Derivative Instruments

Upon entering into a derivative contract, the Company must either designate the derivative instruments as a hedge of the variability of cash flow to be received (cash flow hedge) or the derivatives must be accounted for as non-designated derivatives. We typically use fixed rate swaps and costless collars to manage our risk of exposure to material changes in the price of natural gas and oil. 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, 2003 and 2004 had been designated as cash flow hedges. However, in connection with the preparation of the Company’s consolidated financial statements for the year ended December 31, 2005, the Company determined that it had not timely designated the instruments as a cash flow hedges and was lacking certain other documentation for the derivatives entered into during the periods of 2004 and 2005. As a result, the Company is restating in this Form 10-K/A the consolidated financial information for 2004 (and the quarterly financial data for all periods in 2004 and the first three quarters in 2005), accounting for them as non-designated derivatives. Accordingly, these derivatives will be marked-to-market at the end of each period and the realized and unrealized gain or loss will be recorded as market to market gains and losses on derivatives, net within other income on the Company’s Statement of Income. See Note 3 of the notes to the consolidated financial statements for further discussion of the financial restatement.

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.

For a discussion of the impact of changes in the prices of oil and gas on our hedging transactions, see “Volatility of Oil and Natural Gas Prices” below. Our Board of Directors sets all of our risk management policies, and reviews volumes, types of instruments and counterparties, on a quarterly basis. These policies are followed 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 derivative activities quarterly.

During the third quarter of 2005, we entered into interest rate swap agreements with respect to amounts outstanding under the Second Lien Credit Facility. These arrangements are designed to manage our exposure to interest rate fluctuations during the period beginning January 1, 2006 through June 30, 2007 by effectively exchanging existing obligations to pay interest based on floating rates for obligations to pay interest based on fixed LIBO rates. These derivatives will be marked-to-market at the end of each period and the realized and unrealized gain or loss will be recorded as market to market gains and losses on derivatives, net within other income on the Company’s Statement of Income.

Income Taxes

Under Statement of Financial Accounting Standards No. 109 (“SFAS No. 109”), “Accounting for Income Taxes,” deferred income taxes are recognized at each year end 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. We routinely assess the realizability of our deferred tax assets. We consider future taxable income in making such assessments. If we conclude that it is more likely than not that some portion or all of the deferred tax assets will not be realized under accounting standards, it is reduced by a valuation allowance. However, despite our attempt to make an accurate estimate, the ultimate utilization of our deferred tax assets is highly dependent upon our actual production and the realization of taxable income in future periods.

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.

 
 

 

54