12,114     $ 1,211     $ 136,994     $ 116,527     $ -  

The accompanying notes are an integral part of these consolidated financial statements.



(Dollars in thousands)

Nine Months Ended
September 30,
Net income (loss)                                                                                       
  $ 80,637     $ (2,514 )
Adjustments to reconcile net income (loss) to cash
provided by operating activities:
Depreciation, depletion and amortization                                                                                 
    82,473       56,736  
Impairment of property and equipment                                                                                 
    9,985       9,023  
Exploration costs                                                                                 
    45,266       53,426  
(Gain) loss on sales of property and equipment, net
    (44,027 )     8,505  
Deferred income taxes                                                                                 
    44,881       450  
Non-cash employee compensation                                                                                 
    3,942       1,610  
Unrealized (gain) loss on derivatives                                                                                 
    (23,930 )     15,163  
Settlements on derivatives with financing elements
    40,260       18,950  
Amortization of debt issue costs                                                                                 
    1,049       953  
Accretion of abandonment obligations                                                                                 
    1,669       1,864  
Minority interest, net of tax                                                                                 
    280       3,360  
Changes in operating working capital:
Accounts receivable                                                                                 
    (5,001 )     (15,089 )
Accounts payable                                                                                 
    (10,374 )     15,876  
    (4,054 )     (6,002 )
Net cash provided by operating activities                                                                           
    223,056       162,311  
Additions to property and equipment                                                                                       
    (229,633 )     (180,112 )
Additions to equipment of Larclay JV.                                                                                       
    (1,683 )     (27,403 )
Proceeds from sales of property and equipment                                                                                       
    117,109       1,653  
Change in equipment inventory                                                                                       
    (11,384 )     16,265  
    3,880       (14,217 )
Net cash used in investing activities                                                                           
    (121,711 )     (203,814 )
Proceeds from long-term debt                                                                                       
    -       48,000  
Proceeds from long-term debt of Larclay JV                                                                                       
    5,500       8,727  
Repayments of long-term debt                                                                                       
    (42,500 )     -  
Repayments of long-term debt of Larclay JV                                                                                       
    (17,812 )     (6,562 )
Proceeds from exercise of stock options                                                                                       
    15,915       5,970  
Settlements on derivatives with financing elements                                                                                       
    (40,260 )     (18,950 )
Net cash provided by (used in) financing activities
    (79,157 )     37,185  
CASH EQUIVALENTS                                                                                         
    22,188       (4,318 )
Beginning of period                                                                                       
    12,344       13,840  
End of period                                                                                       
  $ 34,532     $ 9,522  
Cash paid for interest, net of amounts capitalized                                                                                       
  $ 22,239     $ 27,555  

The accompanying notes are an integral part of these consolidated financial statements.



September 30, 2008

1.          Nature of Operations

Clayton Williams Energy, Inc. (a Delaware corporation) and its subsidiaries (collectively, the “Company” or “CWEI”) is an independent oil and gas company engaged in the exploration for and development and production of oil and natural gas primarily in its core areas in Texas, Louisiana and New Mexico.  Approximately 26% of the Company’s outstanding common stock is beneficially owned by Clayton W. Williams, Jr. (“Mr. Williams”), Chairman of the Board and Chief Executive Officer of the Company, and approximately 25% is owned by a partnership in which Mr. Williams’ adult children are limited partners.

Substantially all of the Company’s oil and gas production is sold under short-term contracts which are market-sensitive.  Accordingly, the Company’s financial condition, results of operations, and capital resources are highly dependent upon prevailing market prices of, and demand for, oil and natural gas.  These commodity prices are subject to wide fluctuations and market uncertainties due to a variety of factors that are beyond the control of the Company.  These factors include the level of global demand for petroleum products, foreign supply of oil and gas, the establishment of and compliance with production quotas by oil-exporting countries, the strength of the U.S. dollar, weather conditions, the price and availability of alternative fuels, and overall economic conditions, both foreign and domestic.

2.          Presentation

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

The consolidated financial statements include the accounts of Clayton Williams Energy, Inc., its wholly-owned subsidiaries and the accounts of the Larclay JV (see Note 11).  The Company also accounts for its undivided interests in oil and gas limited partnerships using the proportionate consolidation method.  Under this method, the Company consolidates its proportionate share of assets, liabilities, revenues and expenses of these limited partnerships utilizing accounting policies followed by the Company.  Less than 5% of the Company’s consolidated total assets and total revenues are derived from oil and gas limited partnerships.  All significant intercompany transactions and balances associated with the consolidated operations have been eliminated.

In the opinion of management, the Company's unaudited consolidated financial statements as of September 30, 2008 and for the interim periods ended September 30, 2008 and 2007 include all adjustments which are necessary for a fair presentation in accordance with accounting principles generally accepted in the United States.  These interim results are not necessarily indicative of the results to be expected for the year ending December 31, 2008.

Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted in this Form 10-Q pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”).  These consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in the Company's Form 10-K for the year ended December 31, 2007.



3.          Recent Accounting Pronouncements

In March 2008, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities, an amendment of FASB Statement No. 133” (“SFAS 161”). This statement is intended to improve transparency in financial reporting by requiring enhanced disclosures of an entity’s derivative instruments and hedging activities and their effects on the entity’s financial position, financial performance, and cash flows. SFAS 161 applies to all derivative instruments within the scope of SFAS 133 as well as related hedged items, bifurcated derivatives, and non-derivative instruments that are designated and qualify as hedging instruments. Entities with instruments subject to SFAS 161 must provide more robust qualitative disclosures and expanded quantitative disclosures. SFAS 161 is effective prospectively for financial statements issued for fiscal years and interim periods beginning after November 15, 2008, with early application permitted.  The Company is currently evaluating the disclosure implications of this statement.

In December 2007, the FASB issued SFAS 141R, “Business Combinations” (“SFAS 141R”) and SFAS 160, “Noncontrolling Interests in Consolidated Financial Statements” (“SFAS 160”). SFAS 141R requires most identifiable assets, liabilities, noncontrolling interests, and goodwill acquired in a business combination to be recorded at “fair value.” The Statement applies to all business combinations, including combinations among mutual entities and combinations by contract alone. Under SFAS 141R, all business combinations will be accounted for by applying the acquisition method. SFAS 141R is effective for periods beginning on or after December 15, 2008. SFAS 160 will require noncontrolling interests (previously referred to as minority interests) to be treated as a separate component of equity, not as a liability or other item outside of permanent equity.  The statement applies to the accounting for noncontrolling interests and transactions with noncontrolling interest holders in consolidated financial statements. SFAS 160 is effective for periods beginning on or after December 15, 2008 and will be applied prospectively to all noncontrolling interests, including any that arose before the effective date except that comparative period information must be recast to classify noncontrolling interests in equity, attribute net income and other comprehensive income to noncontrolling interests, and provide other disclosures required by SFAS 160.  The impact on the Company’s financial statements from the adoption of SFAS 141R and SFAS 160 in 2009 will depend on future acquisition activity.

4.          Long-Term Debt

Long-term debt consists of the following:

September 30,
December 31,
(In thousands)
7¾% Senior Notes, due 2013                                                                                    
  $ 225,000     $ 225,000  
Secured bank credit facility, due May 2012                                                                                    
    123,300       165,800  
Secured term loan of Larclay JV, due June 2011                                                                                    
    49,563       61,875  
      397,863       452,675  
Less current maturities(a)                                                                                    
    (18,750 )     (22,500 )
    $ 379,113     $ 430,175  
(a)      Consists of current portion of term loan of Larclay JV.

7¾% Senior Notes due 2013
In July 2005, the Company issued, in a private placement, $225 million of aggregate principal amount of 7¾% Senior Notes due 2013 (“Senior Notes”).  The Senior Notes were issued at face value and bear interest at 7¾% per year, payable semi-annually on February 1 and August 1 of each year, beginning February 1, 2006.

At any time prior to August 1, 2009, the Company may redeem some or all of the Senior Notes at a redemption price equal to 100% of the principal amount of the Senior Notes to be redeemed, plus a make-whole premium, plus any accrued and unpaid interest.  On and after August 1, 2009, the Company may redeem some or all of the Senior Notes at redemption prices (expressed as percentages of principal amount) equal to 103.875% for the twelve-month period beginning on August 1, 2009, 101.938% for the twelve-month period beginning on August 1,

2010, and 100.00% beginning on August 1, 2011 or for any period thereafter, in each case plus accrued and unpaid interest.

The Indenture governing the Senior Notes contains covenants that restrict the ability of the Company and its restricted subsidiaries to:  (i) borrow money; (ii) issue redeemable or preferred stock; (iii) pay distributions or dividends; (iv) make investments; (v) create liens without securing the Senior Notes; (vi) enter into agreements that restrict dividends from subsidiaries; (vii) sell certain assets or merge with or into other companies; (viii) enter into transactions with affiliates; (ix) guarantee indebtedness; and (x) enter into new lines of business.  One such covenant prohibits the Company from borrowing any additional funds under the revolving credit facility if the Company’s outstanding balance on the facility exceeds 30% of Adjusted Consolidated Net Tangible Assets, as defined in the Indenture.  The Company was in compliance with these covenants at September 30, 2008.
Secured Bank Credit Facility
The Company’s secured bank credit facility provides for a revolving loan facility in an amount not to exceed the lesser of the borrowing base, as established by the banks, or that portion of the borrowing base determined by the Company to be the elected borrowing limit.  The borrowing base, which is based on the discounted present value of future net revenues from oil and gas production, is subject to redetermination at any time, but at least semi-annually in May and November, and is made at the discretion of the banks.  If, at any time, the redetermined borrowing base is less than the amount of outstanding indebtedness, the Company will be required to (i) pledge additional collateral, (ii) prepay the excess in not more than five equal monthly installments, or (iii) elect to convert the entire amount of outstanding indebtedness to a term obligation based on amortization formulas set forth in the loan agreement.  Substantially all of the Company’s oil and gas properties are pledged to secure advances under the credit facility.  The borrowing base was reduced in May 2008 from $275 million to $250 million in connection with our sale of certain properties in South Louisiana.  In June 2008, we elected to maintain the borrowing base at $250 million instead of increasing it to levels supported by the collateral values assigned by the banks.  After allowing for outstanding letters of credit totaling $804,000, the Company had $125.9 million available under the credit facility at September 30, 2008.

The revolving credit facility provides for interest at rates based on the agent bank’s prime rate plus margins ranging from .25% to 1%, or if elected by the Company based on LIBOR plus margins ranging from 1.5% to 2.25%.  The Company also pays a commitment fee on the unused portion of the revolving credit facility.  Interest and fees are payable at least quarterly.  The effective annual interest rate on borrowings under the combined credit facility, excluding bank fees and amortization of debt issue costs, for the nine months ended September 30, 2008 was 4.9%.

The loan agreement applicable to the revolving credit facility contains financial covenants that are computed quarterly.  The working capital covenant requires the Company to maintain a ratio of current assets to current liabilities of at least 1 to 1.  Another financial covenant under the credit facility requires the Company to maintain a ratio of indebtedness to cash flow of no more than 3 to 1.  The computations of current assets, current liabilities, cash flow and indebtedness are defined in the loan agreement.  The Company was in compliance with all financial and non-financial covenants at September 30, 2008.

Secured Term Loan of Larclay JV
In connection with the Company’s investment in Larclay JV (see Note 11), Larclay JV obtained a $75 million secured term loan facility from a lender to finance the construction and equipping of 12 new drilling rigs.  The Larclay JV term loan is secured by substantially all of the assets of Larclay JV.  Initially, the Company pledged additional collateral in the form of a $19 million letter of credit.  In February 2007, the letter of credit was cancelled and replaced by a $19.5 million guaranty from the Company.  Although the Company is not a maker on the Larclay JV term loan, it is providing partial credit support for the Larclay JV term loan and is required to fully consolidate the accounts of Larclay JV under FASB Interpretation No. 46R “Consolidation of Variable Interest Entities – an Interpretation of ARB No. 51 (as amended)” (“FIN 46R”).



The Larclay JV term loan, as amended, bears interest at a floating rate based on a LIBOR average, plus 3.25%, and provides for monthly interest payments through June 2007 and monthly principal and interest payments thereafter sufficient to retire the principal balance by 35% in the first year, 25% in each of the next two years, and 15% in the fourth year.  Two voluntary prepayments of $10 million each may be made in 2008 and 2009 without a prepayment penalty.  The Larclay JV term loan prohibits Larclay JV from making any cash distributions to the Company or Lariat until the balance on the term loan is fully repaid, and repayments by Larclay JV of any loans by the Company or Lariat are subordinated to the loans outstanding under the term loan and are subject to other restrictions.  At September 30, 2008, the effective interest rate on the Larclay JV term loan was 6.4%.

5.          Other Non-Current Liabilities

Other non-current liabilities consist of the following:

September 30,
December 31,
(In thousands)
Abandonment obligations                                                                                   
  $ 30,404     $ 30,994  
Minority interest, net of tax                                                                                   
    5,166       4,886  
Other taxes payable                                                                                   
    358       358  
    792       808  
    $ 36,720     $ 37,046  

Changes in abandonment obligations for the nine months ended September 30, 2008 and 2007 are as follows:

Nine Months Ended
September 30,
(In thousands)
Beginning of period                                                                                   
  $ 30,994     $ 27,846  
Additional abandonment obligations from new wells                                                                               
    975       732  
Sales of properties                                                                               
    (1,833 )     (1,602 )
Revisions of previous estimates                                                                               
    (1,401 )     -  
Accretion expense                                                                               
    1,669       1,864  
End of period                                                                                   
  $ 30,404     $ 28,840  

6.          Compensation Plans

Stock-Based Compensation
The Company has reserved 1,798,200 shares of common stock for issuance under the 1993 Stock Compensation Plan (“1993 Plan”).  The 1993 Plan provides for the issuance of nonqualified stock options with an exercise price which is not less than the market value of the Company’s common stock on the date of grant.  All options granted through September 30, 2008 expire 10 years from the date of grant and become exercisable based on varying vesting schedules.  The Company issues new shares, not repurchased shares, to option holders that exercise stock options under the 1993 Plan.  At September 30, 2008, 101,766 shares remain available for issuance under this plan.

The Company has reserved 86,300 shares of common stock for issuance under the Outside Directors Stock Option Plan (“Directors Plan”).  Since the inception of the Directors Plan, the Company has issued options covering 52,000 shares of common stock at option prices ranging from $3.25 to $41.74 per share.  All outstanding options expire 10 years from the grant date and are fully exercisable upon issuance.  At September 30, 2008, 34,300 shares remain available for issuance under this plan.



The following table sets forth certain information regarding the Company’s stock option plans as of and for the nine months ended September 30, 2008:

Value (a)
Outstanding at January 1, 2008
    811,485     $ 20.49              
    4,000     $ 31.16              
Exercised (b)
    (759,847 )   $ 20.94              
Outstanding at September 30, 2008
    55,638     $ 15.02       2.81     $ 3,088,675  
Vested at September 30, 2008
    55,638     $ 15.02       2.81     $ 3,088,675  
Exercisable at September 30, 2008
    55,638     $ 15.02       2.81     $ 3,088,675  
(a)     Based on closing price at September 30, 2008 of $70.53 per share.
(b)     Cash received for options exercised totaled $15.9 million.

The following table summarizes information with respect to options outstanding at September 30, 2008, all of which are currently exercisable.

Outstanding and Exercisable Options
Life in
Range of exercise prices:
$                5.50
$10.00 - $19.74                                                               
$                11.93
$22.90 - $41.74                                                               
$                31.34
$                15.02

The following table presents certain information regarding stock-based compensation amounts for the nine months ended September 30, 2008 and 2007.

Nine Months Ended
September 30,
(In thousands, except per share)
Weighted average grant date fair value of options granted per share
  $ 23.06     $ 27.56  
Intrinsic value of options exercised
  $ 20,423     $ 228  
Stock-based employee compensation expense
  $ 92     $ 110  
Tax benefit
    (32 )     (39 )
Net stock-based employee compensation expense
  $ 60     $ 71  

After-Payout Incentive Plan
The Compensation Committee of the Board of Directors has adopted an incentive plan for officers, key employees and consultants who promote the Company’s drilling and acquisition programs.  Management’s objective in adopting this plan is to further align the interests of the participants with those of the Company by granting the participants an after-payout interest in the production developed, directly or indirectly, by the participants.  The plan generally provides for the creation of a series of partnerships or participation arrangements (“APO Arrangements”) between the Company and the participants to which the Company contributes a portion of its economic interest in wells drilled or acquired within certain areas.  Generally, the Company pays all costs to acquire, drill and produce applicable wells and receives all revenues until it has recovered all of its costs, plus interest (“payout”).  At payout, the participants receive 99% to 100% of all subsequent revenues and pay 99% to 100% of all subsequent expenses attributable to the APO Arrangements.



Between 5% and 7.5% of the Company’s economic interests in specified wells drilled or acquired by the Company subsequent to October 2002 are subject to APO Arrangements (excluding properties acquired in a merger with Southwest Royalties, Inc. in May 2004).  The Company records its allocable share of the assets, liabilities, revenues, expenses and oil and gas reserves of these APO Arrangements in its consolidated financial statements.  The Company recognized $3.9 million of non-cash compensation expense during the nine-month period ended September 30, 2008 and $1.5 million for the nine-month period ended September 30, 2007 for the estimated fair value of the APO Arrangements granted during those periods.

Reward Plans
The Company has created four bonus plans designed to reward eligible officers, employees and other service providers for continued quality service to the Company, and to encourage retention of those persons by providing them the opportunity to receive bonus payments that are based on profits derived from a portion of the Company’s working interest in certain wells drilled by the Company.

One bonus plan was activated in January 2007 and established a quarterly bonus amount equal to the after-payout cash flow from a 22.5% working interest in one well.  Under the plan, two-thirds of the quarterly bonus amount is payable to the participants until the full vesting date of October 25, 2011.  After the full vesting date, the deferred portion of the quarterly bonus amount, with interest at 4.83% per year, as well as 100% of all subsequent quarterly bonus amounts, are payable to participants.

In June 2008, the Company activated three additional bonus plans.  Each of these plans establishes a quarterly bonus amount equal to 7% of the after-payout cash flow from wells drilled in the respective plan areas after the effective date set forth in each plan, which dates range from January 1, 2007 to May 5, 2008.  Under these plans, 100% of the quarterly bonus amount is payable to the participants, and the full vesting date is May 5, 2013.

The quarterly bonus amount in these plans is allocated among the participants based on each participant’s bonus percentage.  To continue as a participant in the plans, participants must remain in the employment or service of the Company through the full vesting date.  Participants who remain in the employment or service of the Company through the full vesting date will continue as participants for the duration of the plans, subject to certain restrictions.  The full vesting date may be accelerated in the event of a change of control or sale transaction, as defined in the plan documents.

The Company recognizes compensation expense related to these bonus plans over the vesting period.  The Company recorded compensation expense of $382,000 for the nine months ended September 30, 2008, and $104,000 for the nine months ended September 30, 2007, in connection with these bonus plans.

7.          Derivatives

Commodity Derivatives
From time to time, the Company utilizes commodity derivatives, consisting of swaps, floors and collars, to attempt to optimize the price received for its oil and gas production.  When using swaps to hedge oil and natural gas production, the Company receives a fixed price for the respective commodity and pays a floating market price as defined in each contract (generally NYMEX futures prices), resulting in a net amount due to or from the counterparty.  In floor transactions, the Company receives a fixed price (put strike price) if the market price falls below the put strike price for the respective commodity.  If the market price is greater than the put strike price, no payments are due from either party.  Costless collars are a combination of puts and calls, and contain a fixed floor price (put strike price) and ceiling price (call strike price).  If the market price for the respective commodity exceeds the call strike price or falls below the put strike price, then the Company receives the fixed price and pays the market price.  If the market price is between the call and the put strike prices, no payments are due from either party.  Commodity derivatives are settled monthly as the contract production periods mature.



The following summarizes information concerning the Company’s net positions in open commodity derivatives applicable to periods subsequent to September 30, 2008.  The settlement prices of commodity derivatives are based on NYMEX futures prices.

MMBtu (a)
Production Period:
4th Quarter 2008                           
    4,100,000     $ 9.17       400,000     $ 82.21  
1st Quarter 2009                           
    2,800,000     $ 8.46       440,000     $ 88.90  
2nd Quarter 2009
    2,700,000     $ 8.47       420,000     $ 88.12  
3rd Quarter 2009
    2,600,000     $ 8.48       440,000     $ 87.89  
4th Quarter 2009                           
    2,450,000     $ 8.49       425,000     $ 87.29  
    4,640,000     $ 8.51       840,000     $ 97.75  
      19,290,000               2,965,000          
(a)     One MMBtu equals one Mcf at a Btu factor of 1,000.

In July 2008, the Company terminated certain fixed-price gas swaps covering 100,000 MMBtu at a price of $10.32 per MMBtu in October 2008, resulting in an aggregate loss of $195,000, which will be paid to the counterparty monthly as the applicable contracts are settled.

In September 2007, the Company terminated certain fixed-priced oil swaps covering 30,000 barrels at a price of $76.65 from October 2008 through December 2008, resulting in an aggregate loss of approximately $332,000, which will be paid to the counterparty monthly as the applicable contracts are settled.

Interest Rate Derivative
At September 30, 2008, the Company was a party to an interest rate swap.  Under this derivative, the Company pays a fixed rate for the notional principal balance and receives a floating market rate based on LIBOR.  The interest rate swap is settled quarterly.  The following summarizes information concerning the Company’s interest rate swap at September 30, 2008.

Interest Rate Swap:
October 1, 2008 to November 3, 2008                                                                                    
  $ 45,000,000       5.73 %

Accounting For Derivatives
The Company accounts for its derivatives in accordance with SFAS 133.  The Company did not designate any of its currently open commodity or interest rate derivatives as cash flow hedges; therefore, all changes in the fair value of these contracts prior to maturity, plus any realized gains or losses at maturity, are recorded as other income (expense) in the Company’s statements of operations.  For the nine months ended September 30, 2008, the Company reported a $62 million net loss on derivatives, consisting of a $23.9 million gain related to changes in mark-to-market valuations and a $85.9 million realized loss for settled contracts.  For the nine months ended September 30, 2007, the Company reported a $13 million loss on derivatives, consisting of a $15.2 million loss related to changes in mark-to-market valuations, net of a $2.2 million realized gain on settled contracts.

8.          Financial Instruments

Cash and cash equivalents, receivables, accounts payable and accrued liabilities were each estimated to have a fair value approximating the carrying amount due to the short maturity of those instruments.  Indebtedness under the Company’s secured bank credit facility was estimated to have a fair value approximating the carrying amount since the interest rate is generally market sensitive.  The estimated fair value of the Company’s Senior Notes at September 30, 2008 and December 31, 2007 was approximately $196.9 million for both periods, based on market valuations.



Determination of Fair Value
The Company adopted SFAS No. 157, “Fair Value Measurements” (“SFAS 157”) (as amended) effective January 1, 2008.  SFAS 157 defines fair value, establishes a framework for measuring fair value, outlines a fair value hierarchy based on the quality of inputs used to measure fair value and enhances disclosure requirements for fair value measurements.  As permitted by FSP No. 157-2, the Company has not applied the provisions of SFAS 157 to nonfinancial assets and liabilities.  The Company has not applied the provisions of SFAS 157 to its asset retirement obligations.

Fair value is defined as the price at which an asset could be exchanged in a current transaction between knowledgeable, willing parties at the measurement date. Where available, fair value is based on observable market prices or parameters or derived from such prices or parameters. Where observable prices or inputs are not available, use of unobservable prices or inputs are used to estimate the current fair value, often using an internal valuation model. These valuation techniques involve some level of management estimation and judgment, the degree of which is dependent on the item being valued.

In accordance with SFAS 157, the Company categorizes its assets and liabilities recorded at fair value in the accompanying consolidated balance sheets based upon the level of judgment associated with the inputs used to measure their fair value. Hierarchical levels, defined by SFAS 157 and directly related to the amount of subjectivity associated with the inputs to fair valuation of these assets and liabilities, are as follows:
      Level 1 -    Inputs are unadjusted, quoted prices in active markets for identical assets or liabilities at the measurement date.

      Level 2 -    Inputs (other than quoted prices included in Level 1) are either directly or indirectly observable for the asset or liability through correlation with market data at the measurement date and for the duration of the instrument’s anticipated life.

      Level 3 -    Inputs reflect management’s best estimate of what market participants would use in pricing the asset or liability at the measurement date. Consideration is given to the risk inherent in the valuation technique and the risk inherent in the inputs to the model.

The fair value of the Company’s investment in common stock of SandRidge (see Note 11) is measured using Level 1 inputs, and is determined by market prices on an active market.

The fair value of derivative contracts are measured using Level 2 inputs, and are determined by either market prices on an active market for similar assets or by prices quoted by a broker or other market-corroborated prices.



The estimated fair values of assets and liabilities included in the accompanying consolidated balance sheets at September 30, 2008 and December 31, 2007 are summarized below.

Fair Value Measurements
September 30, 2008
December 31, 2007
Quoted Prices In
Quoted Prices In
Active Markets For
Active Markets For
Level 1
Level 2
Level 1
Level 2
(In thousands)
Fair value of commodity
  $ -     $ 4,087     $ -     $ 7,191  
Investment securities                                 
    -       -       7,188       -  
Total assets                                    
  $ -     $ 4,087     $ 7,188     $ 7,191  
Fair value of derivatives:
Commodity derivatives
  $ -     $ 29,553     $ -     $ 55,885  
Interest rate derivatives
    -       342       -       1,044  
Total liabilities                                    
  $ -     $ 29,895     $ -     $ 56,929  

9.          Inventory

The Company maintains an inventory of tubular goods and other well equipment for use in its exploration and development drilling activities.  Any gains or losses on disposition of inventory, and any losses on write-down of inventory to its estimated market value, are reported as gain or loss on sales of property and equipment in the accompanying consolidated statements of operations.  The 2007 period included a charge of $8.9 million to write-down inventory to its estimated market value at March 31, 2007.  The write-down resulted primarily from the sale of certain surplus equipment at an auction in March 2007.  The Company received $4.5 million of net proceeds from the auction in April 2007 when the auction sale was consummated.

10.        Income Taxes

The Company’s effective federal and state income tax rate for the nine months ended September 30, 2008 of 35.9% differed from the statutory federal rate of 35% due to increases in the tax provision related primarily to the effects of the recently-enacted Texas Margin Tax and certain non-deductible expenses, offset in part by tax benefits derived from excess statutory depletion deductions.

The Company and its subsidiaries file federal income tax returns with the United States Internal Revenue Service (“IRS”) and state income tax returns in various state tax jurisdictions.  The Company’s tax returns for fiscal years after 2002 currently remain subject to examination by appropriate taxing authorities.  None of the Company’s income tax returns are under examination at this time.

In June 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”). Upon adoption of FIN 48, the Company recorded a liability for taxes payable related to unrecognized tax benefits arising from uncertain tax positions taken by the Company in previous periods.  A reconciliation of the changes in this tax liability as of September 30, 2008 and December 31, 2007 is as follows:

September 30,
December 31,
(In thousands)
Balance at beginning of period                                                                                   
  $ 358     $ -  
Adoption of FIN 48 on January 1, 2007                                                                                
    -       1,585  
Reductions for tax positions of prior years                                                                                
    -       (1,227 )
Balance at end of period                                                                                   
  $ 358     $ 358  



No unrecognized tax benefits originated during the first nine months of 2008.  Reductions in the 2007 tax liability resulted from changes in accounting methods which were submitted to the taxing authority during 2007.  All of the remaining unrecognized tax benefits at September 30, 2008 relate to tax positions for which the ultimate deductibility is highly certain but for which there is uncertainty about the timing of such deductions.  Because of the impact of deferred tax accounting, the disallowance of the shorter deduction period would not affect the annual effective tax rate but would only accelerate the payment of taxes to the taxing authority or change the amount of deferred tax assets related to net operating loss carryforwards.

Tax liabilities recorded under FIN 48 are included in other non-current liabilities in the accompanying consolidated financial statements, and any interest and penalties accrued on unrecognized tax benefits, are recorded as interest expense in the accompanying statements of operations.  However, due to the Company’s net operating loss carryforwards, no interest or penalties have been accrued on the Company’s unrecognized tax benefits.

11.        Investments

Larclay JV
In April 2006, the Company formed a joint venture (“Larclay JV”) with Lariat Services, Inc. (“Lariat”) to construct, own and operate 12 new drilling rigs.  The Company and Lariat each own a 50% interest in Larclay JV.  A lender provided a $75 million secured term loan to Larclay JV to finance most of the cost of constructing and initially equipping the rigs (see Note 4).  The Company has made loans to Larclay JV totaling $10.1 million to finance excess construction costs and its 50% share of working capital assessments made by Larclay JV.  Loans to Larclay JV are due on demand and bear interest, payable monthly, at the same rate as the secured term loan.  However, the loans are subject to a subordination agreement with the secured lender that imposes restrictions on payments of principal and interest on the loans.

Also in April 2006, the Company entered into a three-year drilling contract with Larclay JV assuring the availability of each rig for use in the ordinary course of the Company’s exploration and development drilling program throughout the term of the drilling contract.  The drilling contract expires on the earlier of December 31, 2009 or the termination and liquidation of Larclay JV.  The provisions of the drilling contract provide that the Company contract for each rig on a well-by-well basis at then current market rates.  If a rig is not needed by the Company at any time during the term of the contract, Larclay JV may contract with other operators for the use of such rig, subject to certain restrictions.  If a rig is idle, the Company will pay Larclay JV an idle rig rate ranging from $8,100 per day to $10,300 per day (plus crew labor expenses, if applicable), depending on the size of the rig.  The Company’s maximum potential obligation to pay idle rig rates over the term of this drilling contract, excluding any crew labor expenses, totals approximately $42.2 million at September 30, 2008.  The Company paid $669,000 for idle rig fees during the nine months ended September 30, 2008.

Although the Company and Lariat own equal interests in Larclay JV, the Company meets the definition of the primary beneficiary of Larclay JV’s expected cash flows under FIN 46R.  As the primary beneficiary under FIN 46R, the Company is required to include the accounts of Larclay JV in the Company’s consolidated financial statements.  As of September 30, 2008, Lariat’s equity ownership in the net assets of Larclay JV was $5.2 million, which is recorded as minority interest and included in other non-current liabilities in the accompanying consolidated financial statements.  The Company’s intercompany accounts and profits with Larclay JV have been eliminated in consolidation.

SandRidge Energy Inc.
During the fourth quarter of 2007, SandRidge Energy Inc. (“SandRidge”) became publicly traded and listed its shares on the New York Stock Exchange.  The Company’s original cost investment in SandRidge was increased to fair market value in 2007 and the change in fair market value of $4.2 million, net of tax of $1.5 million, was recorded in accumulated other comprehensive income at December 31, 2007.  In September 2008, the Company sold its investment of 200,460 shares in SandRidge for $4.3 million.  After eliminating the investment, the associated accumulated other comprehensive income and deferred income tax liability, the Company recorded a gain of $1.3 million in other income.



12.        Oil and Gas Properties

The following sets forth the capitalized costs for oil and gas properties as of September 30, 2008 and December 31, 2007.

September 30,
December 31,
(In thousands)
Proved properties                                                                                
  $ 1,348,597     $ 1,258,166  
Unproved properties                                                                                
    137,846       115,924  
Total capitalized costs                                                                                
    1,486,443       1,374,090  
Accumulated depreciation, depletion and amortization
    (752,825 )     (727,739 )
Net capitalized costs                                                                           
  $ 733,618     $ 646,351  

13.        Sales of Property and Equipment

In April 2008, the Company and its affiliates sold all of their interests in 16 producing wells for approximately $89.2 million, net of customary closing adjustments.  The Company recorded a gain of approximately $33.1 million in the second quarter of 2008 in connection with this transaction.  In April 2008, the Company sold a surplus well servicing unit for $1.8 million and recorded a gain of approximately $75,000 in the second quarter of 2008 and sold two 2,000 horsepower drilling rigs in June 2008 for $21.8 million, net of customary closing adjustments and recorded a gain of $5.7 million.  In September 2008, the Company sold its interest in a prospect in North Louisiana for $3.2 million and recorded a gain of $3.1 million.

14.        Segment Information

In accordance with SFAS No. 131 “Disclosures about Segments of an Enterprise and Related Information” (“SFAS 131”), the Company has two reportable operating segments, which are oil and gas exploration and production and contract drilling services.

The following tables present selected financial information regarding the Company’s operating segments for the three-month and nine-month periods ended September 30, 2008 and 2007.

For the Three Months Ended
September 30, 2008
(In thousands)
Oil and Gas
  $ 134,290     $ 16,708     $ (4,013 )   $ 146,985  
Depreciation, depletion and amortization (a)
    35,077       2,699       (565 )     37,211  
Other operating expenses (b)
    81,744       12,991       (3,087 )     91,648  
Interest expense
    4,515       891       -       5,406  
Other (income) expense
    (134,740 )     -       -       (134,740 )
Income (loss) before income taxes and
minority interest
    147,694       127       (361 )     147,460  
Income tax (expense) benefit
    (53,212 )     383       -       (52,829 )
Minority interest, net of tax
    2       (4 )     -       (2 )
Net income (loss)
  $ 94,484     $ 506     $ (361 )   $ 94,629  
Total assets
  $ 869,251     $ 87,794     $ (8,241 )   $ 948,804  
Additions to property and equipment
  $ 125,919     $ 1,066     $ (361 )   $ 126,624  



For the Nine Months Ended
September 30, 2008
(In thousands)
Oil and Gas