Callon Petroleum Company
Annual Report 2002

Plain-text annual report

SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 2002 COMMISSION FILE NUMBER 001-14039 CALLON PETROLEUM COMPANY (Exact name of Registrant as specified in its charter) DELAWARE 64-0844345 --------------------------------- -------------------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 200 NORTH CANAL STREET NATCHEZ, MISSISSIPPI 39120 (601) 442-1601 --------------------------------- --------------------------- (Address of Principal Executive (Registrant's telephone Offices)(Zip Code) number including area code) Securities registered pursuant to Section 12(b) of the Act: TITLE OF EACH CLASS NAME OF EXCHANGE ON WHICH REGISTERED ------------------- ----------------------------------- Convertible Exchangeable Preferred Stock, New York Stock Exchange Series A, Par Value $.01 Per Share Common Stock, Par Value $.01 Per Share New York Stock Exchange Preferred Stock Purchase Rights New York Stock Exchange 11% Senior Subordinated Notes due 2005 New York Stock Exchange 10.25% Senior Subordinated Notes due 2004 New York Stock Exchange Securities registered pursuant to Section 12(g) of the Act: NONE Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X. No . --- --- Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [X] Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes No X . ---- --- The aggregate market value of the voting and non-voting common equity held by nonaffiliates of the registrant was approximately $53,216,000 as of June 28, 2002, and $46,702,000 as of March 7, 2003 (based on the last reported sale price of such stock on the New York Stock Exchange on such dates). As of March 7, 2003, there were 13,919,457 shares of the Registrant's Common Stock, par value $.01 per share, outstanding. Document incorporated by reference: Portions of the definitive Proxy Statement of Callon Petroleum Company (to be filed no later than 120 days after December 31, 2002) relating to the Annual Meeting of Stockholders to be held on May 2, 2003, which is incorporated into Part III of this Form 10-K. 1  PART I. ITEM 1 AND 2. BUSINESS AND PROPERTIES OVERVIEW Callon Petroleum Company has been engaged in the exploration, development, acquisition and production of oil and gas properties since 1950. Our properties are geographically concentrated primarily offshore in the Gulf of Mexico and onshore in Louisiana and Alabama. The public Company was incorporated under the laws of the state of Delaware in 1994 through the consolidation of a publicly traded limited partnership, a joint venture with a consortium of European institutional investors and an independent energy company owned by certain members of current management (the "Consolidation"). As used herein, the "Company," "Callon," "we," "us," and "our" refer to Callon Petroleum Company and its predecessors and subsidiaries unless the context requires otherwise. In 1989, we began increasing our reserves through the acquisition of producing properties that were geologically complex, had (or were analogous to fields with) an established production history from stacked pay zones and were candidates for exploitation. We focused on reducing operating costs and implementing production enhancements through the application of technologically advanced production and recompletion techniques. Over the past seven years, we have also placed emphasis on the acquisition of acreage with exploration and development drilling opportunities in the Gulf of Mexico Shelf area. We acquired an infrastructure of production platforms, gathering systems and pipelines to minimize development expenditures of these drilling opportunities. We also joined with other industry partners, primarily Murphy Exploration and Production, Inc., ("Murphy"), to explore federal offshore blocks acquired in the Gulf of Mexico. Our areas of exploration include the Gulf of Mexico Deepwater area (generally 900 to 5,500 feet of water). We ended the year 2002 with estimated net proved reserves of 236 billion cubic feet of natural gas equivalent ("Bcfe"). This represents a decrease of 22% from 2001 year-end estimated net proved reserves of 303 Bcfe. The major focus of our future operations is expected to continue to be the exploration for and development of oil and gas properties, primarily in the Gulf of Mexico. AVAILABILITY OF REPORTS All of our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to such reports as well as other filings we make pursuant to Section 13(a) and 15(d) of the Securities Exchange Act of 1934 are available free of charge on our Internet website. The address of our Internet website is www.callon.com. Our SEC filings are available on our website as soon as they are posted to the EDGAR database on the SEC's website. BUSINESS STRATEGY Our goal is to increase shareholder value by increasing our reserves, production, cash flow and earnings. We seek to achieve these goals through the following strategies: o Focus on Gulf of Mexico exploration with a balance between shelf and deepwater areas using the latest available technology. o Aggressively explore our existing prospect inventory. o Replenish our prospect inventory with increasing emphasis on prospect generation. 2 o Achieve moderate increases in current production levels through continued shelf exploration. o Achieve significant increases in longer-term production levels through  development of deepwater discoveries and ongoing deepwater exploration. EXPLORATION AND DEVELOPMENT ACTIVITIES Capital expenditures for exploration and development costs related to oil and gas properties totaled approximately $61.9 million in 2002. We incurred approximately $24.4 million in the Gulf of Mexico Shelf area, with approximately $9.7 million related to the Mobile 952/953/955 acceleration project. The Gulf of Mexico Deepwater area expenditures ($24.6 million) accounted for the remainder of the total capital expended, along with $660,000 incurred in leasehold and seismic acquisition costs and $15.2 million of interest and general and administrative costs allocable directly to exploration and development projects. The Gulf of Mexico Deepwater area expenditures were incurred primarily in the production facility fabrication for our Medusa discovery. As a result of drilling successes in the Gulf of Mexico Deepwater area, we are faced with increased costs to develop these significant proved undeveloped reserves. A large portion of these future development costs will be incurred in 2003 and beyond. While management believes that current availability under our existing credit facilities along with current cash flows are expected to meet the needs of these development costs, no assurances can be made that we will be able to fund these development costs. SEC REVIEW OF PROVED RESERVES In October 2002, we received a letter from the SEC requesting supplemental information concerning our operations in the Gulf of Mexico. We believe that a similar letter was sent to other oil and gas companies with off-shore operations. We responded to the SEC's letter on October 18, 2002. On February 21, 2003, we received another letter from the SEC requesting additional information about the procedures we used to classify our offshore reserves as "proved" in our Form 10-K for our fiscal year ended December 31, 2001. The letter also questions the procedures used to classify reserves at our Boomslang property as proved undeveloped reserves at year end 1998. In 2002, we drilled a development well which caused us to reduce our estimated reservoir volumes at our Boomslang property (and record a downward revision of our estimates of the reserves attributable to such property at December 31, 2002) to such an extent that the partners determined that the risk of further development was not economic. The staff of the SEC has asked Callon to restate its financial statements for fiscal years 2000 and 2001 to remove the reserves attributable to Boomslang as proved. We responded to the SEC's second letter on March 13, 2003. We have reviewed the SEC comments with our independent petroleum reserve engineers, Huddleston & Co., Inc., Houston, Texas. Both Huddleston & Co. and Callon believe that our proved reserves were properly classified in accordance with SEC definitions and industry practices. The Company believes the reserve revision has no effect on prior year financial statements as it represents a change in estimate. If the SEC requires us to retroactively classify Boomslang as an unproved property through December, 2002, we would be required to restate our financial position, results of operations, and supplemental oil and gas reserve data from 1998 through 2002. Based on our discussions with others in the oil and gas business, we believe that the SEC is reviewing generally the procedures used by reserve engineers to classify oil and gas reserves as proved in the 3 deepwater areas of the Gulf of Mexico. In particular, the SEC appears to indicate that it is not appropriate to classify reserves as proved without conducting a "flow test." It has not been our practice to conduct a flow test on our deepwater properties prior to classifying the reserves as proved. We believe, and have been advised by Huddleston & Co., that our procedures for classifying our deepwater reserves as proved are in accordance with SEC rules and industry practices. The SEC has asked us, and we have provided substantial detail, about our proved reserves, including the detailed reserve report. At this point, we cannot predict the ultimate outcome of the SEC's review of our proved reserves. With respect to our deepwater projects other than Boomslang, we believe that the outcome of the SEC's review of practices in the oil and gas industry for classifying deepwater reserves as proved should not affect us materially differently than other similarly situated oil and gas companies with deepwater projects. With respect to Boomslang, we believe that reserves attributable to the project were properly classified as proved at year end 1998, 1999, 2000 and 2001, and that no restatement of our financial statements is required as this revision to our Boomslang reserves in 2002 represented a change in estimates of our proved reserves. We cannot make any assurances, however, that the SEC will ultimately agree with this position. RISK FACTORS DECREASE IN OIL AND GAS PRICES MAY ADVERSELY AFFECT OUR RESULTS OF OPERATIONS AND FINANCIAL CONDITION. Our success is highly dependent on prices for oil and gas, which are extremely volatile. Any substantial or extended decline in the price of oil or gas would have a material adverse effect on us. Oil and gas markets are both seasonal and cyclical. The prices of oil and gas depend on factors we cannot control such as weather, economic conditions, and levels of production, actions by OPEC and other countries and government actions. Prices of oil and gas will affect the following aspects of our business: o our revenues, cash flows and earnings; o the amount of oil and gas that we are economically able to produce; o our ability to attract capital to finance our operations and the cost of the capital; o the amount we are allowed to borrow under our senior credit facility; o the value of our oil and gas properties; and o the profit or loss we incur in exploring for and developing our reserves. UNLESS WE ARE ABLE TO REPLACE RESERVES WHICH WE HAVE PRODUCED, OUR CASH FLOWS AND PRODUCTION WILL DECREASE OVER TIME. Our future success depends upon our ability to find, develop and acquire oil and gas reserves that are economically recoverable. As is generally the case for Gulf properties, our producing properties usually have high initial production rates, followed by a steep decline in production. As a result, we must continually locate and develop or acquire new oil and gas reserves to replace those being depleted by production. We must do this even during periods of low oil and gas prices when it is difficult to raise the capital necessary to finance these activities and during periods of high operating costs when it is expensive to contract for drilling rigs and other equipment and personnel necessary to explore for oil and gas. Without successful exploration or acquisition activities, our reserves, production and revenues will decline rapidly. We cannot assure you that we will be able to find and develop or acquire additional reserves at an acceptable cost. A SIGNIFICANT PART OF THE VALUE OF OUR PRODUCTION AND RESERVES IS CONCENTRATED IN A SMALL NUMBER OF OFFSHORE PROPERTIES, AND ANY PRODUCTION PROBLEMS OR INACCURACIES IN RESERVE ESTIMATES RELATED TO THOSE PROPERTIES WOULD ADVERSELY IMPACT OUR BUSINESS. During 2002, 49% of our daily production came from two of our properties in the Gulf of Mexico. Moreover, one property accounted for 33% of our production during this period. If mechanical problems, storms or other events curtailed a substantial 4 portion of this production, our results of operations would be adversely affected. In addition, at December 31, 2002, most of our proved reserves were located in five fields in the Gulf of Mexico, with approximately 93% of our total net proved reserves attributable to these properties. If the actual reserves associated with any one of these producing properties are less than our estimated reserves, our results of operations and financial condition could be adversely affected. OUR FOCUS ON EXPLORATION PROJECTS INCREASES THE RISKS INHERENT IN OUR OIL AND GAS ACTIVITIES. Our business strategy focuses on replacing reserves through exploration, where the risks are greater than in acquisitions and development drilling. Although we have been successful in exploration in the past, we cannot assure you that we will continue to increase reserves through exploration or at an acceptable cost. Additionally, we are often uncertain as to the future costs and timing of drilling, completing and producing wells. Our drilling operations may be curtailed, delayed or canceled as a result of a variety of factors, including: o unexpected drilling conditions; o pressure or inequalities in formations; o equipment failures or accidents; o adverse weather conditions; o compliance with governmental requirements; and o shortages or delays in the availability of drilling rigs and the delivery of equipment. BECAUSE WE DO NOT CONTROL, AND DO NOT OPERATE, ALL OF OUR PROPERTIES, ESPECIALLY OUR DEEPWATER PROPERTIES, WE HAVE LIMITED INFLUENCE OVER THEIR DEVELOPMENT. Our lack of control could result in the following: o the operator may initiate exploration or development on a faster or slower pace than we prefer; o the operator may propose to drill more wells or build more facilities on a project than we have funds for or that we deem appropriate, which may mean that we are unable to participate in the project or share in the revenues generated by the project even though we paid our share of exploration costs; and o if an operator refuses to initiate a project, we may be unable to pursue the project. Any of these events could materially reduce the value of our properties. OUR DEEPWATER OPERATIONS HAVE SPECIAL OPERATIONAL RISKS THAT MAY NEGATIVELY AFFECT THE VALUE OF THOSE ASSETS. Drilling operations in the deepwater area are by their nature more difficult and costly than drilling operations in shallow water. Deepwater drilling operations require the application of more advanced drilling technologies, involving a higher risk of technological failure and usually have significantly higher drilling costs than shallow water drilling operations. Deepwater wells are completed using sub sea completion techniques that require substantial time and the use of advanced remote installation equipment. These operations involve a high risk of mechanical difficulties and equipment failures that could result in significant cost overruns. In deepwater, the time required to commence production following a discovery is much longer than in shallow water and on-shore. Our deepwater discoveries and prospects will require the construction of expensive production facilities and pipelines prior to the beginning of production. We cannot estimate the costs and timing of the construction of these facilities with certainty, and the accuracy of our estimates will be affected by a number of factors beyond our control, including the following: 5 o decisions made by the operators of our deepwater wells; o the availability of materials necessary to construct the facilities; o the proximity of our discoveries to pipelines; and o the price of oil and natural gas. Delays and cost overruns in the commencement of production will affect the value of our deepwater prospects and the discounted present value of reserves attributable to those prospects. Competitive industry conditions may negatively affect our ability to conduct operations. We operate in the highly competitive areas of oil and gas exploration, development and production. We compete for the purchase of leases in the Gulf of Mexico from the U. S. government and from other oil and gas companies. These leases include exploration prospects as well as properties with proved reserves. Factors that affect our ability to compete in the marketplace include: o our access to the capital necessary to drill wells and acquire properties; o our ability to acquire and analyze seismic, geological and other information relating to a property; o our ability to retain the personnel necessary to properly evaluate seismic and other information relating to a property; o the location of, and our ability to access, platforms, pipelines and other facilities used to produce and transport oil and gas production; o the standards we establish for the minimum projected return on an investment of our capital; and o the availability of alternate fuel sources. Our competitors include major integrated oil companies, substantial independent energy companies, and affiliates of major interstate and intrastate pipelines and national and local gas gatherers, many of which possess greater financial, technological and other resources than we do. OUR COMPETITORS MAY USE SUPERIOR TECHNOLOGY, WHICH WE MAY BE UNABLE TO AFFORD OR WHICH WOULD REQUIRE COSTLY INVESTMENT BY US IN ORDER TO COMPETE. Our industry is subject to rapid and significant advancements in technology, including the introduction of new products and services using new technologies. As our competitors use or develop new technologies, we may be placed at a competitive disadvantage, and competitive pressures may force us to implement new technologies at a substantial cost. In addition, our competitors may have greater financial, technical and personnel resources that allow them to enjoy technological advantages and may in the future allow them to implement new technologies before we can. We cannot be certain that we will be able to implement technologies on a timely basis or at a cost that is acceptable to us. One or more of the technologies that we currently use or that we may implement in the future may become obsolete, and we may be adversely affected. For example, marine seismic acquisition technology has been characterized by rapid technological advancements in recent years, and further significant technological developments could substantially impair our 3-D seismic data's value. WE MAY NOT BE ABLE TO REPLACE OUR RESERVES OR GENERATE CASH FLOWS IF WE ARE UNABLE TO RAISE CAPITAL. WE WILL BE REQUIRED TO MAKE SUBSTANTIAL CAPITAL EXPENDITURES TO DEVELOP OUR EXISTING RESERVES, AND TO DISCOVER NEW OIL AND GAS RESERVES. Historically, we have financed these expenditures primarily with cash from operations, proceeds from bank borrowings and proceeds from the sale of debt and equity securities. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources" for a discussion of our capital budget. We cannot assure you that we will be able to raise capital in the future. We also make offers to acquire oil and gas properties in the ordinary course of our business. If these offers are accepted, our capital needs may increase substantially. 6 We expect to continue using our senior credit facility to borrow funds to supplement our available cash. The amount we may borrow under our senior credit facility may not exceed a borrowing base determined by the lenders based on their projections of our future production, future production costs, taxes, commodity prices and any other factors deemed relevant by our lenders. We cannot control the assumptions the lenders use to calculate our borrowing base. The lenders may, without our consent, adjust the borrowing base semiannually or in situations where we purchase or sell assets or issue debt securities. If our borrowings under the senior credit facility exceed the borrowing base, the lenders may require that we repay the excess. If this were to occur, we might have to sell assets or seek financing from other sources. Sales of assets could further reduce the amount of our borrowing base. We cannot assure you that we would be successful in selling assets or arranging substitute financing. If we were not able to repay borrowings under our senior credit facility to reduce the outstanding amount to less than the borrowing base, we would be in default under our senior credit facility. For a description of our senior credit facility and its principal terms and conditions, see "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources." 7 OUR RESERVE INFORMATION REPRESENTS ESTIMATES THAT MAY TURN OUT TO BE INCORRECT IF THE ASSUMPTIONS UPON WHICH THESE ESTIMATES ARE BASED ARE INACCURATE. ANY MATERIAL INACCURACIES IN THESE RESERVE ESTIMATES OR UNDERLYING ASSUMPTIONS WILL MATERIALLY AFFECT THE QUANTITIES AND PRESENT VALUE OF OUR RESERVES. The process of estimating oil and gas reserves is complex. It requires interpretations of available technical data and various assumptions, including assumptions relating to economic factors. Any significant inaccuracies in these interpretations or assumptions could materially affect the estimated quantities and present value of reserves shown in this annual report. In order to prepare these estimates, we must project production rates and the timing of development expenditures. The assumptions regarding the timing and costs to commence production from our deepwater wells used in preparing our reserves are often subject to revisions over time as described under "our deepwater operations have special operational risks that may negatively affect the value of those assets." We must also analyze available geological, geophysical, production and engineering data, the extent, quality and reliability of which can vary. The process also requires economic assumptions, such as oil and gas prices, drilling and operating expenses, capital expenditures, taxes and availability of funds. Therefore, estimates of oil and gas reserves are inherently imprecise. Actual future production, oil and gas prices, revenues, taxes, development expenditures, operating expenses and quantities of recoverable oil and gas reserves most likely will vary from our estimates. Any significant variance could materially affect the estimated quantities and present value of reserves shown in this report. In addition, we may adjust estimates of proved reserves to reflect production history, results of exploration and development, prevailing oil and gas prices and other factors, many of which are beyond our control. You should not assume that the present value of future net cash flows from our proved reserves referred to in this report is the current market value of our estimated oil and gas reserves. In accordance with SEC requirements, we generally base the estimated discounted future net cash flows from our proved reserves on prices and costs on the date of the estimate. Actual future prices and costs may differ materially from those used in the present value estimate. Information about reserves constitutes forward-looking information. See "Forward-Looking Statements" for information regarding forward-looking information. The discounted present value of our oil and gas reserves is prepared in accordance with guidelines established by the SEC. A purchaser of reserves would use numerous other factors to value our reserves. The discounted present value of reserves, therefore, does not represent the fair market value of those reserves. On December 31, 2002, approximately 81.4% of the discounted present value of our estimated net proved reserves were proved undeveloped. Proved undeveloped oil volumes represented 96% of total proved oil reserves. Substantially all of these proved undeveloped reserves were attributable to our deepwater properties. Development of these properties is subject to additional risks as described above. THE SEC MAY REQUIRE US TO BOOK RESERVES AS PROVED IN A MANNER THAT DIFFERS FROM OUR HISTORICAL PRACTICES AND CURRENT INDUSTRY STANDARDS, AND WHICH MAY RESULT IN A SIGNIFICANT DOWNWARD REVISION OF OUR PROVED RESERVES. As discussed above, in October 2002 and February 2003, we received letters from the SEC regarding our Annual Report on Form 10-K for the year ended December 31, 2001 requesting supplemental information concerning our operations in the Gulf of Mexico. The comment letters requested information about the procedures we used to classify our deepwater reserves as proved and requested that our financials be restated to reflect the removal of the Boomslang reserves as proved for all prior periods during which such reserves were reported as proved. We have reviewed the SEC 8 comments with our independent petroleum reserve engineers, Huddleston & Co., Inc. of Houston, Texas. Both Huddleston & Co and Callon believe that such reserves were properly classified as proved. However, if the SEC decides to question our other deepwater properties and these reserves are ultimately required to be reclassified as not proved; our proved reserves will be materially reduced. If the SEC requires us to retroactively classify Boomslang as an unproved property through December, 2002, we would be required to restate our financial position, results of operations, and supplemental oil and gas reserve data from 1998 through 2002. A material reduction in our proved reserves could have a material adverse effect on our financial condition and results of operations. WEATHER, UNEXPECTED SUBSURFACE CONDITIONS, AND OTHER UNFORESEEN OPERATING HAZARDS MAY ADVERSELY IMPACT OUR ABILITY TO CONDUCT BUSINESS. There are many operating hazards in exploring for and producing oil and gas, including: o our drilling operations may encounter unexpected formations or pressures, which could cause damage to equipment or personal injury; o we may experience equipment failures which curtail or stop production; and o we could experience blowouts or other damages to the productive formations that may require a well to be re-drilled or other corrective action to be taken. In addition, any of the foregoing may result in environmental damages for which we will be liable. Moreover, a substantial portion of our operations are offshore and are subject to a variety of risks peculiar to the marine environment such as capsizing, collisions, hurricanes and other adverse weather conditions. These conditions can cause substantial damage to facilities and interrupt production. Offshore operations are also subject to more extensive governmental regulation. We cannot assure you that we will be able to maintain adequate insurance at rates we consider reasonable to cover our possible losses from operating hazards. The occurrence of a significant event not fully insured or indemnified against could materially and adversely affect our financial condition and results of operations. WE MAY NOT HAVE PRODUCTION TO OFFSET HEDGES; BY HEDGING, WE MAY NOT BENEFIT FROM PRICE INCREASES. Part of our business strategy is to reduce our exposure to the volatility of oil and gas prices by hedging a portion of our production. In a typical hedge transaction, we will have the right to receive from the other parties to the hedge the excess of the fixed price specified in the hedge over a floating price based on a market index, multiplied by the quantity hedged. If the floating price exceeds the fixed price, we are required to pay the other parties this difference multiplied by the quantity hedged. We are required to pay the difference between the floating price and the fixed price when the floating price exceeds the fixed price regardless of whether we have sufficient production to cover the quantities specified in the hedge. Significant reductions in production at times when the floating price exceeds the fixed price could require us to make payments under the hedge agreements even though such payments are not offset by sales of production. Hedging will also prevent us from receiving the full advantage of increases in oil or gas prices above the fixed amount specified in the hedge. See "Quantitative and Qualitative Disclosures About Market Risks" for a discussion of our hedging practices. 9 COMPLIANCE WITH ENVIRONMENTAL AND OTHER GOVERNMENT REGULATIONS COULD BE COSTLY AND COULD NEGATIVELY IMPACT PRODUCTION. Our operations are subject to numerous laws and regulations governing the operation and maintenance of our facilities and discharge of materials into the environment or otherwise relating to environmental protection. For a discussion of the material regulations applicable to us, see "Federal Regulations," "State Regulations," and "Environmental Regulations." These laws and regulations may: o require that we acquire permits before commencing drilling; o restrict the substances that can be released into the environment in connection with drilling and production activities; o limit or prohibit drilling activities on protected areas such as wetlands or wilderness areas; and o require remedial measures to mitigate pollution from former operations, such as dismantling abandoned production facilities. Under these laws and regulations, we could be liable for personal injury and clean-up costs and other environmental and property damages, as well as administrative, civil and criminal penalties. We maintain limited insurance coverage for sudden and accidental environmental damages. We do not believe that insurance coverage for environmental damages that occur over time is available at a reasonable cost. Also, we do not believe that insurance coverage for the full potential liability that could be caused by sudden and accidental environmental damages is available at a reasonable cost. Accordingly, we may be subject to liability or we may be required to cease production from properties in the event of environmental damages. FACTORS BEYOND OUR CONTROL AFFECT OUR ABILITY TO MARKET PRODUCTION AND OUR FINANCIAL RESULTS. The ability to market oil and gas from our wells depends upon numerous factors beyond our control. These factors include: o the extent of domestic production and imports of oil and gas; o the proximity of the gas production to gas pipelines; o the availability of pipeline capacity; o the demand for oil and gas by utilities and other end users; o the availability of alternative fuel sources; o the effects of inclement weather; o state and federal regulation of oil and gas marketing; and o federal regulation of gas sold or transported in interstate commerce. Because of these factors, we may be unable to market all of the oil or gas we produce. In addition, we may be unable to obtain favorable prices for the oil and gas we produce. IF OIL AND GAS PRICES DECREASE, WE MAY BE REQUIRED TO TAKE WRITEDOWNS. We may be required to writedown the carrying value of our oil and gas properties when oil and gas prices are low or if we have substantial downward adjustments to our estimated net proved reserves, increases in our estimates of development costs or deterioration in our exploration results. Under the full cost method which we use to account for our oil and gas properties, the net capitalized costs of our oil and gas properties may not exceed the present value, discounted at 10%, of future net cash flows from estimated net proved reserves, using period end oil and gas prices or prices as of the date of our auditor's report, plus the lower of cost or fair market value of our unproved properties. If net capitalized costs of our oil and gas properties exceed this limit, we must charge the amount of the excess to earnings. This type of charge will not affect our cash flows, but will reduce the book value of our stockholders' equity. We review the carrying value of our properties quarterly, based on prices in effect as of the end of each quarter or at the time of reporting our 10 results. Once incurred, a writedown of oil and gas properties is not reversible at a later date, even if prices increase. FORWARD-LOOKING STATEMENTS In this report, we have made many forward-looking statements. We cannot assure you that the plans, intentions or expectations upon which our forward-looking statements are based will occur. Our forward-looking statements are subject to risks, uncertainties and assumptions, including those discussed elsewhere in this report. Forward-looking statements include statements regarding: o our oil and gas reserve quantities, and the discounted present value of these reserves; o the amount and nature of our capital expenditures; o drilling of wells; o the timing and amount of future production and operating costs; o business strategies and plans of management; and o prospect development and property acquisitions. Some of the risks, which could affect our future results and could cause results to differ materially from those expressed in our forward-looking statements include: o general economic conditions; o the volatility of oil and natural gas prices; o the uncertainty of estimates of oil and natural gas reserves; o the impact of competition; o the availability and cost of seismic, drilling and other equipment; o operating hazards inherent in the exploration for and production of oil and natural gas; o difficulties encountered during the exploration for and production of oil and natural gas; o difficulties encountered in delivering oil and natural gas to commercial markets; o changes in customer demand and producers' supply; o the uncertainty of our ability to attract capital; o compliance with, or the effect of changes in, the extensive governmental regulations regarding the oil and natural gas business; o actions of operators of our oil and gas properties; and  o weather conditions. The information contained in this report, including the information set forth under the heading "Risk Factors," identifies additional factors that could affect our operating results and performance. We urge you to carefully consider these factors and the other cautionary statements in this report. Our forward-looking statements speak only as of the date made, and we have no obligation to update these forward-looking statements. CORPORATE OFFICES Our headquarters are located in Natchez, Mississippi, in approximately 51,500 square feet of owned space, with a field office in Houston, Texas. We also maintain owned or leased field offices in the area of the major fields in which we operate properties or have a significant interest. Replacement of any of our leased offices would not result in material expenditures by us as alternative locations to our leased space are anticipated to be readily available. 11 EMPLOYEES We had 100 employees as of December 31, 2002, none of whom are currently represented by a union. We believe that we have good relations with our employees. We employ nine petroleum engineers and seven petroleum geoscientists. FEDERAL REGULATIONS SALES OF NATURAL GAS. Effective January 1, 1993, the Natural Gas Wellhead Decontrol Act deregulated prices for all "first sales" of natural gas. Thus, all sales of gas by the Company may be made at market prices, subject to applicable contract provisions. TRANSPORTATION OF NATURAL GAS. The rates, terms and conditions applicable to the interstate transportation of natural gas by pipelines are regulated by the Federal Energy Regulatory Commission ("FERC") under the Natural Gas Act ("NGA"), as well as under section 311 of the Natural Gas Policy Act ("NGPA"). Since 1985, the FERC has implemented regulations intended to make natural gas transportation more accessible to gas buyers and sellers on an open-access, non-discriminatory basis. The FERC has announced several important transportation-related policy statements and rule changes, including a statement of policy and final rule issued February 25, 2000 concerning alternatives to its traditional cost-of-service rate-making methodology to establish the rates interstate pipelines may charge for their services. The final rule revises FERC's pricing policy and current regulatory framework to improve the efficiency of the market and further enhance competition in natural gas markets. With respect to the transportation of natural gas on or across the Outer Continental Shelf ("OCS"), the FERC requires, as part of its regulation under the Outer Continental Shelf Lands Act, that all pipelines provide open and non-discriminatory access to both owner and non-owner shippers. Although to date the FERC has imposed light-handed regulation on off-shore facilities that meet its traditional test of gathering status, it has the authority to exercise jurisdiction under the Outer Continental Shelf Lands Act ("OCSLA") over gathering facilities, if necessary, to permit non-discriminatory access to service. For those facilities transporting natural gas across the OCS that are not considered to be gathering facilities, the rates, terms, and conditions applicable to this transportation are regulated by FERC under the NGA and NGPA, as well as the OCSLA. SALES AND TRANSPORTATION OF CRUDE OIL. Sales of crude oil and condensate can be made by the Company at market prices not subject at this time to price controls. The price that the Company receives from the sale of these products will be affected by the cost of transporting the products to market. The rates, terms, and conditions applicable to the interstate transportation of oil and related products by pipelines are regulated by the FERC under the Interstate Commerce Act. As required by the Energy Policy Act of 1992, the FERC has revised its regulations governing the rates that may be charged by oil pipelines. The new rules, which were effective January 1, 1995, provide a simplified, generally applicable method of regulating such rates by use of an index for setting rate ceilings. The FERC will also, under defined circumstances, permit alternative ratemaking methodologies for interstate oil pipelines such as the use of cost of service rates, settlement rates, and market-based rates. Market-based rates will be permitted to the extent the pipeline can demonstrate that it lacks significant market power in the market in which it proposes to charge market-based rates. The cumulative effect that these rules may have on moving the Company's production to market cannot yet be determined. With respect to the transportation of oil and condensate on or across the OCS, the FERC requires, as part of its regulation under the OCSLA, that all pipelines provide open and non-discriminatory access to both owner and non-owner shippers. Accordingly, the FERC has the authority to exercise jurisdiction under the OCSLA, if necessary, to permit non-discriminatory access to service. 12 LEGISLATIVE PROPOSALS. In the past, Congress has been very active in the area of natural gas regulation. There are legislative proposals pending in Congress and in various state legislatures which, if enacted, could significantly affect the petroleum industry. At the present time it is impossible to predict what proposals, if any, might actually be enacted by Congress or the various state legislatures and what effect, if any, such proposals might have on the Company's operations. FEDERAL, STATE OR INDIAN LEASES. In the event the Company conducts operations on federal, state or Indian oil and gas leases, such operations must comply with numerous regulatory restrictions, including various nondiscrimination statutes, royalty and related valuation requirements, and certain of such operations must be conducted pursuant to certain on-site security regulations and other appropriate permits issued by the Bureau of Land Management ("BLM") or Minerals Management Service ("MMS") or other appropriate federal or state agencies. The Company's OCS leases in federal waters are administered by the MMS and require compliance with detailed MMS regulations and orders. The MMS has promulgated regulations implementing restrictions on various production-related activities, including restricting the flaring or venting of natural gas. Under certain circumstances, the MMS may require Company operations on federal leases to be suspended or terminated. Any such suspension or termination could materially and adversely affect the Company's financial condition and operations. On March 15, 2000, the MMS issued a final rule effective June 1, 2000 which amends its regulations governing the calculation of royalties and the valuation of crude oil produced from federal leases. Among other matters, this rule amends the valuation procedure for the sale of federal royalty oil by eliminating posted prices as a measure of value and relying instead on arm's length sales prices and spot market prices as market value indicators. Because the Company sells its production in the spot market and therefore pays royalties on production from federal leases, it is not anticipated that this final rule will have any substantial impact on the Company. The Mineral Leasing Act of 1920 ("Mineral Act") prohibits direct or indirect ownership of any interest in federal onshore oil and gas leases by a foreign citizen of a country that denies "similar or like privileges" to citizens of the United States. Such restrictions on citizens of a "non-reciprocal" country include ownership or holding or controlling stock in a corporation that holds a federal onshore oil and gas lease. If this restriction is violated, the corporation's lease can be canceled in a proceeding instituted by the United States Attorney General. Although the regulations of the BLM (which administers the Mineral Act) provide for agency designations of non-reciprocal countries, there are presently no such designations in effect. The Company owns interests in numerous federal onshore oil and gas leases. It is possible that holders of equity interests in the Company may be citizens of foreign countries, which at some time in the future might be determined to be non-reciprocal under the Mineral Act. STATE REGULATIONS Most states regulate the production and sale of oil and natural gas, including requirements for obtaining drilling permits, the method of developing new fields, the spacing and operation of wells and the prevention of waste of oil and gas resources. The rate of production may be regulated and the maximum daily production allowable from both oil and gas wells may be established on a market demand or conservation basis or both. The Company may enter into agreements relating to the construction or operation of a pipeline system for the transportation of natural gas. To the extent that such gas is produced, transported and consumed wholly within one state, such operations may, in certain instances, be subject to the jurisdiction of such state's administrative authority charged with the responsibility of regulating intrastate pipelines. In such event, the rates which the Company could charge for gas, the transportation of gas, and the costs of construction and operation of such 13 pipeline would be impacted by the rules and regulations governing such matters, if any, of such administrative authority. Further, such a pipeline system would be subject to various state and/or federal pipeline safety regulations and requirements, including those of, among others, the Department of Transportation. Such regulations can increase the cost of planning, designing, installing and operating such facilities. The impact of such pipeline safety regulations would not be any more adverse to the Company than it would be to other similar owners or operators of such pipeline facilities. ENVIRONMENTAL REGULATIONS GENERAL. The Company's activities are subject to federal, state and local laws and regulations governing environmental quality and pollution control. Although no assurances can be made, the Company believes that, absent the occurrence of an extraordinary event, compliance with existing federal, state and local laws, rules and regulations regulating the release of materials into the environment or otherwise relating to the protection of the environment will not have a material effect upon the capital expenditures, earnings or the competitive position of the Company with respect to its existing assets and operations. The Company cannot predict what effect future regulation or legislation, enforcement policies, and claims for damages to property, employees, other persons and the environment resulting from the Company's operations could have on its activities. Activities of the Company with respect to natural gas facilities, including the operation and construction of pipelines, plants and other facilities for transporting, processing, treating or storing natural gas and other products, are subject to stringent environmental regulation by state and federal authorities including the United States Environmental Protection Agency ("EPA"). Such regulation can increase the cost of planning, designing, installing and operating such facilities. In most instances, the regulatory requirements relate to water and air pollution control measures. Although the Company believes that compliance with environmental regulations will not have a material adverse effect on it, risks of substantial costs and liabilities are inherent in oil and gas production operations, and there can be no assurance that significant costs and liabilities will not be incurred. Moreover, it is possible that other developments, such as stricter environmental laws and regulations, and claims for damages to property or persons resulting from oil and gas production, would result in substantial costs and liabilities to the Company. SOLID AND HAZARDOUS WASTE. The Company currently owns or leases, and in the past owned or leased, properties that have been used for the exploration and production of oil and gas for many years. Although the Company has utilized operating and disposal practices that were standard in the industry at the time, hydrocarbons or other solid wastes may have been disposed or released on or under the properties owned or leased by the Company or on or under locations where such wastes have been taken for disposal. In addition, many of these properties have been operated by third parties. The Company has no control over such entities' treatment of hydrocarbons or other solid wastes and the manner in which such substances may have been disposed or released. State and federal laws applicable to oil and gas wastes and properties have gradually become stricter over time. Under new laws, the Company could be required to remediate property, including groundwater, containing or impacted by previously disposed wastes (including wastes disposed or released by prior owners or operators, or property contamination, including groundwater contamination by prior owners or operators) or to perform remedial plugging operations to prevent future or mitigate existing contamination. The Company generates wastes, including hazardous wastes that are subject to the federal Resource Conservation and Recovery Act ("RCRA") and comparable state statutes. The Environmental Protection Agency ("EPA") and various state agencies have limited the disposal options for certain wastes, including wastes designated as hazardous under the RCRA and similar state statutes ("Hazardous Wastes"). Furthermore, it is possible that certain wastes generated by the Company's oil and gas operations that are (currently exempt from 14 treatment as) Hazardous Wastes may in the future be designated as Hazardous Wastes under RCRA or other applicable statutes and, therefore, may be subject to more rigorous and costly disposal requirements. SUPERFUND. The federal Comprehensive Environmental Response, Compensation and Liability Act ("CERCLA"), also known as the "Superfund" law, generally imposes joint and several liability for costs of investigation and remediation and for natural resource damages, without regard to fault or the legality of the original conduct, on certain classes of persons with respect to the release into the environment of substances designated under CERCLA as hazardous substances ("Hazardous Substances"). These classes of persons, or so-called potentially responsible parties ("PRPs"), include the current and certain past owners and operators of a facility where there has been a release or threat of release of a Hazardous Substance and persons who disposed of or arranged for the disposal of Hazardous Substances found at a site. CERCLA also authorizes the EPA and, in some cases, third parties to take actions in response to threats to the public health or the environment and to seek to recover from the PRPs the costs of such action. Although CERCLA generally exempts "petroleum" from the definition of Hazardous Substance, in the course of its operations, the Company has generated and will generate wastes that may fall within CERCLA's definition of Hazardous Substance. The Company may also be the owner or operator of sites on which Hazardous Substances have been released. To its knowledge, neither the Company nor its predecessors have been designated as a PRP by the EPA under CERCLA; the Company also does not know of any prior owners or operators of its properties that are named as PRPs related to their ownership or operation of such properties. CLEAN WATER ACT. The Clean Water Act ("CWA") imposes restrictions and strict controls regarding the discharge of wastes including produced waters and other oil and natural gas wastes, into waters of the United States, a term broadly defined. These controls have become more stringent over the years, and it is probable that additional restrictions will be imposed in the future. Permits must be obtained to discharge pollutants into federal waters. The CWA provides for civil, criminal and administrative penalties for unauthorized discharges of oil and hazardous substances and of other pollutants. It imposes substantial potential liability for the costs of removal or remediation associated with discharges of oil or hazardous substances and other pollutants. State laws governing discharges to water also provide varying civil, criminal and administrative penalties and impose liabilities in the case of a discharge of petroleum or its derivatives, or other hazardous substances, into state waters. In addition, the EPA has promulgated regulations that may require us to obtain permits to discharge storm water runoff, including discharges associated with construction activities. In the event of an unauthorized discharge of wastes, the Company may be liable for penalties and costs. OIL POLLUTION ACT. The Oil Pollution Act of 1990 ("OPA"), which amends and augments oil spill provisions of CWA, imposes certain duties and liabilities on certain "responsible parties" related to the prevention of oil spills and damages resulting from such spills in or threatening United States waters or adjoining shorelines. A liable "responsible party" includes the owner or operator of a facility, vessel or pipeline that is a source of an oil discharge or that poses the substantial threat of discharge, or the lessee or permittee of the area in which a discharging facility is located. OPA assigns joint and several liability, without regard to fault, to each liable party for oil removal costs and a variety of public and private damages. Although defenses and limitations exist to the liability imposed by OPA, they are limited. In the event of an oil discharge or substantial threat of discharge, the Company may be liable for costs and damages. The OPA also imposes ongoing requirements on a responsible party, including proof of financial responsibility to cover at least some costs in a potential spill. Certain amendments to the OPA that were enacted in 1996 require owners and operators of offshore facilities that have a worst case oil spill potential of more than 1,000 barrels to demonstrate financial responsibility in amounts ranging from $10 million in specified state waters and $35 million in federal outer continental shelf ("OCS") waters, with higher amounts, up to $150 million based upon worst 15 case oil-spill discharge volume calculations. The Company believes that it has established adequate proof of financial responsibility for its offshore facilities. AIR EMISSIONS. The Company's operations are subject to local, state and federal regulations for the control of emissions from sources of air pollution. Federal and state laws require new and modified sources of air pollutants to obtain permits prior to commencing construction. Major sources of air pollutants are subject to more stringent, federally imposed requirements including additional permits. Federal and state laws designed to control hazardous (toxic) air pollutants, might require installation of additional controls. Administrative enforcement actions for failure to comply strictly with air pollution regulations or permits are generally resolved by payment of monetary fines and correction of any identified deficiencies. Alternatively, regulatory agencies could bring lawsuits for civil penalties or require the Company to forego construction, modification or operation of certain air emission sources. COASTAL COORDINATION. There are various federal and state programs that regulate the conservation and development of coastal resources. The federal Coastal Zone Management Act ("CZMA") was passed in 1972 to preserve and, where possible, restore the natural resources of the Nation's coastal zone. The CZMA provides for federal grants for state management PROGRAMS that regulate land use, water use and coastal development. Various states, such as Alabama, Louisiana and Texas, also have coastal management programs, which provide for, among other things, the coordination among local and state authorities to protect coastal resources through regulating land use, water, and coastal development. Coastal management programs also may provide for the review of state and federal agency rules and agency actions for consistency with the goals and policies of the state coastal management plan. This review may impact agency permitting and review activities and add an additional layer of review to certain activities undertaken by the Company. OSHA AND OTHER REGULATIONS. The Company is subject to the requirements of the federal Occupational Safety and Health Act ("OSHA") and comparable state statutes. The OSHA hazard communication standard, the EPA community right-to-know regulations under Title III of CERCLA and similar state statutes require the Company to organize and/or disclose information about hazardous materials used or produced in its operations. Management believes that the Company is in substantial compliance with current applicable environmental laws and regulations and that continued compliance with existing requirements would not have a material adverse impact on the Company. PROPERTY SUMMARY We are engaged in the exploration, development, acquisition and production of oil and gas properties and natural gas transmission and provide oil and gas property management services for other investors. Our properties are concentrated offshore in the Gulf of Mexico and onshore, primarily, in Louisiana and Alabama. We have historically grown our reserves and production by focusing primarily on low to moderate risk exploration and acquisition opportunities in the Gulf of Mexico Shelf area. Over the last several years, we have expanded our area of exploration to include the Gulf of Mexico Deepwater area. As of December 31, 2002, our estimated net proved reserves totaled 24.0 million barrels of oil ("MBbl") and 91.5 billion cubic feet of natural gas ("Bcf"), with a pre-tax present value, discounted at 10%, of the estimated future net revenues based on constant prices in effect at year-end ("Discounted Cash Flow") of $623.9 million. Gas constitutes approximately 39% of our total estimated proved reserves and approximately 17% of our total estimated proved reserves are proved producing reserves. 16 Our Medusa (Mississippi Canyon Blocks 538/582) discovery and Habanero (Garden Banks Block 341) discovery are projected to begin production late in the third quarter of 2003. Construction of a production facility, subsea completions and flowlines are projected to be completed by the fall of 2003. These two deepwater discoveries are expected to increase our projected production from our existing producing properties by 58% in the second half of 2003. A detail discussion of each of these properties is provided in the Significant Properties section of this report. SIGNIFICANT PROPERTIES The following table shows discounted cash flows and estimated net proved oil and gas reserves by major field, within the focus area, for our seven largest fields and for all other properties combined at December 31, 2002.