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Company's common stock to the extent that the
market value exceeds the exercise price of the option. Variable
plan accounting is applied to the repriced options until the options
are exercised, forfeited, or expire unexercised (See Note 11).
The fair value of each option grant was estimated
on the date of grant using the Black-Scholes option pricing model
with the following assumptions used for grants in 2002, 2003 and
2004: risk free interest rate of 4.8%, 4.0%, and 4.3% respectively,
expected dividend yield of 0%, expected life of 10 years and expected
volatility of 77.7%, 72.2% and 43.2%, respectively.
DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES
Upon entering into a derivative contract, the
Company designates the derivative instruments as a hedge of the
variability of cash flow to be received (cash flow hedge). Changes
in the fair value of a cash flow hedge are recorded in other comprehensive
income to the extent that the derivative is effective in offsetting
changes in the fair value of the hedged item. Any ineffectiveness
in the relationship between the cash flow hedge and the hedged item
is recognized currently in income. Gains and losses accumulated
in other comprehensive income associated with the cash flow hedge
are recognized in earnings as oil and natural gas revenues when
the forecasted transaction occurs. All of the Company's derivative
instruments at December 31, 2002, 2003 and 2004 were designated
as cash flow hedges.
When hedge accounting is discontinued because
it is probable that a forecasted transaction will not occur, the
derivative will continue to be carried on the balance sheet at its
fair value and gains and losses that were accumulated in other comprehensive
income will be recognized in earnings immediately. In all other
situations in which hedge accounting is discontinued, the derivative
will be carried at fair value on the balance sheet with future changes
in its fair value recognized in future earnings. See Note 13 with
respect to the Company's positions with an affiliate of Enron Corp.
The Company typically uses fixed rate swaps
and costless collars to hedge its exposure to material changes in
the price of oil and natural gas. The Company formally documents
all relationships between hedging instruments and hedged items,
as well as its risk management objectives and strategy for undertaking
various hedge transactions. This process includes linking all derivatives
that are designated cash flow hedges to forecasted transactions.
The Company also formally assesses, both at the hedge's inception
and on an ongoing basis, whether the derivatives that are used in
hedging transactions are highly effective in offsetting changes
in cash flows of hedged transactions.
The Company's Board of Directors sets all
of the Company's 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 Company representatives
authorized to execute trades. The Board of Directors also reviews
the status and results of hedging activities quarterly.
INCOME TAXES
Under SFAS No. 109, "Accounting for Income
Taxes," deferred income taxes are recognized 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 deferred tax assets to the
amounts expected to be realized.
CONCENTRATION OF CREDIT RISK
Substantially all of the Company's accounts
receivable result from oil and natural gas sales or joint interest
billings to third parties in the oil and natural gas industry. This
concentration of customers and joint interest owners may impact
the Company's overall credit risk in that these entities may be
similarly affected by changes in economic and other industry conditions.
The Company does not require collateral from its customers and the
Company has not experienced material credit losses on such receivables.
Further, the Company generally has the right to offset revenue against
related billings to joint interest owners. Derivative contracts
subject the Company to a concentration of credit risk. The Company
transacts the majority of its derivative contracts with two counterparties.
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