UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

For the quarterly period ended September 30, 2004

OR

For the transition period from                     to                    

Commission File No. 001-11899

THE HOUSTON EXPLORATION COMPANY

1100 Louisiana Street, Suite 2000
Houston, Texas 77002-5215
(Address of principal executive offices and zip code)

(713) 830-6800
(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Securities Exchange Act of 1934).

As of November 4, 2004, 28,229,624 shares of Common Stock, par value $.01 per share, were outstanding.

THE HOUSTON EXPLORATION COMPANY

TABLE OF CONTENTS

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Forward-Looking Statements

All of the estimates and assumptions contained in this Quarterly Report constitute forward-looking statements as that term is defined in Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking statements generally can be identified by words such as “anticipate,” “believe,” “intend,” “expect,” “continue,” “estimate,” “may,” “project,” “will,” or similar expressions. Forward-looking statements will include all discussions under the caption “Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations” relating to:

•		future production;
•		expected costs and expenses;
•		anticipated capital expenditure;
•		future cash flows and borrowings;
•		pursuit of potential future acquisition opportunities; and
•		sources of funding and the timing of exploration and development.

Although we believe that these forward-looking statements are based on reasonable assumptions, our expectations may not occur, and we cannot guarantee that the anticipated future results will be realized. A number of factors could cause our actual future results to differ materially from those anticipated or implied in the forward-looking statements. These factors include, among other things:

•		the volatility of natural gas and oil prices;
•		the requirement to take writedowns if natural gas and oil prices decline or if our finding and development costs continue to increase;
•		the relatively short production lives of our reserves;
•		our ability to find, develop and acquire natural gas and oil reserves;
•		acquisition and investment risks;
•		our ability to meet our substantial capital requirements;
•		our outstanding indebtedness;
•		the uncertainty of estimates of natural gas and oil reserves and production rates;
•		the inherent hazards and risks involved in our operations;
•		dependence upon operations concentrated in three primary areas;
•		drilling risks;
•		our hedging activities;
•		compliance with environmental and other governmental regulations;
•		the competitive nature of our industry;
•		weather risks and other natural disasters;
•		our customers’ ability to meet their obligations; and,
•		the influence by our significant shareholder, KeySpan Corporation

For additional discussion of these risks uncertainties and assumptions, see “Items 1. and 2. Business and Properties” and “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” contained in our Annual Report on Form 10-K for the year ended December 31, 2003. We undertake no obligation to publicly update or revise any forward-looking statements.

In this Quarterly Report, unless the context requires otherwise, when we refer to “we,” “us” or “our”, we are describing The Houston Exploration Company and through May 31, 2004, our subsidiary on a consolidated basis. Unless otherwise stated, all reserve and production quantities are expressed net to our interests.

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Part I. Financial Information

THE HOUSTON EXPLORATION COMPANY

The accompanying notes are an integral part of these consolidated financial statements.

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THE HOUSTON EXPLORATION COMPANY

The accompanying notes are an integral part of these consolidated financial statements.

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THE HOUSTON EXPLORATION COMPANY

The accompanying notes are an integral part of these consolidated financial statements.

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THE HOUSTON EXPLORATION COMPANY

NOTE 1 — Summary of Organization and Significant Accounting Policies

Our Business

We are an independent natural gas and oil company engaged in the exploration, development, exploitation and acquisition of natural gas and oil reserves in North America. Natural gas is our primary focus. Our primary areas of operations are South Texas, offshore in the shallow waters of the Gulf of Mexico and the Arkoma Basin of Oklahoma and Arkansas. During 2003, we began operations in the Rocky Mountain region, with a current focus on the Uinta Basin of Northeastern Utah and the DJ Basin of Eastern Colorado. In February 2004, we divested our South Louisiana assets and in June 2004, we divested our Appalachian Basin assets in connection with the KeySpan Exchange transaction described below.

We were founded by KeySpan Corporation in December 1985 and completed an initial public offering in 1996. KeySpan is a diversified energy provider whose principal natural gas distribution and electric generation operations are located in the Northeastern United States. As a result of an asset exchange transaction with KeySpan completed on June 2, 2004, and described below, KeySpan’s ownership in the outstanding shares of our common stock was reduced from approximately 54% to 24%. KeySpan’s ownership interest in our common stock was further reduced to 23% at September 30, 2004 as a result of the dilutive effect of stock options exercised during the third quarter of 2004. KeySpan has publicly announced it does not consider its investment in our company to be a core asset and that it may therefore decide from time to time to sell part of its investment in our shares.

KeySpan Exchange and Offering

On June 2, 2004, we completed an asset exchange transaction with KeySpan pursuant to which we redeemed and cancelled 10,800,000 shares of our common stock owned by KeySpan in exchange for all the stock of Seneca-Upshur Petroleum, Inc., our wholly-owned subsidiary, to which we contributed all of our Appalachian Basin assets valued at $60 million and $389 million in cash for a total exchange value of $449 million. This transaction is referred to as the “KeySpan Exchange.” The KeySpan Exchange is intended to qualify as a tax-free exchange under Section 355(a) of the Internal Revenue Code.

To fund the cash portion of the exchange, on June 2, 2004, we sold 6,200,000 shares of our common stock in a registered public offering at $48.00 per share, (the “Offering”) and contributed to Seneca-Upshur substantially all of the net proceeds from the Offering for a total of $282 million together with an additional $107 million of proceeds from bank borrowings. We then conveyed to KeySpan all of the shares of Seneca-Upshur in exchange for 10,800,000 shares of our common stock.

On June 23, 2004, the underwriters of our Offering exercised a portion of their over-allotment option and we sold an additional 620,000 shares of common stock at $48.00 per share for net proceeds of $28.6 million. The proceeds from the over-allotment were used to reduce bank borrowings.

Our redemption and cancellation of the 10,800,000 shares received from KeySpan and our issuance of 6,820,000 new shares resulted in a net 3,980,000 decrease in the outstanding shares of our common stock, and thereby reduced KeySpan’s ownership from approximately 54% to 24%. As a result of the KeySpan Exchange and Offering, our bank borrowings increased by a net $79 million and we incurred approximately $5.1 million in compensation and other expenses related to special bonuses awarded to executives and key employees who assisted in structuring and consummating the transactions. Finally, KeySpan agreed to reduce its representation on our Board of Directors from five to two directors. Our Chief Executive Officer, William G. Hargett, was elected Chairman of the Board replacing Robert B. Catell, Chairman and Chief Executive Officer of KeySpan, who still remains on the Board.

Principles of Consolidation

On June 2, 2004, all of the shares of our wholly-owned subsidiary, Seneca-Upshur, were conveyed to KeySpan in connection with the KeySpan Exchange. Subsequent to the transaction, Seneca-Upshur is no longer a subsidiary of Houston Exploration but is a wholly-owned subsidiary of KeySpan, and as a result, our financial statements reflect the consolidated results of Seneca-Upshur through May 31, 2004. Seneca-Upshur was our only subsidiary, and prior to the KeySpan Exchange, our consolidated financial statements included our accounts and the accounts of Seneca-Upshur. All significant inter-company balances and transactions were eliminated.

Seneca-Upshur is in the exploration and production business in West Virginia with interests in Appalachian Basin assets. As of December 31, 2003, we had 50.5 Bcfe of estimated proved reserves in the Appalachian Basin. Because we account

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THE HOUSTON EXPLORATION COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

for our natural gas and oil assets under the full cost method of accounting, the disposition of our Appalachian Basin assets, which represented only a portion of our full cost pool, is not considered discontinued operations under the Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standards (“SFAS”) 144.

Interim Financial Statements

Our balance sheet at September 30, 2004, and the statements of operations and cash flows for the periods indicated herein have been prepared without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) have been condensed or omitted, although we believe that the disclosures contained herein are adequate to make the information presented not misleading. The balance sheet at December 31, 2003, is derived from the December 31, 2003, audited financial statements, but does not include all disclosures required by GAAP. The financial statements included herein should be read in conjunction with the Consolidated Financial Statements and Notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2003.

In the opinion of our management, these financial statements reflect all adjustments necessary for a fair statement of the results for the interim periods, on a basis consistent with the annual audited financial statements. All such adjustments are of a normal recurring nature. The results of operations for such interim periods are not necessarily indicative of the results for the full year.

Use of Estimates

The preparation of the consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the dates of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Estimates of our remaining proved natural gas and oil reserves are one of our most significant financial estimates. Estimates of proved reserves are key components of our depletion rate for natural gas and oil properties and our full cost ceiling test limitation. Because there are numerous uncertainties inherent in the estimation process, actual results could differ materially from these estimates.

Business Segment Information

SFAS 131, “Disclosures about Segments of an Enterprise and Related Information” establishes standards for reporting information about operating segments. All of our operations involve the exploration, development and production of natural gas and oil and all of our operations are located in the United States. We have a single, company-wide management team that administers all properties as a whole rather than as discrete operating segments. We measure financial performance as a single enterprise and not on an area-by-area basis. Consequently, while we compile and analyze basic operational data by area, we do not prepare separate financial statement information by area and are not, therefore, required to report separate business segment information under SFAS 131.

Revenue Recognition

We use the entitlements method of accounting for the recognition of natural gas and oil revenues. Under this method of accounting, income is recorded based on our net revenue interest in production or nominated deliveries. We incur production gas volume imbalances in the ordinary course of business. Net deliveries in excess of entitled amounts are recorded as liabilities, while net under deliveries are reflected as assets. Imbalances are reduced either by subsequent recoupment of over-and-under deliveries or by cash settlement, as required by applicable contracts. Production imbalances are marked-to-market at the end of each month at the lowest of (i) the price in effect at the time of production; (ii) the current market price; or (iii) the contract price, if a contract is in hand.

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THE HOUSTON EXPLORATION COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

Net Income Per Share

Basic earnings per share is calculated by dividing net income by the weighted average number of shares of common stock outstanding during the period. No dilution for any potentially dilutive securities is included. Fully diluted earnings per share is calculated by applying the treasury stock method to adjust the average number of common shares outstanding for the dilutive effect, if any, of the assumed conversion of potentially convertible securities.

The calculation of shares outstanding for fully diluted EPS does not include the effect of outstanding stock options to purchase 404,001 and 1,843,150 shares for the three months ended September 30, 2004 and 2003, respectively, and 907,956 and 1,880,107 shares for the nine months ended September 30, 2004 and 2003, respectively, because to include would have an antidilutive effect on earnings per share.

Comprehensive Income

Comprehensive Income includes Net Income and certain items recorded directly to Stockholders’ Equity and Classified as Other Comprehensive Income. The table below summarizes Comprehensive Income and provides the components of the change in Accumulated Other Comprehensive Income for the three-month and nine-month periods ended September 30, 2004 and 2003, respectively.

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THE HOUSTON EXPLORATION COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

Natural Gas and Oil Properties

Full Cost Accounting. We use the full cost method to account for our natural gas and oil properties. Under full cost accounting, all costs incurred in the acquisition, exploration and development of natural gas and oil reserves are capitalized into a “full cost pool.” Capitalized costs include costs of all unproved properties, internal costs directly related to our natural gas and oil activities and capitalized interest. We amortize these costs using a unit-of-production method. We compute the provision for depreciation, depletion and amortization quarterly by multiplying production for the quarter by a depletion rate. The depletion rate is determined by dividing our total unamortized cost base by net equivalent proved reserves at the beginning of the quarter. Our total unamortized cost base is the sum of our:

•		full cost pool (including assets associated with retirement obligations); plus,
•		estimates for future development costs; less,
•		unevaluated properties and their related costs; less,
•		estimates for salvage.

Costs associated with unevaluated properties are excluded from the amortization base until we have made a determination as to the existence of proved reserves. We review our unevaluated properties at the end of each quarter to determine whether the costs incurred should be reclassified to the full cost pool and thereby subject to amortization. Sales of natural gas and oil properties are accounted for as adjustments to the full cost pool, with no gain or loss recognized, unless the adjustment would significantly alter the relationship between capitalized costs and proved reserves.

Under full cost accounting rules, total capitalized costs are limited to a ceiling equal to the present value of future net revenues, discounted at 10% per annum, plus the lower of cost or fair value of unproved properties less income tax effects (the “ceiling limitation”). We perform a quarterly ceiling test to evaluate whether the net book value of our full cost pool exceeds the ceiling limitation. If capitalized costs (net of accumulated depreciation, depletion and amortization) less related deferred taxes are greater than the discounted future net revenues or ceiling limitation, a writedown or impairment of the full cost pool is required. A writedown of the carrying value of the full cost pool is a non-cash charge that reduces earnings and impacts stockholders’ equity in the period of occurrence and typically results in lower depreciation, depletion and amortization expense in future periods. Once incurred, a writedown is not reversible at a later date.

The ceiling test is calculated using natural gas and oil prices in effect as of the balance sheet date and adjusted for “basis” or location differential, held constant over the life of the reserves. We use derivative financial instruments that qualify for cash flow hedge accounting under SFAS 133 to hedge against the volatility of natural gas prices, and in accordance with SEC guidelines, we include estimated future cash flows from our hedging program in our ceiling test calculation. In addition, subsequent to the adoption of SFAS 143, “Accounting for Asset Retirement Obligations,” the future cash outflows associated with settling asset retirement obligations are not included in the computation of the discounted present value of future net revenues for the purposes of the ceiling test calculation.

Unevaluated Properties. The costs associated with unevaluated properties and properties under development are not initially included in the amortization base and relate to unproved leasehold acreage, seismic data, wells and production facilities in progress and wells pending determination together with interest costs capitalized for these projects. Unevaluated leasehold costs are transferred to the amortization base with the costs of drilling the related well or upon expiration of a lease. Costs of seismic data are allocated to various unproved leaseholds and transferred to the amortization base with the associated leasehold costs on a specific project basis. Costs associated with successful wells in progress and wells pending determination are transferred to the amortization base once a determination is made whether or not proved reserves can be assigned to the property. Costs of dry holes are transferred to the amortization base immediately upon determination that the well is unsuccessful. All items included in our unevaluated property balance are assessed on a quarterly basis for possible impairment or reduction in value. We believe that substantially all of the costs included in our unevaluated property balance will be evaluated in the next four years.

Classification of Intangible Leasehold Costs

In September 2004, FASB issued FASB Staff Position (“FSP”) FAS 142-2, “Application of FASB Statement 142, Goodwill and Other Intangible Assets to Oil and Gas Producing Entities.” This FSP was issued as a result of questions arising as to whether the scope exception in paragraph 8(b) of SFAS 142 includes the balance sheet classification and disclosures for drilling and mineral rights of oil and gas producing entities. The FSP FAS 142-2 concludes that the scope

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THE HOUSTON EXPLORATION COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

exception in SFAS 142 does extend to the balance sheet classification and disclosure provisions for drilling and mineral rights of oil and gas producing entities that are within the scope of SFAS 19, “Financial Accounting and Reporting by Oil and Gas Producing Companies.” As a result, mineral rights held under lease or other contractual arrangements together with cash costs for the acquisition of natural gas and oil leasehold interests are not required to be separately classified as intangibles on the balance sheet. Historically, we have included these types of intangible leasehold costs as a component of natural gas and oil properties, which is consistent with the FSP. As such, our consolidated financials statements were not affected.

Asset Retirement Obligations

On January 1, 2003, we adopted SFAS 143, “Accounting for Asset Retirement Obligations,” which addresses accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. For us, asset retirement obligations (“ARO”) represent the systematic, monthly accretion and depreciation of future abandonment costs of tangible assets such as platforms, wells, service assets, pipelines, and other facilities. SFAS 143 requires that the fair value of a liability for an asset’s retirement obligation be recorded in the period in which it is incurred if a reasonable estimate of fair value can be made, and that the corresponding cost is capitalized as part of the carrying amount of the related long-lived asset. The liability is accreted to its then present value each period, and the capitalized cost is depreciated over the useful life of the related asset. If the liability is settled for an amount other than the recorded amount, a gain or loss is recognized and an a