KCS ENERGY INC - 10-K Annual Report

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K

[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 2004
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM TO

COMMISSION FILE NUMBER 001-13781
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KCS ENERGY, INC.
(Exact name of registrant as specified in its charter)

DELAWARE 22-2889587
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
5555 SAN FELIPE ROAD, SUITE 1200, 77056
HOUSTON, TEXAS (Zip Code)
(Address of principal executive offices)

REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (713) 877-8006

SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:

SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:
NONE
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 [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes [X] No [ ]
The aggregate market value of the 46,513,928 shares of the registrant's
common stock, par value $0.01 per share, held by non-affiliates of the
registrant at the $13.32 closing price on June 30, 2004 (the last business day
of the registrant's most recently completed second fiscal quarter) was
$619,565,521.
Indicate by check mark whether the registrant has filed all documents and
reports required to be filed by Section 12, 13 or 15(d) of the Securities
Exchange Act of 1934 subsequent to the distribution of securities under a plan
confirmed by a court. Yes [ ] No [ ]
Not applicable. Although the registrant was involved in bankruptcy
proceedings during the preceding five years, the registrant did not distribute
securities under its plan of reorganization.
The number of shares of the registrant's common stock, par value $0.01 per
share, outstanding as of the close of business on March 10, 2005: 49,777,229.

DOCUMENTS INCORPORATED BY REFERENCE
Portions of the registrant's Proxy Statement for the Annual Meeting of
Stockholders to be held on May 26, 2005 are incorporated by reference into Part
III of this annual report on Form 10-K. Except with respect to information
specifically incorporated by reference in this Form 10-K, the Proxy Statement
for the Annual Meeting of Stockholders is not deemed to be filed as part hereof.
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TABLE OF CONTENTS

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Quantities of natural gas are expressed in this annual report on Form 10-K
in terms of thousand cubic feet (Mcf), million cubic feet (MMcf) or billion
cubic feet (Bcf). Natural gas sales volumes and amounts hedged under derivative
contracts may be expressed in terms of one million British thermal units
(MMBtu), which is equal to one Mcf containing 1,000 British thermal units (Btu)
per cubic foot. The average Btu content of our natural gas reserves is in excess
of 1,000 Btu per cubic foot. Oil and natural gas liquids are quantified in terms
of barrels (bbls) and thousands of barrels (Mbbls). Oil and natural gas liquids
are compared with natural gas in terms of thousand cubic feet equivalent (Mcfe),
million cubic feet equivalent (MMcfe) and billion cubic feet equivalent (Bcfe).
For purposes of comparing oil and natural gas liquids to natural gas on a per
unit equivalent basis, one barrel of oil or natural gas liquids is the energy
equivalent of six Mcf of natural gas. With respect to information relating to
our working interest in wells or acreage, "net" oil and gas wells or acreage is
determined by multiplying gross wells or acreage by our working interest in the
oil and gas wells or acreage. Unless otherwise specified, all references to
wells and acres are gross. Working interest, or "WI", is the net percentage
ownership interest in a well that gives the owner the right to drill, produce
and conduct operating activities on the property and a share of the production.

References to "proved reserves" in this annual report on Form 10-K refer to
the estimated quantities of crude oil, natural gas and natural gas liquids which
geological and engineering data demonstrate with reasonable certainty to be
recoverable in future years from known reservoirs under existing economic and
operating conditions. The term "proved developed reserves" refers to reserves
that can be expected to be recovered through existing wells with existing
equipment and operating methods. The term "proved undeveloped reserves" refers
to reserves that are expected to be recovered from new wells on undrilled
acreage, or from existing wells where a relatively major expenditure is required
for recompletion. The term "recompletion" refers to the completion for
production of an existing wellbore in another formation from that in which the
well has previously been completed. The term "productive well" refers to a well
that is producing oil or natural gas or that is capable of production. The term
"workover" refers to operations on a producing well to restore or increase
production from an existing formation or recomplete to a new formation.

This annual report on Form 10-K refers to the pre-tax present value of
estimated future net revenues, or "PV-10 value," of our oil and natural gas
reserves. The PV-10 value of reserves refers to the pre-tax present value of
estimated future net revenues, computed by applying year-end prices to estimated
future production from the reserves, deducting estimated future expenditures,
and applying a discount factor of 10%. In accordance with applicable
requirements of the Securities and Exchange Commission, the PV-10 value is
generally based on prices and costs as of the date of the estimate. In contrast,
the actual future prices and costs may be materially higher or lower. Please do
not interpret the PV-10 values as the current market value of our properties'
estimated oil and natural gas reserves. The standardized measure of discounted
future net cash flows, or "Standardized Measure", differs from PV-10 value
because Standardized Measure includes the present value effect of future income
taxes.

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PART I

ITEM 1. BUSINESS.

GENERAL

KCS Energy, Inc., a Delaware corporation, is an independent oil and gas
company engaged in the acquisition, exploration, development and production of
natural gas and crude oil. Our properties are primarily located in the
Mid-Continent and onshore Gulf Coast regions of the United States. We also have
interests in producing properties in Michigan, California, Wyoming and offshore
Gulf of Mexico. As of December 31, 2004, our oil and natural gas properties were
estimated to have net proved reserves of approximately 328 Bcfe with a PV-10
value of $814 million. Approximately 88% of our net proved reserve base was
natural gas and approximately 76% was classified as proved developed. We operate
approximately 84% of our proved oil and natural gas reserve base. The following
table sets forth the estimated quantities of proved reserves attributable to our
principal operating regions as of December 31, 2004.

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(1) Includes Michigan and Wyoming

(2) Includes California

In 2004, we produced an average of 109.2 MMcfe per day compared to 95.2
MMcfe per day in 2003. We plan to continue growing our reserves and production
through a balanced investment program in low-risk exploitation activities in the
Mid-Continent and Gulf Coast regions and moderate-risk, higher potential
exploration drilling programs primarily in the onshore Gulf Coast region.

We are a publicly-owned company whose stock is traded on the New York Stock
Exchange under the symbol "KCS." We were incorporated in Delaware in 1988 in
connection with the spin-off of the non-utility businesses of a New Jersey-based
natural gas distribution company. Our principal executive offices are located at
5555 San Felipe Road, Suite 1200, Houston, Texas 77056. Our telephone number is
(713) 877-8006. Unless the context otherwise requires, the terms "KCS," "we,"
"our" or "us" refer to KCS Energy, Inc. and its subsidiaries.

2004 HIGHLIGHTS

The year ended December 31, 2004 was an outstanding year for us. We drilled
a record 130 wells during 2004, of which 126 were completed, resulting in a 97%
success rate and significantly increased production and reserves. In 2004, gross
production increased 15%, to 40 Bcfe, while net production after production
payment delivery obligations, that do not contribute to cash flow from operating
activities, increased 25% compared to 2003. Natural gas and oil reserves
increased 22% to 328 Bcfe as of December 31, 2004 compared to 268 Bcfe as of
December 31, 2003. In total, we added 94.5 Bcfe of proved reserves during 2004,
of which 97% was through the drill bit. Total oil and gas capital expenditures
were $166.7 million.

In 2004, we continued to execute our strategies of focusing on low-risk
development and exploitation drilling in our core operating areas and to commit
approximately 15% of our capital expenditure budget to moderate-risk,
higher-potential exploration prospects primarily in the onshore Gulf Coast
region. In 2005, we plan to commit approximately 15% to 20% of our capital
expenditure budget to such exploration projects. We continue to focus primarily
on natural gas prospects. We have continued our disciplined hedging program
designed to protect against price declines while participating to a large extent
in future price increases. In this

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way, we endeavor to ensure that we generate a sufficient level of cash flow to
carry out a capital expenditure program sufficient to at least replace our
expected production and still benefit if prices rise.

We further strengthened our financial condition in 2004 and provided
additional financial flexibility by completing a $175 million senior notes
offering. The new senior notes bear interest at an annual rate of 7 1/8% and
mature in 2012. The proceeds of this issuance were used to redeem our $125
million 8 7/8% senior subordinated notes due 2006, including an early redemption
premium, and to repay the $22 million outstanding under our bank credit
facility. As of December 31, 2004, we had $6.6 million of cash on hand and $100
million of unused committed borrowing capacity under our bank credit facility.
We plan to maintain a conservative capital structure. Please read Note 6 to our
Consolidated Financial Statements for more information regarding our senior
notes and our bank credit facility.

We believe that the steps taken during 2004, along with our multi-year
drilling prospect inventory, position us to increase production and reserves in
2005 and beyond.

COMPETITIVE STRENGTHS AND BUSINESS STRATEGIES

We intend to continue to increase production and reserves to optimize
stockholder value by executing the following strategies:

- Focus on Natural Gas -- As of December 31, 2004, our proved reserves were
88% natural gas. We believe that the future need for natural gas in the
United States will continue to grow and that natural gas is better
insulated from the price volatility associated with global geopolitical
instability. In addition, North American supplies of natural gas have
been declining in recent years. Lease operating expenses associated with
natural gas properties are also typically less than oil properties, which
allows us to maintain our low per-unit cost structure.

- Grow Through the Drill Bit -- We believe our personnel possess
exceptional knowledge in identifying, drilling and stimulating tight rock
formations. We also think that the economics of drilling self-generated
prospects are superior to those of acquiring reserves. Over the last
three years, we have added 217 Bcfe to our reserves, of which 95% were
through the drill bit. With our inventory of drilling prospects, we
believe that we are well-positioned to continue growing our reserves and
production.

- Exploit Our Large Inventory of Drilling Projects -- We have a significant
inventory of future drilling locations in targeted areas. Generally,
these locations range in depth from 5,000 feet to 13,000 feet and are low
risk opportunities. Most of the locations are step-out or extension wells
from existing production.

- Concentrate in Core Areas -- We concentrate our drilling programs
predominately in the Mid-Continent and Gulf Coast regions. Operating in
concentrated areas helps us to better control our overhead by enabling us
to manage a greater amount of acreage with fewer employees and minimize
incremental costs of increased drilling and production. Our strategy of
targeting our operations in relatively concentrated areas permits us to
more efficiently capitalize on our base of geological, engineering,
exploration, development, completion and production experience in these
regions. The areas we produce generally have high price realizations
relative to benchmark prices for natural gas production and favorable
operating costs.

- Control Drilling and Production Operations -- We operate approximately
84% of our proved oil and natural gas reserve base as of December 31,
2004. We prefer to generate and retain operating control over our own
prospects rather than owning non-operated interests. This allows us to
more effectively control operating costs, the timing and plans for future
development, the level of drilling and the marketing of production on the
properties. In addition, as an operator, we receive reimbursements for
overhead from other working interest owners, which reduces our general
and administrative expenses. During the year ended December 31, 2004, we
controlled the drilling operations on 93 of the 130 wells in which we
participated.

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- Search for Complimentary Acquisitions -- We proactively search for
acquisitions in our core areas to expand our acreage position and
drilling inventory. Two recent examples of this were the O'Connor Ranch
acreage acquisition in the third quarter of 2004 that compliments our
south Texas drilling program and our recently announced acquisition of
properties in our North-Louisiana-East Texas core operating area. Please
read Note 15 to our Consolidated Financial Statements for more
information regarding our recently announced acquisition which is
currently scheduled to close in mid-April 2005.

- Employ Experienced Technical Professionals -- We employ oil and gas
professionals, including geophysicists, petrophysicists, geologists,
petroleum engineers, production and reservoir engineers and landmen who
have an average of approximately 25 years of experience in their
technical fields. We continually apply our extensive in-house expertise
and advanced technologies to benefit our drilling and completion
operations.

- Maintain Financial Flexibility -- The timing of most of our capital
expenditures is discretionary. Consequently, we have a significant degree
of flexibility to adjust the level of expenditures according to market
conditions. We currently anticipate spending approximately $190 million,
exclusive of acquisitions, on capital projects in 2005. We expect that
these projects will be funded primarily with internally generated cash
flow.

- Control Risk -- We allocate approximately 80% of our capital on an annual
basis to low risk development and exploitation projects and the remainder
to moderate risk exploration plays. We set limits on the amount of
capital we will invest in any one exploration project. We hedge a portion
of our oil and natural gas to protect against downward price swings, and
we control costs closely to ensure the best possible profit margins. In
addition, we turnkey our drilling operations where economic in order to
reduce drilling risk.

CORE OPERATING AREAS

MID-CONTINENT

In the Mid-Continent region, we concentrate our drilling programs primarily
in north Louisiana, east Texas, Oklahoma (Anadarko and Arkoma basins) and west
Texas. Our Mid-Continent operations provide us with a solid base for production
and reserve growth. We plan to continue to exploit areas within the various
basins that require low-risk exploitation wells for additional reservoir
drainage. Our exploitation wells are generally step-out and extension type wells
with moderate reserve potential. During 2004, we drilled 101 wells in this
region with a success rate of 97%. In 2005, we plan to drill 90 to 115 wells in
this region, approximately half of which are planned in the Elm Grove Field
which is our largest field. We will also pursue drilling in the Sawyer Canyon,
Joaquin, Terryville and Talihina fields and have budgeted $20 million to
commence development of the properties being acquired in April 2005.

- Elm Grove Field -- Located in Bossier Parish of north Louisiana,
production from this field comes from the Hosston and Cotton Valley
formations. These zones are composed of low permeability rocks that
require large fracture stimulation treatments to produce. We operate nine
sections with WI ranging from 89 to 100%. We also have lesser interests
ranging from 5% to 82% in six other adjacent sections. In 2004, the field
contributed about 26% of our net production. As of December 31, 2004, we
had 116 Bcfe of proved reserves in this field that accounted for
approximately 38% of our PV-10 value.

We began a development program in late 2002 that included the drilling of
six wells. In 2003, we drilled 19 wells and in 2004 41 additional wells,
all of which were successful. This drilling activity increased gross
operated production from 6 MMcfe per day in 2002 to over 45 MMcfe per day
as of December 31, 2004. In 2005, we plan to drill 45 to 50 proved
undeveloped and step-out locations to continue growing production and
reserves.

- Sawyer Canyon Field -- Our second largest field, contributing
approximately 11% of our net production in 2004, is located in Sutton
County, west Texas. We are actively producing and developing on lands
comprising approximately 33,500 acres. Over the last several years, we
have been conducting drilling programs targeting shallow Canyon sandstone
formations. We have a 92% to 100% WI in most
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of the areas we are actively drilling. We drilled 25 wells in 2004 and
plan to drill approximately 20 to 30 additional wells in 2005.

- Joaquin Field -- We operate and have rights to approximately 8,200 acres
in this property located just west of the Texas-Louisiana border in
Shelby County, Texas which produce Travis Peak sands at depths of 6,000
to 8,600 feet. In 2004, we drilled nine wells in this field and
anticipate drilling approximately ten additional wells in 2005.

- Terryville Field -- We have 5,160 acres in this developing play. We
recently drilled our third well to test the potential of the Cotton
Valley sands in this area. We have preliminarily budgeted seven wells for
the acreage in 2005 which could lead to a future multi-well development
program of the acreage.

GULF COAST

In the Gulf Coast region, we concentrate our drilling programs primarily in
south Texas. We also have working interests in several minor non-operated
offshore and Mississippi salt basin properties. We conduct development programs
and pursue moderate-risk, higher potential exploration drilling programs in this
region. Our Gulf Coast operations have numerous exploration prospects that are
expected to provide us additional growth. During 2004, we drilled 13 exploration
and 16 development wells in this region with a success rate of 97%. We
anticipate drilling 40 to 50 wells in this region in 2005, approximately
three-fourths of which will be exploratory. In 2004, exploration success was
achieved in the La Reforma and Coquat fields. In the third quarter of 2004, we
acquired a 42,300 acre lease on the O'Connor Ranch and license to approximately
100 square miles of 3D seismic data in Goliad County, Texas. The 2005 drilling
program will be concentrated in O'Connor Ranch, La Reforma, Coquat and Austin
fields and the West Mission Valley area.

Wilcox Trend -- Our projects in the Wilcox trend are mostly located in
Harris, Goliad, Victoria and Live Oak counties in Texas. Our primary objectives
are the abnormally pressured Middle Wilcox sands, although we also produce from
normal-pressured Frio, Yegua and Upper Wilcox zones. Sandstones in these
formations are found at depths between 4,000 to 13,000 feet. In 2004, we drilled
five Wilcox exploration wells, all of which were successful. In addition, we
drilled seven Wilcox development wells. Normally, we generate these prospects
and retain a 25% to 60% WI. Over the last several years we have been expanding
our efforts in this area. In 2001, we purchased interests in the West Mission
Valley Field and participated in the discovery of the Marshall Field. In 2003,
we participated in discoveries at the Five Mile Creek Field and the East
Marshall Field. In 2004, we participated in the following areas:

- West Mission Valley Area, Goliad and Victoria Counties, Texas. We
drilled seven Wilcox wells in 2004, four of which we operated, with WI
ranging from 25% to 50%. Reservoirs are mid-Wilcox in age and are at
moderate depth ranges of 10,000 to 12,000 feet. We plan to drill an
additional nine Wilcox wells in this area in 2005.

- Coquat Field, Live Oak County, Texas. We drilled four successful wells
in 2004 in this KCS-operated field with WI ranging from 40% to 57%. The
drilling program increased our gross field production from less than 1
MMcfepd to over 21 MMcfepd. Four to five wells are scheduled for drilling
in Coquat in 2005, one of these, the Meider #7A, has been drilled and is
completing now. All of the productive zones are abnormally pressured
Wilcox reservoirs from 10,000 to 13,000 feet.

- O'Connor Ranch, Goliad County, Texas. In the third quarter of 2004, we
purchased 42,300 acres with accompanying 100 miles of 3D seismic data in
this KCS-operated field where our WI ranges from 55% to 95%. This
property is located immediately south and adjacent to West Mission
Valley. It is also contiguous to our production area in the Austin Field.
In 2005, we plan to drill 15 to 20 Frio wells at depths ranging of 3,000
to 4,000 feet. We also plan to drill Yegua prospects at depths
approximating 7,000 feet and Wilcox prospects at depths ranging from
12,000 to 14,500 feet.

Vicksburg Trend -- We also pursue Vicksburg formation prospects primarily
in our La Reforma Field in Hidalgo County, Texas. We drilled a successful
initial test well in late 2002, drilled one additional well in 2003 and four
wells in 2004. Since beginning this drilling program we have increased gross
production in this field

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from below 5 MMcfpd to over 50 MMcfepd in 2004. We plan on drilling three to
four additional wells in the La Reforma Field in 2005. Our WI in these wells is
either 24% or 31.5% depending on the well's location.

Other Gulf Coast -- We have minor, non-operated working interests in
several offshore blocks and in several fields in the Mississippi salt basin.

OTHER OPERATING AREAS

We also operate and own majority interests in fields located in the Niagran
Reef play of Michigan, several fields in Wyoming and one field in the Los
Angeles basin in California. As of December 31, 2004, these properties accounted
for approximately 10% of our PV-10 value. In 2004, we drilled four wells in
Michigan and participated in two development wells in a Wyoming unit.

OIL AND GAS PROPERTIES

We hold interests in all of our oil and gas properties through two
operating subsidiaries: KCS Resources, Inc., a Delaware corporation, and
Medallion California Properties Company, a Texas corporation. The oil and gas
properties referred to in this annual report on Form 10-K are held by these
subsidiaries. We treat all operations as one line of business.

The following table sets forth the number of gross and net producing wells
by region as of December 31, 2004.

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(1) Includes Michigan and Wyoming

(2) Includes California

OIL AND NATURAL GAS RESERVES

The following table sets forth, as of December 31, 2004, summary
information with respect to estimates of our proved oil and natural gas reserves
based on year-end prices. Oil and natural gas prices as of December 31, 2004 are
not necessarily indicative of the prices that we expect to receive in the
future. Accordingly, the pre-tax present value of future net revenues in the
following table should not be construed to be the current market value of the
estimated oil and natural gas reserves.

In accordance with Securities and Exchange Commission guidelines, the
estimates of future net revenues from our proved reserves and the present values
of our proved reserves are made using oil and natural gas sales prices in effect
as of the dates of those estimates and are held constant throughout the life of
the properties except where those guidelines permit alternate treatment. Natural
gas prices are based on either a contract price or a December 31, 2004 spot
price of $6.18 per MMBtu, adjusted by lease for Btu content, transportation

7

fees and regional price differentials. Oil prices are based on a December 31,
2004 West Texas Intermediate posted price of $40.25 per barrel, adjusted by
lease for gravity, transportation fees and regional price differentials. The
prices for natural gas and oil are subject to substantial seasonal fluctuations,
and prices for each are subject to substantial fluctuations as a result of
numerous other factors. Please read "Management's Discussion and Analysis of
Financial Condition and Results of Operations" and "Business -- Risk Factors"
for further discussion of these and other factors.

The estimates of our proved oil and natural gas reserves and associated
revenues, as of December 31, 2004, were prepared by us and were audited by
Netherland Sewell & Associates, Inc., or NSAI. NSAI follows the general
principles set forth in the standards pertaining to the estimating and auditing
of oil and gas reserve information promulgated by the Society of Petroleum
Engineers, or SPE.

A reserve audit as defined by the SPE is not the same as a financial audit.
The SPE's definition of a reserve audit includes the following concepts:

- A reserve audit is an examination of reserve information that is
conducted for the purpose of expressing an opinion as to whether such
reserve information, in the aggregate, is reasonable and has been
estimated and presented in conformity with generally accepted petroleum
engineering and evaluation principles.

- The estimation of reserves is an imprecise science due to the many
unknown geologic and reservoir factors that can only be estimated through
sampling techniques. Since reserves are only estimates, they cannot be
audited for the purpose of verifying exactness. Instead, reserve
information is audited for the purpose of reviewing in sufficient detail
the policies, procedures and methods used by a company in estimating its
reserves so that the reserve auditors may express an opinion as to
whether, in the aggregate, the reserve information furnished by the
company is reasonable and has been estimated and presented in conformity
with generally accepted petroleum engineering and evaluation principles.

- The methods and procedures used by a company, and the reserve information
furnished by the company, must be reviewed in sufficient detail to permit
the reserve auditor, in its professional judgment, to express an opinion
as to the reasonableness of the reserve information. In some cases, the
auditing procedure may require the reserve auditor to prepare its own
estimates of reserve information for particular properties. The
desirability of preparing its own estimates is determined by the reserve
auditor exercising its professional judgment.

In performing our reserve audit, NSAI does prepare its own estimates of
reserves for the majority our properties. As part of the audit process, we and
NSAI compare our reserve estimates, and often share additional data in order to
understand and narrow the gaps on properties where there are major variances in
the estimates. Once NSAI is satisfied that the reserve estimates are reasonable
and that their audit objectives have been met, the process is deemed complete.
When compared on a well-by-well or lease-by-lease basis, some of our estimates
of net proved reserves are greater and some are less than the estimates of NSAI.
We have been advised by NSAI that it generally issues a completed audit opinion
if its reserve estimates are within ten percent of a company's reserve
estimates. At the conclusion of the audit process, it is NSAI's opinion, as set
forth in its audit letter, that our estimates of our proved oil and natural gas
reserves and associated future net revenues are, in the aggregate, reasonable
and have been prepared in accordance with generally accepted petroleum
engineering and evaluation principles.

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PRODUCTION

The following table presents certain information with respect to production
attributable to our properties including average sales prices and unit costs for
the years ended December 31, 2004, 2003 and 2002.

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(a) Includes delivery obligations dedicated to a production payment transaction
whereby in February 2001 we sold 43.1 Bcfe (38.3 Bcf of natural gas and 797
Mbbl of oil) to be delivered over 60 months (the "Production Payment').
Production includes 5,170 MMcfe in 2004, 6,807 MMcfe in 2003 and 11,196
MMcfe in 2002 dedicated to the Production Payment. Please read Note 1 to
our Consolidated Financial Statements for more information on the
Production Payment.

(b) We sold properties in 2002 to reduce debt.

(c) We discontinued making new investments in VPPs in 1999 and final deliveries
from our VPP program were received in November 2002. The average production
cost per Mcfe in 2002 excludes the production received under our purchased
VPP program because that production was free from these expenses.

(d) The average realized prices reported above include the non-cash effects of
volumes delivered under the Production Payment as well as the unwinding of
various derivative contracts terminated in 2001. These items do not
generate cash to fund our operations. Excluding these items, the average
realized price per Mcfe was $5.85, $5.05 and $3.19 in 2004, 2003 and 2002,
respectively. For further information, please read "Management's Discussion
and Analysis of Financial Condition and Results of Operation -- Major
Influences on Results of Operations."

ACREAGE

The following table sets forth our developed and undeveloped leased acreage
as of December 31, 2004. The leases in which we have an interest are for varying
primary terms, and many require the payment of delay rentals to continue the
primary term. The operator may surrender the leases at any time by notices to
the

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lessors, the cessation of production, fulfillment of commitments, or failure to
make timely payments of delay rentals.

TITLE TO INTERESTS

We believe that title to the various interests set forth above is
satisfactory and consistent with the standards generally accepted in the oil and
gas industry, subject only to immaterial exceptions that do not detract
substantially from the value of the interests or materially interfere with their
use in our operations. Our owned interests may be subject to one or more
royalty, overriding royalty and other outstanding interests customary in the
industry. The interests may additionally be subject to obligations or duties
under applicable laws, ordinances, rules, regulations and orders of arbitral or
governmental authorities. In addition, the interests may be subject to burdens,
including production payments, net profits interests, development obligations
under oil and gas leases and other encumbrances, easements and restrictions.

DRILLING ACTIVITIES

During the three-year period ended December 31, 2004, we participated in
drilling 261 (169.2 net) wells with a success rate of 91%. During 2004, we
participated in drilling 130 (91.7 net) wells with a success rate of 97%. Our
drilling results for 2004 include 115 development wells and 15 exploration wells
with success rates of 98% and 87%, respectively. All of our drilling activities
are conducted through arrangements with independent contractors. The following
table sets forth certain information with respect to our drilling activities
during the years ended December 31, 2004, 2003 and 2002.

As of December 31, 2004, we were participating in the drilling of eight
(3.9 net) wells.

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OTHER FACILITIES

Our principal executive offices and those of our operating subsidiaries are
leased in modern office buildings in Houston, Texas and Tulsa, Oklahoma.

We believe that all of our property, plant and equipment are well
maintained, in good operating condition and suitable for the purposes for which
they are used.

REGULATION

General. Our business is affected by numerous laws and regulations,
including energy, environmental, conservation, tax and other laws and
regulations relating to the energy industry. Changes in any of these laws and
regulations could have a material adverse effect on our business. In light of
the many uncertainties related to current and future laws and regulations,
including their applicability to us, we may be unable to predict the overall
effect of current and future laws and regulations on our future operations.

We believe that our operations comply in all material respects with all
applicable laws and regulations. Although applicable laws and regulations have a
substantial impact upon the energy industry, generally these laws and
regulations do not appear to affect us any differently, or to any greater or
lesser extent, than other similar companies in the energy industry. The
following discussion describes certain laws and regulations applicable to the
energy industry and is qualified in its entirety by the foregoing.

State Regulations Affecting Production Operations. Our onshore
exploration, production and exploitation activities are subject to regulation at
the state level. Laws and regulations vary from state to state, but generally
include laws to regulate drilling and production activities and to promote
resource conservation. Examples of these state laws and regulations include laws
that:

- require permits and bonds to drill and operate wells;

- regulate the method of drilling and casing wells;

- establish surface use and restoration requirements for properties upon
which wells are drilled;

- regulate plugging and abandonment of wells;

- regulate the disposal of fluids used or produced in connection with
operations;

- regulate the location of wells, including establishing the minimum size
of drilling units and the minimum spacing between wells;

- concern unitization or pooling of oil and natural gas properties;

- establish maximum rates of production from oil and natural gas wells; and

- restrict the venting or flaring of natural gas.

These laws and regulations may adversely affect the profitability of affected
properties or our operations. We are unable to predict the future cost or impact
of complying with these regulations.

Federal Regulations Affecting Production Operations. We also operate
federal oil and natural gas leases that are subject to the regulation of the
United States Bureau of Land Management, or BLM, and the United States Minerals
Management Service, or MMS. Leases regulated by the BLM and MMS contain
relatively standardized terms requiring compliance with detailed regulations and
orders. These regulations specify, for example, lease operating, safety and
conservation standards, well plugging and abandonment requirements, and surface
restoration requirements. In addition, the BLM and MMS generally require us to
post surety bonds or other acceptable financial assurances to assure that our
obligations will be met. The cost of these bonds or other financial assurances
can be substantial and we may be unable to obtain bonds or other financial
assurances in all cases. Under certain circumstances, the BLM or MMS may require
operations on federal leases to be suspended or terminated. Any suspension or
termination under these leases may adversely affect our interests.

11

Additional proposals and proceedings that might affect the oil and natural
gas industry are pending before Congress, the Federal Energy Regulatory
Commission, or FERC, the MMS, the BLM, state commissions and the courts. We are
unable to predict when or whether any such proposals may become effective.
Historically, the natural gas industry has been very heavily regulated and for
many years was subject to price controls imposed by the federal government. The
current regulatory approach pursued by various agencies and Congress may not
continue indefinitely and it is possible Congress (or in the case of some
natural gas sales, the FERC) could reimpose price controls in the future.
Notwithstanding the foregoing, we do not anticipate that compliance with
existing federal, state and local laws, rules and regulations will have a
material or significantly adverse effect upon our capital expenditures, earnings
or competitive position.

Operating Hazards and Environmental Matters. The oil and natural gas
business involves a variety of operating risks, including the risk of fires,
natural disasters, explosions, well blowouts, adverse weather conditions,
mechanical problems, including pipe failure, abnormally pressured formations,
and environmental accidents, including oil spills, natural gas leaks or
ruptures, and discharges of toxic gases or other pollutants. The occurrence of
these risks could result in substantial losses to us due to personal injury,
loss of life, damage to or destruction of wells, production facilities, natural
resources or other property or equipment, pollution and other environmental
damage. These occurrences could also subject us to clean-up obligations,
regulatory investigation, penalties or suspension of operations. Although we
believe we are adequately insured, these hazards may hinder or delay drilling,
development and production operations.

Oil and natural gas operations are subject to extensive federal, state and
local laws and regulations that regulate the discharge of materials into the
environment or otherwise relate to the protection of the environment. These laws
and regulations may:

- require the acquisition of a permit before drilling commences;

- restrict the types, quantities and concentration of substances that can
be released into the environment;

- restrict drilling activities on certain lands, including wetlands or
other protected areas; and

- impose substantial liabilities for pollution resulting from drilling and
production operations.

Failure to comply with these laws and regulations may also result in civil and
criminal fines and penalties.

Our properties, and any wastes spilled or disposed of by us, may be subject
to federal or state environmental laws that could require us to remove the
wastes or remediate contamination. For example, the Comprehensive Environmental
Response, Compensation and Liability Act, or CERCLA, also known as the
"Superfund" law, imposes liability, without regard to fault or the original
conduct, on certain classes of persons who are considered to be responsible for
the release of a "hazardous substance" into the environment. These persons
include the present or former owner or operator of the disposal site or sites
where the release occurred and companies that disposed, or arranged for the
disposal, of the hazardous substances. Under CERCLA, these persons may be
subject to joint and several liability for the costs of cleaning up the
hazardous substances, for damages to natural resources and for the costs of
certain health studies. In addition, neighboring landowners and other third
parties may assert claims for personal injury and property damage allegedly
caused by the release of hazardous substances.

Our operations may also be subject to the Clean Air Act, or CAA, and
comparable state and local requirements. Pursuant to these requirements, we may
be required to incur certain capital expenditures for air pollution control
equipment in connection with maintaining or obtaining permits and approvals
relating to air emissions. We do not believe that our operations will be
materially adversely affected by these requirements.

In addition, the United States Oil Pollution Act, or OPA, requires owners
and operators of facilities in or near rivers, creeks, wetlands, coastal waters,
offshore waters, and other United States waters to adopt and implement plans and
procedures to prevent oil spills. OPA also requires affected facility owners and
operators in coastal waters to demonstrate that they have at least $10 million
in financial resources to pay for the costs of the remediation of an oil spill
and compensating any parties damaged by an oil spill. These financial assurances
may be increased to as much as $150 million depending on a facility's worst case
oil spill discharge volume and other relative operational, environmental and
human health risks.

12

Our operations are also subject to the federal Clean Water Act, or CWA, and
analogous state laws. Among other matters, these laws may prohibit the discharge
of waters produced in association with hydrocarbons into coastal waters. To
comply with this prohibition, we may be required to incur capital expenditures
or increased operating expenses. The CWA also regulates discharges of storm
water runoff. This program requires covered facilities to obtain individual
permits, participate in a group permit or seek coverage under a general permit.
While certain of our properties may require permits for discharges of storm
water runoff, we believe that we will be able to obtain, or be included under,
these permits as necessary. Coverage under these permits may require us to make
minor modifications to existing facilities and operations that would not have a
material adverse effect on us.

Pursuant to the Safe Drinking Water Act, underground injection control, or
UIC, wells, including wells used in enhanced recovery and disposal operations
associated with oil and natural gas exploration and production activities, are
subject to regulation. These regulations include permitting, bonding, operating,
maintenance and reporting requirements.

In addition, the disposal of wastes containing naturally occurring
radioactive material, which is commonly encountered during oil and natural gas
production, is regulated under state law. Typically, wastes containing naturally
occurring radioactive material can be managed on-site or disposed of at
facilities licensed to receive such waste at costs that are not expected to be
material.

RISK FACTORS

THE OIL AND NATURAL GAS MARKET IS VOLATILE AND THE PRICE OF OIL AND NATURAL GAS
FLUCTUATES, WHICH MAY ADVERSELY AFFECT OUR CASH FLOWS AND THE VALUE OF OUR OIL
AND NATURAL GAS RESERVES.

Our future revenues and profits and the value of our oil and natural gas
reserves will depend substantially on the demand and prices we receive for
produced oil and natural gas. Oil and natural gas prices have been and are
likely to continue to be volatile in the future. The recent oil and natural gas
prices may not continue and could drop precipitously in a short period of time.
The prices of oil and natural gas are subject to wide fluctuations in response
to a variety of factors beyond our control, including the following:

- relatively minor changes in the supply of, and demand for, domestic and
foreign oil and natural gas;

- market uncertainty;

- the ability of members of the Organization of Petroleum Exporting
Countries to agree upon and maintain oil prices and production controls;

- the level of consumer product demand;

- political conditions in international oil-producing regions, such as the
Middle East, Nigeria and Venezuela;

- weather conditions;

- domestic and foreign governmental regulations and taxes;

- the price and availability of alternative fuels;

- overall domestic and global economic conditions;

- the price of oil and natural gas imports;

- the effect of worldwide energy conservation measures; and

- the proximity to and capacity of transportation facilities.

These external factors and the volatile nature of the energy markets make
it difficult to reliably estimate future prices of oil and natural gas.

13

As oil and natural gas prices decline, we are affected in several ways:

- we are paid less for our oil and natural gas, thereby reducing our cash
flows;

- exploration and development activity may decline as some projects may
become uneconomic and either are delayed or eliminated;

- our lenders could reduce the borrowing base under our bank credit
facility because of lower oil and natural gas reserve values, thereby
reducing our liquidity and possibly requiring mandatory loan repayments;
and

- access to other sources of capital, such as equity or long-term debt
markets, could be severely limited or unavailable in a low price
environment.

Accordingly, any substantial or extended decline in oil or natural gas
prices may have material adverse effects on our cash flow, liquidity and
profitability and may cause us to be unable to meet our financial obligations or
make planned capital expenditures.

WE MAY BE UNABLE TO SATISFY OUR FUTURE CAPITAL REQUIREMENTS.

We make substantial capital expenditures in connection with the
acquisition, exploration and development of our oil and natural gas properties.
In the past, we have funded these capital expenditures with cash flow from
operations, funds from long-term debt financings, including bank financings
secured by our oil and natural gas assets, and funds from equity financings. Our
future cash flows are subject to a number of factors, some of which are beyond
our control, including the following:

- the price of oil and natural gas;

- the level of production from existing wells;

- operating and development costs; and

- our success in locating and producing new reserves.

The availability of long-term debt and equity financing is also subject to
these factors. Investors in our debt securities view our future cash flow as a
measure of our ability to make principal and interest payments. In addition, the
availability of funds under our bank credit facility is based on the value of
our estimated oil and natural gas reserves and our cash flows, which in turn are
based on prices of oil and natural gas and the amount and timing of production.
Similarly, investors in our equity securities consider both the value of our oil
and natural gas properties and our cash flow in evaluating our prospects for
growth and profitability. If our future cash flows decrease, however, and we are
unable to obtain additional long-term debt or equity financing or our borrowing
base under our bank credit facility is re-determined to a lower amount, we may
be unable to satisfy our future capital requirements.

WE MAY BE UNABLE TO SUCCESSFULLY IDENTIFY, EXECUTE OR EFFECTIVELY INTEGRATE
FUTURE ACQUISITIONS, WHICH MAY NEGATIVELY AFFECT OUR RESULTS OF OPERATIONS.

Acquisitions of oil and natural gas businesses and properties have been an
important element of our business, and we will continue to pursue acquisitions
in the future. In the last several years, we have pursued and consummated
acquisitions that allow us to drill development and extension wells. Although we
regularly engage in discussions with, and submit proposals to, acquisition
candidates, suitable acquisitions may not be available in the future on
reasonable terms as there is intense competition for acquisition opportunities
in our industry. If we do identify an appropriate acquisition candidate, we may
be unable to successfully negotiate the terms of an acquisition, finance the
acquisition or, if the acquisition occurs, effectively integrate the acquired
business into our existing business. Negotiations of potential acquisitions and
the integration of acquired business operations may require a disproportionate
amount of management's attention and our resources. Even if we complete
additional acquisitions, continued acquisition financing may not be available or
available on reasonable terms, any new businesses may not generate revenues
comparable to our existing business, the anticipated cost efficiencies or
synergies may not be realized and these businesses may not be integrated

14

successfully or operated profitably. The success of any acquisition will depend
on a number of factors, many of which are beyond our control, including:

- the ability to estimate accurately the recoverable volumes of reserves;

- the ability to estimate accurately rates of future production and future
net revenues attainable from the reserves;

- future oil and natural gas prices;

- operating costs; and

- the ability to estimate accurately potential environmental and other
liabilities.

Our inability to successfully identify, execute or effectively integrate
future acquisitions may negatively affect our results of operations. Even though
we perform a due diligence review (including a review of title and other
records) of the major properties we seek to acquire that we believe is
consistent with industry practices, these reviews are inherently incomplete. It
is generally not feasible for us to review in-depth every individual property
and all records involved in each acquisition. However, even an in-depth review
of records and properties may not necessarily reveal existing or potential
problems or permit us to become familiar enough with the properties to assess
fully their deficiencies and potential. Even when problems are identified, we
may not be able to obtain contractual indemnities from the sellers for
liabilities that it created and we may assume certain environmental and other
risks and liabilities in connection with the acquired businesses and properties.
The discovery of any material liabilities associated with our acquisitions could
harm our results of operations.

In addition, acquisitions of businesses may require additional debt or
equity financing, resulting in additional leverage or dilution of ownership. Our
bank credit facility and the indenture governing our senior notes contain
certain covenants that limit, or which may have the effect of limiting, among
other things, acquisitions, capital expenditures, the sale of assets and the
incurrence of additional indebtedness.

THERE ARE NUMEROUS UNCERTAINTIES INHERENT IN ESTIMATING QUANTITIES OF PROVED OIL
AND NATURAL GAS RESERVES AND FUTURE NET REVENUES.

The quantities and values of our proved reserves included in this annual
report and in the other documents we file with, or furnish to, the Securities
and Exchange Commission are only estimates and are subject to numerous
uncertainties. Reserve estimating is a subjective process of determining the
size of underground accumulations of oil and natural gas that cannot be measured
in an exact manner. Estimates of economically recoverable oil and natural gas
reserves and of future net revenues may vary considerably from the actual
results because of a number of variable factors and assumptions involved. These
include:

- the effects of regulation by governmental agencies;

- future oil and natural gas prices;

- operating costs;

- the method by which the reservoir is produced as well as the properties
of the rock;

- relationships with landowners, working interest partners, pipeline
companies and others;

- severance and excise taxes;

- development costs; and

- workover and remedial costs.

In addition, volumetric calculations are often used to estimate initial
reserves from a field. These estimates utilize data including the area that a
well is expected to drain, rock properties derived from log analysis,
anticipated reservoir fluid properties, abandonment pressure and estimates of
recovery factors. As production data becomes available, the actual performance
is often used to project the final reserves. As such,

15

initial reserve estimates are much less precise in nature. The actual
production, revenues and expenditures related to our reserves may vary
materially from the engineers' estimates.

Furthermore, we may make changes to our estimates of reserves and future
net revenues. These changes, which may be material, may be based on the
following factors:

- well performance;

- results of development including drilling and workovers;

- oil and natural gas prices;

- performance of counterparties under agreements to which we are a party;
and

- operating and development costs.

Actual future net revenues may also be materially affected by the following
factors:

- the amount and timing of actual production and costs incurred with such
production;

- the supply of, and demand for, oil and natural gas; and

- the changes in governmental regulations or taxation.

Ultimately, the timing in producing and the costs incurred in developing
and producing will affect the actual present value of oil and natural gas. In
addition, the Securities and Exchange Commission requires that we apply a 10%
discount factor in calculating PV-10 value for reporting purposes. This may not
be the most appropriate discount factor to apply because it does not take into
account the interest rates in effect, the risks associated with us and our
properties, or the oil and natural gas industry in general.

For the foregoing reasons, you should not assume that the present value of
future net cash flows from our proved reserves referred to in this annual report
or in our other reports filed with, or furnished to, the Securities and Exchange
Commission is the current market value of our estimated oil and natural gas
reserves. In accordance with Securities and Exchange Commission requirements, we
base the estimated discounted future net cash flows from our proved reserves on
prices and costs on the date of the estimate. Actual prices and costs since the
date of the estimate and future prices and costs may differ materially from
those used in the net present value estimate, and as a result, net present value
estimates using current prices and costs may be significantly more or less than
the estimate which is provided in this annual report or in our other reports
filed with, or furnished to, the Securities and Exchange Commission.

OUR OPERATING ACTIVITIES INVOLVE SIGNIFICANT RISKS THAT ARE INHERENT IN THE OIL
AND NATURAL GAS INDUSTRY, WHICH MAY RESULT IN SUBSTANTIAL LOSSES, AND INSURANCE
MAY BE UNAVAILABLE OR INADEQUATE TO PROTECT US AGAINST THESE RISKS.

Our operations are subject to numerous operating risks that are beyond our
control, are inherent in the oil and natural gas industry and could result in
substantial losses. These risks include:

- fires;

- natural disasters;

- explosions;

- well blowouts;

- adverse weather conditions;

- mechanical problems, including pipe failure;

- abnormally pressured formations; and

- environmental accidents, including oil spills, natural gas leaks or
ruptures, or other discharges of toxic gases or other pollutants.

16

The occurrence of these risks could result in substantial losses due to
personal injury, loss of life, damage to or destruction of wells, production
facilities, natural resources or other property or equipment, pollution and
other environmental damage. These occurrences could also subject us to clean-up
obligations, regulatory investigation, penalties or suspension of operations.
Further, our operations may be materially curtailed, delayed or canceled as a
result of numerous factors, including:

- unexpected drilling conditions;

- the presence of unanticipated pressure or irregularities in formations;

- equipment failures or accidents;

- title problems;

- weather conditions;

- compliance with governmental requirements; and

- costs of, shortages or delays in the availability of, drilling rigs or in
the delivery of equipment and experienced labor.

In accordance with customary industry practice, we maintain insurance
against some, but not all, of the risks described above. The levels of insurance
we maintain may not be adequate to fully cover any losses or liabilities. We may
not be able to maintain insurance at commercially acceptable premium levels or
at all. The occurrence of a significant event, not fully insured or indemnified
against, could have a material adverse effect on our financial condition and
operations.

WE MAY BE UNABLE TO PRODUCE SUFFICIENT AMOUNTS OF OIL AND NATURAL GAS AND, AS A
RESULT, OUR PROFITABILITY AND CASH FLOW WILL DECLINE.

We may drill new wells that are not productive or we may not recover all or
any portion of our investment. Drilling for oil and natural gas may be
unprofitable due to a number of risks, including:

- wells may not be productive, either because commercially productive
reservoirs were not encountered or for other reasons;

- wells that are productive may not provide sufficient net reserves to
return a profit after taking into account leasehold, geophysical and
geological, drilling, operating and other costs; and

- the costs of drilling, completing and operating wells are often
uncertain.

If we are unable to produce sufficient amounts of oil and natural gas, our
profitability and cash flow will decline.

IF WE ARE UNABLE TO ACQUIRE OR DISCOVER ADDITIONAL RESERVES, OUR RESERVES AND
PRODUCTION WILL DECLINE MATERIALLY.

Our prospects for future growth and profitability depend primarily on our
ability to replace oil and natural gas reserves through acquisitions and
exploratory and development drilling. Acquisitions may not be available at
attractive prices or at all. The decision to purchase, explore or develop a
property depends in part on geophysical and geological analyses and engineering
studies that are often inconclusive or subject to varying interpretations. As a
consequence, our acquisition, exploration and development activities may not
result in significant additional reserves or reserves that are economically
recoverable. Without the acquisition, discovery or development of additional
reserves, our proved reserves and production will decline materially.

OUR FAILURE TO REMAIN COMPETITIVE WITH OUR NUMEROUS COMPETITORS, MANY OF WHICH
HAVE SUBSTANTIALLY GREATER RESOURCES THAN WE DO, COULD ADVERSELY AFFECT OUR
RESULTS OF OPERATIONS.

The oil and natural gas industry is highly competitive in the search for,
and development and acquisition of, reserves and in the marketing of oil and
natural gas production. We compete with major oil and natural gas

17

companies, other independent oil and natural gas concerns and individual
producers and operators in most aspects of our business, including the
following:

- the acquisition of oil and natural gas businesses and properties;

- the exploration, development, production and marketing of oil and natural
gas;

- the acquisition of properties and equipment; and

- the hiring and retention of personnel necessary to explore for, develop,
produce and market oil and natural gas.

Many of these competitors have substantially greater financial and other
resources than we do. If we are unable to successfully compete against our
competitors, our business, prospects, financial condition and results of
operations may be adversely affected.

WE ARE SUBJECT TO COMPLEX LAWS AND REGULATIONS, INCLUDING ENVIRONMENTAL
REGULATIONS, THAT MAY ADVERSELY AFFECT THE COST, MANNER OR FEASIBILITY OF DOING
BUSINESS.

Our business is subject to numerous federal, state and local laws and
regulations, including energy, environmental, conservation, tax and other laws
and regulations relating to the energy industry. Please read "-- Regulation"
above. We are subject to various federal, state and local laws and regulations
relating to the discharge of materials into, and protection of, the environment.
These laws and regulations may, among other things:

- limit drilling locations or the rate of allowable hydrocarbon production
from a well;

- affect the cost, terms and availability of oil and natural gas
transportation by pipeline;

- impose liability on us under an oil and natural gas lease for the cost of
pollution clean-up and remediation resulting from operations;

- impose liability on us for personal injuries and property damage;

- subject us to liability for pollution damages, including oil spills,
discharge of hazardous materials and reclamation costs; and

- require suspension or cessation of operations in affected areas and
subject the lessee to administrative, civil and criminal penalties.

Any of these liabilities, penalties, suspensions, terminations or
regulatory changes could make it more expensive for us to conduct our business
or cause us to limit or curtail some of our operations.

Environmental laws have in recent years become more stringent and have
generally sought to impose greater liability on a larger number of potentially
responsible parties. While we are not currently aware of any situation involving
an environmental claim that would likely have a material adverse effect on our
business, it is always possible that an environmental claim with respect to one
or more of our current properties or a business or property that one of our
predecessors owned or used could arise and could involve the expenditure of a
material amount of funds. Although we maintain insurance coverage which we
believe is customary in the industry, we are not fully insured against all
environmental risks.

The Department of Transportation, through the Office of Pipeline Safety and
Research and Special Programs Administration, has implemented a series of rules
requiring operators of natural gas and hazardous liquid pipelines to develop
integrity management plans for pipelines that, in the event of failure, could
impact certain high consequence areas. These rules also require operators to
conduct baseline integrity assessments of all applicable pipeline segments
located in the high consequence areas. We continually are in the process of
identifying any of our pipeline segments that may be subject to these rules. We
have developed an integrity management plan for all covered pipeline segments.
We do not expect to incur significant costs in achieving compliance with these
rules.

18

Further, hydrocarbon-producing states regulate conservation practices and
the protection of correlative rights. These regulations affect our operations
and limit the quantity of hydrocarbons we may produce and sell.

The oil and natural gas regulatory environment could change in ways that
could substantially increase the cost of complying with the requirements of
environmental and other regulations. We cannot predict whether, or when, new
laws and regulations may be enacted or adopted, and we cannot predict the cost
of compliance with changing laws and regulations or their effects on oil and
natural gas use or prices.

WE HAVE LIMITED CONTROL OVER THE ACTIVITIES ON PROPERTIES THAT WE DO NOT
OPERATE, WHICH COULD HAVE A MATERIAL ADVERSE EFFECT ON THE REALIZATION OF OUR
TARGETED RETURNS OR LEAD TO UNEXPECTED FUTURE COSTS.

Although we operate most of the properties in which we have an interest,
other companies operate some of the properties. We have limited ability to
influence or control the operation or future development of these non-operated
properties or the amount of capital expenditures that we are required to fund
for their operation. Our dependence on the operator and other working interest
owners for these projects and our limited ability to influence or control the
operation and future development of these properties could have a material
adverse effect on the number of wells we drill, realization of our targeted
returns or lead to unexpected future costs.

THE CONCENTRATION OF OUR CUSTOMERS IN THE ENERGY INDUSTRY COULD INCREASE OUR
EXPOSURE TO CREDIT RISK, WHICH COULD RESULT IN LOSSES.

The concentration of our customers in the energy industry may impact our
overall exposure to credit risk, either positively or negatively, in that
customers may be similarly affected by prolonged changes in economic and
industry conditions. We perform ongoing credit evaluations of our customers and
do not generally require collateral in support of our trade receivables. We
maintain reserves for credit losses and, generally, actual losses have been
consistent with our expectations, with the exception of losses we sustained
relating to obligations of certain Enron entities to KCS.

IF WE ARE UNSUCCESSFUL TRANSPORTING OUR OIL AND NATURAL GAS TO MARKET AT
COMMERCIALLY ACCEPTABLE PRICES, OUR PROFITABILITY WILL DECLINE.

We deliver oil and natural gas through gathering systems and pipelines that
we do not own. Our ability to transport our oil and natural gas to market at
commercially acceptable prices or at all depends on, among other factors, the
following:

- the availability, proximity and capacity of third-party gathering
systems, processing facilities and pipelines;

- changes in supply and demand; and

- general economic conditions.

Our inability to respond appropriately to changes in any of the foregoing
factors could negatively affect our profitability.

In addition, the transportation by pipeline of oil and natural gas in
interstate commerce is heavily regulated by the FERC, including regulation of
the cost, terms and conditions for such transportation service, and in the case
of natural gas, the construction and location of pipelines. The transportation
by pipeline of oil and natural gas in intrastate commerce is generally subject
to varying degrees of state regulation of the cost, terms and conditions of
service. While we are not directly subject to these regulations, they affect the
cost and availability of transportation of our production to market.

UNINSURED JUDGMENTS OR A RISE IN INSURANCE PREMIUMS MAY ADVERSELY IMPACT OUR
RESULTS OF OPERATIONS.

Exploration for, and production of, oil and natural gas can be hazardous,
involving unforeseen occurrences. Accordingly, in the ordinary course of
business, we are subject to various claims and litigation. Although we maintain
insurance to cover certain potential claims and losses arising from our
operations in accordance with customary industry practices and in amounts that
management believes to be prudent, we

19

could become subject to a judgment for which we are not adequately insured and
beyond the amounts that we currently have reserved or anticipate reserving.
Additionally, the terrorist attacks of September 11, 2001 and the continued
hostilities in the Middle East and other sustained military campaigns may
adversely impact our ability to obtain insurance or impact the cost of this
insurance, either of which may adversely impact our results of operations.

TERRORIST ATTACKS AND CONTINUED HOSTILITIES IN THE MIDDLE EAST OR OTHER
SUSTAINED MILITARY CAMPAIGNS MAY ADVERSELY IMPACT OUR FINANCIAL CONDITION AND
OPERATIONS.

The terrorist attacks that took place in the United States on September 11,
2001 were unprecedented events that have created many economic and political
uncertainties, some of which may materially adversely impact our business. The
continued threat of terrorism and the impact of military and other action,
including U.S. military operations in Iraq, will likely lead to continued
volatility in prices for crude oil and natural gas and could affect the markets
for our operations. In addition, future acts of terrorism could be directed
against companies operating in the United States. The United States government
has issued public warnings that indicate that energy assets might be specific
targets of terrorist organizations. These developments have subjected our
operations, and those of our purchasers, to increased risks and, depending on
their ultimate magnitude, may adversely impact our financial condition and
operations.

OUR SUCCESS DEPENDS ON KEY MEMBERS OF SENIOR MANAGEMENT, THE LOSS OF WHOM COULD
DISRUPT OUR CUSTOMER RELATIONSHIPS AND BUSINESS OPERATIONS.

We believe our continued success depends in large part on the sustained
contributions of our chief executive officer and chairman of the board of
directors, James W. Christmas, our president and chief operating officer,
William N. Hahne, and our management team and technical personnel. We rely on
our executive officers and senior management to identify and pursue new business
opportunities and identify key growth opportunities. In addition, the
relationships and reputation that members of our management team have
established and maintained in the oil and natural gas community contribute to
our ability to maintain positive customer relations and to identify new business
opportunities. The loss of services of Messrs. Christmas or Hahne or one or more
senior management or technical staff could significantly impair our ability to
identify and secure new business opportunities and otherwise disrupt operations.
We do not maintain key person life insurance on any of our senior management
members.

WE ENGAGE IN HEDGING TRANSACTIONS, WHICH MAY LIMIT OUR POTENTIAL GAINS AND
EXPOSE US TO RISK OF FINANCIAL LOSS.

We periodically purchase or sell derivative instruments covering a portion
of our expected production in order to manage our exposure to price risk in
marketing our oil and natural gas. These instruments may include futures
contracts and options sold on the New York Mercantile Exchange and privately
negotiated forwards, swaps and options. These transactions may limit our
potential gains if oil and natural gas prices were to rise substantially over
the prices established by hedging. These transactions also may expose us to the
risk of financial loss in certain circumstances, including the following:

- production is less than the volume hedged;

- there is a widening of price differentials between delivery points for
our production and the delivery point assumed in hedging arrangements;

- the counterparties to our derivative instruments fail to perform their
contract obligations;

- we fail to make timely deliveries; and

- a sudden, unexpected event materially impacts oil or natural gas prices.

20

SHORTAGE OF DRILLING RIGS, EQUIPMENT, SUPPLIES OR PERSONNEL MAY DELAY OR
RESTRICT OUR OPERATIONS.

The oil and natural gas industry is cyclical and, from time to time, there
is a shortage of drilling rigs, equipment, supplies or personnel. During these
periods, the costs and delivery times of drilling rigs, equipment and supplies
are substantially greater. In addition, demand for, and wage rates of, qualified
drilling rig crews rise with increases in the number of active rigs in service.
Shortages of drilling rigs, equipment, supplies or personnel may increase
drilling costs or delay or restrict our exploration and development operations,
which in turn could impair our financial condition and results of operations.

OUR LEVERAGE AND DEBT SERVICE OBLIGATIONS MAY ADVERSELY AFFECT OUR CASH FLOW AND
OUR FINANCIAL AND OPERATING ACTIVITIES.

As of December 31, 2004, we had $175 million of total debt outstanding. Our
level of indebtedness may have important consequences for us, including the
following:

- our ability to obtain additional financing for acquisitions, working
capital or other expenditures could be impaired or financing may not be
available on acceptable terms;

- a substantial portion of our cash flow will be used to make interest and
principal payments on our debt, reducing the funds that would otherwise
be available for our operations and future business opportunities;

- a substantial decrease in our revenues as a result of lower oil and
natural gas prices, decreased production or other factors could make it
difficult for us to meet debt service requirements and force us to modify
our operations; and

- making us more vulnerable to a downturn in our business or the economy in
general.

IN ADDITION TO OUR CURRENT INDEBTEDNESS, WE MAY BE ABLE TO INCUR SUBSTANTIALLY
MORE DEBT. THIS COULD EXACERBATE THE RISKS DESCRIBED ABOVE.

Together with our subsidiaries, we may be able to incur substantially more
debt in the future. Although our bank credit facility and the indenture
governing our senior notes contain restrictions on our incurrence of additional
indebtedness, these restrictions are subject to a number of qualifications and
exceptions, and under certain circumstances, indebtedness incurred in compliance
with these restrictions could be substantial. Also, these restrictions do not
prevent us from incurring obligations that do not constitute indebtedness as
defined in the relevant agreement. As of December 31, 2004, we had $100 million
of borrowing capacity available under our bank credit facility and an unlimited
amount of capacity available under our indenture, in each case subject to a
number of qualifications. To the extent new debt is added to our current debt
levels, the risks described above could substantially increase.

WE ARE DEPENDENT ON OUR SUBSIDIARIES FOR OUR CASH FLOW.

We are a holding company with no material assets other than the equity
interests of our subsidiaries. Our subsidiaries conduct substantially all of our
operations and directly own substantially all of our assets. Therefore, our
operating cash flow and ability to meet our debt obligations will depend on the
cash flow provided by our subsidiaries in the form of loans, dividends or other
payments to us as a shareholder, equity holder, service provider or lender. The
ability of our subsidiaries to make such payments to us will depend on their
earnings, tax considerations, legal restrictions and restrictions under their
indebtedness.

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OUR BANK CREDIT FACILITY AND INDENTURE GOVERNING OUR SENIOR NOTES IMPOSE
RESTRICTIONS ON US THAT MAY AFFECT OUR ABILITY TO SUCCESSFULLY OPERATE OUR
BUSINESS AND OUR ABILITY TO MAKE PAYMENTS ON OUR INDEBTEDNESS.

Our bank credit facility and the indenture governing our senior notes
include covenants that, among other things, restrict our ability to:

- borrow money;

- create liens;

- sell or transfer any of our material property;

- merge into or consolidate with any third party or sell or dispose of all
or substantially all of our assets; and

- make capital expenditures.

We are also required by our bank credit facility to maintain specified
interest coverage and current ratios. All of these and other covenants may
restrict our ability to expand or to pursue our business strategies. Adverse
financial or economic developments may cause us to breach these covenants. The
breach of any of these covenants could result in a default under our debt,
causing the debt to become due and payable. We may not be able to repay the debt
due as a result of an acceleration.

From time to time, we may require consents or waivers from our lenders to
permit any necessary actions that are prohibited by our debt and financing
arrangements. If in the future our lenders refuse to provide any necessary
waivers of the restrictions contained in our debt and financing arrangements,
then we could be in default under our debt and financing arrangements, and we
could be prohibited from undertaking actions that are necessary to maintain and
expand our business.

ANTI-TAKEOVER PROVISIONS IN OUR CERTIFICATE OF INCORPORATION, BY-LAWS AND
DELAWARE LAW COULD DISCOURAGE A CHANGE OF CONTROL OF OUR COMPANY AND COULD
NEGATIVELY AFFECT OUR STOCK PRICE.

Provisions in our certificate of incorporation and by-laws, each as amended
to date, and applicable provisions of the Delaware General Corporation Law may
make it more difficult and expensive for a third party to acquire control of us
even if a change of control would be beneficial to the interests of our
stockholders. These provisions could discourage potential takeover attempts and
could adversely affect the market price of our common stock. Our certificate of
incorporation and by-laws, each as amended to date:

- classify the board of directors into staggered, three-year terms, which
may lengthen the time required to gain control of our board of directors;

- limit who may call special meetings;

- prohibit stockholder action by written consent, requiring all actions to
be taken at a meeting of the stockholders;

- do not permit cumulative voting in the election of directors, which would
otherwise allow holders of less than a majority of stock to elect some
directors;

- limit the ability of stockholders to remove directors by providing that
they may only be removed for cause; and

- allow our board of directors to determine the powers, preferences or
rights and the qualifications, limitations and restrictions of shares of
our preferred stock.

In addition, Section 203 of the Delaware General Corporation Law may
discourage, delay or prevent a change in control by prohibiting us from engaging
in a business combination with an interested stockholder for a period of three
years after the person becomes an interested stockholder.

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COMPETITION

We operate in the highly competitive exploration and production segment of
the oil and gas industry. We compete with major oil and natural gas companies,
other independent oil and natural gas concerns and individual producers and
operators in the areas of reserve and leasehold acquisitions and the
exploration, development, production and marketing of oil and natural gas, as
well as contracting for equipment and the hiring of personnel. The principal
competitive factors in acquiring, discovering, producing and marketing oil and
natural gas reserves are the availability and hiring of qualified personnel,
technology and financial resources. We may be at a disadvantage to many of our
competitors in one or more of these areas due to our size relative to other
companies in the industry.

MARKETING AND CUSTOMERS

We market the majority of the natural gas and oil production from
properties we operate for both our account and the account of the other working
and royalty interest owners in these properties. In some instances, we also
market our non-operated natural gas and crude oil production to enhance price
realization and cash flow. The production is sold to a variety of purchasers.
The terms of sale under the majority of existing contracts are short-term,
usually one to three months in duration. The prices received for natural gas and
oil sales are tied to monthly or daily indices as quoted in industry
publications.

In order to achieve more predictable cash flow and reduce exposure to price
volatility of natural gas and crude oil, we utilize fixed price sales and
derivative agreements for a portion of our production with unaffiliated third
parties. Please read Note 11 to our Consolidated Financial Statements for
information regarding our derivative instruments.

In 2004, one customer, Louis Dreyfus Energy Services LP, accounted for 19%
of our consolidated revenue. Other than the amortization of deferred revenue
associated with the Production Payment, no customer accounted for more than 10%
of our consolidated revenues in 2003 or 2002.

SEASONALITY

Demand for natural gas and oil is seasonal and is principally related to
weather conditions and access to pipeline transportation.

EMPLOYEES

As of December 31, 2004, we employed a total of 133 persons. None of our
employees are represented by a labor union. Relations between us and our
employees are considered to be satisfactory.

AVAILABLE INFORMATION

Our Internet website is www.kcsenergy.com. The Investor Relations portion
of our Internet website is www.kcsenergy.com/html/investor.html and it contains
information about us, including our annual report on Form 10-K, quarterly
reports on Form 10-Q, current reports on Form 8-K and amendments to those
reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities
Exchange Act of 1934, as amended. These reports are available free of charge on
the Investor Relations portion of our Internet website on the same day that we
electronically file these materials with, or furnish these materials to, the
Securities and Exchange Commission.

ITEM 2. PROPERTIES.

Reference is made to Item 1. Business, "-- Oil and Gas Properties," "-- Oil
and Natural Gas Reserves," "-- Production," "-- Acreage," "-- Title to
Interests," "-- Drilling Activities" and "-- Other Facilities" included
elsewhere in this annual report on Form 10-K.

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ITEM 3. LEGAL PROCEEDINGS.

Reference is made to Note 12 to our Consolidated Financial Statements
included elsewhere in this annual report on Form 10-K.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.

No matter was submitted to a vote of our security holders through the
solicitation of proxies or otherwise during the fourth quarter of the fiscal
year ended December 31, 2004.

PART II

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND
ISSUER PURCHASES OF EQUITY SECURITIES.

Our common stock is traded on the New York Stock Exchange under the symbol
"KCS." As of March 1, 2005, there were approximately 917 holders of record of
our common stock. This number does not include any beneficial owners for whom
shares of common stock may be held in "nominee" or "street" name. The following
table sets forth, for each quarterly period during fiscal 2004 and 2003, the
high and low sales price per share of our common stock, as reported in the
composite transaction reporting system.

On March 11, 2005, the last reported sales price of our common stock on the
New York Stock Exchange was $16.26 per share.

DIVIDEND POLICY

We have not declared or paid any cash dividends on our common stock since
1999. We intend to retain earnings for use in the operation and expansion of our
business, and therefore do not anticipate declaring or paying a cash dividend on
our common stock in the foreseeable future. In addition, our bank credit
facility prohibits the payment of cash dividends on our common stock.

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EQUITY COMPENSATION PLAN INFORMATION

The following table sets forth information with respect to shares of our
common stock that may be issued upon the exercise of options, warrants and
rights under all of our existing equity compensation plans as of December 31,
2004.

- ---------------

(1) Represents options granted under our 2001 Employee and Directors Stock Plan.
Excludes warrants to purchase 200,000 shares of our common stock whose
exercise price is $4.00 per share. The warrants were exercised in full in
March 2005 and therefore are no longer outstanding. Please read Note 8 to
our Consolidated Financial Statements for more information on the warrants.

(2) Includes 977,606 shares authorized for issuance pursuant to our 2001
Employee and Directors Stock Plan, 754,070 shares authorized for issuance
pursuant to our employee stock purchase program and 657,316 shares
authorized for issuance in connection with our savings and investment
(401(k)) plan.

INFORMATION REGARDING EQUITY COMPENSATION PLANS THAT HAVE NOT BEEN APPROVED BY
STOCKHOLDERS

KCS Energy, Inc. 2001 Employees and Directors Stock Plan, or 2001 Stock
Plan. The 2001 Stock Plan was adopted as part of our plan of reorganization, or
the Plan, under Chapter 11 of Title 11 of the United States Bankruptcy Code. The
Plan was approved by our stockholders and creditors. However, our stockholders
did not consider and vote on the 2001 Stock Plan independently of their
consideration of the Plan. The 2001 Stock Plan provides that stock options,
stock appreciation rights, restricted stock and bonus stock may be granted to
our employees. The 2001 Stock Plan provides that each non-employee director will
be granted stock options for 1,000 shares of our common stock on an annual
basis. The 2001 Stock Plan also provides that in lieu of cash, each non-employee
director may be issued shares of our common stock with a fair market value equal
to 50% of the non-employee directors' annual retainer. The 2001 Stock Plan
provides that the option price of shares issued under the plan shall be equal to
the market price on the date of grant. All options expire ten years after the
date of grant. The 2001 Stock Plan provides for the issuance of up to 4,362,868
shares of our common stock. As of December 31, 2004, grants of 586,279
restricted shares were outstanding under the 2001 Stock Plan. Please read Note 5
to our Consolidated Financial Statements for a discussion of the terms of the
restricted stock.

Other Plans. Shortly after our formation in May 1988, we adopted, among
other benefit programs, an employee stock purchase plan and a savings and
investment plan. The stockholders of our former parent company did not
specifically vote to approve these plans, but they did approve a plan
authorizing our spin-off and formation that included provisions stating the
intent to adopt benefit plans similar to those of the former parent.

Employee Stock Purchase Plan. Under the employee stock purchase plan,
eligible employees and directors may purchase full shares from us at a price per
share equal to 90% of the market value determined by the closing price on the
date of purchase. The maximum annual purchase amount for our employees is the
number of shares costing no more than 10% of the eligible employee's annual base
salary. The maximum annual purchase amount for our directors is 6,000 shares.
Please read Note 5 to our Consolidated Financial Statements for more
information.

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Savings and Investment Plan. Under the savings and investment plan,
eligible employees may contribute a portion of their compensation, as defined in
the plan, to the savings and investment plan, subject to certain Internal
Revenue Service limitations. We may provide matching contributions, currently
set by the board of directors at 50% of the employee's contribution (up to 6% of
the employee's compensation, subject to certain regulatory limitations). The
savings and investment plan also contains a profit-sharing component whereby the
board of directors may declare annual discretionary profit-sharing
contributions. Our matching contributions and discretionary profit-sharing
contributions vest over a four-year employment period. Once the four-year
employment period has been satisfied, all of our matching contributions and
discretionary profit-sharing contributions immediately vest. Please read Note 4
to our Consolidated Financial Statements for more information.

ITEM 6. SELECTED FINANCIAL DATA.

The following table sets forth our selected historical financial data for
each of the five years in the period ended December 31, 2004. The selected
historical financial data set forth below has been derived from our audited
consolidated financial statements included elsewhere in this annual report on
Form 10-K. Please read "Management's Discussion and Analysis of Financial
Condition and Results of Operations" and our audited consolidated financial
statements and related notes included elsewhere in this annual report on Form
10-K for a discussion of factors that affect the comparability of this
information and material uncertainties that may cause this information not to be
indicative of our future financial condition or results of operations.

- ---------------

(1) Includes a $13.9 million income tax benefit related to the reversal of the
remaining portion of our valuation allowance against net deferred income tax
assets.

(2) Includes a $20.2 million income tax benefit related to the reversal of a
portion of our valuation allowance against net deferred income tax assets
and a $0.9 million non-cash charge related to the cumulative effect of an
accounting change as a result of the adoption of SFAS No. 143, "Accounting
for Asset Retirement Obligations."

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(3) Includes a $15.9 million non-cash write-down to zero of the book value of
net deferred tax assets and a $6.2 million non-cash charge for the
cumulative effect of an accounting change related to the amortization method
of oil and gas properties.

(4) Excludes debt classified as current liability.

(5) Included in current liabilities.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.

The following is a discussion and analysis of our financial condition and
results of operations and should be read in conjunction with our consolidated
financial statements and related notes included elsewhere in this annual report
on Form 10-K.

FORWARD-LOOKING STATEMENTS

The information discussed in this annual report on Form 10-K includes
"forward-looking statements" within the meaning of Section 27A of the Securities
Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934,
as amended. All statements, other than statements of historical facts, included
herein concerning, among other things, planned capital expenditures, increases
in oil and natural gas production, the number of anticipated wells to be drilled
in the future, future cash flows and borrowings, pursuit of potential
acquisition opportunities, our financial position, business strategy and other
plans and objectives for future operations, are forward-looking statements.
These forward-looking statements are identified by their use of terms and
phrases such as "may," "will," "expect," "estimate," "project," "plan,"
"believe," "achievable," "anticipate" and similar terms and phrases. Although we
believe that the expectations reflected in any forward-looking statements are
reasonable, they do involve certain assumptions, risks and uncertainties. Our
actual results could differ materially from those anticipated in these
forward-looking statements as a result of certain factors, including:

- the timing and success of our drilling activities;

- the volatility of prices and supply of, and demand for, oil and natural
gas;

- the numerous uncertainties inherent in estimating quantities of proved
oil and natural gas reserves and actual future production rates and
associated costs;

- our ability to successfully identify, execute or effectively integrate
future acquisitions;

- the usual hazards associated with the oil and gas industry (including
fires, natural disasters, well blowouts, adverse weather conditions, pipe
failure, spills, explosions and other unforeseen hazards);

- our ability to effectively transport and market our oil and natural gas;

- the results of our hedging transactions;

- the availability of rigs, equipment, supplies and personnel;

- our ability to acquire or discover additional reserves;

- our ability to satisfy future capital requirements;

- changes in regulatory requirements;

- the credit risks associated with our customers;

- economic and competitive conditions;

- our ability to retain key members of senior management and key employees;

- uninsured judgments or a rise in insurance premiums;

- our outstanding indebtedness;

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- continued hostilities in the Middle East and other sustained military
campaigns and acts of terrorism or sabotage; and

- if underlying assumptions prove incorrect.

These and other risks are described in greater detail in "Business -- Risk
Factors" included elsewhere in this annual report on Form 10-K. All
forward-looking statements attributable to us or persons acting on our behalf
are expressly qualified in their entirety by these factors. Other than as
required under the securities laws, we do not assume a duty to update these
forward-looking statements, whether as a result of new information, subsequent
events or circumstances, changes in expectations or otherwise.

OVERVIEW

The year ended December 31, 2004 was an outstanding year for us. We drilled
a record 130 wells during 2004, of which 126 were completed, resulting in a 97%
success rate and significantly increased production and reserves. In 2004, gross
production increased 15%, to 40 Bcfe, while net production after production
payment delivery obligations that do not contribute to cash flow from operating
activities increased 25% compared to 2003. Natural gas and oil reserves
increased 22% to 328 Bcfe as of December 31, 2004 compared to 268 Bcfe as of
December 31, 2003. In total, we added 94.5 Bcfe of proved reserves during 2004,
of which 97% was through the drill bit. Total oil and gas capital expenditures
were $166.7 million.

In 2004, we continued to execute our strategies of focusing on low-risk
development and exploitation drilling in our core operating areas and to commit
approximately 15% of our capital expenditure budget to moderate-risk,
higher-potential exploration prospects primarily in the onshore Gulf Coast
region. In 2005, we plan to commit approximately 15% to 20% of our capital
expendi