Derivative Instruments

The Company uses derivatives, typically fixed-rate swaps and costless collars, to manage price and interest rate risk underlying our oil and gas production and the variable interest rate on the Second Lien Credit Facility. 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.

The Company’s Board of Directors sets all of our risk management policies and reviews volume limitations, types of instruments and counterparties, on a quarterly basis. These policies require that derivative instruments be executed only 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 approved 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.

Upon entering into a derivative contract, the Company either designates the derivative instrument as a hedge of the variability of cash flow to be received (cash flow hedge) or the derivative must be accounted for as a non-designated derivative. All of the Company’s derivative instruments at December 31, 2005 and December 31, 2006 were treated as non-designated derivatives and the unrealized gain/(loss) related to the mark-to-market valuation was included in the Company’s earnings.

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. See “Item 1A. 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 “—Summary of Critical Accounting Policies—Oil and Natural Gas Properties” and “Item 1A. Risk Factors— We may record ceiling limitation write-downs that would reduce our shareholders’ equity.”

To mitigate some of our commodity price risk, we engage periodically in certain other limited derivative activities including price swaps, costless collars and, occasionally, put options, in order to establish some price floor protection. We do not hold or issue derivative instruments for trading purposes.

Total oil purchased and sold under swaps and collars during 2006, 2005 and 2004 were 82,200 Bbls, 108,500 Bbls and 121,700 Bbls, respectively. Total natural gas purchased and sold under swaps and collars in 2006, 2005 and 2004 were 5,171,000 MMBtu, 3,892,000 MMBtu and 3,936,000 MMBtu, respectively. The net gains (losses) realized by the Company under such derivative arrangements were $5.6 million, $(2.3) million and $(1.0) million for 2006, 2005 and 2004, respectively, and were included in net gain (loss) on derivatives.

As of December 31, 2006, 2005 and 2004 unrealized gains and (losses) on oil and gas derivatives of $9.9 million, $(4.2) million and $0.4 million, respectively, were included in net gain (loss) on derivatives.

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 derivative transactions with two