.

Brigham Exploration Company ("Brigham") participated in the drilling of two wells operated by the Company. Mr. Webster is a member of the Board of Directors of Brigham. Mr. Webster is also a managing director of a merchant banking affiliate of the beneficial owner of approximately 35% of the common stock of the parent company of Brigham Oil and Gas, LP. The terms of the operating agreements between the Company and Brigham are consistent with standard industry practices.

During the year ended December 31, 2002, the Company sold a 2% working interest in certain leases in Matagorda County, TX to Mr. Webster. The terms of the sale were the same as other sales of working interests in the same leases to industry partners.

See Notes 6 and 8 for a discussion of the Subordinated Notes and Series B Preferred Stock, respectively, with parties that include members of the Company's Board of Directors.

In December 1999, the Company reduced the exercise price of certain warrants originally issued to affiliates of Enron Corp. in January 1998. There were 250,000 warrants that expire in January 2005 to purchase the Company's common stock at $4.00 per share outstanding as of December 31, 2001 and 2002.

12. DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITY

The Company's operations involve managing market risks related to changes in commodity prices. Derivative financial instruments, specifically swaps, futures, options and other contracts, are used to reduce and manage those risks. The Company addresses market risk by selecting instruments whose value fluctuations correlate strongly with the underlying commodity being hedged. The Company enters into swaps, options, collars and other derivative contracts to hedge the price risks associated with a portion of anticipated future oil and natural gas production. While the use of hedging arrangements limits the downside risk of adverse price movements, it may also limit future gains from favorable movements. Under these agreements, payments are received or made based on the differential between a fixed and a variable product price. These agreements are settled in cash at expiration or exchanged for physical delivery contracts. The Company enters into the majority of its hedging transactions with two counterparties and a netting agreement is in place with those counterparties. The Company does not obtain collateral to support the agreements but monitors the financial viability of counterparties and believes its credit risk is minimal on these transactions. In the event of nonperformance, the Company would be exposed to price risk. The Company has some risk of accounting loss since the price received for the product at the actual physical delivery point may differ from the prevailing price at the delivery point required for settlement of the hedging transaction.

In November 2001, the Company had no-cost collars with an affiliate of Enron Corp., designated as hedges, covering 2,553,000 MMBtu of natural gas production from December 2001 through December 2002. The value of these derivatives at that time was $0.8 million. Because of Enron's financial condition, the Company concluded that the derivatives contracts were no longer effective and thus did not qualify for hedge accounting treatment. As required by SFAS No. 133, the value of these derivative instruments as of November 2001 $(0.8 million) was recorded in accumulated other comprehensive income and will be reclassified into earnings over the original term of the derivative instruments. An allowance for the related asset totalling $0.8 million, net of tax of $0.4 million, was charged to other expense. At December 31, 2001, $0.7 million, net of tax of $0.4 million, remained in accumulated other comprehensive income related to the deferred gains on these derivatives. The remaining balance in other comprehensive income was reported as oil and natural gas revenues in 2002 as the terms of the original derivative expired.

As of December 31, 2002, $0.4 million, net of tax of $0.2 million, remained in accumulated other comprehensive income related to the valuation of the Company's hedging positions.

Total oil purchased and sold under swaps and collars during 2000, 2001 and 2002 were 87,900 Bbls, 18,000 Bbls and 131,300 Bbls, respectively. Total natural gas purchased and sold under swaps and collars in 2000, 2001 and 2002 were 1,590,000 MMBtu and 3,087,000 MMBtu and 2,314,000 MMBtu, respectively. The net gains and (losses) realized by the Company under such hedging arrangements were $(1.5 million), $2.0 million and $(0.9 million) for 2000, 2001 and 2002, respectively, and are included in oil and natural gas revenues.

At December 31, 2001 the Company had no derivative instruments outstanding designated as hedge positions. At December 31, 2002 the Company had the following outstanding hedge positions:

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