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. |