derivatives that are used in hedging transactions are highly effective in offsetting changes in cash flows of hedged transactions.

Our Board of Directors sets all of our hedging policy, including volumes, types of instruments and counterparties, on a quarterly basis. These policies are implemented by management through the execution of trades by either the President or Chief Financial Officer after consultation and concurrence by the President, Chief Financial Officer and Chairman of the Board. The master contracts with the authorized counterparties identify the President and Chief Financial Officer as the only representatives authorized to execute trades. The Board of Directors also reviews the status and results of hedging activities quarterly.

Income Taxes

Under Statement of Financial Accounting Standards No. 109 ("SFAS No. 109"), "Accounting for Income Taxes," deferred income taxes are recognized at each yearend for the future tax consequences of differences between the tax bases of assets and liabilities and their financial reporting amounts based on tax laws and statutory tax rates applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established when necessary to reduce the deferred tax asset to the amount expected to be realized.

Contingencies

Liabilities and other contingencies are recognized upon determination of an exposure, which when analyzed indicates that it is both probable that an asset has been impaired or that a liability has been incurred and that the amount of such loss is reasonably estimable.

VOLATILITY OF OIL AND NATURAL GAS PRICES

Our revenues, future rate of growth, results of operations, financial condition and ability to borrow funds or obtain additional capital, as well as the carrying value of our properties, are substantially dependent upon prevailing prices of oil and natural gas. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Risk Factors -- Natural gas and oil prices are highly volatile, and lower prices will negatively affect our financial results."

We periodically review the carrying value of our oil and natural gas properties under the full cost accounting rules of the Commission. See " -- Critical Accounting Policies and Estimates -- Oil and Natural Gas Properties" and " -- Risk Factors -- We may record ceiling limitation write-downs that would reduce our shareholders' equity."

Total oil purchased and sold under swaps and collars during 2001, 2002 and 2003 were 18,000 Bbls, 131,300 Bbls and 193,600 Bbls, respectively. Total natural gas purchased and sold under swaps and collars in 2001, 2002 and 2003 were 3,087,000 MMBtu, 2,314,000 MMBtu and 2,739,000 MMBtu respectively. The net gains and (losses) realized by us under such hedging arrangements were $2.0 million, $(0.9 million) and $(1.8 million) for 2001, 2002 and 2003, respectively, and are included in oil and natural gas revenues.

To mitigate some of our commodity price risk, we engage periodically in certain limited hedging activities but only to the extent of buying protection price floors. We record the costs and any benefits derived from these price floors as a reduction or increase, as applicable, in natural gas and oil sales revenue; these reductions and increases were not significant for any year presented in the financial information included or incorporated in this prospectus. The costs to purchase put options are amortized over the option period. We do not hold or issue derivative instruments for trading purposes.

As of December 31, 2003, $0.2 million, net of tax of $0.1 million, remained in accumulated other comprehensive income related to the valuation of our hedging positions.

While the use of hedging arrangements limits the downside risk of adverse price movements, it may also limit our ability to benefit from increases in the prices of natural gas and oil. We enter into the majority of our hedging transactions with two counterparties and have a netting agreement in place with those counterparties. We do not obtain collateral to support the agreements but monitor the financial viability of counterparties and believe our credit risk is minimal on these transactions. Under these arrangements, 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. In the event of nonperformance, we would be exposed again to price risk. We have some risk of financial loss because 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. Moreover, our hedging arrangements generally do not apply to all of our production and thus provide only partial price protection against declines in commodity prices. We expect

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