Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

        This Form 10-Q and the information referenced herein contain statements that constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. The words “plan,” “expect,” “project,” “estimate,” “assume,” “believe,” “anticipate,” “intend,” “budget,” “forecast,” “predict” and other similar expressions are intended to identify forward-looking statements. These statements appear in a number of places and include statements regarding our plans, beliefs or current expectations, including the plans, beliefs and expectations of our officers and directors. We use the terms “Stone,” “Stone Energy,” “Company,” “we,” “us” and “our” to refer to Stone Energy Corporation.

        When considering any forward-looking statement, you should keep in mind the risk factors that could cause our actual results to differ materially from those contained in any forward-looking statement. Important factors that could cause actual results to differ materially from those in the forward-looking statements herein include the timing and extent of changes in commodity prices for oil and gas, operating risks and other risk factors as described in our 2003 Annual Report on Form 10-K as filed with the Securities and Exchange Commission. Furthermore, the assumptions that support our forward-looking statements are based upon information that is currently available and is subject to change. We specifically disclaim all responsibility to publicly update any information contained in a forward-looking statement or any forward-looking statement in its entirety and therefore disclaim any resulting liability for potentially related damages. All forward-looking statements attributable to Stone Energy Corporation are expressly qualified in their entirety by this cautionary statement.

Overview

        Stone Energy Corporation is an independent oil and gas company engaged in the acquisition, exploration, development, production and operation of oil and gas properties located primarily in the Gulf Coast Basin.

        Our business strategy, which has remained consistent since 1990, is to increase production, cash flow and reserves through the acquisition, exploitation and development principally of mature oil and gas properties. Currently, our property base consists of 71 active properties, 60 in the Gulf Coast Basin and 11 in the Rocky Mountains, and 30 primary term leases in the Gulf of Mexico. We serve as operator on 42 of our active properties, which enables us to better control the timing and cost of rejuvenation activities. We believe that there will continue to be opportunities to acquire properties in the Gulf Coast Basin due to the increased focus by many of our competitors on projects away from the onshore and shallow water shelf regions of the Gulf of Mexico.

Critical Accounting Policies

        Our 2003 Annual Report on Form 10-K describes the accounting policies that we believe are critical to the reporting of our financial position and operating results and that require management’s most difficult, subjective or complex judgments. Our most significant estimates are:

• remaining proved oil and gas reserves;
• timing of our future drilling activities;
• accruals of operating costs and production revenue;
• future costs to develop and abandon our oil and gas properties;
• the effectiveness of derivative positions; and
• classification of unevaluated property costs.

        This Quarterly Report on Form 10-Q should be read together with the discussion contained in our 2003 Annual Report on Form 10-K regarding these critical accounting policies.

Other Factors Affecting Our Business and Financial Results

        In addition to the matters discussed above, our business, financial condition and results of operations are affected by a number of other factors. This Quarterly Report on Form 10-Q should be read in conjunction with the discussion in our 2003 Annual Report on Form 10-K regarding these other risk factors.

Results of Operations

        The following tables set forth certain information with respect to our oil and gas operations.

        Net Income.   During the second quarter of 2004, net income totaled $35.9 million, or $1.33 per share, compared to $28.6 million, or $1.08 per share reported for the second quarter of 2003. For the six months ended June 30, 2004, net income totaled $71.7 million, or $2.67 per share, compared to $84.5 million, or $3.18 per share, during the comparable 2003 period. All per share amounts are on a diluted basis. The increase in second quarter net income was primarily due to an increase in oil production volumes and realized oil and natural gas prices as discussed below.

        Prices.    Prices realized during the second quarter of 2004 averaged $37.09 per Bbl of oil and $5.86 per Mcf of natural gas, or 22% higher, on an Mcfe basis, than second quarter 2003 average realized prices of $28.34 per Bbl of oil and $5.05 per Mcf of natural gas. Average realized prices during the first half of 2004 were $35.79 per Bbl of oil and $5.67 per Mcf of natural gas compared to $30.96 per Bbl of oil and $5.88 per Mcf of natural gas realized during the first half of 2003. All unit pricing amounts include the cash settlement of hedging contracts.

        During the second quarters of 2004 and 2003, hedging transactions reduced the average price we received for natural gas by $0.16 and $0.03 per Mcf, respectively. Hedging transactions for natural gas during the first half of 2004 and 2003 also decreased the average price we received for natural gas by $0.15 and $0.01 per Mcf, respectively.

        Production.    Oil production during the second quarter of 2004 totaled approximately 1.6 million barrels compared to 1.4 million barrels produced during the second quarter of 2003, representing a 12% increase over 2003. Natural gas production during the second quarter of 2004 totaled 14.4 Bcf or 6% less than the 15.4 Bcf produced during the second quarter of 2003. Year-to-date 2004 production totaled 3.1 million barrels of oil and 29.1 Bcf of natural gas compared to 2.8 million barrels of oil and 31.9 Bcf of natural gas produced during the comparable 2003 period.

        Oil and Gas Revenue.    Due to the increases in oil production volumes and realized prices, oil and gas revenue increased 21% to $142.2 million, compared to $117.2 million for the second quarter of 2003. Year-to-date 2004 oil and gas revenue totaled $275.8 million compared to $274.8 million during the comparable 2003 period.

        Expenses.    Normal lease operating expenses during the second quarter of 2004 totaled $17.1 million or 9% higher than normal lease operating expenses of $15.7 million for the comparable quarter in 2003. For the first six months of 2004, normal lease operating expenses totaled $33.9 million compared to $30.7 million during the comparable period of 2003. The increase in normal lease operating costs for 2004 was the combined result of an increase in the number of active wells, increases in overall industry service costs over 2003 and higher oil production volumes during 2004, which are more costly to produce as compared to natural gas.

        Major maintenance expenses, which represent major repair and maintenance costs that vary from period to period, totaled $5.8 million during the second quarter of 2004 compared to $2.5 million in the second quarter of 2003. Second quarter 2004 major maintenance expenses consisted primarily of replacement wells on Mississippi Canyon Block 109 and Vermilion Block 131. During the six months ended June 30, 2004 and 2003, major maintenance expenses totaled $8.9 million and $5.2 million, respectively. Stone expects third quarter 2004 major maintenance expenses to increase approximately 75% over second quarter 2004 amounts based upon planned operations.

        Effective January 1, 2003, management elected to change to the units of production method of amortizing proved oil and gas property costs versus the formerly used future gross revenue method. The cumulative effect of the change in accounting principle was $4.0 million, net of tax, and was recorded as a charge during the first quarter of 2003. Depreciation, depletion and amortization (“DD&A”) on oil and gas properties for the second quarter of 2004 totaled $49.4 million compared to $40.4 million for the second quarter of 2003. For the six months ended June 30, 2004 and 2003, DD&A expense totaled $95.4 million and $81.3 million, respectively. The increase in 2004 DD&A on a unit basis is the result of increases in the full-cycle cost of finding and developing proved reserves and the impact of drilling results.

        As a result of debt repayments and the redemption of our $100 million of senior subordinated notes during 2003, interest expense for the second quarter of 2004 decreased 23% to $4.0 million, compared to $5.2 million during the second quarter of 2003. For the six months ended June 30, 2004, interest expense totaled $7.9 million compared to $10.7 million during the comparable period in 2003.

        During the second quarter of 2004, we incurred $2.4 million of other expenses, which included $0.9 million of deferred financing costs written off in connection with our previous credit agreement and $1.5 million of expenses related to the final judgment in the Goodrich lawsuit. (See Part II, Item 1. Legal Proceedings)

Recent Accounting Developments

        Stock-Based Compensation.   On March 31, 2004, the FASB issued a proposed Statement, “Share-Based Payment,” that addresses the accounting for share-based payment transactions in which an enterprise receives employee services in exchange for equity instruments of the enterprise, such as stock options. The proposed Statement would eliminate the ability to account for share-based compensation transactions using the APB Opinion No. 25 and generally would require instead that such transactions be accounted for using a fair value-based method. Stone currently accounts for stock-based compensation using APB Opinion No. 25. The proposed Statement, if adopted, would require us to begin accounting for stock options under this method beginning in fiscal year 2005. It is currently not known whether the implementation of this proposed Standard would result in financial results materially different from those presented in Note 8 – Stock-Based Compensation. The FASB is expected to issue a final rule on this topic during the fourth quarter of 2004.

Hedging Activities

        Stone has entered into zero premium collars for a portion of our expected 2005 oil and natural gas production from the Gulf Coast Basin. The natural gas collars effectively hedge 20,000 MMBtu per day at a floor price of $4.00 per MMBtu and a ceiling price of $13.50 per MMBtu and an additional 20,000 MMBtu per day at a floor price of $4.50 per MMBtu and a ceiling price of $10.25 per MMBtu. The oil collars effectively hedge 8,000 Bbls per day at floor price of $28.00 per Bbl and an average ceiling price of $52.83 per Bbl. The contracts require payments to the counterparties if the average price is above the ceiling price or payment from the counterparties if the average price is below the floor price.

        The following is a breakdown of derivative expenses for the respective periods:

Liquidity and Capital Resources

        Cash Flow.    Net cash flow provided by operating activities for the six months ended June 30, 2004 was $188.3 million compared to $213.1 million reported in the comparable period in 2003. Net cash flow used in investing activities totaled $200.3 million and $157.4 million during the first half of 2004 and 2003, respectively, which primarily represents our investment in oil and gas properties. Net cash flow provided by (used in) financing activities totaled $26.1 million and ($54.7) million for the six months ended June 30, 2004 and 2003, respectively, which primarily represents borrowings and repayments under our bank credit facility. In total, cash and cash equivalents increased from $17.1 million as of December 31, 2003 to $31.2 million as of June 30, 2004.

        We had a working capital deficit at June 30, 2004 of $4.7 million. Working capital deficits are not unusual at the end of a period, and are usually the result of accounts payable related to exploration and development costs. We believe that our working capital balance should be viewed in conjunction with availability of borrowings under our bank credit facility when measuring liquidity. See Bank Credit Facility.

        Capital Expenditures.   Second quarter 2004 additions to oil and gas property costs of $111.9 million included $45.4 million of acquisition costs, $3.7 million of capitalized salaries, general and administrative expenses and $1.6 million of capitalized interest. Year-to-date 2004 additions to oil and gas property costs of $202.1 million include $47.4 million of acquisition costs, $7.9 million of capitalized salaries, general and administrative expenses and $3.2 million of capitalized interest. These investments were financed by cash flow from operating activities, borrowings under our credit facility and working capital.

        Budgeted Capital Expenditures.   Our current estimated 2004 capital expenditures budget, excluding acquisitions and capitalized salaries, general and administrative expenses and interest, is approximately $280 million. While the 2004 capital expenditures budget does not include any projected acquisitions, we continue to seek growth opportunities that fit our specific acquisition profile.

        Based upon our outlook for oil and gas prices and production rates, we expect cash flow from operations to be sufficient to fund the remaining 2004 capital expenditures budget. However, if oil and gas prices or production rates fall below our current expectations, we believe that the available borrowings under our bank credit facility will be sufficient to fund the capital expenditures in excess of operating cash flow.

        Bank Credit Facility.    On April 30, 2004, we entered into a four-year $500 million senior unsecured credit facility with a syndicated bank group. The new facility has an initial borrowing base of $425 million and replaces the previous $350 million credit facility. Borrowings outstanding at June 30, 2004 under our bank credit facility totaled $192.0 million, and letters of credit totaling $13.1 million have been issued under the facility. At August 6, 2004, we had $230.9 million of borrowings available under the credit facility and the weighted average interest rate under the credit facility was approximately 2.8%. The borrowing base under the new credit facility is re-determined periodically based on the bank group’s evaluation of our proved oil and gas reserves.

Defined Terms

        Oil and condensate are stated in barrels (“Bbls”) or thousand barrels (“MBbl”). Natural gas is stated herein in billion cubic feet (“Bcf”), million cubic feet (“MMcf”) or thousand cubic feet (“Mcf”). Oil and condensate are converted to natural gas at a ratio of one barrel of liquids per six Mcf of gas. Bcfe, MMcfe, and Mcfe represent one billion cubic feet, one million cubic feet and one thousand cubic feet of gas equivalent, respectively. MMBtu represents one million British Thermal Units and BBtu represents one billion British Thermal Units. An active property is an oil and gas property with existing production. A primary term lease is an oil and gas property with no existing production, in which we have a specific time frame to establish production without losing the rights to explore the property. Liquidity is defined as the ability to obtain cash quickly either through the conversion of assets or incurrence of liabilities.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Commodity Price Risk

        Our major market risk exposure continues to be the pricing applicable to our oil and gas production. Our revenues, profitability and future rate of growth depend substantially upon the market prices of oil and natural gas, which fluctuate widely. Oil and gas price declines and volatility could adversely affect our revenue, cash flows and profitability. Price volatility is expected to continue. In order to manage our exposure to oil and gas price declines, we occasionally enter into hedging arrangements to secure a price for a portion of our expected oil and natural gas production. We do not enter into hedging transactions for trading purposes.

        Our hedging policy provides that not more than one-half of our estimated production quantities can be hedged without the consent of the Board of Directors. See Item 1. Financial Statements – Note 3 – Hedging Activities for a detailed discussion of hedges in place to manage our exposure to oil and natural gas price declines.

Interest Rate Risk

        Stone had long-term debt outstanding of $392.0 million at June 30, 2004, of which $200.0 million, or approximately 51%, bears interest at a fixed rate of 8¼%. The remaining $192.0 million of debt outstanding at June 30, 2004 bears interest at a floating rate. At August 6, 2004, the weighted average interest rate under our floating-rate debt was approximately 2.8%. At June 30, 2004, we had no interest rate hedge positions in place to reduce our exposure to changes in interest rates.

        Since the filing of our 2003 Annual Report on Form 10-K, there have been no material changes in reported market risk as it relates to interest rates and commodity prices.

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

        Our chief executive officer and our chief financial officer, with the participation of other members of our senior management, reviewed and evaluated the effectiveness of Stone’s disclosure controls and procedures as of the end of the quarterly period ended June 30, 2004. Based on this evaluation, our chief executive officer and chief financial officer believe:

• Stone’s disclosure controls and procedures were effective to ensure that information required to be disclosed by Stone in the reports it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms; and
   
• Stone’s disclosure controls and procedures were effective to ensure that information required to be disclosed by Stone in the reports that is files or submits under the Securities Exchange Act of 1934 was accumulated and communicated to Stone’s management, including Stone’s chief executive officer and chief financial officer, as appropriate to allow timely decisions regarding required disclosure.

Internal Controls Over Financial Reporting

        There has not been any change in our internal control over financial reporting that occurred during our quarterly period ended June 30, 2004 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II – OTHER INFORMATION

Item 1.  Legal Proceedings

        Goodrich Petroleum Corporation, Goodrich Petroleum Company, L.L.C. and Goodrich Petroleum Company-Lafitte, L.L.C. filed civil action number 2000-06437, in Harris County, Texas, against Stone Energy Corporation, seeking seismic data at Lafitte Field and unspecified damages. On October 29, 2003, after a trial of this matter, the jury awarded Goodrich Petroleum Company-Lafitte, L.L.C. damages in the amount of approximately $0.5 million. On May 28, 2004, the presiding judge rendered a final judgment in this case and awarded the plaintiff an additional $1.5 million in recovery of plaintiff’s attorneys’ fees and pre-judgment interest of approximately $0.1 million, which has been accrued in other expenses as of June 30, 2004. The court has also ordered Goodrich to pay $0.1 million to Stone in recovery of defendant’s attorneys’ fees. Either party may appeal the final judgment or file a motion for a new trial. There has been no indication whether the plaintiff will appeal this decision.

Item 4.   Submission of Matters to a Vote of Security Holders

        The following matters were submitted to a vote of security holders during Stone’s Annual Meeting of Stockholders held on May 20, 2004:

        No other Director was standing for election. James H. Stone, Robert A. Bernhard and David H. Welch are Class III Directors whose terms expire with the 2005 Annual Meeting of stockholders. Peter K. Barker, D. Peter Canty, Raymond B. Gary and David R. Voelker are Class I Directors whose terms expire with the 2006 Annual Meeting of Stockholders.

Item 5.  Other Information

        As previously disclosed, Joe R. Klutts elected to retire from the Board of Directors effective May 20, 2004. The Company entered into a Confidentiality Agreement and a letter agreement, each dated June 1, 2004, with Mr. Klutts to provide geological consulting services in the Weeks Bay area of Iberia Parish, Louisiana, in return for a possible two percent overriding royalty interest if the Company elects to pursue prospects generated by him in that area.

Item 6.    Exhibits and Reports on Form 8-K