UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(Mark One)

Commission file number 1-16295

ENCORE ACQUISITION COMPANY

Registrant’s telephone number, including area code: (817) 877-9955

Not applicable
(Former name, former address and former fiscal year, if changed since last report)

     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.

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

ENCORE ACQUISITION COMPANY
TABLE OF CONTENTS

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

ENCORE ACQUISITION COMPANY

CONSOLIDATED BALANCE SHEETS

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

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ENCORE ACQUISITION COMPANY

CONSOLIDATED STATEMENTS OF OPERATIONS

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

2

ENCORE ACQUISITION COMPANY

CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY

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

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ENCORE ACQUISITION COMPANY

CONSOLIDATED STATEMENTS OF CASH FLOWS

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

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ENCORE ACQUISITION COMPANY

1. Formation of Encore

     Encore Acquisition Company (“Encore” or the “Company”), a Delaware corporation, is a growing independent energy company engaged in the acquisition, development and exploitation of North American oil and natural gas reserves. Since the Company’s inception in 1998, Encore has sought to acquire high-quality assets with potential for upside through low-risk development drilling projects. Encore’s properties are currently located in four core areas: the Cedar Creek Anticline (“CCA”), of Montana and North Dakota; the Permian Basin of West Texas and Southeastern New Mexico; the Mid Continent area, which includes the Arkoma and Anadarko Basins of Oklahoma, the North Louisiana Salt Basin, the East Texas Basin and the Barnett Shale near Fort Worth, Texas; and the Rocky Mountains.

2. Basis of Presentation

     In the opinion of management, the accompanying unaudited consolidated financial statements of Encore include all adjustments necessary to present fairly our financial position as of June 30, 2004, results of operations for the three and six months ended June 30, 2004 and 2003, and cash flows for the six months ended June 30, 2004 and 2003. All adjustments are of a recurring nature. These interim results are not necessarily indicative of results for an entire year.

     Certain amounts and disclosures have been condensed or omitted from these consolidated financial statements pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Therefore, these consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes thereto included in the Company’s 2003 Annual Report filed on Form 10-K.

     Employee stock options and restricted stock awards are accounted for at intrinsic value in accordance with the provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”). Accordingly, no compensation expense is recorded for stock options that are granted to employees or non-employee directors with an exercise price equal to or above the Company’s stock price on the date of grant. However, compensation expense is recorded for the fair value of the restricted stock granted to employees. During the second quarter of 2004, the Company awarded 57,161 shares of restricted stock under the Company’s 2000 Incentive Stock Plan. The shares vest in equal annual installments over the next three years and are contingent only upon continued employment. Deferred compensation of $1.6 million was recorded in conjunction with the grants, and will be expensed over the related vesting period.

     If employee stock options were accounted for at fair value in accordance with the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation,” the Company’s reported net income and net income per share amounts would have been adjusted to the pro forma amounts indicated below (in thousands, except per share amounts):

(a)

For the quarter ended June 30, 2004, 6,509 shares of employee stock options and 1,810 shares of restricted stock, which were issued and outstanding at March 31, 2004, were forfeited. For the first half of 2004, 12,685 shares of employee stock options and 9,176 shares of restricted stock, which were issued and outstanding at December 31, 2003, were forfeited.

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3. Business Combinations

Cortez Acquisition

     On April 14, 2004, the Company purchased all of the outstanding capital stock of Cortez Oil & Gas, Inc. (“Cortez”), a privately held, independent oil and natural gas company, for a total purchase price of $126.3 million, which includes cash paid to Cortez’ former shareholders of $85.8 million, the repayment of $39.4 million of Cortez’s debt, and transition costs incurred of $1.1 million.

     Encore funded the acquisition with a portion of the net proceeds from the issuance of the 6¼ Notes (see Note 4). The net proceeds from the notes were placed in escrow upon the closing of the offering and were released to fund the Cortez acquisition in accordance with the terms of the escrow agreement with the initial purchasers of the 6¼% Notes.

     The acquired oil and natural gas properties are located primarily in the CCA of Montana, the Permian Basin of West Texas and Southeastern New Mexico and in the Mid Continent area, including the Anadarko and Arkoma Basins of Oklahoma and the Barnett Shale north of Fort Worth, Texas. Cortez’ operating results are included in Encore’s Consolidated Statement of Operations for the period April through June 2004.

     The calculation of the total purchase price and the calculation of the fair value of net assets acquired at April 14, 2004, are as follows (in thousands):

     The purchase price allocation resulted in $38.6 million of goodwill primarily as the result of the difference between the fair value of oil and gas properties and their assumed tax basis. None of the goodwill is deductible for income tax purposes. Furthermore, in accordance with SFAS No. 142, “Goodwill and Intangible Assets,” goodwill is not amortized, but is tested for impairment on a quarterly basis, which involves the use of estimates related to the fair market value of the business operations and reporting unit with which goodwill is associated. Currently, Encore has one reporting level. Losses, if any, resulting from impairment tests will be reflected in operating income in the Consolidated Statement of Operations.

4. Debt

Issuance of 6 ¼ % Senior Subordinated Notes

     On April 2, 2004, the Company issued $150.0 million of 6¼% Senior Subordinated Notes maturing April 15, 2014 (the “6¼% Notes”). The offering was made through a private placement. The 6¼% Notes were resold by the initial purchasers pursuant to Rule 144A and Regulation S. The Company estimates net proceeds of approximately $146.2 million after paying all costs associated with the offering. The net proceeds were used to fund the acquisition of Cortez (see Note 3) and repay amounts outstanding under the Company’s revolving credit facility. Concurrently with the issuance of the 6¼% Notes, the Company entered into a registration rights agreement whereby Encore agreed to file a registration statement offering to exchange the 6¼% Notes for registered notes with substantially identical terms. The Company filed the registration statement on June 30, 2004 on Form S-4. The registration statement

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was declared effective by the SEC on July 14, 2004, and the related offer to exchange the outstanding Notes for registered notes was launched on July 21, 2004. The exchange offer expires at 5:00 p.m., New York City time, on August 19, 2004.

     The 6¼% Notes mature on April 15, 2014, and all amounts outstanding will be due and payable at that time. Interest is paid semi-annually on April 15 and October 15. The indenture governing the 6¼% Notes contains substantially the same covenants and restrictions as the 8⅜% Notes.

Letters of Credit

     The Company had $14.4 million of outstanding letters of credit at June 30, 2004. These letters of credit are posted primarily with two counterparties to the Company’s hedging contracts and are used in lieu of cash margin deposits with those counterparties.

5. Asset Retirement Obligations

     In August 2001, the Financial Accounting Standards Board issued SFAS 143, “Accounting for Asset Retirement Obligations,” which the Company adopted as of January 1, 2003. This statement requires the Company to record a liability in the period in which an asset retirement obligation is incurred in an amount equal to the discounted estimated fair value of the obligation. Also, upon initial recognition of the liability, the Company must capitalize an equal amount of asset cost. Thereafter, each quarter, this liability is accreted and, if needed, adjusted up to the final cost. Accretion expense is included in ‘Other operating’ expense in the Company’s Consolidated Statements of Operations.

     The adoption of SFAS 143 on January 1, 2003 resulted in a cumulative effect of accounting change adjustment to record (i) a $4.0 million increase in the carrying values of proved properties, (ii) a $2.1 million decrease in accumulated depletion, depreciation, and amortization, (iii) a $5.2 million increase in non-current liabilities, and (iv) a gain of $0.9 million, net of tax.

     The following table shows net income and basic and diluted net income per common share as reported, as well as pro forma amounts as if the Company had adopted SFAS 143 prior to January 1, 2003 (in thousands, except per common share amounts):

     The Company’s primary asset retirement obligations relate to future plugging and abandonment expenses on our oil and natural gas properties and related facilities disposal. As of June 30, 2004, the Company had $3.0 million held in an escrow account from which funds are released only for reimbursement of plugging and abandonment expenses on our Bell Creek property. This amount is included in ‘Other assets’ in the accompanying Consolidated Balance Sheet. The following table summarizes the changes in the Company’s future abandonment liability from January 1, 2004 through June 30, 2004 (in thousands):

6. Income Taxes

     Reconciliation of income tax expense with tax at the Federal statutory rate is as follows (in thousands):

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7. Earnings Per Share (EPS)

     The following table sets forth basic and diluted EPS computations for the three and six months ended June 30, 2004 and 2003 (in thousands, except per share data):

(a)

There were no shares of antidilutive restricted stock outstanding for the three months ended June 30, 2004 and 2003. For the quarter ended June 30, 2004 and 2003, outstanding employee stock options of 25,000 and 240,000 were excluded from the calculation of diluted earnings per share because their effect would have been antidilutive.

8. Derivative Financial Instruments

     The following tables summarize the Company’s open commodity derivative instruments designated as hedges as of June 30, 2004:

Oil Derivative Instruments at June 30, 2004

Natural Gas Derivative Instruments at June 30, 2004

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     Encore recognizes in the Consolidated Statement of Operations derivative fair value gains and losses related to changes in the mark-to-market value of the Company’s basis swaps and certain other commodity derivatives that are not designated for hedge accounting; ineffectiveness of commodity derivative contracts designated as hedges; and changes in the mark-to-market value of the Company’s interest rate swap.

     In order to more effectively hedge the cash flows received on oil and natural gas production, the Company enters into financial instruments whereby Encore swaps certain per Bbl or per Mcf floating market indices for a fixed amount. These market indices are a component of the price Encore is paid on its actual production. By fixing this component of the Company’s marketing price, Encore is able to realize a net price with a more consistent differential to NYMEX. Since NYMEX is the basis of all the Company’s derivative oil hedging contracts and some of the natural gas contracts, a more consistent differential results in more effective hedges. However, management has elected not to use hedge accounting for certain of these contracts because it is more cost effective not to designate such derivatives as hedges. Instead, the Company marks these contracts to market each quarter through ‘Derivative fair value (gain) loss’ in the Consolidated Statements of Operations. Thus, as these contracts do not change Encore’s overall hedged volumes, average prices presented in the tables above are exclusive of any effect of these non-hedge instruments. As of June 30, 2004, the mark-to-market value of these contracts was $0.1 million.

     The oil put contracts in place at June 30, 2004 that the Company did not designate as cash flow hedges represented 2,500 Bbls in the second half of 2004. The Company also had natural gas floor contracts not designated as hedges representing 5,000 Mcf per day for 2004.

Interest Rate Derivatives

     The following table summarizes the Company’s only interest rate swap contract at June 30, 2004:

     This contract does not qualify for hedge accounting and, thus, the changes in its fair market value are recorded in ‘Derivative fair value (gain) loss’ on the Consolidated Statements of Operations. During the quarter ended June 30, 2004, a loss of $1.1 million related to the interest rate swap was recorded in the Consolidated Statement of Operations.

     The actual gains or losses the Company realizes from derivative transactions may vary significantly from the deferred loss amount recorded in stockholders’ equity at June 30, 2004 due to fluctuation of prices in the commodities markets.

9. Financial Statements of Subsidiary Guarantors

     As of June 30, 2004, all of the Company’s subsidiaries were subsidiary guarantors of the Company’s outstanding 8⅜% and 6¼% notes. Since (i) each subsidiary guarantor is 100% owned by the Company, (ii) the Company has no assets or operations that are independent of its subsidiaries, (iii) the subsidiary guarantees are full and unconditional and joint and several and (iv) all of the Company’s subsidiaries are subsidiary guarantors, the Company has not included the financial statements of each subsidiary in this report. The subsidiary guarantors may without restriction transfer funds to the Company in the form of cash dividends, loans, and advances.

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

     This document contains forward-looking statements that are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements involve risks and uncertainties. Actual results may differ materially from those anticipated in our forward-looking statements due to many factors, including, but not limited to, those set forth under “— SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS” contained in Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, in Encore’s 2003 Annual Report on Form 10-K. The following discussion should be read in conjunction with the consolidated financial statements and notes thereto included in this document and Encore’s 2003 Form 10-K.

Second Quarter 2004 Highlights

     Our financial and operating results for the quarter ended June 30, 2004 included the following highlights:

•

During the second quarter of 2004, we had quarterly net income of $18.0 million ($0.58 per diluted share), which represents an increase of 27% over second quarter 2003 net income of $14.2 million ($0.47 per diluted share). Second quarter 2004 net income was negatively impacted by $1.1 million ($0.03 per share) of exploration expense. Higher production volumes and commodity prices resulted in record oil and natural gas revenues of $70.1 million for the second quarter of 2004. This represents a 37% increase over the $51.2 million of oil and natural gas revenues reported for the second quarter of 2003. Our average net combined price rose to $31.54 per BOE for the second quarter of 2004 over the $26.32 per BOE reported in the second quarter of 2003.

•

Our earnings were driven by record production volumes averaging 24,434 BOE per day in the second quarter of 2004 as compared to 21,398 BOE per day in the second quarter of 2003, an increase of 14%. During the current quarter, oil production averaged 18,557 Bbls per day and natural gas production averaged 35,260 Mcf per day. Natural gas production volumes in the current quarter reflect an increase of 61% over the level reported in the second quarter of 2003 as a result of our Elm Grove and Cortez acquisitions that closed in the second half of 2003 and the first half of 2004, respectively. Our recently completed Overton acquisition is not reflected in the operating results in the second quarter of 2004.

•

Lease operations expense increased from $4.69 per BOE reported in the second quarter of 2003 to $4.91 per BOE in the second quarter of 2004. The increase in our average per BOE rate was attributable to production declines in our fields that have relatively low lease operations expense compared to our other properties and an increase in prices paid for outside services. General and administrative expense decreased from $1.20 per BOE in the second quarter of 2003 to $1.14 per BOE in the second quarter of 2004 as costs were spread over higher production volumes. DD&A expense per BOE of $5.06 for the second quarter of 2004 increased, as expected, from the $3.96 per BOE recorded for the second quarter of 2003 resulting from higher than historical finding, development, and acquisition costs.

•

We invested $40.2 million in development projects during the second quarter of 2004, $9.3 million of which was invested in our high-pressure air injection (“HPAI”) tertiary recovery projects in the Little Beaver Unit and the Pennel Unit of the CCA. The capital was invested in 23 (18.6 net) new operated vertical producing wells, 5 (5.0 net) horizontal wells, 15 (14.9 net) operated horizontal re-entry wells and 1 (1.0 net) operated service/injection well. We also participated in the drilling of 19 (2.4 net) non-operated vertical producing wells. We drilled one exploratory dry hole in the Barnett Shale area that was acquired in the Cortez acquisition.

•

Recent acquisitions include the acquisition of natural gas properties in Overton Field located in Smith County, Texas, additional interests in Elm Grove Field, and the acquisition of Cortez.

•

On June 30, 2004, we filed a new registration statement on Form S-3 with the SEC. The registration statement, which was declared effective by the SEC on July 9, 2004, allows us to issue an aggregate of $500 million of common stock, preferred stock, senior debt and subordinated debt.

•

On June 10, 2004, we issued and sold 2,000,000 shares of our common stock to the public at a price of $26.95 per share. The shares were sold under our prior shelf registration statement, which was declared effective by the SEC in August 2003. The net proceeds of the offering, after underwriting discounts and commissions and other expenses of the offering, were approximately $53.0 million. We used the net proceeds of this offering to repay indebtedness under our revolving

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credit facility and for general corporate purposes, including funding the previously announced purchase of natural gas properties in Overton Field in Smith County, Texas.

•

On April 2, 2004, we sold $150 million of 6¼% Senior Subordinated Notes due 2014 in a private placement. We estimate net proceeds of $146.2 million after deducting commissions and paying other costs associated with the offering. Subsequent to the initial offering, we filed a registration statement with the SEC to exchange registered notes for the unregistered notes.

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Results of Operations

     The following table sets forth selected operating information for the periods presented:

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Comparison of Quarter Ended June 30, 2004 to Quarter Ended June 30, 2003

     Set forth below is our comparison of operations during the second quarter of 2004 with the second quarter of 2003.

     Revenues and Production Volumes. The following table illustrates the primary components of oil and natural gas revenue for the three months ended June 30, 2004 and 2003, as well as each quarter’s respective oil and natural gas volumes (in thousands, except per unit amounts):

     Oil revenues increased from second quarter 2003 to second quarter 2004 by $12.2 million, due to a higher realized average oil price and a slight increase in volumes. Our realized average oil price increased $6.13 per Bbl in the second quarter of 2004 over the same period in 2003 primarily as a result of a $9.13 per Bbl increase in our average wellhead price offset by an increase in hedging payments. This increase in our average wellhead price is in line with the increase in the overall market price for oil as reflected in the $9.41 per Bbl increase in the average NYMEX price over the same period.

     Natural gas revenues increased by $6.7 million in the second quarter of 2004 compared to the second quarter of 2003 due to an increase in volumes and a slight increase in our realized average natural gas price. Production volumes increased 1,220 MMcf in the second quarter of 2004 as compared to the second quarter of 2003 due to the Elm Grove acquisition, which was completed during the third quarter of 2003 and the Cortez acquisition, which was completed in the second quarter of 2004.

     Lease operations expense. Lease operations expense for the second quarter of 2004 increased as compared to the second quarter of 2003 by $1.8 million. The increase is primarily attributable to an increase in production volumes attributable to the Elm Grove and Cortez acquisitions. Lease operations expense per BOE increased by $0.22. The increase in our average per BOE rate was attributable to production declines in our fields that have relatively low lease operations expense compared to our other properties and an increase in prices paid for outside services.

     Production, ad valorem, and severance taxes. Production, ad valorem, and severance taxes for the second quarter of 2004 increased as compared to the same period in 2003 by approximately $2.1 million due to increased revenues. As a percentage of oil and natural gas revenues (excluding the effects of hedges), production, ad valorem, and severance taxes for the second quarter of 2004 decreased slightly when compared to the second quarter of 2003, down to 9.1% from 9.4%. The decrease is attributable to the addition of the Elm Grove properties added in the third quarter of 2003 and the Cortez properties added in the second quarter of 2004, which have a lower rate as a percentage of oil and natural gas revenues than our historical average. The effect of hedges is excluded from oil and natural gas revenues in the calculation of these percentages because this method more closely reflects the method used to calculate actual production, ad valorem, and severance taxes paid to taxing authorities.

     General and administrative (“G&A”) expense. G&A expense (excluding non-cash stock based compensation) increased $0.2 million for the second quarter of 2004 as compared to the second quarter of 2003. The overall increase is primarily a result of increased staffing levels added to maintain the Company’s larger asset base. G&A expense (excluding non-cash stock based

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compensation) decreased 5% on a per BOE basis from $1.20 in the second quarter of 2003 to $1.14 per BOE in the second quarter of 2004 as costs were spread over higher production volumes.

     Non-cash stock based compensation expense. Non-cash stock based compensation expense increased $0.2 million from the three months ended June 30, 2003 to the three months ended June 30, 2004. This expense represents the amortization of deferred compensation which is being amortized to expense over the vesting period of restricted stock granted under the 2000 Incentive Stock Plan. The increase is the result of the increase in total deferred compensation to be recorded, which is due to an increase in the number of shares outstanding and an increase in our stock price.

     Depletion, depreciation, and amortization (“DD&A”) expense. DD&A expense for the second quarter of 2004 increased by $3.5 million as compared to the second quarter of 2003, due to a $1.10 increase in the per BOE rate and an increase in production. The per BOE rate increased, as expected, from the $3.96 per BOE recorded in the second quarter of 2003 to $5.06 in the second quarter of 2004 as a result of higher than historical finding, development, and acquisition costs.

     Exploration expense. Exploration expense was $1.7 million for the three months ended June 30, 2004 as compared to zero for the same period in 2003. This expense is mainly attributable to the dry hole drilled in the Barnett Shale area that was acquired in the Cortez acquisition. The well was spudded by Cortez prior to acquisition.

     Derivative fair value (gain) loss. During the second quarter of 2004, we recorded a $1.0 million derivative fair value loss as compared to the $0.6 million gain recorded in the second quarter of 2003. The components of the derivative fair value (gain) loss reported in the quarterly periods are as follows (in thousands):

     Other operating expense. Other operating expense for the second quarter of 2004 increased by $0.4 million as compared to the second quarter of 2003. This increase is attributable to higher third party transportation expenses in the second quarter of 2004 and higher accretion expense related to our future abandonment liability.

     Interest expense. Interest expense increased $2.3 million in the quarter ended June 30, 2004 compared to the quarter ended June 30, 2003. The increase in interest expense is due to the issuance of the 6 ¼% Notes, slightly offset by a decrease in non-cash amortization of the deferred loss on interest rate swaps. The weighted average interest rate, net of hedges, for the second quarter of 2004 was 7.9% compared to 10.7% for the second quarter of 2003, as the 6 ¼% rate on the newly issued bonds is lower than our historical average rate. The following table illustrates the components of interest expense for the three months ended June 30, 2004 and 2003 (in thousands):

(a)

Amount represents non-cash amortization of the deferred loss on interest rate swaps from other comprehensive income to interest expense. This unrealized loss relates to previously outstanding interest rate swaps which no longer qualified for hedge accounting. We have since cash settled these interest rate swaps and the swaps are no longer outstanding.

     Income taxes. Income tax expense for the second quarter of 2004 increased as compared to the second quarter of 2003 by $1.6 million. This increase is due in part to the $5.3 million increase in income before income taxes, offset by a decrease in our effective tax rate from 37.2% in the second quarter of 2003 to 35.7% in the second quarter of 2004. The decrease in our effective tax rate is due to an increase in Section 43 credits generated from investments in high-pressure air injection on our CCA properties during the second

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quarter of 2004 as compared to the second quarter of 2003. Section 43 credits increased from $0.01 million generated during the second quarter of 2003 to $1.5 million generated in the second quarter of 2004.

Comparison of Six Months Ended June 30, 2004 to Six Months Ended June 30, 2003

     Set forth below is our comparison of operations during the first six months of 2004 with the first six months of 2003.

     Revenues and Production Volumes. The following table illustrates the primary components of oil and natural gas revenue for the six months ended June 30, 2004 and 2003, as well as each period’s respective oil and natural gas volumes (in thousands, except per unit amounts):

     Oil revenues increased from the first six months of 2003 to the first six months of 2004 by $12.5 million, primarily due to a higher realized average oil price. Our realized average oil price increased $3.65 per Bbl for the six months ended June 30, 2004 over the same period in 2003 primarily as a result of an increase in our average wellhead price. The $5.15 per Bbl increase in our average wellhead price is in line with the increase in the overall market price for oil as reflected in the $5.34 per Bbl increase in the average NYMEX price over the same period.

     Natural gas revenues increased by $9.9 million for the six months ended June 30, 2004 over the same period in 2003 primarily due to an increase in volumes. Production volumes increased 1,811 MMcf for the six months ended June 30, 2004 as compared to the same period in 2003 due to the Elm Grove acquisition, which was completed during the third quarter of 2003 and the Cortez acquisition, which was completed in the second quarter of 2004. Our average wellhead price received remained relatively flat, which is consistent with the overall market price for natural gas, as reflected in the slight average NYMEX price change over the period.

     Lease operations expense. Lease operations expense for the six months ended June 30, 2004 increased as compared to the same period in 2003 by $3.1 million. The increase is primarily attributable to the production from the Elm Grove and Cortez acquisitions, which closed in the third quarter of 2003 and the second quarter of 2004, respectively. Lease operations expense per BOE increased by $0.37. The increase in our average per BOE rate was attributable to production declines in our fields that have relatively low lease operations expense compared to our other properties and an increase in prices paid for outside services.

     Production, ad valorem, and severance taxes. Production, ad valorem, and severance taxes increased by approximately $1.7 million for the six months ended June 30, 2004 over the same period in 2003 due to increased revenues. As a percentage of oil and natural gas revenues (excluding the effects of hedges), production, ad valorem, and severance taxes for the first half of 2004 decreased when compared to the first half of 2003, down to 9.0% from 9.6%. The decrease is attributable to the addition of the Elm Grove properties added in the third quarter of 2003 and the Cortez properties added in the second quarter of 2004, which have a lower rate as a percentage of oil and natural gas revenues than our historical average. The effect of hedges is excluded from oil and natural gas revenues in the calculation of these percentages because this method more closely reflects the method used to calculate actual production, ad valorem, and severance taxes paid to taxing authorities.

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     General and administrative expense. G&A expense (excluding non-cash stock based compensation) decreased slightly for the six months ended June 30, 2004 over the same period in 2003. G&A expense (excluding non-cash stock based compensation) decreased 8% on a per BOE basis from $1.22 in the six months ended June 30, 2003 to $1.12 per BOE in the six months ended June 30, 2004 as costs were spread over higher production volumes.

     Non-cash stock based compensation expense. Non-cash stock based compensation expense increased $0.3 million from the six months ended June 30, 2003 to the six months ended June 30, 2004. This expense represents the amortization of deferred compensation which is being amortized to expense over the vesting period of restricted stock granted under the 2000 Incentive Stock Plan. The increase is the result of the increase in total deferred compensation to be recorded, which is due to an increase in the number of shares granted and an increase in our stock price.

     Depletion, depreciation, and amortization expense. DD&A expense for the first six months of 2004 increased by $5.0 million as compared to the same period in 2003, due to a $0.88 increase in the per BOE rate and an increase in production. The per BOE rate increased, as expected, from the $3.94 per BOE recorded for the six months ended June 30, 2003 to $4.82 for the six months ended June 30, 2004 as a result of higher than historical finding, development, and acquisition costs.

     Exploration expense. Exploration expense was $1.7 million for the six months ended June 30, 2004 as compared to zero for the same period in 2003. This expense is mainly attributed to the dry hole drilled in the Barnett Shale area that was acquired in the Cortez acquisition. The well was spudded by Cortez prior to acquisition.

     Derivative fair value (gain) loss. During the first six months of 2004, we recorded a $1.1 million derivative fair value loss as compared to the $1.8 million gain recorded in the same period in 2003. The components of the derivative fair value (gain) loss reported in the quarterly periods are as follows (in thousands):

     Other operating expense. Other operating expense for the six months ended June 30, 2004 increased by $1.2 million as compared to the same period in 2003. This increase is attributable to higher third party transportation expenses in 2004, and higher accretion expense related to our future abandonment liability, and inclusion of $0.5 million gain related to the sale of an Enron receivable in the first quarter of 2003.

     Interest expense. Interest expense increased $2.0 million in the six months ended June 30, 2004 compared to the six months ended June 30, 2003. The increase in interest expense is due to the issuance of the 6 ¼% Notes, slightly offset by a decrease in non-cash amortization of the deferred loss on interest rate swaps. The weighted average interest rate, net of hedges, for the first six months of 2004 was 8.1% compared to 10.4% in the same period in 2003 as our average interest rate benefited from the issuance of the 6 ¼% Notes during the second quarter of 2004. The following table illustrates the components of interest expense for the six months ended June 30, 2004 and 2003 (in thousands):