UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

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, 2007

Commission file number 1-08246

Southwestern Energy Company

(Exact name of Registrant as specified in its charter)

Delaware

(State or other jurisdiction of

incorporation or organization)

 

71-0205415

(I.R.S. Employer

Identification No.)

2350 North Sam Houston Parkway East, Suite 125, Houston, Texas

(Address of principal executive offices)

 

77032

(Zip Code)

(281) 618-4700

Registrant's telephone number, including area code

Securities registered pursuant to Section 12(b) of the Act:

Title of each class

Common Stock, Par Value $0.01

(including associated stock purchase rights)

 

Name of each exchange on which registered

New York Stock Exchange

Securities registered pursuant to Section 12(g) of the Act: None

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yesx     Noo   


Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yeso    Nox   

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. Yesx   Noo   

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. x 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act.  (Check one):


Large accelerated filer x

Accelerated filer o

Non-accelerated filer o

Smaller reporting company o


Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes o     No x 


The aggregate market value of the voting stock held by non-affiliates of the registrant was $7,412,186,555 based on the New York Stock Exchange – Composite Transactions closing price on June 30, 2007, of $44.50. For purposes of this calculation, the registrant has assumed that its directors and executive officers are affiliates.

As of February 22, 2008, the number of outstanding shares of the registrant’s Common Stock, par value $0.01, was 170,971,532.  


Document Incorporated by Reference

Portions of the registrant’s definitive proxy statement to be filed with respect to the annual meeting of stockholders to be held on or about May 6, 2008 are incorporated by reference into Part III of this Form 10-K.




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SOUTHWESTERN ENERGY COMPANY
ANNUAL REPORT ON FORM 10-K
For Fiscal Year Ended December 31, 2007

TABLE OF CONTENTS

 

   

Page

PART I    
Item 1. Business 3
 

Glossary of Certain Industry Terms

20
Item 1A. Risk Factors 22
Item 1B. Unresolved Staff Comments 30
Item 2. Properties 30
Item 3. Legal Proceedings 32
Item 4. Submission of Matters to a Vote of Security Holders 32
 

Executive Officers of the Registrant

33
PART II    
Item 5.

Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

34
 

Stock Performance Graph

35
Item 6.

Selected Financial Data

36
Item 7.

Management's Discussion and Analysis of Financial Condition and Results of Operations

 
 

Overview

38
 

Results of Operations

39
 

Liquidity and Capital Resources

46
 

Critical Accounting Policies

50
 

Cautionary Statement about Forward-Looking Statements

53
Item 7A.

Quantitative and Qualitative Disclosures about Market Risk

55
Item 8.

Financial Statements and Supplementary Data

57
 

Index to Consolidated Financial Statements

57
Item 9.

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

87
Item 9A.

Controls and Procedures

87
Item 9B.

Other Information

87
     
PART III

 

 
Item 10.

Directors, Executive Officers and Corporate Governance

87
Item 11.

Executive Compensation

87
Item 12.

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

88
Item 13.

Certain Relationships and Related Transactions, and Director Independence

88
Item 14.

Principal Accounting Fees and Services

88
 

 

 
PART IV

 

 
Item 15.

Exhibits, Financial Statement Schedules

88

 

EXHIBIT INDEX

This Annual Report on Form 10-K includes certain statements that may be deemed to be “forward-looking” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, or the Exchange Act. We refer you to “Risk Factors” in Item 1A of Part I and to “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Cautionary Statement about Forward-Looking Statements” in Item 7 of Part II of this Form 10-K for a discussion of factors that could cause actual results to differ materially from any such forward-looking statements. The electronic version of this Annual Report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those forms filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act are available free of charge as soon as reasonably practicable after they are filed with the Securities and Exchange Commission, or the SEC, on our website at www.swn.com.  Our corporate governance guidelines and the charters of the Audit, Compensation, Nominating and Governance and Retirement Committees of our Board of Directors are available on our website, and are available in print free of charge to any stockholder upon request.



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ITEM 1.  BUSINESS

Southwestern Energy Company is an independent energy company primarily engaged in the exploration for and production of natural gas within the United States.  We also focus on creating and capturing additional value through our natural gas gathering and marketing businesses, which we refer to as our Midstream Services.  We operate principally in three segments – Exploration and Production, or E&P, Midstream Services and Natural Gas Distribution:


·

Exploration and Production - Our primary business is natural gas and oil exploration, development and production within the United States, with operations principally located in Arkansas, Oklahoma and Texas.  Our operations are primarily conducted through our wholly-owned subsidiaries, SEECO, Inc. and Southwestern Energy Production Company, or SEPCO. SEECO operates exclusively in Arkansas, holds a large base of both developed and undeveloped gas reserves and conducts both the drilling program for the Fayetteville Shale play and the ongoing conventional drilling program in the Arkansas part of the Arkoma Basin. SEPCO conducts development drilling and exploration programs in the Oklahoma portion of the Arkoma Basin and in Texas.  DeSoto Drilling, Inc., or DDI, a wholly-owned subsidiary of SEPCO, operates drilling rigs in the Fayetteville Shale play and in East Texas.


·

Midstream Services - Our Midstream Services segment generates revenue from gathering fees associated with the transportation of natural gas to market and through the marketing of our own gas production and some third-party natural gas.  Our gathering subsidiary, DeSoto Gathering Company, L.L.C., engages in gas gathering activities primarily related to the development of our Fayetteville Shale play.  Our gas marketing subsidiary, Southwestern Energy Services Company, or SES, captures downstream opportunities which arise through marketing and transportation activity.  


·

Natural Gas Distribution - Our wholly-owned subsidiary, Arkansas Western Gas Company, or AWG, operates integrated natural gas distribution systems in northern Arkansas serving approximately 152,000 retail customers.  On November 14, 2007, we announced that we had entered into a definitive agreement for the sale of AWG to SourceGas LLC for $224 million plus working capital.  Upon the consummation of the pending sale of AWG, we will cease to have any natural gas distribution operations.  Subject to regulatory approval, the sale is expected to close approximately mid-year 2008.

The vast majority of our operating income and earnings before interest, taxes, depreciation, depletion and amortization, or EBITDA, is derived from our E&P business.  In 2007, 94% of our operating income and 95% of our EBITDA were generated from our E&P business. Our Midstream Services and Natural Gas Distribution segments each generated 3% of our operating income and 3% and 2%, respectively, of our EBITDA in 2007.  In 2006, 96% of our operating income and 93% of our EBITDA were generated from our E&P business.  In 2006, our Midstream Services and Natural Gas Distribution segments each generated 2% of our operating income and 1% and 3%, respectively, of our EBITDA.  In 2005, our E&P, Midstream Services and Natural Gas Distribution segments generated 95%, 3% and 2% of our operating income and 94%, 3% and 3% of our EBITDA, respectively. EBITDA is a non-GAAP measure. We refer you to “Business — Other Items — Reconciliation of Non-GAAP Measures” in Item 1 of Part I of this Form 10-K for a table that reconciles EBITDA with our net income.

Our Business Strategy

We are focused on providing long-term growth in the net asset value of our business.   In our E&P business, we prepare an economic analysis for each investment opportunity based upon the expected present value added for each dollar to be invested, which we refer to as Present Value Index, or PVI.  The PVI of the future expected cash flows for each project is determined using a 10% discount rate. We target creating at least $1.30 of discounted pre-tax PVI for each dollar we invest in our E&P projects. Our actual PVI results are utilized to help determine the allocation of our future capital investments.  The key elements of our E&P business strategy are:

·

Exploit and Develop Our Existing Asset Base.  We seek to maximize the value of our existing asset base by developing properties that have production and reserve growth potential while also controlling per unit production costs.  Our primary focus is our Fayetteville Shale play, where we hold approximately 906,700 net acres.  We believe our large acreage position holds significant production and reserve growth potential.  We intend to continue to develop our acreage position by accelerating our drilling program and by improving individual well results through the use of advanced technologies and detailed technical analysis of our properties.  Approximately 95% of the $61 million budgeted for seismic and other geological and geophysical, or G&G, expenditures in 2008 will be allocated to our Fayetteville Shale acreage to acquire an additional 370 square miles of three-dimensional (3-D) seismic data.  This,



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along with approximately 525 square miles of 3-D seismic data that we have acquired through December 31, 2007, will give us seismic data on approximately 45% of our net acreage position in the Fayetteville Shale.

·

Maximize Efficiency through Economies of Scale.  In our key operating areas, the concentration of our properties allows us to achieve economies of scale that result in lower costs.  In our Fayetteville Shale play, we have achieved significant cost savings by operating a fleet of drilling rigs designed specifically for the play. In addition, we are building a sizeable gas gathering system in the Fayetteville Shale play that will allow us to reduce our per unit production costs.

·

Control Operations and Costs.  We seek to serve as the operator of the wells in which we have a significant interest.  As the operator, we are better positioned to control the timing and plans for future enhancement and exploitation efforts, the costs of enhancing, drilling, completing and producing the wells, and the marketing negotiations for our gas and oil production to maximize both production volumes and wellhead price.

·

Hedge Production to Stabilize Cash Flow.  As of December 31, 2007, the average proved reserves-to-production ratio, or reserve life, of our estimated proved reserves was approximately 12.8 years.  Our long-lived reserves provide us with relatively predictable production.  We maintain an active natural gas hedging program on our production to protect cash flows that we use for capital investments.  As of December 31, 2007, we had hedges in place on approximately 102.0 Bcf of 2008 gas production (representing approximately 70% of our targeted 2008 production) and 79.0 Bcf of 2009 gas production.  Additionally, we have financially protected 91.3 Bcf and 3.6 Bcf for 2008 and 2009, respectively, in order to reduce the effects of changes in market differentials on prices we receive on future gas production volumes.

·

Grow Through New Exploration and Development Activities.  We actively seek to find and develop new conventional natural gas and oil properties, as well as new unconventional resource plays, with significant exploration and exploitation potential which we refer to as New Ventures. New prospects are evaluated primarily based on repeatability, multi-well potential and land availability as well as other criteria.  Our Fayetteville Shale play began as a New Venture project in 2002.  As of December 31, 2007, we held 156,465 net undeveloped acres in New Ventures, which includes approximately 88,000 net undeveloped acres targeting the Devonian-aged Marcellus Shale in Appalachia, where we intend to initiate drilling in 2008.

Recent Developments

Senior Note Offering.  In January 2008, we completed a private placement offering of $600 million principal amount of 7.5% Senior Notes due 2018.  The net proceeds of the offering were used to repay a portion of the amounts outstanding under our revolving credit facility.

2008 Planned Capital Investments and Production Guidance.  On December 19, 2007, we announced a planned capital investment program for 2008 of $1.46 billion, which includes $1.33 billion for our E&P segment, $101 million for our Midstream Services segment, and $25 million for our Natural Gas Distribution segment and other corporate purposes.  Our 2008 capital program is expected to be primarily funded by internally-generated cash flow, borrowings under our revolving credit facility and/or funds raised in the public debt markets, proceeds from the sale of AWG and divestitures of certain E&P assets.  We also announced our targeted 2008 gas and oil production of approximately 148.0 to 152.0 Bcfe, an increase of approximately 30 to 35% over our 2007 production.

Sale of AWG.  On November 9, 2007, we entered into a definitive agreement with SourceGas LLC, pursuant to which SourceGas has agreed to purchase all of the capital stock of AWG for $224 million plus working capital, subject to possible adjustment based on a “seasonality factor” that could reduce the purchase price by up to 2.5% depending upon when the transaction closes.  Subject to regulatory approval, the transaction is expected to close approximately mid-year 2008.  Upon consummation of the sale, we will cease to engage in the natural gas distribution business.

Amendment of Revolving Credit Facility.  On October 12, 2007, we entered into an amendment of our revolving credit facility pursuant to which, among other things, (i) the amount by which our revolving credit facility could be increased through the “accordion” feature was raised from $250 million to $500 million (thereby increasing the maximum aggregate borrowing capacity under our revolving credit facility from $1 billion to $1.25 billion) and (ii) our subsidiaries (other than AWG) were provided with the ability, without limit, to guarantee our indebtedness.  In connection with the amendment, we partially exercised our option under the “accordion” feature and increased our current borrowing capacity from $750 million to $1 billion.



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Exploration and Production

Historically, we have operated our E&P business in four primary regions — the Arkoma Basin, East Texas, the Permian Basin and the onshore Gulf Coast.  In 2008, our operations will primarily be focused in the Arkoma Basin and East Texas.    We will continue to actively seek to develop new conventional exploration projects as well as unconventional plays with significant exploration and exploitation potential .



Operating income from our E&P segment was $358.1 million in 2007, up from $237.3 million in 2006 and $234.8 million in 2005.  EBITDA from our E&P segment was $640.5 million in 2007, compared to $386.4 million in 2006 and $325.9 million in 2005.  The increases in both our operating income and EBITDA in 2007 and 2006 were due to increased production volumes and higher realized prices, partially offset by increases in operating costs and expenditures.  EBITDA is a non-GAAP measure. We refer you to “Business — Other Items — Reconciliation of Non-GAAP Measures” in Item 1 of Part I of this Form 10-K for a reconciliation of EBITDA with our net income.

Our estimated proved natural gas and oil reserves were 1,450 Bcfe at year-end 2007, compared to 1,026 Bcfe at year-end 2006 and 827 Bcfe at year-end 2005. The overall increase in total estimated proved reserves in the past three years is primarily due to the discovery and development of the Fayetteville Shale play in Arkansas, the accelerated development of our Overton Field in East Texas and our continued conventional drilling program in the Arkoma Basin.  The after-tax PV-10, or standardized measure of discounted future net cash flows relating to proved gas and oil reserve quantities, was $2.0 billion at year-end 2007, compared to $1.0 billion at year-end 2006 and $1.4 billion at year-end 2005.  The reconciling difference in after-tax PV-10 and pre-tax PV-10 (a non-GAAP measure which is reconciled in the 2007 Summary Operating Data table below) is the discounted value of future income taxes on the estimated cash flows.  Our year-end 2007 estimated proved reserves had a present value of estimated future net cash flows before income tax, or pre-tax PV-10, of $2.6 billion, compared to $1.3 billion at year-end 2006 and $2.0 billion at year-end 2005.  We believe that the pre-tax PV-10 value of the estimated cash flows related to our estimated proved reserves is a useful supplemental disclosure to the after-tax PV-10 value.  While pre-tax PV-10 is based on prices, costs and discount factors that are comparable from company to company, the after-tax PV-10 is dependent on the unique tax situation of each individual company.  We understand that securities analysts use pre-tax PV-10 as one measure of the value of a company’s current proved reserves and to compare relative values among peer companies without regard to income taxes.  The decrease in year-end 2006 pre-tax and after-tax PV-10 values of our reserves as compared to year-end 2005 is primarily due to a lower market price for natural gas at December 31, 2006.  At year-end 2007, the market prices for natural gas and crude oil that were used to calculate our PV-10 value were $6.80 per Mcf and $92.50 per barrel, respectively, compared to $5.64 per Mcf and $57.25 per barrel at year-end 2006 and $10.08 per Mcf and $61.04 per barrel at year-end 2005.  We refer you to Note 7 in the consolidated financial statements for a discussion of our standardized measure of discounted future cash flows related to our proved natural gas and oil reserves, to the risk factor “Although our estimated natural gas and oil reserve data is independently audited, our estimates may still prove to be inaccurate” in Item 1A of Part I of this Form 10-K, and to “Management’s Discussion and Analysis of Financial Condition and Results of Operations Cautionary Statement about Forward-Looking Statements” in Item 7 of Part II of this Form 10-K for a discussion of the risks inherent in utilization of standardized measures and estimated reserve data.



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Approximately 96% of our year-end 2007 estimated proved reserves were natural gas and 64% were classified as proved developed, compared to 95% and 65%, respectively, in 2006. We operate approximately 90% of our reserves, based on our PV-10 value, and our average reserve life approximated 12.8 years at year-end 2007. Sales of natural gas production accounted for 94% of total operating revenues for this segment in 2007, 91% in 2006 and 92% in 2005. Natural gas production has generated a substantial portion of total operating revenues as a result of the natural gas focus of our capital investments in the past three years.

The reserve replacement ratio is an important analytical measure used within the E&P industry by investors and peers to evaluate performance results. There are limitations as to the usefulness of this measure as it does not reflect the cost of adding the reserves or indicate the potential value of the reserve additions. Our reserve replacement ratio has exceeded 300% for the last three years, including 2007 where our results were primarily driven by reserve additions associated with our Fayetteville Shale play. In 2007, we replaced 474% of our production volumes by adding 507.9 Bcfe of proved natural gas and oil reserves and having net upward revisions of 31.0 Bcfe. Of the reserve additions, 281.2 Bcfe were proved developed and 226.7 Bcfe were proved undeveloped.  The upward reserve revisions during 2007 were primarily due to improved performance of wells in our Fayetteville Shale play.  

In 2006 and 2005, our reserve replacement ratios were 386% (from reserve additions of 365.5 Bcfe primarily driven by additions resulting from our drilling programs in the Fayetteville Shale play, East Texas and conventional Arkoma) and 399% (from reserve additions of 274.7 Bcfe primarily driven by additions resulting from our drilling programs in East Texas and conventional Arkoma), respectively, including net downward reserve revisions of 86.6 Bcfe in 2006 and 31.7 Bcfe in 2005. Of the 2006 reserve additions, 153.6 Bcfe were proved developed and 211.9 Bcfe were proved undeveloped.  Of the 2005 reserve additions, 107.4 Bcfe were proved developed and 167.3 Bcfe were proved undeveloped.  The downward reserve revisions during 2006 were primarily due to a comparative decrease in year-end gas prices, combined with performance revisions in our East Texas and conventional Arkoma Basin properties, which were partially offset by an upward performance revision in our Fayetteville Shale properties. The downward reserve revisions in 2005 were primarily due to adjustments to the terminal decline rates for wells at our Overton Field and declines associated with our Gulf Coast properties.

For the period ending December 31, 2007, our three-year average reserve replacement ratio, including revisions, was 430%. Our reserve replacement ratio for 2007, excluding the effect of reserve revisions, was 447%, compared to 505% in 2006 and 450% in 2005. Excluding reserve revisions, our three-year average reserve replacement ratio is 465%.

Since 2000, the substantial majority of our reserve additions have been generated from our drilling programs in the conventional Arkoma Basin, East Texas and, more recently, the Fayetteville Shale play. We expect these drilling programs to continue to be a major source of our reserve additions in the future; however, our ability to add reserves is dependent upon a number of factors that are beyond our control. We refer you to the risk factors “Our drilling plans for the Fayetteville Shale play are subject to change” and “Our exploration, development and drilling efforts and our operations of our wells may not be profitable or achieve our targeted returns” in Item 1A of Part I of this Form 10-K and to “Management’s Discussion and Analysis of Financial Condition and Results of Operations Cautionary Statement about Forward-Looking Statements” in Item 7 of Part II of this Form 10-K for a more detailed discussion of these factors and other risks.

In addition, proved undeveloped reserves will require us to make significant additional investments. We expect that our proved undeveloped reserves of 526 Bcfe as of December 31, 2007, will require us to invest an additional $995 million in order for those reserves to be brought to production. Our proved undeveloped reserve additions during 2007 are expected to be developed and to begin to generate cash inflows over the next five years. Our ability to make the necessary investments to generate these cash inflows is subject to factors that may be beyond our control. We refer you to the risk factors “We may have difficulty financing our planned capital investments, which could adversely affect our growth” and “Our future level of indebtedness and the terms of our financing arrangements may adversely affect operations and limit our growth” in Item 1A of Part I of this Form 10-K and to “Management’s Discussion and Analysis of Financial Condition and Results of Operations Cautionary Statement about Forward-Looking Statements” in Item 7 of Part II of this Form 10-K for a more detailed discussion of these factors and other risks.

The following table provides information as of December 31, 2007, related to proved reserves, well count, net acreage and PV-10, and 2007 annual information as to production and capital investments, for each of our operating areas, for our New Ventures and overall :



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2007 SUMMARY OPERATING DATA

  Arkoma                    
 

 

  Fayetteville   East       Gulf   New    
  Conventional   Shale Play   Texas   Permian   Coast   Ventures   Total

Estimated Proved Reserves:

                         

Total Reserves (Bcfe)

304

 

716

 

353

 

60

 

12

 

5

 

1,450

   Percent of Total

21%

 

49%

 

24%

 

4%

 

1%

 

1%

 

100%

   Percent Natural Gas

100%

 

100%

 

97%

 

31%

 

96%

 

100%

 

96%

   Percent Proved Developed

77%

 

43%

 

91%

 

79%

 

100%

 

100%

 

64%

           

Production (Bcfe)

23.8

 

53.5

 

29.9

 

4.7

 

1.4

 

0.3

 

113.6

Capital Investments (millions)(1)

$148

 

$960

 

$201

 

$20

 

$4

 

$42

 

$1,375

Total Gross Producing Wells

1,098

 

497

 

466

 

406

 

34

 

14

 

2,515

Total Net Producing Wells

550

 

377

 

392

 

138

 

12

 

9

 

1,478

           

Total Net Acreage

       491,791(2)

 

     781,300(3)

 

     118,904(4)

 

37,400

 

8,837

 

     168,236(5)

 

1,606,468

Net Undeveloped Acreage

       299,599(2)

 

     637,560(3)

 

      91,148(4)

 

8,944

 

5,795

 

      156,465(5)

 

1,199,511

                           

PV-10:

           

   Pre-tax (millions)(6)

$638

 

$1,038

 

$659

 

$212

 

$33

 

$12

 

$2,592

   PV of taxes (millions)(6)

142

 

231

 

147

 

47

 

7

 

3

 

577

   After-tax (millions)(6)

$496

 

$807

 

$512

 

$165

 

$26

 

$9

 

$2,015

   Percent of Total

25%

 

40%

 

25%

 

8%

 

1%

 

1%

 

100%

   Percent Operated

85%

 

96%

 

99%

 

49%

 

33%

 

81%

 

90%


(1)  Our Total and Fayetteville Shale play capital investments exclude $5 million related to the purchase of drilling rig related equipment.  

(2)  Includes 123,442 net developed acres and 1,930 net undeveloped acres in our Conventional Arkoma Basin operating area that are also within our Fayetteville Shale focus area but not included in the Fayetteville Shale acreage in the table above.

(3)  Assuming successful wells are not drilled and leases are not extended, leasehold expiring over the next three years will be 16,561 acres in 2008, 96,601 acres in 2009 and 145,722 acres in 2010.

(4)  Assuming successful wells are not drilled to develop the acreage and leases are not extended, leasehold expiring over the next three years will be 7,737 acres in 2008, 33,274 acres in 2009 and 4,474 acres in 2010.

(5)  Includes New Ventures opportunities such as the Marcellus Shale play in Pennsylvania.  

(6)  Pre-tax PV-10 (a non-GAAP measure) is one measure of the value of a company’s proved reserves that we believe is used by securities analysts to compare relative values among peer companies without regard to income taxes.  The reconciling difference in pre-tax PV-10 and the after-tax PV-10, or standardized measure, is the discounted value of future income taxes on the estimated cash flows from our proved oil and gas reserves.

We refer you to Note 7 in the consolidated financial statements for a more detailed discussion of our proved natural gas and oil reserves as well as our standardized measure of discounted future cash flows related to our proved natural gas and oil reserves.  We also refer you to the risk factor “Although our estimated natural gas and oil reserve data is independently audited, our estimates may still prove to be inaccurate” in Item 1A of Part I of this Form 10-K and to “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Cautionary Statement about Forward-Looking Statements” in Item 7 of Part II of this Form 10-K for a discussion of the risks inherent in utilization of standardized measures and estimated reserve data.

Arkoma Basin

We have traditionally operated in a portion of the Arkoma Basin located in western Arkansas that is primarily within the boundaries of our utility gathering system, which we refer to as the “Fairway.”  In recent years, we have expanded our activity in the Arkoma Basin to the south and east of the traditional Fairway area and west into the Oklahoma portion of the basin.  Our drilling program in the Arkoma Basin is comprised of both conventional and unconventional activities.  We refer to our drilling program targeting stratigraphic Atokan-age objectives in Oklahoma and Arkansas as the “conventional Arkoma” drilling program.  Our Fayetteville Shale play represents our unconventional drilling program in the Arkoma Basin.   At December 31, 2007, we had approximately 1,020 Bcf of natural gas reserves in the Arkoma Basin, representing approximately 70% of our total reserves, up from 577 Bcf at year-end 2006 and 372 Bcf at year-end 2005.

Fayetteville Shale Play.  Our Fayetteville Shale play, which we announced in August 2004, is now the primary focus of our E&P business.  The Fayetteville Shale is an unconventional gas reservoir located on the Arkansas side of the Arkoma Basin, ranging in thickness from 50 to 550 feet and ranging in depth from 1,500 to 6,500 feet.  The shale is a Mississippian-age shale that is the geologic equivalent of the Caney Shale found on the Oklahoma side of the Arkoma Basin and the Barnett Shale found in north Texas.   Approximately 716 Bcf of our reserves at year-end 2007 were


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attributable to our Fayetteville Shale play, up from approximately 300 Bcf in 2006 and 101 Bcf in 2005. Gross production from our operated wells in the Fayetteville Shale play increased from approximately 100 MMcf per day at the beginning of 2007 to approximately 325 MMcf per day by year-end.  Approximately 15 MMcf per day of our production at December 31, 2007, was from 10 wells producing from conventional reservoirs located in four separate counties.  Our net production from the Fayetteville Shale play was 53.5 Bcf in 2007, compared to 11.8 Bcf in 2006 and 1.8 Bcf in 2005.  Our production in 2008 is estimated to range between 90 and 95 Bcf from the Fayetteville Shale.

At December 31, 2007, we held approximately 906,700 net acres in the play area (637,560 net undeveloped acres, 143,740 net developed acres held by Fayetteville Shale production and approximately 125,400 net acres held by conventional production).  Our leases generally require that we drill at least one producing well per governmental drilling unit (640 acres) in order to prevent our leases from expiring upon the expiration date.  At year-end 2007, approximately 18% of our leasehold acreage was held by production, excluding our acreage in the traditional Fairway portion of the Arkoma Basin.  We refer you to the risk factor “We may have difficulty drilling all of the wells that are necessary to hold our Fayetteville Shale acreage before the initial lease terms expire, which could result in the loss of certain leasehold rights” in Item 1A of Part I of this Form 10-K.  Excluding our acreage held by conventional production, our acreage position as of December 31, 2007 had an average lease term of 6 years, an average royalty interest of 15% and was obtained at an average cost of $116 per acre.  For more information about acreage and well count, we refer you to “Properties” in Item 2 of Part I of this Form 10-K.

In 2006, the Arkansas Oil and Gas Commission approved field rules in the Fayetteville Shale, the Moorefield Shale and the Chattanooga Shale as “unconventional sources of supply.”  Under the rules, each drilling unit would consist of a governmental section of approximately 640 acres and operators would be permitted to drill up to 16 wells per drilling unit for each unconventional source of supply.  We refer you to the risk factor “We may have difficulty drilling all of the wells that are necessary to hold our Fayetteville Shale acreage before the initial lease terms expire, which could result in the loss of certain leasehold rights” in Item 1A of Part I of this Form 10-K.

As of December 31, 2007, we had spud a total of 699 wells in the play, 601 of which were operated by us and 98 of which were outside-operated wells.  Of the wells spud, 415 were in 2007, 196 were in 2006 and 67 were in 2005.  Of the wells spud in 2007, 410 were designated as horizontal wells.  At year-end 2007, 478 wells had been drilled and completed, including 415 horizontal wells.  Of the 415 horizontal wells, 372 wells were fracture stimulated using either slickwater or crosslinked gel stimulation treatments, or a combination thereof.

Our total proved net gas reserves booked in the play at year-end 2007 were 716 Bcf from a total of 935 locations, of which 497 were proved developed producing, 14 were proved developed non-producing and 424 were proved undeveloped.  Of the 935 locations, 871 were horizontal.  Our proved developed reserves have ranged from less than 100,000 Mcf to 4.7 Bcf per well and the average gross proved reserves for the wells included in our year-end reserves was approximately 1.5 Bcf, compared to 1.15 Bcf per well at the end of 2006 and 0.95 Bcf per well at the end of 2005.  Total proved gas reserves booked in the play in 2006 totaled approximately 300 Bcf from a total of 434 locations, of which 162 were proved developed producing, 9 were proved developed nonproducing and 263 were proved undeveloped.  Total proved gas reserves booked in the play in 2005 totaled 101 Bcf from a total of 177 locations, of which 54 were proved developed producing, 6 were proved developed non-producing and 117 were proved undeveloped. If the Fayetteville Shale play continues to be successfully developed, over the next few years, we expect a continued significant level of proved undeveloped reserves in the Fayetteville Shale play.

Since we announced our discovery of the play in 2004, we have progressively increased our capital investments in the area resulting in significant growth in our production and reserves over the past three years.   In 2007, we invested approximately $960 million in our Fayetteville Shale play, which included $789 million to spud 415 wells, resulting in reserve additions of 401.6 Bcf.  Previous reserve estimates were further revised upward in 2007 by 67.9 Bcfe due primarily to improved well performance.  In addition, we invested $25 million for leasehold acquisition, $97 million for 3-D seismic, and $49 million in capitalized costs and other expenses.  In 2006, we invested approximately $388 million, which included $316 million to spud 196 wells, $29 million for leasehold acquisition, $14 million for seismic and $29 million in capitalized costs and other expenses.  In 2005, we invested approximately $119 million, which included $67 million to spud 67 wells, $41 million for leasehold acquisition, $4 million for seismic and $7 million in capitalized costs.  In 2008, we plan to invest approximately $1 billion in our Fayetteville Shale play, which includes drilling approximately 475 horizontal wells, approximately 40 vertical wells targeting the shallower conventional reservoirs above the Fayetteville Shale and shooting 3-D seismic over a large portion of our Fayetteville Shale acreage.  At December 31, 2007, we had acquired approximately 525 square miles of 3-D seismic data and plan to acquire an additional 370 square miles of 3-D seismic data during 2008, the total of which will give us seismic data on approximately 45% of our net acreage position in the Fayetteville Shale.


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We believe that our Fayetteville Shale acreage holds significant development potential. Our strategy going forward is to increase our production through development drilling while also determining the economic viability of the undrilled portion of our acreage.  Our drilling program with respect to our Fayetteville Shale play is flexible and will be impacted by a number of factors, including the results of our horizontal drilling efforts, our ability to determine the most effective and economic fracture stimulation methods, the extent to which we can replicate the results of our most successful Fayetteville Shale wells in other Fayetteville Shale acreage and the natural gas and oil commodity price environment.  As we continue to gather data about the Fayetteville Shale, it is possible that additional information may cause us to alter our drilling schedule or determine that prospects in some portion of our acreage position should not be pursued at all. We refer you to the risk factor “Our drilling plans for the Fayetteville Shale play are subject to change” in Item 1A of Part I of this Form 10-K.

Conventional Arkoma Program. Our conventional Arkoma drilling program continues to provide a solid foundation for our E&P program and represents a significant percentage of our total production and reserves.   Approximately 304 Bcf of our reserves at year-end 2007 were attributable to our conventional Arkoma wells.  In 2007, we invested approximately $148 million and participated in 114 wells in our conventional Arkoma properties, of which 81 were successful and 23 were in progress at year-end, resulting in an 89% success rate and adding new reserves of 60.6 Bcf.  Prior to 2007, production over the last few years from the basin was fairly constant as new production stemming from our drilling program offset the natural production decline from existing wells.  However, in 2007 we experienced 18% growth in our production volumes to 23.8 Bcf, compared to 20.1 Bcf in 2006 and 20.2 Bcf in 2005.

Our strategy in the Fairway is to continue to delineate new geologic prospects and extend previously identified trends using our extensive expertise in the area.   In recent years, we have extended our development program into other areas of the basin that had previously been less explored.   One of these is our Ranger Anticline area, which we refer to as Ranger, located at the southern edge of the Arkansas portion of the basin.  Our wells at Ranger have primarily targeted the Upper and Lower Borum tight gas sands between 5,000 and 8,000 feet in depth.  We drilled our first successful well at Ranger in 1997 and as our understanding of the geology at Ranger has grown, the potentially productive area in the field has expanded.

From 1997 through year-end 2007, we successfully drilled 156 out of 185 wells at Ranger, adding 114 net Bcf of reserves.  During 2007, we successfully completed 52 out of 67 wells at Ranger (excluding 12 wells in progress at year-end), which added 25.5 net Bcf of new reserves.   Wells completed in 2007 had average estimated ultimate gross reserves of 1.1 Bcf per well.  Net production from the field increased by 67% to 9.5 Bcf during 2007, compared to 5.7 Bcf in 2006 and 5.6 Bcf in 2005.  Our average working interest in the 156 successful wells drilled through December 31, 2007, is 76% and our average net revenue interest is 61%.  At December 31, 2007, we held approximately 81,920 gross acres at Ranger, of which 19,840 acres were developed.   We believe that Ranger holds additional future development potential.

We began drilling at our Midway prospect area located approximately 11 miles north of Ranger two years ago and, through year-end 2006, we had drilled a total of six wells.  In 2007, we began to accelerate drilling at Midway with the drilling of 26 wells which were all either productive or in progress at year-end.  Our wells at Midway primarily produce from the same productive zones as our wells at Ranger.  Depending on the performance of these wells, there may be significant additional drilling potential on our Midway acreage.  At year-end 2007, we held approximately 31,000 gross acres in our Midway prospect area.

Our conventional Arkoma Basin drilling program continues to be an important focus for our capital program and we intend to conduct development drilling and workover programs that, at a minimum, will maintain our production and reserve base in this area.  In 2008, we plan to invest approximately $132 million in our conventional Arkoma program and will drill approximately 100 to 110 wells, including 40 wells in the Ranger Anticline area and 45 wells in the Midway area.

East Texas

Our East Texas operations are primarily located in the Overton Field in Smith County, Texas, and our Angelina River Trend area located in Angelina, Nacogdoches, San Augustine and Shelby Counties in Texas.   At December 31, 2007, we had approximately 353 Bcfe of reserves in East Texas, representing approximately 24% of our total reserves, compared to 383 Bcfe at year-end 2006 and 369 Bcfe at year-end 2005.

Overton Field. Our original interest in the Overton Field (which was approximately 10,800 gross acres) was acquired in April 2000 for $6 million.   Our wells in the Overton Field produce from four Taylor series sands in the Cotton Valley formation at approximately 12,000 feet.  When we acquired the field, it was primarily developed on 640-acre spacing, or one well per square mile.  Analogous Cotton Valley fields in the area have been drilled to 80-acre spacing, and


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in some cases to 40-acre spacing.  At December 31, 2007, we held approximately 24,400 gross acres in the Overton Field with an average working interest of 96% and an average net revenue interest of 77%.  

Our proved reserves in the Overton Field were 315 Bcfe at year-end 2007, compared to 367 Bcfe at year-end 2006 and 353 Bcfe at year-end 2005.   In 2007, our drilling program was focused on drilling our proved undeveloped locations in the field.  We invested approximately $96 million to drill 45 wells at the Overton Field, all of which were successful, resulting in new reserve additions of 6.6 Bcfe.  The 2007 reserve additions at Overton were limited because the reserves from drilling our proved undeveloped locations were already included in our prior years’ reserve totals.  Additionally in 2007, previous reserve estimates for Overton were revised downward by 33.2 Bcfe due primarily to higher decline rates in newer wells than was expected.  In 2006, we invested approximately $155 million to drill 66 wells, all of which were successful, resulting in reserve additions of 88.0 Bcfe, including a net downward reserve revision of 47.2 Bcfe that was primarily a result of comparatively lower year-end gas prices as well as performance revisions in some of our existing wells.  In 2005, we invested approximately $158 million to drill 80 wells, all of which were successful, resulting in reserve additions of 82.8 Bcfe, including revisions.

Net production from our Overton Field was 25.1 Bcfe in 2007, compared to 29.8 Bcfe in 2006 and 26.7 Bcfe in 2005.  We expect our production from the Overton Field to decline over time due to the fact that the field is now almost fully developed and due to the natural production decline in existing wells.

Angelina River Trend. Our Angelina River Trend properties are concentrated in several separate development areas located primarily in four different counties in East Texas targeting both the Travis Peak and James Lime formation. Our 2007 drilling results include a new discovery at our Jebel prospect area located in Shelby County, Texas, in the James Lime formation and are collectively referred to as Angelina.  The Timberstar-Mills 1H horizontal discovery well was completed in December 2007 with an initial production rate of 12.1 MMcf per day and was producing approximately 4.0 MMcf per day as of February 22, 2008. At December 31, 2007, we held approximately 75,755 gross undeveloped acres and 11,456 gross developed acres at Angelina with an average working interest of 72.6% and an average net revenue interest of 55.7%.

Our proved reserves in the Angelina area were 33 Bcfe at year-end 2007, compared to 16 Bcfe at year-end 2006 and 13 Bcfe at year-end 2005.   Through December 31, 2007, we had drilled a total of 59 wells at Angelina primarily targeting the Travis Peak or James Lime formations, with all but one well being successful. In 2007, we invested approximately $88 million to drill 31 wells at Angelina, all but one of which were successful or in progress at December 31, 2007, resulting in reserve additions of 22.6 Bcfe.  In 2006, we invested approximately $40 million to drill 16 wells, all of which were successful. In 2005, we invested approximately $18.7 million to drill 9 wells, all of which were successful.   The average estimated ultimate recovery of gas and oil reserves from new wells completed in 2007 was approximately 1.3 gross Bcfe per well, compared to 0.8 gross Bcfe per well in 2006 and 1.6 gross Bcfe per well in 2005.   Net production from our Angelina properties was 2.5 Bcfe in 2007, compared to 1.8 Bcfe in 2006 and 0.9 Bcf in 2005.  

In 2008, we plan to invest approximately $122 million to drill approximately 40 wells in East Texas, including 30 to 35 wells in Angelina.  Of these wells, we intend to participate in up to 10 to 15 James Lime horizontal wells.

Permian Basin and Gulf Coast

Our Permian Basin properties are primarily located in west Texas and southeast New Mexico.   At December 31, 2007, our proved reserves in the Permian Basin were 60 Bcfe, compared to approximately 51 Bcfe at year-end 2006 and 59 Bcfe at year-end 2005.  Our production in the basin during 2007 was 4.7 Bcfe, compared to 5.8 Bcfe in 2006 and 6.9 Bcfe in 2005.  The decreases in production during both 2007 and 2006 were due to the natural decline in these properties, partially offset by our drilling program.  In 2007, we invested $20 million in the Permian Basin and drilled 14 wells, of which 13 were successful, resulting in reserve additions of 11.0 Bcfe.  In 2006, we invested $25 million in the Permian Basin and drilled 12 wells, all of which were successful, resulting in reserve additions of 8.5 Bcfe.  Our 2006 reserve additions were more than offset by a net downward reserve revision of 10.7 Bcfe related to lower commodity prices at year-end and performance revisions.  In 2005, we invested $15 million in the Permian Basin and drilled 16 wells, 15 of which were successful, resulting in reserve additions of 4.7 Bcfe.   At year-end 2007, we held approximately 109,468 gross acres in the Permian Basin, with an average working interest of 37% and an average net revenue interest of 30% in the wells in which we participate on this acreage.  For more information about acreage and well count, refer to “Properties” in Item 2 of Part I of this Form 10-K.

Our Gulf Coast properties are located onshore in Texas.   Proved reserves in our Gulf Coast properties totaled 12 Bcfe at December 31, 2007, compared to approximately 15 Bcfe at year-end 2006 and 27 Bcfe at year-end 2005.  Net production from this area in 2007 was 1.4 Bcfe, compared to 2.6 Bcfe in 2006 and 3.9 Bcfe in 2005.  The decrease in


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reserves and production during 2007 was due to the natural decline in these properties.  The decline in reserves in 2006 was primarily due to the divestiture of our South Louisiana properties.  During the fourth quarter of 2006, we completed the sale of our remaining South Louisiana properties to a private company for $12.7 million.  These properties had proved reserves of 7.0 Bcfe and produced approximately 1.1 Bcfe annually.  With this divestiture, we no longer have producing properties in the South Louisiana area.   In 2007, we invested approximately $4 million in our Texas Gulf Coast properties.  In 2006, we invested approximately $7 million that resulted in reserve additions of 0.2 Bcfe which were more than offset by downward reserve revisions .  In 2005, we invested approximately $8 million resulting in reserve additions of 3.7 Bcfe which were more than offset by downward revisions of 10.2 Bcfe.  

We are currently evaluating the potential divestiture of all or a portion of our properties in the Permian Basin and Gulf Coast to help fund a portion of our 2008 capital investments program.

New Ventures

We have personnel dedicated to the research and identification of active and potential plays, focusing on unconventional plays (including coalbed methane, shale gas and basin-centered gas) as well as determining the technological methods best suited to developing these plays, such as horizontal drilling and fracture stimulation techniques ..  New prospects are primarily evaluated based on repeatability, multi-well potential and land availability as well as other criteria.  

At December 31, 2007, we held 156,465 net undeveloped acres in areas of the United States outside of our core operating areas in connection with New Ventures that we are pursuing.  This compares to 89,592 net undeveloped acres held at year-end 2006 and 116,633 net undeveloped acres held at year-end 2005.  Of the 156,465 net undeveloped acres held at year-end 2007, approximately 88,000 net undeveloped acres were located in Pennsylvania in the Marcellus Shale play and approximately 49,500 acres were located in Culberson County, Texas, in the Barnett Shale play in the Permian Basin. We sold our acreage in Culberson County in early 2008 for $6.3 million. In 2007, we invested approximately $42 million in our New Ventures program, including $17.5 million to purchase acreage in the Marcellus Shale play.  We also invested approximately $10.5 million in 2007 to spud 25 wells in our Riverton coalbed methane project in Caldwell Parish, Louisiana, of which 18 were successful and 7 were in progress at year-end.  We have approximately 32,000 net acres in this project area targeting the Tertiary-age lower Wilcox coals at a depth of approximately 2,800 feet. Additionally in 2007, we invested $5.2 million to participate in 5 outside-operated Woodford Shale wells in Oklahoma.

In 2006, we invested approximately $46 million as part of our New Ventures program to drill 7 exploration wells, of which 5 were successful.  In 2005, we invested approximately $26 million as part of our New Ventures program to drill 6 exploration wells, of which 4 were successful.

In 2008, we plan to invest approximately $26 million in various New Ventures projects, including drilling 3 vertical test wells in the Marcellus Shale play in Pennsylvania.  

Acquisitions and Divestitures

There were no significant acquisitions or divestitures of gas and oil properties in 2007 or 2005.

In 2006, we sold our remaining South Louisiana properties to a private company for $12.7 million. These properties had proved reserves of 7.0 Bcfe and produced approximately 1.1 Bcfe annually.  With this divestiture, we no longer have producing properties in the South Louisiana area.  In 2006, we acquired additional working interests in our Overton Field for approximately $9 million and also acquired interests in our Riverton coalbed methane project located in Caldwell Parish, Louisiana, for approximately $9 million.   In total, we purchased 2.9 Bcfe of proved reserves for $18 million at an average cost of $6.09 per Mcfe.  The cost per Mcfe was higher than for prior acquisitions due to the potential existence of future drilling opportunities that were not classified as proved.

Capital Investments

During 2007, we invested a total of $1.38 billion in our E&P business and participated in drilling 653 wells, 439 of which were successful, 17 were dry and 197 were in progress at year-end.  Of the 197 wells in progress at year-end, 141 were located in our Fayetteville Shale play.  Our investments focused primarily on our active drilling programs in the Fayetteville Shale play, East Texas, and the conventional Arkoma Basin, which accounted for 70%, 15%, and 11% of our E&P capital investments in 2007, respectively.  We invested approximately $960 million in our Fayetteville Shale play, $201 million in East Texas, $148 million in our conventional Arkoma Basin program, $20 million in the Permian Basin, $4 million in the Gulf Coast and $42 million in New Ventures.


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Of the $1.38 billion invested in 2007, approximately $1.13 billion was invested in exploratory and development drilling and workovers, $66 million for leasehold acquisition, $100 million for seismic expenditures, $2 million for producing property acquisitions, and $77 million in capitalized interest and expenses and other technology-related expenditures.  In 2006, we invested approximately $767 million in our primary E&P business activities and participated in drilling 382 wells. Additionally, we invested $94 million for the purchase of drilling rigs and related equipment which were sold in December 2006 as part of a sale and leaseback transaction. Of the $767 million invested in 2006, approximately $196 million was invested in exploratory drilling, $421 million in development drilling and workovers, $49 million for leasehold acquisition, $21 million for seismic expenditures, $18 million for producing property acquisitions and $62 million in capitalized interest and expenses and other technology-related expenditures.  In 2005, we invested approximately $451 million in our E&P business, including $35 million related to the construction of drilling rigs, and participated in drilling 247 wells.   The increases in capital investments and wells drilled over the last two years are primarily due to the acceleration of our drilling program in the Fayetteville Shale play.

In 2008, we plan to invest approximately $1.33 billion in our E&P program and participate in drilling between 650 and 680 wells.  The Fayetteville Shale play will be the primary focus of our capital investments, where we plan to invest approximately $1 billion in 2008.  Our capital investments in 2008 will also include approximately $122 million in East Texas, approximately $132 million in our conventional drilling program in the Arkoma Basin, and $26 million in New Ventures projects.

Of the $1.33 billion allocated to our 2008 E&P capital budget, approximately $1.09 billion will be invested in development and exploratory drilling, $61 million in seismic and other G&G expenditures (including approximately $58 million in our Fayetteville Shale play), $42 million in leasehold, and $142 million in capitalized interest and expenses as well as equipment, facilities and technology-related expenditures.  We refer you to “Management's Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources — Capital Investments” for additional discussion of our planned capital investments in 2008.

Other Revenues

Other revenues and operating income for 2007, 2006 and 2005 included pre-tax gains of $6.4 million, $4.0 million and $3.1 million, respectively, related to the sale of gas-in-storage inventory.  

Sales and Major Customers

Our daily natural gas equivalent production averaged 311.1 MMcfe in 2007, compared to 198.1 MMcfe in 2006 and 167.1 MMcfe in 2005.  Total natural gas equivalent production was 113.6 Bcfe in 2007, compared to 72.3 Bcfe in 2006 and 61.0 Bcfe in 2005.   Our natural gas production was 109.9 Bcf in 2007, compared to 68.1 Bcf in 2006 and 56.8 Bcf in 2005.  The increase in production in 2007 resulted primarily from a 41.7 Bcf increase in production from the Fayetteville Shale play and a 3.7 Bcf increase in production from our conventional Arkoma Basin activities, offset by a 2.1 Bcfe decrease in our East Texas production.  The increase in 2006 production resulted primarily from a 10.0 Bcf increase in production related to our Fayetteville Shale play and a 4.0 Bcfe increase in production from East Texas, partially offset by a decrease in production from our Gulf Coast and Permian Basin properties.  We also produced 614,000 barrels of oil in 2007, compared to 698,000 barrels of oil in 2006 and 705,000 barrels of oil in 2005.  Our oil production decreased during 2007 due to the sale of our South Louisiana properties in the fourth quarter of 2006.   For 2008, we are targeting total natural gas and crude oil production of approximately 148.0 to 152.0 Bcfe, which equates to a growth rate of approximately 30% to 35% above our 2007 production volumes.

The majority of our gas production and all of our oil production is sold to unaffiliated purchasers.   These combined gas and oil sales to unaffiliated purchasers accounted for 96% of total E&P revenues in 2007, 92% in 2006, and 90% in 2005.   In 2007, our largest unaffiliated purchaser accounted for approximately 2% of total E&P revenues.  

Our utility subsidiary, AWG, also purchases a portion of our gas production.  These sales are made by SEECO primarily under contracts obtained under a competitive bidding process.  We refer you to “Natural Gas Distribution — Gas Purchases and Supply” for further discussion of these contracts.  Sales to AWG accounted for approximately 4% of total E&P revenues in 2007, 7% in 2006, and 9% in 2005.  SEECO’s sales to AWG were 4.8 Bcf in 2007, compared to 4.7 Bcf in 2006 and 5.1 Bcf in 2005.  Sales to AWG are primarily driven by the utility’s changing supply requirements due to variations in the weather and SEECO’s ability to obtain gas supply contracts that are periodically placed out for competitive bids. SEECO’s gas production provided approximately 36% of the utility’s requirements in 2007, 41% in 2006, and 38% in 2005.  We also sell gas directly to industrial and commercial transportation customers located on AWG’s gas distribution systems.  SEECO also owns an unregulated natural gas storage facility that has historically been utilized to help meet its peak seasonal sales commitments.  The storage facility is connected to AWG’s distribution system.  We


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expect future increases in sales of our gas production to come primarily from sales to unaffiliated purchasers.  Future sales to AWG will be dependent upon our success in obtaining gas supply contracts from them.   Sales of gas and oil production are conducted under contracts that reflect current short-term prices and are subject to seasonal price swings.  We are unable to predict changes in the market demand and price for natural gas, including changes that may be induced by the effects of weather on demand of both affiliated and unaffiliated customers for our production.

We realized an average wellhead price of $6.80 per Mcf for our natural gas production in 2007, compared to $6.55 per Mcf in 2006 and $6.51 per Mcf in 2005, including the effect of hedges.  Our hedging activities increased our average gas price $0.64 per Mcf in 2007 and $0.18 per Mcf in 2006 and decreased our average gas price $1.22 per Mcf in 2005.  Our average oil price realized was $69.12 per barrel in 2007, compared to $58.36 per barrel in 2006 and $42.62 per barrel in 2005, including the effect of hedges.  None of our crude oil production was hedged during 2007.  Our hedging activities lowered our average oil price $4.81 per barrel in 2006 and $11.75 per barrel in 2005.

We periodically enter into various hedging and other financial arrangements with respect to a portion of our projected natural gas and crude oil production in order to support certain desired levels of cash flow and to minimize the impact of price fluctuations.  Our policies prohibit speculation with derivatives and limit swap agreements to counterparties with appropriate credit standings. At December 31, 2007, we had hedges in place on 102.0 Bcf, or approximately 70% of our targeted 2008 gas production, and 79.0 Bcf of our expected 2009 gas production.  Subsequent to December 31, 2007 and prior to February 22, 2008, we hedged 16.0 Bcf of 2008, 17.0 Bcf of 2009 and 16.0 Bcf of 2010 gas production under fixed price swaps with average prices of $8.99, $8.53 and $8.55 per Mcf, respectively.  In addition, we hedged 8.0 Bcf of 2009 and 2.0 Bcf of 2010 gas production using costless collars. The collars relating to 2009 production have a weighted average floor and ceiling price of $8.00 and $10.05 per Mcf, respectively; and the collars relating to 2010 production have a weighted average floor and ceiling price of $8.50 and $10.20 per Mcf, respectively. As of February 22, 2008, we have hedged approximately 80% of our 2008 anticipated gas production. At February 22, 2008, we did not have hedges in place for any of our oil production for 2008, 2009, or 2010.  We refer you to Item 7A of this Form 10-K, “Quantitative and Qualitative Disclosures about Market Risks,” for further information regarding our hedge position at December 31, 2007.

Disregarding the impact of hedges, the average price received for our gas production has historically been approximately $0.30 to $0.50 per Mcf lower than average NYMEX spot market prices.  In 2007, the difference in our average price received was approximately $0.70 per Mcf lower than average NYMEX spot market prices, disregarding the impact of hedges.  In 2006 and 2005, widening market differentials caused the difference in our average price received to be approximately $0.90 per Mcf lower than average spot market prices.  Assuming a NYMEX commodity price of $7.00 per Mcf of gas for 2008, our differential for the average price received for our gas production is expected to be approximately $0.60 to $0.70 per Mcf below the NYMEX Henry Hub index price, including the impact of our basis hedges.  Assuming a NYMEX commodity price of $70.00 per barrel of oil for 2008, we expect the average price received for our oil production to be approximately $1.50 per barrel lower than average spot market prices, as market differentials reduce the average prices received.

Impact of Federal Regulation of Sales of Natural Gas 

Historically, the sale of natural gas in interstate commerce has been regulated pursuant to the Natural Gas Act of 1938, or the NGA, the Natural Gas Policy Act of 1978, or the NGPA, and regulations promulgated thereunder by the Federal Energy Regulatory Commission, or the FERC.  In 1989, Congress enacted the Natural Gas Wellhead Decontrol Act, or the Decontrol Act.  The Decontrol Act removed all NGA and NGPA price and non-price controls affecting wellhead sales of natural gas effective January 1, 1993 and sales by producers of natural gas can be made at uncontrolled market prices.  

The natural gas industry historically has been heavily regulated and from time to time proposals are introduced by Congress and the FERC and judicial decisions are rendered that impact the conduct of business in the natural gas industry.  There can be no assurance that the less stringent regulatory approach recently pursued by the FERC and Congress will continue. We refer you to “Other Items — Environmental Matters” and the risk factor “We incur substantial costs to comply with government regulations, especially regulations relating to environmental protection, and could incur even greater costs in the future” in Item 1A of Part I of this Form 10-K for a discussion of the impact of government regulation on our natural gas distribution business.

Oil Price Controls and Transportation Rates

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allowed for an increase in the cost of transporting oil to the purchaser.  The implementation of these regulations has not had a material adverse effect on our results of operations.  

Competition

All phases of the oil and gas industry are highly competitive.  We compete in the acquisition of properties, the search for and development of reserves, the production and sale of natural gas and oil and the securing of labor and equipment required to conduct our operations.  Our competitors include major oil and gas companies, other independent oil and gas companies and individual producers and operators.  Many of these competitors have financial and other resources that substantially exceed those available to us.

Competition in Arkansas has increased in recent years due largely to the development of improved access to interstate pipelines and our discovery of the Fayetteville Shale play.  The competition for new leases in the Fayetteville Shale play has become especially intense.  Due to our significant leasehold acreage position in Arkansas and our long-time presence and reputation in the area, we believe we will continue to be successful in acquiring new leases in Arkansas.  While improved intrastate and interstate pipeline transportation in Arkansas should increase our access to markets for our gas production, these markets will also be served by a number of other suppliers.  Consequently, we will encounter competition that may affect both the price we receive and contract terms we must offer. Outside Arkansas, we are less established and face competition from a larger number of other producers.

Commencing in 1992, the FERC issued a series of orders (collectively, “Order No. 636”), which require interstate pipelines to provide transportation separately, or “unbundled,” from the pipelines’ sales of gas.  Order No. 636 also requires pipelines to provide open-access transportation on a basis that is equal for all shippers.  Although Order No. 636 does not directly regulate our activities, the FERC has stated that it intends for Order No. 636 to foster increased competition within all phases of the natural gas industry.  Starting in 2000, the FERC issued a series of orders (collectively, “Order No. 637”), which imposed a number of additional reforms designed to enhance competition in natural gas markets.  Among other things, Order No. 637 revised the FERC pricing policy by waiving price ceilings for short-term released capacity for a two-year period, and effected changes in FERC regulations relating to scheduling procedures, capacity segmentation, pipeline penalties, rights of first refusal and information reporting.  The implementation of these orders has not had a material adverse effect on our results of operations to date.

We cannot predict whether and to what extent any market reforms initiated by the FERC or any new energy legislation will achieve the goal of increasing competition, lessening preferential treatment and enhancing transparency in markets in which our natural gas is sold.  However, we do not believe that we will be disproportionately affected as compared to other natural gas producers and marketers by any action taken by the FERC or any other legislative body.

Midstream Services

Our Midstream Services segment generates revenue and operating income through gathering fees associated with the transportation of natural gas to market and through the marketing of our own gas production and third-party natural gas.

Our operating income from this segment was $13.2 million on revenues of $962.0 million in 2007, compared to $4.1 million on revenues of $475.2 million in 2006 and $5.7 million on revenues of $459.9 million in 2005. The increases in revenues are largely attributable to increased volumes marketed, higher purchased gas costs and increased gathering revenues.  The decrease in operating income during 2006 was due to increased operating costs and expenses that resulted from increased staffing and other costs associated with our growing gathering activities, and a decrease in the margin generated by our marketing activities caused in part by increased volatility of locational market differentials in our core operating areas .

EBITDA generated by our midstream services segment was $18.8 million in 2007, compared to $5.3 million in 2006 and $6.0 million in 2005.  The increase in 2007 operating income and EBITDA was primarily due to increased gathering revenues and marketing margins, partially offset by increased operating costs and expenses.  We expect that the operating income and EBITDA of our Midstream Services segment will increase significantly over the next few years as we continue to develop our Fayetteville Shale acreage. The decrease in 2006 operating income and EBITDA was primarily due to increased operating costs and expenses that resulted from increased staffing and other costs associated with our growing gathering activities. EBITDA is a non-GAAP measure. We refer you to “Business — Other Items —Reconciliation of Non-GAAP Measures” in Item 1 of Part I of this Form 10-K for a table that reconciles EBITDA with our net income.  


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Gas Gathering

Our gas gathering subsidiary, DeSoto Gathering Company, L.L.C., or DGC, engages in gathering activities related to the development of our Fayetteville Shale play.  In 2007, we invested approximately $107.4 million related to these activities and had gathering revenues of $37.7 million, compared to $48.7 million invested and $7.9 million in revenues in 2006 and $15.8 million invested and $1.0 million in revenues in 2005.  DGC is rapidly expanding its network of gathering pipelines and facilities throughout the Fayetteville Shale region. During 2007, DGC gathered approximately 78.7 Bcf of gas volumes in the Fayetteville Shale play area, including 7.6 Bcf of third-party natural gas. In 2006, DGC gathered approximately 14.6 Bcf of gas and 2.3 Bcf of gas in 2005. The increase in volumes gathered in 2007 and 2006 was primarily due to our growing production volumes from the Fayetteville Shale. At the end of 2007, DGC had approximately 556 miles of pipe from the individual wellheads to the transmission lines and compression equipment had been installed at approximately 26 central point gathering facilities in the field.  Gathering revenues and expenses for this segment are expected to grow substantially over the next few years as gathering systems for our Fayetteville Shale play are expanded to support the development of our acreage and the increased development activity undertaken by other operators in the area.

Gas Marketing

Our gas marketing subsidiary, SES, allows us to capture downstream opportunities which arise through marketing and transportation activity. Our current marketing operations primarily relate to the marketing of our own gas production and some third-party natural gas.  During 2007, we marketed 145.7 Bcf of natural gas, compared to 72.7 Bcf in 2006 and 61.9 Bcf in 2005.  Purchases from our E&P subsidiaries accounted for 91% of total volumes marketed in 2007, compared to 86% in 2006 and 78% in 2005.  

Competition

Our gas marketing activities compete with numerous other companies offering the same services, many of which possess larger financial and other resources than we have.  Some of these competitors are affiliates of companies with extensive pipeline systems that are used for transportation from producers to end-users. Other factors affecting competition are the cost and availability of alternative fuels, the level of consumer demand and the cost of and proximity to pipelines and other transportation facilities.  We believe that our ability to compete effectively within the marketing segment in the future depends upon establishing and maintaining strong relationships with producers and end-users. We also experience competition for our gathering services in the Fayetteville Shale play area from several other producers and non-affiliated gathering companies and we expect this competition to continue in the future.

Regulation

On March 15, 2006, the Department of Transportation, or the DOT, issued new rules pertaining to certain gathering lines. Compliance with the new rules has not had a material adverse impact on our operations. We refer you to “Other Items — Environmental Matters” and the risk factor “We incur substantial costs to comply with government regulations, especially regulations relating to environmental protection, and could incur even greater costs in the future” in Item 1A of Part I of this Form 10-K for a discussion of the impact of government regulation on our Midstream Services business.

Natural Gas Distribution

We distribute natural gas to approximately 152,000 customers in northern Arkansas through our subsidiary, AWG.  On November 14, 2007, we announced that we had entered into a definitive agreement for the sale of AWG to SourceGas LLC for $224 million plus working capital.  Upon the consummation of the pending sale of AWG, we will cease to have any natural gas distribution operations.  Subject to regulatory approval, the sale is expected to close approximately mid-year 2008.

Operating income for our Natural Gas Distribution segment was $10.0 million in 2007, compared to $4.5 million in 2006 and $4.9 million in 2005.  EBITDA generated by our utility segment was $15.8 million in 2007, compared to $10.5 million in 2006 and $11.7 million in 2005.  The increase in 2007 operating income and EBITDA was due to the implementation of a rate increase effective August 1, 2007, colder weather and a decrease in operating costs and expenses.  The decrease in 2006 operating income and EBITDA resulted primarily from warmer than normal weather and increased operating costs and expenses, which more than offset a rate increase that became effective October 31, 2005.  EBITDA is a non-GAAP measure. We refer you to “Business — Other Items — Reconciliation of Non-GAAP Measures” in Item 1 of Part I of this Form 10-K for a table that reconciles EBITDA with our net income.  


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Gas Purchases and Supply

AWG purchases its system gas supply through a competitive bidding process and directly at the wellhead under long-term contracts with flexible pricing provisions.  In 2007, SEECO successfully bid on gas supply packages representing approximately 51% of the requirements for AWG for 2008, compared to approximately 53% for 2007 and 44% for 2006.  The contracts awarded to SEECO expire in 2009.

AWG also purchases gas under its gas supply packages from unaffiliated suppliers accessed by interstate pipelines.  These purchases are under firm contracts with one-year to two-year terms.  The rates charged by most suppliers include demand components to ensure availability of gas supply and a commodity component that is based on monthly indexed market prices.  The pipeline transportation rates include demand charges to reserve pipeline capacity and commodity charges based on volumes transported.  Less than 4% of the utility’s gas purchases are under take-or-pay contracts.  AWG believes that it does not have a significant exposure to take-or-pay liabilities resulting from these contracts and expects to be able to continue to satisfactorily manage these contracts.

AWG has a natural gas storage facility connected to its distribution system in northwest Arkansas that it utilizes to help meet its peak seasonal demands.  The utility also owns a liquefied natural gas facility and contracts with an interstate pipeline for additional storage capacity to serve its system in the northeastern part of the state.  These contracts involve demand charges based on the maximum deliverability, capacity charges based on the maximum storage quantity and charges for the quantities injected and withdrawn.

The utility’s rate schedules include a cost of gas rider whereby the projected cost of purchased gas is permitted to be billed to customers.  The difference between actual costs of purchased gas and gas costs recovered from customers is deferred each month and is billed or credited, as appropriate, to customers in subsequent months.

AWG enters into hedging activities from time to time with respect to its gas purchases to protect against the inherent price risks of adverse price fluctuations.  Our gas distribution segment hedged 4.0 Bcf, 3.1 Bcf, and 4.2 Bcf, respectively, in 2007, 2006, and 2005, which had the effect of increasing its total gas supply costs by $7.5 million, $7.7 million, and $2.4 million, respectively.  At December 31, 2007, AWG had 2.0 Bcf of future gas purchases hedged at an average purchase price of $8.61 per Mcf.  We refer you to Item 7A of this Form 10-K, “Quantitative and Qualitative Disclosures about Market Risk,” and Note 8 to the consolidated financial statements for additional information.

Markets and Customers

At December 31, 2007, AWG provided natural gas to approximately 135,000 residential, 17,000 commercial and 192 industrial customers, while also providing gas transportation services to approximately 123 end-use and off-system customers.   Approximately 67% of AWG’s customers are located in the Fayetteville-Springdale-Rogers MSA in northwest Arkansas.  In recent years, AWG has experienced customer growth of approximately 2% annually.  In 2007, customer growth was less than 1% due primarily to a decline in employment growth in the Fayetteville-Springdale-Rogers MSA. Total gas throughput in 2007 was 23.6 Bcf, compared to 21.8 Bcf in 2006 and 23.2 Bcf in 2005.  The higher volumes in 2007 were primarily due to colder weather.  The lower volumes in both 2006 and 2005 primarily resulted from warmer weather and customer conservation brought about by high gas prices in recent years.  Weather in AWG’s service territory during 2007 was 9% warmer than normal and 8% colder than in 2006.  Weather in 2006 was 17% warmer than normal and 8% warmer than in 2005.  

Residential and Commercial.  Approximately 88% of the utility’s revenues in 2007 were from residential and commercial markets.  Residential and commercial customers combined accounted for 58% of total gas throughput for the gas distribution segment in 2007, compared to 56% in 2006 and 57% in 2005.  Gas volumes sold to residential customers were 8.6 Bcf in 2007, compared to 7.5 Bcf in 2006 and 8.1 Bcf in 2005.  Gas sold to commercial customers totaled 5.1 Bcf in 2007, compared to 4.7 Bcf in 2006 and 5.1 Bcf in 2005.  The fluctuations in gas volumes sold to both residential and commercial customers were driven primarily by the effects of weather and customer conservation.  The gas heating load is one of the most significant uses of natural gas and is sensitive to outside temperatures.  Sales, therefore, vary throughout the year.  Profits, however, have become less sensitive to fluctuations in temperature as tariffs implemented contain a weather normalization clause to lessen the impact of revenue increases and decreases that might result from weather variations during the winter heating season.

Industrial and End-use Transportation.  Deliveries to AWG’s industrial and end-use transportation customers were 9.8 Bcf in 2007, 9.6 Bcf in 2006 and 10.0 Bcf in 2005.  No industrial customer accounts for more than 10% of AWG’s total throughput.  AWG offers a transportation service that allows larger business customers to obtain their own


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gas supplies directly from other suppliers.  Off-system transportation volumes were 0.3 Bcf in 2007, 0.1 Bcf in 2006 and less than 0.1 Bcf in 2005.  As of December 31, 2007, a total of 123 customers used the end-use transportation service.

Competition

AWG has historically maintained a price advantage over alternative fuels such as electricity, fuel oil and propane for most applications, enabling it to achieve excellent market penetration levels.  However, AWG has experienced a general trend in recent years toward lower rates of usage among its customers, largely as a result of conservation efforts, as well as increasing competition from alternative fuels that has eroded its price advantage.  AWG also has the ability to enter into special contracts with larger commercial and industrial customers that contain lower pricing provisions than the approved tariffs.  These contracts can be used to meet competition from alternate fuels or threats of bypass and must be approved by the Arkansas Public Service Commission, or the APSC.

Regulation

AWG’s rates and operations are regulated by the APSC and AWG must obtain the approval of the APSC in order to increase the rates it charges to its customers.  AWG operates through municipal franchises that are perpetual by virtue of state law but may not be exclusive within a geographic area.

In July 2007, the APSC approved a rate increase for our utility segment totaling $5.8 million annually, exclusive of costs to be recovered through the utility’s purchase gas adjustment clause.  The rate increase became effective for billings rendered on or after August 1, 2007.  The APSC order provided for an allowed return on equity of 9.5% and an assumed capital structure of 55% debt and 45% equity.  AWG had originally filed the application for a general rate increase of approximately $13.1 million, requesting a capital structure using the modified balance sheet approach inclusive of a 50/50 debt-to-equity ratio and a 10.79% return on equity (ROE).  In this rate case, the APSC approved a Trial Billing Determinant Adjustment Mechanism to mitigate the effects of declining use per customer, including lost revenues associated with energy efficiency programs.  AWG’s last rate increase of $4.6 million annually was effective October 31, 2005, where the APSC approved an allowed ROE of 9.7%.  Rate increase requests, which may be filed in the future, will depend on APSC ratemaking policies, customer growth, increases in operating expenses and additional investment in property, plant and equipment.

As the regulatory focus of the natural gas industry has shifted from the federal level to the state level, some utilities across the nation have been required to unbundle residential sales services from transportation services in an effort to promote greater competition.  There is no such legislation in Arkansas and no regulatory directives related to natural gas are presently pending.  In recent years, there have been efforts by the Arkansas legislature and the APSC concerning the issues of deregulation of the retail sale of electricity and a large-user access program for electric service choice.  Legislation adopted in 2001 for deregulation of the retail sale of electricity was repealed in 2003 and no legislative action has been taken regarding implementing a large-user access program.

On January 12, 2006, the APSC initiated a notice of inquiry regarding a rulemaking for developing and implementing energy efficiency programs.  Following a collaborative process, the APSC issued energy efficiency rules on January 11, 2007.  These rules require all gas and electric utilities, excluding electric cooperatives, to file energy efficiency plans and programs with the APSC.  AWG has filed and received approval for its initial energy efficiency plan, and is in the process of implementing Quick Start programs.  Comprehensive programs are to be implemented in 2009.  AWG is recovering the costs of these programs from its customers. 

On December 19, 2006, the APSC issued affiliate transactions rules, which were subsequently revised to address concerns expressed by the parties to the rulemaking proceeding.  AWG has filed the Affiliate Transactions Compliance Procedures required by the rules.

Gas distribution revenues in future years will be impacted by APSC policies, customer growth, customer usage and rate increases allowed by the APSC.  We refer you to “Other Items — Environmental Matters” and the risk factor “We incur substantial costs to comply with government regulations, especially regulations relating to environmental protection, and could incur even greater costs in the future” in Item 1A of Part I of this Form 10-K for a discussion of the impact of government regulation on our natural gas distribution business.


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Transportation and Other

On May 2, 2006, we sold our 25% interest in NOARK Pipeline System, Limited Partnership (NOARK), a partnership that owns a 723-mile integrated interstate pipeline system known as Ozark Gas Transmission System, to Atlas Pipeline Partners, L.P. for $69.0 million, resulting in a pre-tax gain of $10.9 million. In connection with the sale, we assumed $39.0 million of partnership debt that we had previously guaranteed. Our share of NOARK’s results of operations was a pre-tax gain of $0.9 million in 2006 prior to the sale, compared to a pre-tax gain of $1.6 million in 2005.

Historically, our other operations have consisted of the activities of our wholly-owned subsidiary, A. W. Realty Company, a company with real estate development activities concentrated on tracts of land located near our offices in Fayetteville, Arkansas.  There were no sales of commercial real estate in 2007 or 2006. As of December 31, 2007, A. W. Realty Company owned an interest in approximately 15 acres of undeveloped real estate near our offices in Fayetteville, Arkansas, and 225 acres in or near Conway, Arkansas, related to our operations in the Fayetteville Shale play.

Other Items

Reconciliation of Non-GAAP Measures

EBITDA is defined as net income plus interest, income tax expense, depreciation, depletion and amortization.  We have included information concerning EBITDA in this Form 10-K because it is used by certain investors as a measure of the ability of a company to service or incur indebtedness and because it is a financial measure commonly used in our industry.  EBITDA should not be considered in isolation or as a substitute for net income, net cash provided by operating activities or other income or cash flow data prepared in accordance with generally accepted accounting principles or as a measure of our profitability or liquidity.  EBITDA as defined above may not be comparable to similarly titled measures of other companies.

We believe that net income is the financial measure calculated and presented in accordance with generally accepted accounting principles that is most directly comparable to EBITDA as defined.  The following table reconciles EBITDA, as defined, with net income for the years-ended December 31, 2007, 2006 and 2005:

 


2007

E&P

 

Midstream  Services

 

Natural Gas Distribution

 

Other

 

Total

Net income

$

211,876

 

$

6,933

 

$

2,746

 

$

  (381)

 

$

221,174

Depreciation, depletion and amortization

282,387

 

5,527

 

6,423

 

163

 

294,500

Net interest expense

16,926

 

2,006

 

4,941

 

 

23,873

Provision for income taxes

   129,315

 

       4,294

 

       1,672

 

          574

 

    135,855

EBITDA

$ 640,504

 

$   18,760

 

$   15,782

 

$        356

 

675,402

 

 

 

 

 

 

 

 

 

 

2006

 

 

 

 

 

 

 

 

 

Net income

$

151,157

 

$

2,976

 

$

2,190

 

$

6,313

 

$

162,636

Depreciation, depletion and amortization

143,500

 

1,773

 

6,428

 

94

 

151,795

Net interest expense

508

 

 

171

 

 

679

Provision for income taxes

     91,276

 

          554

 

       1,698

 

       5,871

 

      99,399

EBITDA

$ 386,441

 

$     5,303

 

$   10,487

 

$   12,278

 

414,509

 

 

 

 

 

 

 

 

 

 

2005

 

 

 

 

 

 

 

 

 

Net income

$

144,349

 

$

2,962

 

$

203

 

$

246

 

$

147,760

Depreciation, depletion and amortization

89,229

 

303

 

7,010

 

99

 

96,641

Net interest expense

8,416

 

1,054

 

4,429

 

1,141

 

15,040

Provision for income taxes

     83,921

 

       1,668

 

            11

 

           831

 

      86,431

EBITDA

$ 325,915

 

$     5,987

 

$   11,653

 

$      2,317

 

345,872


Environmental Matters

Our operations are subject to numerous federal, state and local laws and regulations including the Comprehensive Environmental Response, Compensation and Liability Act, or CERCLA, the Clean Water Act, the Clean Air Act and similar state statutes.  These laws and regulations require permits for drilling wells and the maintenance of bonding requirements in order to drill or operate wells and also regulate the spacing and location of wells, the method of drilling and casing wells, the surface use and restoration of properties upon which wells are drilled, the plugging and abandoning of


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wells, the prevention and cleanup of pollutants and other matters.  We maintain insurance against costs of clean-up operations, but we are not fully insured against all such risks.  Although future environmental obligations are not expected to have a material impact on the results of our operations or financial condition, there can be no assurance that future developments, such as increasingly stringent environmental laws or enforcement thereof, will not cause us to incur material environmental liabilities or costs.

Failure to comply with these laws and regulations may result in the assessment of administrative, civil and criminal fines and penalties and the imposition of injunctive relief.  Changes in environmental laws and regulations occur frequently, and any changes that result in more stringent and costly waste handling, storage, transport, disposal or cleanup requirements could materially adversely affect our operations and financial position, as well as those in the natural gas and oil industry in general.  Although we believe that we are in substantial compliance with applicable environmental laws and regulations and that continued compliance with existing requirements will not have a material adverse impact on us, there can be no assurance that this trend will continue in the future.  

The Oil Pollution Act, as amended, or the OPA, and regulations thereunder impose a variety of requirements on “responsible parties” related to the prevention of oil spills and liability for damages resulting from such spills in United States’ waters.  A “responsible party” includes the owner or operator of an onshore facility, pipeline or vessel, or the lessee or permittee of the area in which an offshore facility is located.  OPA assigns liability to each responsible party for oil cleanup costs and a variety of public and private damages.  While liability limits apply in some circumstances, a party cannot take advantage of liability limits if the spill was caused by gross negligence or willful misconduct or resulted from violation of a federal safety, construction or operating regulation.  If the party fails to report a spill or to cooperate fully in the cleanup, liability limits likewise do not apply.  Few defenses exist to the liability imposed by OPA.  OPA imposes ongoing requirements on a responsible party, including the preparation of oil spill response plans and proof of financial responsibility to cover environmental cleanup and restoration costs that could be incurred in connection with an oil spill.  

CERCLA, also known as the “Superfund law,” imposes liability, without regard to fault or the legality of the original conduct, on certain classes of persons that are considered to be responsible for the release of a “hazardous substance” into the environment.  These persons include the owner or operator of the disposal site or sites where the release occurred and companies that transported or disposed or arranged for the transport or disposal of the hazardous substances found at the site. Persons who are or were responsible for releases of hazardous substances under CERCLA may be subject to joint and several liability for the costs of cleaning up the hazardous substances that have been released into the environment and for damages to natural resources, and it is not uncommon for neighboring landowners and other third parties to file claims for personal injury and property damage allegedly caused by the hazardous substances released into the environment.  

The Resource Conservation and Recovery Act, as amended, or the RCRA, generally does not regulate wastes generated by the exploration and production of natural gas and oil.  The RCRA specifically excludes from the definition of hazardous waste “drilling fluids, produced waters and other wastes associated with the exploration, development or production of crude oil, natural gas or geothermal energy.”  However, legislation has been proposed in Congress from time to time that would reclassify certain natural gas and oil exploration and production wastes as “hazardous wastes,” which would make the reclassified wastes subject to much more stringent handling, disposal and clean-up requirements. If such legislation were to be enacted, it could have a significant impact on our operating costs, as well as the natural gas and oil industry in general.  Moreover, ordinary industrial wastes, such as paint wastes, waste solvents, laboratory wastes and waste oils, may be regulated as hazardous waste.

We own or lease, and have in the past owned or leased, onshore properties that for many years have been used for or associated with the exploration and production of natural gas and oil.  Although we have utilized operating and disposal practices that were standard in the industry at the time, hydrocarbons or other wastes may have been disposed of or released on or under the properties owned or leased by us on or under other locations where such wastes have been taken for disposal. In addition, a portion of these properties have been operated by third parties whose treatment and disposal or release of wastes was not under our control.  These properties and the wastes disposed thereon may be subject to CERCLA, the Clean Water Act, the RCRA and analogous state laws.  Under such laws, we could be required to remove or remediate previously disposed wastes (including waste disposed of or released by prior owners or operators) or property contamination (including groundwater contamination by prior owners or operators), or to perform remedial plugging or closure operations to prevent future contamination.   

The Federal Water Pollution Control Act, as amended, or the FWPCA, imposes restrictions and strict controls regarding the discharge of produced waters and other natural gas and oil waste into navigable waters.  Permits must be obtained to discharge pollutants to waters and to conduct construction activities in waters and wetlands.  The FWPCA and similar state laws provide for civil, criminal and administrative penalties for any unauthorized discharges of pollutants


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and unauthorized discharges of reportable quantities of oil and other hazardous substances.  Many state discharge regulations and the Federal National Pollutant Discharge Elimination System general permits issued by the Environmental Protection Agency, or the EPA, prohibit the discharge of produced water and sand, drilling fluids, drill cuttings and certain other substances related to the natural gas and oil industry into coastal waters.  Although the costs to comply with zero discharge mandates under federal or state law may be significant, the entire industry is expected to experience similar costs and we believe that these costs will not have a material adverse impact on our results of operations or financial position.  The EPA has adopted regulations requiring certain natural gas and oil exploration and production facilities to obtain permits for storm water discharges. Costs may be associated with the treatment of wastewater or developing and implementing storm water pollution prevention plans.

Employees

At December 31, 2007, we had 1,521 total employees, including 383 employed by our drilling subsidiary and 373 employed by AWG.  None of our employees were covered by a collective bargaining agreement at year-end 2007.  We believe that our relationships with our employees are good.

GLOSSARY OF CERTAIN INDUSTRY TERMS

The definitions set forth below shall apply to the indicated terms as used in this Form 10-K.  All volumes of natural gas referred to herein are stated at the legal pressure base of the state or area where the reserves exist and at 60 degrees Fahrenheit and in most instances are rounded to the nearest major multiple.

"Bcf"  One billion cubic feet of gas.

"Bcfe"  One billion cubic feet of gas equivalent.  Determined using the ratio of one barrel of crude oil to six Mcf of natural gas.

"Bbl"  One stock tank barrel, or 42 U.S. gallons liquid volume, used herein in reference to crude oil or other liquid hydrocarbons.

"Btu"  British thermal unit, which is the heat required to raise the temperature of a one-pound mass of water from 58.5 to 59.5 degrees Fahrenheit.

"Development drilling"  The drilling of a well within the proved area of an oil or gas reservoir to the depth of a stratigraphic horizon known to be productive.

"Downspacing"   The process of drilling additional wells within a defined producing area to increase recovery of natural gas and oil from a known reservoir.

"EBITDA"  Represents net income attributable to common stock plus interest, income taxes, depreciation, depletion and amortization.  We refer you to “Business — Other Items — Reconciliation of Non-GAAP Measures” in Item 1 of Part I of this Form 10-K for a table that reconciles EBITDA with our net income from our audited financial information.

"Exploratory prospects or locations"  A location where a well is drilled to find and produce natural gas or oil reserves not classified as proved, to find a new reservoir in a field previously found to be productive of oil or gas in another reservoir or to extend a known reservoir.

"Fracture stimulation" A process whereby fluids mixed with proppants are injected into a wellbore under pressure in order to fracture, or crack open, reservoir rock, thereby allowing oil and/or natural gas trapped in the reservoir rock to travel through the fractures and into the well for production.

"Gross acreage or gross wells"  The total acres or wells, as the case may be, in which a working interest is owned.

"Infill drilling"  Drilling wells in between established producing wells, see also “Downspacing.”

"MBbls"  One thousand barrels of crude oil or other liquid hydrocarbons.

"Mcf"  One thousand cubic feet of natural gas.


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"Mcfe"  One thousand cubic feet of natural gas equivalent.  Determined using the ratio of one barrel of crude oil to six Mcf of natural gas.

"MMBbls"  One million barrels of crude oil or other liquid hydrocarbons.

"MMBtu"  One million Btu’s.

"MMcf"  One million cubic feet of natural gas.

"MMcfe"  One million cubic feet of natural gas equivalent.  Determined using the ratio of one barrel of crude oil to six Mcf of natural gas.

"Net acres or net wells"  The sum of the fractional working interests owned in gross acres or gross wells.

"Net revenue interest"  Economic interest remaining after deducting all royalty interests, overriding royalty interests and other burdens from the working interest ownership.

"NYMEX"  The New York Mercantile Exchange.

"Operating interest"  An interest in natural gas and oil that is burdened with the cost of development and operation of the property.

"Play"  A term applied to a portion of the exploration and production cycle following the identification by geologists and geophysicists of areas with potential oil and gas reserves.

"Present Value Index" or "PVI"  A measure that is computed for projects by dividing the dollars invested into the PV-10 resulting from the investment.

"Producing property"  A natural gas and oil property with existing production.

"Proved developed reserves" Proved reserves that can be expected to be recovered from existing wells with existing equipment and operating methods. For additional information, see the SEC’s definition in Rule 4-10(a)(3) of Regulation S-X, which is available at the SEC’s website, http://www.sec.gov/about/forms/regs-x.pdf, page 41.


"Proved reserves"  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. For additional information, see the SEC’s definition in Rule 4-10(a)(2)(i) through (iii) of Regulation S-X, which is available at the SEC’s website, http://www.sec.gov/about/forms/regs-x.pdf, page 41.

"Proved undeveloped reserves"  Proved 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.  Reserves on undrilled acreage shall be limited to those drilling units that offset productive units and that are reasonably certain of production when drilled. For additional information, see the SEC’s definition in Rule 4-10(a)(4) of Regulation S-X, which is available at the SEC’s website, http://www.sec.gov/about/forms/regs-x.pdf, page 41.


"PV-10"  When used with respect to natural gas and oil reserves, PV-10 means the estimated future gross revenue to be generated from the production of proved reserves, net of estimated production and future development costs, using prices and costs in effect as of the date of the report or estimate, without giving effect to non-property related expenses such as general and administrative expenses, debt service and future income tax expense or to depreciation, depletion and amortization, discounted using an annual discount rate of 10%.  Also referred to as “present value.” After-tax PV-10 is also referred to as “standardized measure” and is net of future income tax expense.

"Recomplete" This term refers to the technique of drilling a separate well-bore from all existing casing in order to reach the same reservoir, or redrilling the same well-bore to reach a new reservoir after production from the original reservoir has been abandoned.  

"Reserve replacement ratio" The sum of the estimated net proved reserves added through discoveries, extensions, infill drilling and acquisitions (which may include or exclude reserve revisions of previous estimates) for a specified period of time divided by production for that same period of time.


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"Royalty interest"  An interest in a natural gas and oil property entitling the owner to a share of oil or gas production free of production costs.

"Unconventional play" A play in which the targeted reservoirs generally fall into one of three categories: (1) tight sands, (2) coal beds, and (3) gas shales. The reservoirs tend to cover large areas and lack the readily apparent traps, seals and discrete hydrocarbon-water boundaries that typically define conventional reservoirs. These reservoirs generally require stimulation treatments or other special recovery processes in order to produce economic flow rates.

"Undeveloped acreage"  Lease acreage on which wells have not been drilled or completed to a point that would permit the production of commercial quantities of natural gas and oil regardless of whether such acreage contains proved reserves.

"Well spacing" The regulation of the number and location of wells over an oil or gas reservoir, as a conservation measure.  Well spacing is normally accomplished by order of the regulatory conservation commission.  The order may be statewide in its application (subject to change for local conditions) or it may be entered for each field after its discovery.  

"Working interest"  An operating interest that gives the owner the right to drill, produce and conduct operating activities on the property and to receive a share of production.

"Workovers"  Operations on a producing well to restore or increase production.

"WTI"  West Texas Intermediate, the benchmark crude oil in the United States.

ITEM 1A.  RISK FACTORS

In addition to the other information included in this Form 10-K, the following risk factors should be considered in evaluating our business and future prospects. The risk factors described below are not necessarily exhaustive and investors are encouraged to perform their own investigation with respect to us and our business. Investors should also read the other information included in this Form 10-K, including our financial statements and the related notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Cautionary Statement about Forward-Looking Statements.”

Natural gas and oil prices are volatile.  Volatility in natural gas and oil prices can adversely affect our results and the price of our common stock.  This volatility also makes valuation of natural gas and oil producing properties difficult and can disrupt markets.

Natural gas and oil prices have historically been, and are likely to continue to be, volatile.  The prices for natural gas and oil are subject to wide fluctuation in response to a number of factors, including:

·

relatively minor changes in the supply of and demand for natural gas and oil;

·

market uncertainty;

·

worldwide economic conditions;

·

weather conditions;

·

import prices;

·

political conditions in major oil producing regions, especially the Middle East;

·

actions taken by OPEC;  

·

competition from other sources of energy; and

·

economic, political and regulatory developments.

Price volatility makes it difficult to budget and project the return on exploration and development projects involving our natural gas and oil properties and to estimate with precision the value of producing properties that we may own or propose to acquire.  In addition, unusually volatile prices often disrupt the market for natural gas and oil properties, as buyers and sellers have more difficulty agreeing on the purchase price of properties.  Our quarterly results of operations may fluctuate significantly as a result of, among other things, variations in natural gas and oil prices and production performance.  In recent years, natural gas and oil price volatility has become increasingly severe.  


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A substantial or extended decline in natural gas and oil prices would have a material adverse affect on us.

Natural gas and oil prices have recently been at or near their highest historical levels.  A substantial or extended decline in natural gas and oil prices would have a material adverse effect on our financial position, our results of operations, our access to capital and the quantities of natural gas and oil that may be economically produced by us.  A significant decrease in price levels for an extended period would negatively affect us in several ways including:

·

our cash flow would be reduced, decreasing funds available for capital investments employed to replace reserves or increase production;

·

certain reserves would no longer be economic to produce, leading to both lower proved reserves and cash flow; and

·

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

Consequently, our revenues and profitability would suffer.

Lower natural gas and oil prices may cause us to record ceiling test write-downs.   

We use the full cost method of accounting for our natural gas and oil operations.  Accordingly, we capitalize the cost to acquire, explore for and develop natural gas and oil properties.  Under the full cost accounting rules of the SEC, the capitalized costs of natural gas and oil properties - net of accumulated depreciation, depletion and amortization, and deferred income taxes - may not exceed a “ceiling limit.”  This is equal to the present value of estimated future net cash flows from proved natural gas and oil reserves, discounted at 10 percent, plus the lower of cost or fair value of unproved properties included in the costs being amortized, net of related tax effects.

These rules generally require pricing future natural gas and oil production at the unescalated natural gas and oil prices in effect at the end of each fiscal quarter, including the impact of derivatives qualifying as hedges.  They also require a write-down if the ceiling limit is exceeded, even if prices declined for only a relatively short period of time.  Once a write-down is taken, it cannot be reversed in future periods even if natural gas and oil prices increase.

If natural gas and oil prices decline below levels at December 31, 2007, a write-down may occur.  Write-downs required by these rules do not impact cash flow from operating activities but do reduce net income and stockholders' equity.

We may have difficulty financing our planned capital investments, which could adversely affect our growth.

We have experienced and expect to continue to experience substantial capital expenditure and working capital needs, particularly as a result of our drilling program. Our planned capital investments for 2008 are expected to significantly exceed the net cash generated by our operations.  We expect to borrow under our credit facility to fund capital investments that are in excess of our net cash flow and cash on hand.  Our ability to borrow under our credit facility is subject to certain conditions.  At December 31, 2007, we were in compliance with the borrowing conditions of our credit facility.  If we are not in compliance with the terms of our credit facility in the future, we may not be able to borrow under it to fund our capital investments.  We also cannot be certain that other additional financing will be available to us on acceptable terms or at all.  In the event additional capital resources are unavailable, we may curtail our drilling, development and other activities or be forced to sell some of our assets on an untimely or unfavorable basis.  Any such curtailment or sale could have a material adverse effect on our results and future operations.

Working interest owners of some of our properties may be unwilling or unable to cover their portion of development costs, which could change our exploration and development plans.  

Some of our working interest owners may have difficulties obtaining the capital needed to finance their activities, or may believe that estimated drilling and completion costs are excessive. As a result, these working interest owners may be unable or unwilling to pay their share of well costs as they become due. These problems could cause us to change our development plans for these properties.


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Although our estimated natural gas and oil reserve data is independently audited, our estimates may still prove to be inaccurate.

Our reserve data represents the estimates of our reservoir engineers made under the supervision of our management.  Our reserve estimates are audited each year by Netherland, Sewell & Associates, Inc., or NSA, an independent petroleum engineering firm.  In conducting its audit, the engineers and geologists of NSA study our major properties in detail and independently develop reserve estimates.  NSA’s audit consists primarily of substantive testing, which includes a detailed review of major properties that account for approximately 81% of the present worth of our total proved reserves.  NSA’s audit process consists of sorting all fields by descending present value order and selecting the fields from highest value to descending value until the selected fields account for more than 80% of the present worth of our reserves.  The properties in the bottom 20% of the total present worth are the lowest value properties and are not reviewed in the audit.  The fields included in approximately the top 81% present value as of December 31, 2007 accounted for approximately 85% of our total proved reserves and approximately 90% of our proved undeveloped reserves.  In the conduct of its audit, NSA did not independently verify the data that we provided to them with respect to ownership interests, oil and gas production, well test data, historical costs of operations and development, product prices, or any agreements relating to current and future operations of the properties and sales of production.  NSA has advised us that if, in the course of its audit, something came to its attention that brought into question the validity or sufficiency of any such information or data, NSA did not rely on such information or data until it had satisfactorily resolved any questions relating thereto or had independently verified such information or data. The estimates of Netherland, Sewell & Associates, Inc. may differ significantly on an individual property basis from our estimates. When, in the aggregate, such differences are within 10%, Netherland, Sewell & Associates, Inc. is generally satisfied that the estimates of proved reserves are reasonable.  


Reserve estimates are prepared for each of our properties annually by the reservoir engineers assigned to the asset management team in the geographic locations in which the property is located.  These estimates are reviewed by senior engineers who are not part of the asset management teams and by the president of our E&P subsidiaries.  Finally, the estimates of our proved reserves together with the audit report of Netherland, Sewell & Associates, Inc. are reviewed by our Board of Directors.  There are numerous uncertainties and risks that are inherent in estimating quantities of natural gas and oil reserves and projecting future rates of production and timing of development expenditures as many factors are beyond our control.  We incorporate many factors and assumptions into our estimates including:


·

expected reservoir characteristics based on geological, geophysical and engineering assessments;

·

future production rates based on historical performance and expected future operating and investment activities;

·

future oil and gas prices and quality and locational differentials; and

·

future development and operating costs.


Although we believe our assumptions are reasonable based on the information available to us at the time we prepare our estimates, our actual results could vary considerably from estimated quantities of proved natural gas and oil reserves (in the aggregate and for a particular geographic location), production, revenues, taxes and development and operating expenditures.  In addition, our estimates of reserves may be subject to downward or upward revision based upon production history, results of future exploration and development, prevailing natural gas and oil prices, severance taxes, operating and development costs and other factors.  In 2007, our reserves were revised upward by 31.0 Bcfe, primarily due to improved performance in our Fayetteville Shale properties, which was partially offset by a downward revision in our Overton properties.  In 2006, our reserves were revised downward by 86.6 Bcfe, primarily due to lower prevailing oil and gas prices at year-end combined with performance revisions in some of our East Texas and conventional Arkoma Basin properties, which were partially offset by an upward performance revision in our Fayetteville Shale properties.  In 2005, our reserves were revised downward by 31.7 Bcfe, primarily due to unexpected declines associated with our Gulf Coast properties and minor changes to decline rates for our wells at the Overton Field.  These revisions represented no greater than 8% of our total reserve estimates in each of these years, which we believe is indicative of the effectiveness of our internal controls.  Because we review our reserve projections for every property at the end of every year, any material change in a reserve estimate is included in subsequent reserve reports.


Finally, recovery of undeveloped reserves generally requires significant capital investments and successful drilling operations.  At December 31, 2007, approximately 36% of our estimated proved reserves were undeveloped.  Our reserve data assume that we can and will make these expenditures and conduct these operations successfully, which may not occur.  Please read “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Cautionary Statement about Forward-Looking Statements” in Item 7 of Part II of this Form 10-K for additional information regarding the uncertainty of reserve estimates.


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Our future level of indebtedness and the terms of our financing arrangements may adversely affect operations and limit our growth.

At December 31, 2007, we had total long-term indebtedness of $977.6 million, including borrowings of $842.2 million under our revolving credit facility.  In January 2008, we issued $600 million of senior notes and used the net proceeds to repay outstanding amounts under our revolving credit facility.  At February 22, 2008, we had total long-term indebtedness of $1,063.6 million, including borrowings of $328.2 million under of revolving credit facility.  We currently expect to utilize the borrowing availability under our revolving credit facility in order to fund a portion of our capital investments in 2008.  See also our risk factor headed “We may have difficulty financing our planned capital investments which could adversely affect our growth,” above.

The terms of the indenture relating to our outstanding senior notes, our revolving credit facility and the master lease agreement relating to our drilling rigs, which we collectively refer to as our “financing agreements,” impose restrictions on our ability and, in some cases, the ability of our subsidiaries to take a number of actions that we may otherwise desire to take, including one or more of the following:

·

incurring additional debt, including guarantees of indebtedness;

·

redeeming stock or redeeming debt;

·

making investments;

·

creating liens on our assets; and

·

selling assets.

Our level of indebtedness and off-balance sheet obligations, and the covenants contained in our financing agreements, could have important consequences for our operations, including:

·

requiring us to dedicate a substantial portion of our cash flow from operations to required payments, thereby reducing the availability of cash flow for working capital, capital investments and other general business activities;

·

limiting our ability to obtain additional financing in the future for working capital, capital investments, acquisitions and general corporate and other activities;

·

limiting our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate; and

·

detracting from our ability to successfully withstand a downturn in our business or the economy generally.

Our ability to comply with the covenants and other restrictions in our financing agreements may be affected by events beyond our control, including prevailing economic and financial conditions.  If we fail to comply with the covenants and other restrictions, it could lead to an event of default and the acceleration of our obligations under those agreements, and in the case of the master lease agreement, loss of use of our drilling rigs.  We may not have sufficient funds to make such payments.  If we are unable to satisfy our obligations with cash on hand, we could attempt to refinance such debt, sell assets or repay such debt with the proceeds from an equity offering.  We cannot assure you that we will be able to generate sufficient cash flow to pay the interest on our debt, to meet our lease obligations, or that future borrowings, equity financings or proceeds from the sale of assets will be available to pay or refinance such debt or obligations.  The terms of our financing agreements may also prohibit us from taking such actions.  Factors that will affect our ability to raise cash through an offering of our capital stock, a refinancing of our debt or a sale of assets include financial market conditions and our market value and operating performance at the time of such offering or other financing.  We cannot assure you that any such proposed offering, refinancing or sale of assets can be successfully completed or, if completed, that the terms will be favorable to us.

If we fail to find or acquire additional reserves, our reserves and production will decline materially from their current levels.

The rate of production from natural gas and oil properties generally declines as reserves are depleted.  Except to the extent that we acquire additional properties containing proved reserves, conduct successful exploration and development activities, successfully apply new technologies or, through engineering studies, identify additional behind-pipe zones or secondary recovery reserves, our proved reserves will decline materially as reserves are produced.  Future


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natural gas and oil production is, therefore, highly dependent upon our level of success in acquiring or finding additional reserves.

Our drilling plans for the Fayetteville Shale play are subject to change.

As of December 31, 2007, we had drilled and completed 478 wells relating to our Fayetteville Shale play.  At year-end 2007, approximately 18% of our leasehold acreage was held by production, excluding our acreage in the traditional Fairway portion of the Arkoma Basin. Our drilling plans with respect to our Fayetteville Shale play are flexible and are dependent upon a number of factors, including the extent to which we can replicate the results of our most successful Fayetteville Shale wells on our other Fayetteville Shale acreage as well as the natural gas and oil commodity price environment.  The determination as to whether we continue to drill wells in the Fayetteville Shale may depend on any one or more of the following factors:

·

our ability to determine the most effective and economic fracture stimulation for the Fayetteville Shale formation;

·

material changes in natural gas prices;

·

changes in the estimates of costs to drill or complete wells;

·

the extent of our success in drilling and completing horizontal wells;

·

our ability to reduce our exposure to costs and drilling risks;

·

the costs and availability of drilling equipment;

·

success or failure of wells drilled in similar formations or which would use the same production facilities;

·

receipt of additional seismic or other geologic data or reprocessing of existing data;

·

the extent to which we are able to effectively operate our own drillings rigs; or

·

availability and cost of capital.

We continue to gather data about our prospects in the Fayetteville Shale, and it is possible that additional information may cause us to alter our drilling schedule or determine that prospects in some portion of our acreage position should not be pursued at all.

We may have difficulty drilling all of the wells that are necessary to hold our Fayetteville Shale acreage before the initial lease terms expire, which could result in the loss of certain leasehold rights.

Approximately 259,000 net acres of our Fayetteville Shale acreage will expire in the next three years if we do not drill successful wells to develop the acreage or otherwise take action to extend the leases.  As discussed above under “Our drilling plans for the Fayetteville Shale play are subject to change,” our ability to drill wells depends on a number of factors, including certain factors that are beyond our control.  The number of wells we will be required to drill to retain our leasehold rights will be determined by field rules established by the Arkansas Oil and Gas Commission, or the AOGC. However, current rules are subject to change and could impair our ability to drill or maintain our acreage position.  To the extent that any field rules prevent us from successfully drilling wells in certain areas, we may not be able to drill the wells required to maintain our leasehold rights for certain of our Fayetteville Shale acreage.

If our Fayetteville Shale drilling program fails to produce a significant supply of natural gas, our investments in our gas gathering operations could be lost and our commitments for transportation on pipelines could make the sale of our gas uneconomic, which could have an adverse effect on our results of operations, financial condition and cash flows.

As of December 31, 2007, we had invested approximately $161 million in our gas gathering operations and we intend to invest approximately $101 million in 2008.  Our gas gathering business will largely rely on gas sourced in our Fayetteville Shale play area in Arkansas.  In addition, we have signed a precedent agreement committing us to a portion of the transportation fees related to the Fayetteville and Greenville laterals being built to service the Fayetteville Shale play area by Texas Gas Transmission, LLC, a subsidiary of Boardwalk Pipeline Partners, LP, or TGT.  Our gas gathering subsidiary has also entered into multiple firm transportation agreements relating to gas volumes from our Fayetteville Shale play.  If our Fayetteville Shale drilling program fails to produce a significant supply of natural gas, our investments in our gas gathering operations could be lost, and we could be forced to pay transportation fees on pipeline capacity that we


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would not be using.  These events could have an adverse effect on our results of operations, financial condition and cash flows.

An increase in the Arkansas severance tax on natural gas could adversely impact the economic feasibility of the Fayetteville Shale play and our results of operations.

The State of Arkansas currently levies severance taxes on a broad range of minerals and other natural resources, including natural gas and oil. Currently, the Arkansas severance tax on natural gas is equal to 0.3 cents per 1000 cubic feet.  There are presently efforts being undertaken in Arkansas within and without the legislature to modify the severance tax on natural gas so that it is based on a percentage of the market value of the natural gas at the time and point of severance, and to have that percentage be as much as 7%. A 1934 amendment to the Arkansas constitution requires a three-fourths vote by both the House and Senate to raise the severance tax. However, if the severance tax increase is proposed through a ballot initiative, a simple majority of the Arkansas voters can approve the proposed increase. The attorney general of Arkansas recently approved the wording of a ballot initiative that would raise the natural gas severance tax in Arkansas to 7% of the market value of the gas at the time of severance. The governor of Arkansas has publicly stated his support for an increase in the natural gas severance tax to levels comparable to those in Texas and Oklahoma and indicated that, if the natural gas production industry and the legislature do not agree to raise the severance tax, he may introduce a ballot initiative in 2008. The deadline for submitting the petition for proposed initiated acts to the secretary of state’s office is July 7, 2008, and the petition must contain 61,974 signatures from registered Arkansas voters in order to be placed on the general election ballot.  If enacted, an increase in the severance tax on natural gas could impact the economic feasibility of our Fayetteville Shale play and our results of operations.

Our exploration, development and drilling efforts and our operations of our wells may not be profitable or achieve our targeted returns.

We require significant amounts of undeveloped leasehold acreage in order to further our development efforts.  Exploration, development, drilling and production activities are subject to many risks, including the risk that no commercially productive reservoirs will be discovered.  We invest in property, including undeveloped leasehold acreage that we believe will result in projects that will add value over time. However, we cannot assure you that all prospects will result in viable projects or that we will not abandon our initial investments. Additionally, there can be no assurance that leasehold acreage acquired by us will be profitably developed, that new wells drilled by us in prospects that we pursue will be productive or that we will recover all or any portion of our investment in such leasehold acreage or wells.  Drilling for natural gas and oil may involve unprofitable efforts, not only from dry wells but also from wells that are productive but do not produce sufficient net reserves to return a profit after deducting drilling, operating and other costs.  In addition, wells that are profitable may not achieve our targeted rate of return.  Our ability to achieve our target PVI results are dependent upon the current and future market prices for natural gas and crude oil, costs associated with producing natural gas and crude oil and our ability to add reserves at an acceptable cost.  We rely to a significant extent on seismic data and other advanced technologies in identifying leasehold acreage prospects and in conducting our exploration activities.  The seismic data and other technologies we use do not allow us to know conclusively prior to acquisition of leasehold acreage or drilling a well whether natural gas or oil is present or may be produced economically.  The use of seismic data and other technologies also requires greater pre-drilling expenditures than traditional drilling strategies.

In addition, we may not be successful in implementing our business strategy of controlling and reducing our drilling and production costs in order to improve our overall return.  The cost of drilling, completing and operating a well is often uncertain, and cost factors can adversely affect the economics of a project.  Further, our drilling operations may be curtailed, delayed or canceled as a result of numerous factors, including unexpected drilling conditions, title problems, pressure or irregularities in formations, equipment failures or accidents, adverse weather conditions, environmental and other governmental requirements and the cost of, or shortages or delays in the availability of, drilling rigs, equipment and services.

We incur substantial costs to comply with government regulations, especially regulations relating to environmental protection, and could incur even greater costs in the future.

Our exploration, production, development and gas distribution and marketing operations are regulated extensively at the federal, state and local levels.  We have made and will continue to make large expenditures in our efforts to comply with these regulations, including environmental regulation. The natural gas and oil regulatory environment could change in ways that might substantially increase these costs.  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.  In addition, at the U.S. federal level, the Federal Energy Regulatory Commission regulates interstate


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transportation of natural gas under the Natural Gas Act.  Other regulated matters include marketing, pricing, transportation and valuation of royalty payments.

As an owner or lessee and operator of natural gas and oil properties, and an owner of gas gathering, transmission and distribution systems, we are subject to various federal, state and local regulations relating to discharge of materials into, and protection of, the environment.  These regulations may, among other things, impose liability on us for the cost of pollution clean-up resulting from operations, subject us to liability for pollution damages, and require suspension or cessation of operations in affected areas.  Changes in or additions to regulations regarding the protection of the environment could significantly increase our costs of compliance, or otherwise adversely affect our business.

One of the responsibilities of owning and operating natural gas and oil properties is paying for the cost of abandonment. Effective January 1, 2003, companies were required to reflect abandonment costs as a liability on their balance sheets. We may incur significant abandonment costs in the future which could adversely affect our financial results.

Natural gas and oil drilling and producing operations involve various risks.

Our operations are subject to all the risks normally incident to the operation and development of natural gas and oil properties and the drilling of natural gas and oil wells, including encountering well blowouts, cratering and explosions, pipe failure, fires, formations with abnormal pressures, uncontrollable flows of oil, natural gas, brine or well fluids, release of contaminants into the environment and other environmental hazards and risks.

We maintain insurance against many potential losses or liabilities arising from our operations in accordance with customary industry practices and in amounts that we believe to be prudent.  However, our insurance does not protect us against all operational risks.  For example, we do not maintain business interruption insurance.  Additionally, pollution and environmental risks generally are not fully insurable.  These risks could give rise to significant costs not covered by insurance that could have a material adverse effect upon our financial results.  

We cannot control activities on properties we do not operate.  Failure to fund capital investments may result in reduction or forfeiture of our interests in some of our non-operated projects.

We do not operate some of the properties in which we have an interest and we have limited ability to exercise influence over operations for these properties or their associated costs.  As of December 31, 2007, approximately 10% of our gas and oil properties, based on PV-10 value, are operated by other companies.  Our dependence on the operator and other working interest owners for these projects and our limited ability to influence operations and associated costs could materially adversely affect the realization of our targeted returns on capital in drilling or acquisition activities and our targeted production growth rate.  The success and timing of drilling, development and exploitation activities on properties operated by others depend on a number of factors that are beyond our control, including the operator's expertise and financial resources, approval of other participants for drilling wells and utilization of technology.  

When we are not the majority owner or operator of a particular natural gas or oil project, we may have no control over the timing or amount of capital investments associated with such project.  If we are not willing or able to fund our capital investments relating to such projects when required by the majority owner or operator, our interests in these projects may be reduced or forfeited.

Our ability to sell our natural gas and crude oil production could be materially harmed if we fail to obtain adequate services such as transportation and processing.

Our ability to bring natural gas and crude oil production to market depends on a number of factors including the availability and proximity of pipelines, gathering systems and processing facilities. In some of the areas where we have operations, we deliver natural gas and crude oil through gathering systems and pipelines that we do not own.  With respect to our Fayetteville Shale production, we intend to use the Fayetteville and Greenville laterals being built by TGT to sell our production. The laterals are supposed to be available in January 2009. A delay in the commencement of operations of the Fayetteville and Greenville laterals, the unavailability of other facilities due to market conditions, mechanical reasons or otherwise could have an adverse impact on our results of operations and financial condition.  Any significant change affecting these facilities or our failure to obtain access to existing or future facilities on acceptable terms could restrict our ability to conduct normal operations.


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Shortages of oilfield equipment, services and qualified personnel could adversely affect our results of operations.  

The demand for qualified and experienced field personnel to drill wells and conduct field operations, geologists, geophysicists, engineers and other professionals in the natural gas and oil industry can fluctuate significantly, often in correlation with natural gas and oil prices, causing periodic shortages. For example, during the last half of 2006, we had difficulty obtaining additional well completion services due to a shortage of completion crews in our Fayetteville Shale play area, which resulted in a higher inventory of wells that had been drilled but were awaiting completion.  There have also been shortages of drilling rigs and other equipment, as demand for rigs and equipment has increased along with the number of wells being drilled.  These factors also cause significant increases in costs for equipment, services and personnel.  Higher natural gas and oil prices generally stimulate increased demand and result in increased prices for drilling rigs, crews and associated supplies, equipment and services.  We cannot be certain when we will experience shortages or price increases, which could adversely affect our profit margin, cash flow and operating results or restrict our ability to drill wells and conduct ordinary operations.

Our business could be adversely affected by competition with other companies.  

The natural gas and oil industry is highly competitive, and our business could be adversely affected by companies that are in a better competitive position.  As an independent natural gas and oil company, we frequently compete for reserve acquisitions, exploration leases, licenses, concessions, marketing agreements, equipment and labor against companies with financial and other resources substantially larger than we possess.  Many of our competitors may be able to pay more for exploratory prospects and productive natural gas and oil properties and may be able to define, evaluate, bid for and purchase a greater number of properties and prospects than we can.  Our ability to explore for natural gas and oil prospects and to acquire additional properties in the future will depend on our ability to conduct operations, to evaluate and select suitable properties and to consummate transactions in this highly competitive environment.  In addition, many of our competitors have been operating in some of our core areas for a much longer time than we have or have established strategic long-term positions in geographic regions in which we may seek new entry.

We have made significant investments in our drilling rig operations; however, we are still dependent on third-party drilling companies.  We also have limited experience in operating drilling rigs.

We have made significant investments in our drilling rig operations, including commitments to lease 15 drilling rigs and related equipment and have hired, as of December 31, 2007, 383 employees for our drilling subsidiary, DeSoto Drilling, Inc.  The 15 drilling rigs will not be sufficient to meet the needs of our drilling program and we will still be dependent upon third-party rig providers in order to execute our drilling program in 2008 and beyond, even if we make additional investments. There can be no assurance that our drilling rig operations will not have an adverse effect on our relationships with our existing third-party rig providers or our ability to secure third-party rigs from other providers.  We may also compete with third-party rig providers for qualified personnel, which could adversely affect our relationships with rig providers. If our existing third-party rig providers discontinue their relationships with us, we may not be able to secure alternative rigs on a timely basis, or at all.  Even if we are able to secure alternative rigs, there can be no assurance that replacement rigs will be of equivalent quality or that pricing and other terms will be favorable to us.  If we are unable to secure third-party rigs or if the terms are not favorable to us, our financial condition and results of operations could be adversely affected.

In addition, we cannot assure you that we will be able to continue to attract and retain qualified field personnel to operate our drilling rigs or to otherwise effectively conduct our drilling operations.  If we are unable to retain qualified personnel or to effectively conduct our drilling operations, our financial and operating results may be adversely affected.

We depend upon our management team and our operations require us to attract and retain experienced technical personnel.  

The successful implementation of our business strategy and handling of other issues integral to the fulfillment of our business strategy depends, in part, on our experienced management team, as well as certain key geoscientists, geologists, engineers and other professionals employed by us.  The loss of key members of our management team or other highly qualified technical professionals could have a material adverse effect on our business, financial condition and operating results.

Our hedging activities may prevent us from benefiting from price increases and may expose us to other risks.

To reduce our exposure to fluctuations in the prices of natural gas and oil, we enter into hedging arrangements with respect to a portion of our expected production.  As of December 31, 2007, we had hedges on approximately 70 % of


29 SWN


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our targeted 2008 natural gas production.  Our price risk management activities increased revenues by $70.7 million in 2007 and $8.7 million in 2006, but decreased revenues by $77.2 million in 2005.  To the extent that we engage in hedging activities, we may be prevented from realizing the benefits of price increases above the levels of the hedges.  

In addition, such transactions may expose us to the risk of financial loss in certain circumstances, including instances in which:

·

our production is less than expected;

·

there is a widening of price differentials between delivery points for our production and the delivery point assumed in the hedge arrangement;

·

the counterparties to our futures contracts fail to perform the contracts; or

·

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

Finally, future market price volatility could create significant changes to the hedge positions recorded on our financial statements.  We refer you to “Quantitative and Qualitative Disclosures about Market Risk” in Item 7A of Part II of this Form 10-K.

Our certificate of incorporation, bylaws, and stockholder rights plan contain provisions that could make it more difficult for someone to either acquire us or affect a change of control.

Our stockholder rights plan, together with certain provisions of our certificate of incorporation and bylaws, could discourage an effort to acquire us, gain control of the company, or replace members of our executive management team. These provisions could potentially deprive our stockholders of opportunities to sell shares of our common stock at above-market prices.


ITEM 1B. UNRESOLVED STAFF COMMENTS.

None.


ITEM 2.  PROPERTIES

For additional information about our natural gas and oil operations, we refer you to Notes 6 and 7 to the consolidated financial statements.  For information concerning capital investments, we refer you to “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources — Capital Investments.”  We also refer you to Item 6, “Selected Financial Data” in Part II of this Form 10-K for information concerning natural gas and oil produced.

The following information is provided to supplement the information that is presented in Item 8 of Part II of this Form 10-K.  For a further description of our natural gas and oil properties, we refer you to “Business — Exploration and Production.”

Leasehold acreage as of December 31, 2007:

 

 

Undeveloped

 

Developed

 

 

Gross

 

Net

 

Gross

 

Net

 

Conventional Arkoma(1)

390,362

 

299,599

 

298,270

 

192,192

 

Fayetteville Shale Play(2)

930,560

 

637,560

 

206,720

 

143,740

 

East Texas(3)

110,617

 

91,148

 

39,477

 

27,756

 

Permian Basin

16,291

 

8,944

 

93,177

 

28,456

 

Gulf Coast

12,369

 

5,795

 

10,809

 

3,042

 

New Ventures(4)

163,196

 

156,465

 

14,715

 

11,771

 

 

1,623,395

 

1,199,511

 

663,168

 

406,957

 



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(1)  Includes 123,442 net developed acres and 1,930 net undeveloped acres in our Conventional Arkoma Basin operating area that are also within our Fayetteville Shale focus area but not included in the Fayetteville Shale acreage in the table above.

(2)  Assuming we do not drill successful wells to develop the acreage and do not extend the leases in our undeveloped acreage in the Fayetteville Shale play, leasehold expiring over the next three years will be 16,561 net acres in 2008, 96,601 net acres in 2009 and 145,722 net acres in 2010.

(3)  Assuming we do not drill successful wells to develop the acreage and do not extend the leases in our undeveloped acreage in the Angelina River Trend and Jebel areas in East Texas, leasehold expiring over the next three years will be 7,737 net acres in 2008, 33,274 net acres in 2009 and 4,474 acres in 2010.

(4)  Includes New Ventures opportunities such as the Marcellus Shale play in Pennsylvania.  

 

Producing wells as of December 31, 2007:

 

Gas

Oil

Total

Gross Wells Operated

 

Gross

Net

Gross

Net

Gross

Net

Conventional Arkoma

1,098

550

-

-

1,098

550

513

Fayetteville Shale Play

497

377

-

-

497

377

429

East Texas

464

390

2

2

466

392

440

Permian Basin

150

25

256

113

406

138

52

Gulf Coast

30

12

4

-

34

12

3

New Ventures

14

9

-

-

14

9

11

 

2,253

1,363

262

115

2,515

1,478

1,448

Wells drilled during the year:

 

 

 

Exploratory

 

 

 

Productive Wells

Dry Holes

Total

 

Year

 

Gross

Net

Gross

Net

Gross

Net

 

2007

 

97.0

69.4

5.0

3.7

102.0

73.1

 

2006

 

48.0

40.0

4.0

2.3

52.0

42.3

 

2005

 

15.0

13.4

2.0

1.8

17.0

15.2

 

 

 

 

Development

 

 

 

Productive Wells

Dry Holes

Total

 

Year

 

Gross

Net

Gross

Net

Gross

Net

 

2007

 

342.0

225.2

12.0

8.5

354.0

233.7

 

2006

 

182.0

138.8

5.0

3.4

187.0

142.2

 

2005

 

182.0

141.7

6.0

3.3

188.0

145.0





Wells in progress as of December 31, 2007:

 

Gross

 Net

Exploratory

48.0

35.5

Development

149.0

100.8

Total

197.0

136.3


During 2007, we were required to file Form 23, “Annual Survey of Domestic Oil and Gas Reserves,” with the Department of Energy.  The basis for reporting reserves on Form 23 is not comparable to the reserve data included in Note 7 to the consolidated financial statements in Item 8 to this Form 10-K. The primary differences are that Form 23 reports gross reserves, including the royalty owners’ share, and includes reserves for only those properties of which we are the operator.


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Miles of Pipe

At December 31, 2007, our Midstream Services segment had 556 miles of pipe in its gathering systems located in Arkansas.


The following table provides information concerning miles of pipe of our Natural Gas Distribution segment as of December 31, 2007.  For a further description of AWG's properties, we refer you to “Business — Natural Gas Distribution.”

 

 

Total

Gathering

395

Transmission

1,038

Distribution

4,360

 

5,793


Title to Properties

We believe that we have satisfactory title to substantially all of our active properties in accordance with standards generally accepted in the oil and gas industry.  Our properties are subject to customary royalty and overriding royalty interests, certain contracts relating to the exploration, development, operation and marketing of production from such properties, consents to assignment and preferential purchase rights, liens for current taxes, applicable laws and other burdens, encumbrances and irregularities in title, which we believe do not materially interfere with the use of or affect the value of such properties.  Prior to acquiring undeveloped properties, we perform a title investigation that is thorough but less vigorous than that conducted prior to drilling, which is consistent with standard practice in the oil and gas industry.  Before we commence drilling operations on properties that we operate, we conduct a thorough title examination and perform curative work with respect to significant defects before proceeding with operations.  We have performed a thorough title examination with respect to substantially all of our active properties that we operate.

ITEM 3.  LEGAL PROCEEDINGS  

We are subject to laws and regulations relating to the protection of the environment. Our policy is to accrue environmental and cleanup related costs of a non-capital nature when it is both probable that a liability has been incurred and when the amount can be reasonably estimated. Management believes any future remediation or other compliance related costs will not have a material effect on our financial position or reported results of operations.


We are subject to litigation and claims that have arisen in the ordinary course of business. Management believes, individually or in aggregate, such litigation and claims will not have a material adverse impact on our financial position or our results of operations but these matters are subject to inherent uncertainties and management's view may change in the future. If an unfavorable final outcome were to occur, there exists the possibility of a material impact on our financial position and the results of operations for the period in which the effect becomes reasonably estimable. We accrue for such items when a liability is both probable and the amount can be reasonably estimated.


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


None.   



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EXECUTIVE OFFICERS OF THE REGISTRANT

Name

Officer Position

Age

Years Served as Officer

Harold M. Korell

President, Chief Executive Officer and Chairman of the Board

63

11

    

Greg D. Kerley

Executive Vice President and Chief Financial Officer

52

18

    

Richard F. Lane

Executive Vice President, and President, Southwestern Energy Production Company and SEECO, Inc.

50

9

    

Mark K. Boling

Executive Vice President, General Counsel and Secretary

50

6

    

Gene A. Hammons

President, Southwestern Midstream Services Company

62

3


Mr. Korell was elected as Chairman of the Board in May 2002 and has served as Chief Executive Officer since January 1999 and President since October 1998.  He joined us in 1997 as Executive Vice President and Chief Operating Officer.  From 1992 to 1997, he was employed by American Exploration Company where he was most recently Senior Vice President-Operations.  From 1990 to 1992, he was Executive Vice President of McCormick Resources and from 1973 to 1989, he held various positions with Tenneco Oil Company, including Vice President-Production.

Mr. Kerley was appointed to his present position in December 1999.  Previously, he served as Senior Vice President and Chief Financial Officer from 1998 to 1999, Senior Vice President-Treasurer and Secretary from 1997 to 1998, Vice President-Treasurer and Secretary from 1992 to 1997, and Controller from 1990 to 1992.  Mr. Kerley also served as the Chief Accounting Officer from 1990 to 1998.

Mr. Lane was appointed to Executive Vice President of Southwestern Energy Company and promoted to President, SEECO, Inc. and Southwestern Energy Production Company in December 2005.  He was appointed to the position of Executive Vice President, SEECO, Inc. and Southwestern Energy Production Company in December 2001.  Previously, he served as Senior Vice President from February 2001 and Vice President-Exploration from February 1999.  Mr. Lane joined us in February 1998 as Manager-Exploration.  From 1993 to 1998, he was employed by American Exploration Company where he was most recently Offshore Exploration Manager.  Previously, he held various managerial and geological positions at FINA, Inc. and Tenneco Oil Company.

Mr. Boling was appointed to his present position in December 2002.  He joined us as Senior Vice President, General Counsel and Secretary in January 2002.  Prior to joining the company, Mr. Boling had a private law practice in Houston specializing in the natural gas and oil industry from 1993 to 2002.  Previously, Mr. Boling was a partner with Fulbright and Jaworski L.L.P. where he was employed from 1982 to 1993.

Mr. Hammons was promoted to President of Southwestern Midstream Services Company in December 2005.  He joined the company in July 2005 as Vice President of Southwestern Midstream Services Company.  Prior to joining us, he provided consulting services to clients in the natural gas industry.  Previously, Mr. Hammons was employed by El Paso Natural Gas Company and Burlington Resources and held managerial positions in facility design and installation, gathering management and marketing over the course of his combined 28-year tenure.  

All officers are elected at the Annual Meeting of the Board of Directors for one-year terms or until their successors are duly elected.  There are no arrangements between any officer and any other person pursuant to which he was selected as an officer.  There is no family relationship between any of the named executive officers or between any of them and our directors.


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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 “SWN.”  On February 22, 2008, the closing price of our stock was $61.72 and we had 2,201 stockholders of record.  The following table presents the high and low sales prices for closing market transactions as reported on the New York Stock Exchange, which prices have been adjusted as appropriate to reflect the two-for-one stock splits effected in June 2005 and November 2005.

 

  Range of Market Prices

Quarter Ended

 

2007

  2006  

2005

March 31

 

$41.28

$32.87

 

$43.42

$29.33

 

$15.47

$11.22

June 30  

$50.18

$41.38

 

$39.97

$24.80

  $23.49 $14.20
September 30  

$45.70

$35.99

 

$37.47

$27.95

  $37.18 $24.78
December 31  

$56.53

$42.51

 

$42.59

$27.86

  $41.15 $31.30


We have indefinitely suspended payment of quarterly cash dividends on our common stock.


Issuer Purchases of Equity Securities


We did not repurchase any shares of our equity securities during 2007.


Recent Sales of Unregistered Equity Securities

 

We did not sell any unregistered equity securities during 2007.



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STOCK PERFORMANCE GRAPH


The following graph compares, for the last five years, the performance of our common stock to the S&P MidCap 400 Index and the Dow Jones U.S. Exploration & Production Index (previously known as the Dow Jones Oil — Secondary Index).  The chart assumes that the value of the investment in our common stock and each index was $100 at December 31, 2002, and that all dividends were reinvested.  The stock performance shown on the graph below is not indicative of future price performance.

 


 

 

 

 

 

 

 

 

 

 

12/31/02

12/31/03

12/31/04

12/31/05

12/31/06

12/31/07

Southwestern Energy Company

100

209

443

1,256

1,224

1,947

Dow Jones U.S. Exploration & Production

100

131

186

307

324

465

S&P MidCap 400 Index

100

136

158

178

196

212




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ITEM 6. SELECTED FINANCIAL DATA


The following table sets forth a summary of selected historical financial information for each of the years in the five-year period ended December 31, 2007. This information and the notes thereto are derived from our financial statements. We refer you to “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Financial Statements and Supplementary Data.”

 

2007

 

 2006

 

 2005

 

 2004

 

 2003

 

 

(in thousands except share, per share, stockholder data and percentages)

Financial Review

Operating revenues

   

   

   

   

   

Exploration and production

 

$

795,944

 

$

491,545

 

$

403,234

 

$

286,924

 

$

176,245

Midstream services

961,994

475,207

459,890

314,977

201,976

Gas distribution and other

 

174,914

 

172,655

 

179,375

 

158,698

 

140,829

Intersegment revenues

(677,721)

(376,295)

(366,170)

(283,462)

(191,649)

 

1,255,131

 

763,112

 

676,329

 

477,137

 

327,401

Operating costs and expenses

                             

Gas purchases - midstream services

   

306,336

   

128,387

   

124,730

   

60,804

   

39,428

Gas purchases - gas distribution

 

85,445

 

79,363

 

82,689

 

64,311

 

52,585

Operating and general

166,095

132,691

101,500

78,231

70,479

Depreciation, depletion and amortization

293,914

151,290

96,211

73,674

55,948

Taxes, other than income taxes

 

21,875

 

25,109

 

25,279

 

17,830

 

11,619

 

873,665

 

516,840

 

430,409

 

294,850

 

230,059

Operating income

 

381,466

 

246,272

 

245,920

 

182,287

 

97,342

Interest expense, net

(23,873)

(679)

(15,040)

(16,992)

(17,311)

Other income (expense)

 

(219)

 

17,079

 

4,784

 

(362)

 

797

Minority interest in partnership

(345)

(637)

(1,473)

(1,579)

(2,180)

Income before income taxes and accounting change

   

357,029

   

262,035

   

234,191

   

163,354

   

78,648

Income taxes

                             

Current

    -     -    

-

   

-

   

-

Deferred

  135,855   99,399  

86,431

 

59,778

 

28,896

 

135,855

 

99,399

 

86,431

 

59,778

 

28,896

Income before accounting change

  221,174   162,636  

147,760

 

103,576

 

49,752

Cumulative effect of adoption of accounting principle

    -     -    

-

   

-

   

(855)

Net income

$

221,174

$

162,636

$

147,760

$

103,576

$

48,897

                               

Return on equity

  13.4%   11.3%  

13.3%

 

23.1%

 

14.3%

                               

Net cash provided by operating activities

  $

622,735

  $

429,937

  $

304,482

  $

237,897

  $

109,099

Net cash used in investing activities

  $

(1,513,497)

  $

(630,006)

  $

(452,918)

  $

(285,448)

  $

(161,656)

Net cash provided by financing activities

  $

849,667

  $

19,291

  $

370,906

  $

47,509

  $

52,144

Common Stock Statistics(1)
Earnings per share:

           

   

   

Basic

$ 1.31 $ 0.97 $

0.98

$

0.72

$

0.37

Diluted

$ 1.27 $ 0.95 $

0.95

$

0.70

$

0.36

Cash dividends declared and paid per share

  $ -   $ -   $

-

  $

-

  $

-

Book value per average diluted share

$ 9.48 $ 8.38 $

7.10

$

3.03

$

2.49

Market price at year-end

$ 55.72 $ 35.05 $

35.94

$

12.67

$

5.98

Number of stockholders of record at year-end

    2,275     2,412    

2,126

   

2,022

   

2,026

Average diluted shares outstanding

  173,721,330   171,287,750  

156,309,039

 

147,851,088

 

136,951,736


(1)

 2004 and 2003 restated to reflect two-for-one stock splits effected in June and November 2005.



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Table of Contents

 

 

2007

2006

2005

2004

2003

Capitalization (in thousands)

       

   

   

   

Total debt

$

978,800

  $

137,800

  $

100,000

  $

325,000

  $

278,800

Common stockholders' equity

 

1,646,500

   

1,434,643

   

1,110,304

   

447,677

   

341,561

Total capitalization

$

2,625,300

  $

1,572,443

  $

1,210,304

  $

772,677

  $

620,361

Total assets

$

3,622,716

  $

2,379,069

  $

1,868,524

  $

1,146,144

  $

890,710

Capitalization ratios:

                 

Debt

 

37.3%

   

8.8%

   

8.3%

   

42.1%

   

44.9%

Equity

 

62.7%

   

91.2%

   

91.7%

   

57.9%

   

55.1%

Capital Investments (in millions) (1)

 

   

   

   

   

Exploration and production

 

 

 

 

 

 

 

 

 

 

Exploration and development

$

1,375.2

$

767.4

$

416.2

$

282.0

$

170.9

Drilling rigs and related equipment (2)

 

4.5

 

93.6

 

35.1

 

-

 

-

 

 

1,379.7

 

861.0

  451.3  

282.0

 

170.9

Midstream services

107.4

48.7

15.8

-

-

Gas distribution

11.4

11.2

10.9

7.3

8.2

Other

 

4.6

   

21.5

   

5.1

   

5.7

   

1.1

 

$

1,503.1

 

$

942.4

 

$

483.1

 

$

295.0

 

$

180.2

Exploration and Production

 

   

   

       

Natural gas:

                       

Production, Bcf

 

109.9

   

68.1

   

56.8

   

50.4

   

38.0

Average price per Mcf, including hedges

$

6.80

  $

6.55

  $

6.51

  $

5.21

  $

4.20

Average price per Mcf, excluding hedges

$

6.16

  $

6.37

  $

7.73

  $

5.80

  $

5.15

Oil:

                 

Production, MBbls

 

614

   

698

   

705

   

618

   

531

Average price per barrel, including hedges

$

69.12

  $

58.36

  $

42.62

  $

31.47

  $

26.72

Average price per barrel, excluding hedges

$

69.12

  $

63.17

  $

54.37

  $

40.55

  $

29.66

Total gas and oil production, Bcfe

 

113.6

   

72.3

   

61.0

   

54.1

   

41.2

Lease operating expenses per Mcfe

$

.73

  $

.66

  $

.48

  $

.38

  $

.39

General and administrative expenses per Mcfe

$

.48

  $

.58

  $

.46

  $

.36

  $

.41

Taxes other than income taxes per Mcfe

$

.16

  $

.30

  $

.37

  $

.28

  $

.22

Proved reserves at year-end:

                         

Natural gas, Bcf

1,396.9

978.9

772.3

594.5

457.0

Oil, MBbls

8,912

7,898

9,079

8,508

7,675

Total reserves, Bcfe

 

1,450.3

   

1,026.3

   

826.8

   

645.5

   

503.1

                             

Midstream Services

 

   

   

   

   

Gas volumes marketed

 

145.7

   

72.7

   

61.9

   

57.0

   

42.7

Gas volumes gathered

 

78.7

   

14.6

   

2.3

   

-

-

                             

Natural Gas Distribution

 

   

   

   

   

Sales and transportation volumes, Bcf

 

23.6

   

21.8

   

23.2

   

24.0

   

24.7

Off-system transportation, Bcf (3)

 

0.3

   

0.1

   

-

   

1.0

   

0.3

Total volumes delivered

 

23.9

   

21.9

   

23.2

   

25.0

   

25.0

Customers at year-end:

 

 

   

 

   

 

       

Residential

134,616

133,679

130,654

127,622

124,776

Commercial

 

17,180

   

17,151

   

16,996

   

16,815

   

16,623

Industrial

 

192

   

173

   

170

   

175

   

174

 

 

151,988

   

151,003

   

147,820

   

144,612

   

141,573

Degree days

 

3,699

   

3,413

   

3,744

   

3,678

   

3,969

Percent of normal

 

91%

   

83%

   

91%

   

90%

   

99%


(1)  Capital investments include a reduction of $20.6 million for 2007 and increases of $88.9 million, $28.1 million, $3.9 million and $12.0 million for 2006, 2005, 2004 and 2003, respectively, related to the change in accrued expenditures between years.

(2)  The 2006 and 2005 drilling rigs and related equipment capital investments were sold in December 2006 as part of a sale and leaseback transaction.

(3)  2005 off-system transportation volumes were less than 0.1 Bcf.




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


This Form 10-K contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in forward-looking statements for many reasons, including the risks described in “Cautionary Statement about Forward-Looking Statements” below, in Item 1A, “Risk Factors” in Part I and elsewhere in this annual report. You should read the following discussion with the “Selected Financial Data” and our consolidated financial statements and related notes included elsewhere in this Form 10-K.

OVERVIEW

Southwestern Energy Company is an independent energy company primarily focused on the exploration and production of natural gas within the United States. Our operations principally are located in Arkansas, Oklahoma and Texas. We are also focused on creating and capturing additional value at and beyond the wellhead through our established natural gas gathering and marketing businesses, which we refer to collectively as our Midstream Services.  We operate principally in three segments: Exploration and Production (E&P), Midstream Services and Natural Gas Distribution.  Upon the consummation of the pending sale of our utility subsidiary, Arkansas Western Gas Company, we will cease to have any natural gas distribution operations. We refer you to Note 1 to the consolidated financial statements for additional information. The transaction is subject to certain closing conditions and regulatory approvals and is expected to close approximately mid-year 2008. Pursuant to Statement of Financial Accounting Standards No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets" (FAS 144), the assets and liabilities of Arkansas Western Gas Company (“AWG”) have been reclassified as “held for sale” in our December 31, 2007 and 2006 balance sheets. However, the results of operations for AWG continue to be consolidated in the statements of operations and are not presented as “discontinued operations.” We refer you to Note 2 to the consolidated financial statements for additional information.

We are focused on providing long-term growth in the net asset value of our business, which we achieve in our E&P business through the drillbit. We prepare economic analyses for each of the investment opportunities in our E&P business and rank them based upon the expected present value added for each dollar invested, which we refer to as PVI. The PVI of the future expected cash flows for each project is determined using a 10% discount rate. Our actual PVI results are utilized to help determine the allocation of our future capital investments.  

We derive the vast majority of our operating income and cash flow from the natural gas production of our E&P business and expect this to continue in the future.  We expect that growth in our operating income and revenues will primarily depend on natural gas prices and our ability to increase our natural gas production.  In recent years, there has been significant price volatility in natural gas and crude oil prices due to a variety of factors we cannot control or predict.  These factors, which include weather conditions, political and economic events, and competition from other energy sources, impact supply and demand for natural gas, which determines the pricing.  In addition, the price we realize for our gas production is affected by our hedging activities as well as locational differences in market prices.  Our ability to increase our natural gas production is dependent upon our ability to economically find and produce natural gas, our ability to control costs and our ability to market natural gas on economically attractive terms to our customers.


In 2007, our gas and oil production increased 57% to 113.6 Bcfe, and in 2006 our production increased 19% to 72.3 Bcfe. The increases in production in both 2007 and 2006 primarily resulted from increases in production from our Fayetteville Shale play in Arkansas. We are targeting 2008 gas and oil production of 148 to 152 Bcfe, an increase of 30% to 35% over our 2007 production. Our year-end reserves grew 41% in 2007 to 1,450.3 Bcfe, up from 1,026.3 Bcfe at the end of 2006. These increases were also primarily fueled by the continued development of our Fayetteville Shale play.


We reported net income of $221.2 million in 2007, or $1.27 per share on a fully diluted basis, up 36% from the prior year. Net income in 2006 increased approximately 10% to $162.6 million, or $0.95 per share, compared to 2005. The increase in net income in 2007 was a result of increased production volumes in our E&P segment, partially offset by increased operating costs and expenses and increased interest expense. The increase in net income in 2006 was a result of increased production volumes in our E&P segment, a gain on the sale of our NOARK investment and decreased interest expense, partially offset by increased operating costs and expenses. Our cash flow from operating activities increased 45% to $622.7 million in 2007 and 41% to $429.9 million in 2006, primarily due to increases in net income and adjustments to net income for non-cash expenses.


Operating income for our E&P segment was $358.1 million in 2007, $237.3 million in 2006 and $234.8 million in 2005. Operating income for our E&P segment increased in 2007 due to increased production volumes, partially offset by increased operating costs and expenses. Operating income for our Midstream Services segment was $13.2 million in 2007,



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compared to $4.1 million in 2006 and $5.7 million in 2005. Operating income for our Midstream Services segment increased in 2007 due to an increase in gathering revenues related to our Fayetteville Shale play and an increase in the margin generated from marketing of natural gas, partially offset by increased operating costs and expenses. Operating income for our Midstream Services segment decreased in 2006 as increased gathering revenues were more than offset by increased operating costs and expenses and a decrease in the margin generated by our marketing activities. Operating income for our Natural Gas Distribution segment was $10.0 million in 2007, compared to $4.5 million in 2006 and $4.9 million in 2005. The increase in operating income for our Natural Gas Distribution segment in 2007 resulted from a rate increase implemented in August 2007, from colder weather and a decrease in operating costs and expenses. The decrease in operating income for our Natural Gas Distribution segment in 2006 resulted primarily from warmer weather and increased operating costs and expenses.


Our capital investments totaled approximately $1.5 billion in 2007, up from $942.4 million in the prior year. We invested $1.38 billion in our E&P segment in 2007, compared to $861.0 million in 2006 (including $93.6 million invested in drilling rigs) and $451.3 million in 2005 (including $35.1 million invested in drilling rigs). Funds for our 2007 capital investments were provided by borrowings under our revolving credit facility, cash flow from operations and cash proceeds from a December 2006 drilling rig sale and leaseback transaction. As a result of our increased borrowings, our total debt-to-capitalization ratio increased to 37% at December 31, 2007, up from 9% at December 31, 2006.


For 2008, our planned capital investments are $1.46 billion, approximately equal to the level of our 2007 capital investments, and include $1.33 billion for our E&P segment, $101 million for our Midstream Services segment and $25 million for other corporate purposes (including improvements to the utility system in advance of the pending sale). The $1.33 billion of E&P investments includes approximately $1.0 billion for the development of our Fayetteville Shale play and approximately 82% of our 2008 E&P capital is allocated to drilling. In addition to the planned investments in the Fayetteville Shale play, our E&P investments in 2008 will also focus on our active drilling programs in East Texas and other conventional drilling in the Arkoma Basin. We expect our capital investments in 2008 to be funded from internally-generated cash flow, borrowings under our revolving credit facility, funds raised in the debt markets and proceeds from the sale of our utility and the anticipated divestiture of certain E&P assets.

RESULTS OF OPERATIONS

Exploration and Production

     

 

Year Ended December 31,

 

 

2007

 

2006

 

2005

 

 

 

 

 

 

 

 

Revenues (in thousands)

$ 795,944

 

$ 491,545

$ 403,234

 

Operating income (in thousands)

$ 358,079

$ 237,307

$ 234,759

             

Gas production (Bcf)

109.9

 

68.1

 

56.8

 

Oil production (MBbls)

614

 

698

 

705

 

   Total production (Bcfe)

113.6

 

72.3

 

61.0

 
             

Average gas price per Mcf, including hedges

$

6.80

 

$

6.55

 

$

6.51

 

Average gas price per Mcf, excluding hedges

$

6.16

 

$

6.37

 

$

7.73

 

Average oil price per Bbl, including hedges

$

69.12

 

$

58.36

 

$

42.62

 

Average oil price per Bbl, excluding hedges

$

69.12

 

$

63.17

 

$

54.37

 
             

Average unit costs per Mcfe:

 

 

 

 

 

 

   Lease operating expenses

$

0.73

 

$

0.66

 

$

0.48

 

   General & administrative expenses

$

0.48

 

$

0.58

 

$

0.46

 

   Taxes other than income taxes

$

0.16

 

$

0.30

 

$

0.37

 

   Full cost pool amortization

$

2.41

 

$

1.90

 

$

1.42

 


Revenues, Operating Income and Production


Revenues. Revenues for our E&P segment increased 62% in 2007 to $795.9 million primarily due to a 57% increase in total gas and oil production. Revenues increased 22% in 2006 to $491.5 million, primarily due to a 19% increase in our production volumes. We expect our production volumes to continue to increase primarily due to the development of our Fayetteville Shale play in Arkansas.  Gas and oil prices are difficult to predict and are subject to wide price fluctuations.  As of February 22, 2008, we have hedged 118.0 Bcf, 104.0 Bcf and 18.0 Bcf of our 2008, 2009 and 2010 gas production, respectively, in order to limit our exposure to price fluctuations. Revenues for 2007, 2006 and 2005 also include pre-tax gains of $6.4 million, $4.0 million and $3.1 million, respectively, related to the sale of gas-in-storage inventory.



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Operating Income. Operating income from our E&P segment was $358.1 million in 2007, an increase of 51% from $237.3 million in 2006, as the increase in our revenues was partially offset by increased operating costs and expenses. Operating income was up 1% in 2006 compared to 2005 as the increase in revenues was largely offset by increased operating costs and expenses.


Production. Gas and oil production was up approximately 57% to 113.6 Bcfe in 2007 and up 19% to 72.3 Bcfe in 2006, compared to prior periods. The increase in 2007 was primarily the result of a 41.7 Bcf increase in production from our Fayetteville Shale play. The increase in 2006 was the result of a 10.0 Bcf increase in production from our Fayetteville Shale play and a 4.0 Bcf increase in our East Texas production, partially offset by declines in production from our Permian and Gulf Coast properties. Our net production from the Fayetteville Shale play was 53.5 Bcf in 2007, up from 11.8 Bcf in 2006 and 1.8 Bcf in 2005.


Gas sales to unaffiliated purchasers were up 66% to 105.1 Bcf in 2007 and up 23% to 63.4 Bcf in 2006, compared to the prior years. Sales to unaffiliated purchasers are primarily made under contracts that reflect current short-term prices and are subject to seasonal price swings. Intersegment sales to AWG increased slightly to 4.8 Bcf in 2007 and decreased 7% to 4.7 Bcf in 2006. Future increases in demand for our gas production are expected to come from sales to unaffiliated purchasers. We are unable to predict changes in the market demand and price for natural gas, including weather-related changes affecting demand of both affiliated and unaffiliated customers for our production.


We are targeting 2008 gas and oil production of 148.0 to 152.0 Bcfe, an increase of 30% to 35% over our 2007 production. Our 2008 production volumes could also be impacted by the anticipated sale of certain E&P assets. Based on early production histories and modeling and assuming continued positive results, approximately 90.0 to 95.0 Bcf of our 2008 targeted gas production is projected to come from our activities in the Fayetteville Shale play. Although we expect production volumes in 2008 to increase, we cannot guarantee our success in discovering, developing, and producing reserves, including with respect to our Fayetteville Shale play. Our ability to discover, develop and produce reserves is dependent upon a number of factors, many of which are beyond our control, including the availability of capital, the timing and extent of changes in natural gas and oil prices and competition. There are also many risks inherent to the discovery, development and production of natural gas and oil. We refer you to “Risk Factors” in Item 1A of Part I of this Form 10-K for a discussion of these risks and the impact they could have on our financial condition and results of operations.


Commodity Prices

We periodically enter into various hedging and other financial arrangements with respect to a portion of our projected natural gas and crude oil production in order to ensure certain desired levels of cash flow and to minimize the impact of price fluctuations, including fluctuations in locational market differentials (we refer you to Item 7A of this Form 10-K and Note 9 to the consolidated financial statements for additional discussion). The average price realized for our gas production, including the effects of hedges, increased to $6.80 per Mcf in 2007 and increased slightly to $6.55 per Mcf in 2006. The changes in the average price realized primarily reflect changes in average annual spot market prices and the effects of our price hedging activities. Our hedging activities increased the average gas price $0.64 per Mcf in 2007, compared to an increase of $0.18 per Mcf in 2006 and a reduction of $1.22 per Mcf in 2005. In recent years, locational differences in market prices for natural gas have been wider than historically experienced. Disregarding the impact of hedges, historically the average price received for our gas production was approximately $0.30 to $0.50 per Mcf lower than average NYMEX spot market prices due to the locational market differentials. However, during 2007, 2006 and 2005, widening market differentials caused the difference in our average price received for our gas production to be approximately $0.70 to $0.90 per Mcf lower than spot market prices.  Assuming a NYMEX commodity price for 2008 of $7.00 per Mcf of gas, our differential for the average price received for our gas production is expected to be approximately $0.60 to $0.70 per Mcf below the NYMEX Henry Hub index price, including the impact of our basis hedges. As of December 31, 2007, we have financially protected future gas production volumes of 91.3 Bcf in 2008 and 3.6 Bcf in 2009 from the impact of widening basis differentials through our hedging activities and sales arrangements.  


In addition to the basis hedges discussed above, at December 31, 2007, we had NYMEX commodity price hedges in place on 102.0 Bcf of 2008 and 79.0 Bcf of 2009 expected future gas production.  Subsequent to December 31, 2007 and prior to February 22, 2008, we hedged 16.0 Bcf of 2008, 17.0 Bcf of 2009 and 16.0 Bcf of 2010 gas production under fixed price swaps with average prices of $8.99, $8.53 and $8.55 per Mcf, respectively.  In addition, we hedged 8.0 Bcf of 2009 and 2.0 Bcf of 2010 gas production using costless collars. The collars relating to 2009 production have a weighted average floor and ceiling price of $8.00 and $10.05 per Mcf, respectively; and the collars relating to 2010 production have a weighted average floor and ceiling price of $8.50 and $10.20 per Mcf, respectively. We have also basis protected an additional 2.1 Bcf of 2008 gas production with an average differential price of $0.26 below NYMEX spot rates. As of February 22, 2008, we have hedged approximately 80% of our 2008 anticipated gas production.



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We realized an average price of $69.12 per barrel for our oil production for the year ended December 31, 2007, up approximately 18% from the prior year. We did not hedge any of our 2007 oil production.  The 2006 realized average price of $58.36 per barrel, including the effects of hedges, was up 37% from 2005. The average prices we received for our oil production in 2006 and 2005 were reduced by $4.81 and $11.75 per barrel, respectively, due to the effects of our hedging activities. Assuming a NYMEX commodity price of $70.00 per barrel of oil for 2008, we expect the average price received for our oil production during 2008 to be approximately $1.50 per barrel lower than average spot market prices as market differentials reduce the average prices received.


Operating Costs and Expenses

Lease operating expenses per Mcfe for the E&P segment were $0.73 in 2007, compared to $0.66 in 2006 and $0.48 in 2005. Lease operating expenses per unit of production increased in 2007 and 2006 due primarily to increases in our gathering and compression costs related to our operations in the Fayetteville Shale play. We expect our per unit operating cost for this segment to range between $0.85 and $0.90 per Mcfe in 2008 primarily due to increased production volumes from the Fayetteville Shale play.

 

General and administrative expenses for the E&P segment were $0.48 per Mcfe in 2007, down from $0.58 per Mcfe in 2006 and up from $0.46 per Mcfe in 2005. The decrease in general and administrative costs per Mcfe in 2007 as compared to 2006 was due to the effects of our increased production volumes. In total, general and administrative expenses for the E&P segment were $54.8 million in 2007, $41.9 million in 2006 and $28.2 million in 2005. The increases in total general and administrative costs since 2005 were due primarily to increased payroll and related costs associated with the expansion of our E&P operations due to the Fayetteville Shale play and to increased incentive compensation costs. We added 243 new employees during 2007, most of which were hired in our E&P segment, compared to 494 employees added in 2006. We expect our cost per unit for general and administrative expenses to continue to decline in 2008 and range between $0.42 and $0.47 per Mcfe. The expected decrease in per unit costs in 2008 is due to increased production volumes from our Fayetteville Shale play and a reduced rate of expansion in our E&P workforce. Future changes in our general and administrative expenses for this segment are primarily dependent upon our salary costs, level of pension expense, stock-based compensation expensing under Statement on Financial Accounting Standards No. 123R “Share-Based Payment” (FAS 123R) and the amount of incentive compensation paid to our employees. For eligible employees, a portion of incentive compensation is based on the achievement of certain operating and performance results, including production, proved reserve additions, present value added for each dollar of capital invested, and lease operating expenses and general and administrative expenses per unit of production, while another portion is discretionary based upon an employee’s performance. Additional discretionary awards may also be awarded under the incentive compensation plan. See “Critical Accounting Policies” below for further discussion of pension expense.

Our full cost pool amortization rate averaged $2.41 per Mcfe for 2007, $1.90 per Mcfe for 2006 and $1.42 per Mcfe for 2005. The amortization rate is impacted by timing and amount of reserve additions and the costs associated with those additions, revisions of previous reserve estimates due to both price and well performance, write-downs that result from full cost ceiling tests, proceeds from the sale of properties that reduce the full cost pool and the levels of costs subject to amortization. We cannot predict our future full cost pool amortization rate with accuracy due to the variability of each of the factors discussed above, as well as other factors, including but not limited to the uncertainty of the amount of future reserves attributed to our Fayetteville Shale play. Unevaluated costs excluded from amortization were $372.4 million at the end of 2007, compared to $166.8 million at the end of 2006 and $122.3 million at the end of 2005. The increase in unevaluated costs since December 31, 2005, resulted primarily from an increase in our undeveloped leasehold acreage and seismic costs for our Fayetteville Shale play and the related increased drilling activity.


Taxes other than income taxes per Mcfe were $0.16 in 2007, $0.30 in 2006 and $0.37 in 2005, and vary from year to year due to changes in severance and ad valorem taxes that primarily result from the mix of our production volumes and fluctuations in commodity prices. Additionally, we accrued $4.9 million in 2007 for severance tax refunds related to our East Texas production.


The timing and amount of production and reserve additions attributed to our Fayetteville Shale play could have a material impact on our per unit costs; if production or reserves additions are lower than projected, our per unit costs would increase.


We utilize the full cost method of accounting for costs related to the exploration, development and acquisition of natural gas and oil reserves. Under this method, all such costs (productive and nonproductive), including salaries, benefits and other internal costs directly attributable to these activities are capitalized and amortized on an aggregate basis over the estimated lives of the properties using the units-of-production method. These capitalized costs are subject to a ceiling test



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that limits such pooled costs to the aggregate of the present value of future net revenues attributable to proved natural gas and oil reserves discounted at 10 percent (standardized measure) plus the lower of cost or market value of unproved properties. Any costs in excess of the ceiling are written off as a non-cash expense. The expense may not be reversed in future periods, even though higher natural gas and oil prices may subsequently increase the ceiling. Full cost companies must use the prices in effect at the end of each accounting quarter, including the impact of derivatives qualifying as hedges, to calculate the ceiling value of their reserves.  However, commodity price increases subsequent to the end of a reporting period but prior to the release of periodic reports may be utilized to calculate the ceiling value of reserves. At December 31, 2007, 2006 and 2005, our unamortized costs of natural gas and oil properties did not exceed this ceiling amount. At December 31, 2007, the ceiling value of our reserves was calculated based upon quoted market prices of $6.80 per Mcf for Henry Hub gas and $92.50 per barrel for West Texas Intermediate oil, adjusted for market differentials. Cash flow hedges of gas production in place at December 31, 2007 increased the calculated ceiling value by approximately $163 million (net of tax). We had approximately 181.0 Bcf of future gas production hedged at December 31, 2007. At December 31, 2006, the ceiling value of our reserves was calculated based upon quoted market prices of $5.64 per Mcf for Henry Hub gas and $57.25 per barrel for West Texas Intermediate oil, and at December 31, 2005, the ceiling value of our reserves was calculated based upon quoted market prices of $10.08 per Mcf for Henry Hub gas and $61.04 per barrel for West Texas Intermediate oil. Decreases in market prices from December 31, 2007 levels, as well as changes in production rates, levels of reserves, the evaluation of costs excluded from amortization, future development costs, and service costs could result in future ceiling test impairments.


Inflation impacts our E&P operations by generally increasing our operating costs and the costs of our capital additions. The effects of inflation on our operations prior to 2000 were minimal due to low inflation rates. However, since 2001, as commodity prices have increased, the impact of inflation has intensified in our E&P segment as shortages in drilling rigs, third-party services and qualified labor have risen due to increased activity levels in the natural gas and oil industry. We have endeavored to mitigate rising costs by obtaining vendor pricing commitments for multiple projects and by offering performance bonuses related to increased economic efficiencies. During 2007, our E&P operations experienced decreases in certain costs and third-party services primarily due to increased vendor competition in our Fayetteville Shale operating area.


Midstream Services

     

 

Year Ended December 31,

 

 

2007

 

2006

 

2005

 

 

($ in millions, except volumes)

 

Revenues - marketing

$  924.3

 

$  467.3

$  458.9

 

Revenues - gathering

$    37.7

 

$      7.9

$      1.0

 

Gas purchases - marketing

$  915.1

$  458.9

$  451.1

Operating costs and expenses

$    33.7

 

$    12.2

 

$      3.1

 

Operating income

$    13.2

 

$      4.1

 

$      5.7

 

Gas volumes marketed (Bcf)

145.7

 

72.7

 

61.9

 

Gas volumes gathered (Bcf)

78.7

 

14.6

 

2.3

 


Revenues from our Midstream Services segment were up 102% in 2007 and up 3% in 2006, as compared to prior years. The increases in revenues in 2007 and 2006 resulted from increases in volumes marketed and increased gathering revenues, primarily relating to the Fayetteville Shale play. Increases and decreases in marketing revenues due to changes in commodity prices are largely offset by corresponding changes in gas purchase expenses. Midstream Services had gathering revenues of $37.7 million in 2007 related to its gathering systems in Arkansas, compared to $7.9 million in 2006. Gathering volumes, revenues and expenses for this segment are expected to continue to grow at a fast pace as reserves related to our Fayetteville Shale play are developed and production increases.

Operating income from our Midstream Services segment increased 222% in 2007 as a result of the increases in gathering revenues and marketing margins, partially offset by increased operating costs and expenses. Operating income from our Midstream Services segment decreased 28% in 2006 due to increased operating costs and expenses that resulted from increased staffing and other costs associated with our growing gathering activities. The margin generated from natural gas marketing activities was up 10% in 2007 and up 8% in 2006 from the prior years. Margins fluctuate depending on the prices paid for commodities and the ultimate disposition of those commodities. The increase in volumes marketed in 2007 and 2006 resulted from marketing our increased production volumes, primarily related to our Fayetteville Shale play, and volumes for third parties in areas where we have production. Of the total volumes marketed, production from our E&P subsidiaries accounted for 91% in 2007, 86% in 2006 and 78% in 2005. We enter into hedging activities from time to time with respect to our gas marketing activities to provide margin protection. We refer you to “Quantitative and Qualitative Disclosures about Market Risk” and Note 9 to the consolidated financial statements for additional information.


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In 2006, our Midstream Services unit entered into a three-year firm transportation agreement with Ozark Gas Transmission System to transport volumes increasing to 220,000 MMBtu per day in the later stages of the contract.  Additionally, in January 2007 we entered into a separate two-year firm transportation agreement with Ozark Gas Transmission System to transport volumes of 50,000 MMBtu per day. In 2006, one of our Midstream Services subsidiaries entered into a precedent agreement pursuant to which it will contract for firm gas transportation services on two newly-proposed pipeline laterals and related facilities of Texas Gas Transmission, LLC (Texas Gas), a subsidiary of Boardwalk Pipeline Partners, LP.  Depending on regulatory approvals, the expected in-service date for both laterals is January 1, 2009. See “Contractual Obligations and Contingent Liabilities and Commitments” below for further discussion.


Natural Gas Distribution

     

 

Year Ended December 31,

 

 

2007

 

2006

 

2005

 

 

($ in thousands except for per Mcf amounts)

 
            

Revenues

$ 174,466

 

$ 172,207

$ 178,482

 

Gas purchases

$ 111,338

$ 112,922

$ 120,852

Operating costs and expenses

$   53,168

$   54,811

$   52,719

Operating income

$     9,960

$     4,474

$     4,911

             

Sales and end-use transportation deliveries (Bcf)

23.6

 

21.8

 

23.2

 
             

Sales customers at year-end

   151,988

   151,003

147,820

 

Average sales rate per Mcf

$     11.07

$     12.30

$     11.85

 
 

 

 

 

     

Heating weather - degree days

3,699

3,413

3,744

 

   Percent of normal

91%

 

83%

 

91%

 


On November 9, 2007, we entered a definitive agreement for the sale of all capital stock of our utility subsidiary, AWG, to SourceGas LLC for $224 million plus working capital. The transaction is subject to certain closing conditions and regulatory approvals and is expected to close by mid-year 2008. The assets and liabilities associated with AWG have been reclassified as “held for sale” as of December 31, 2007 and 2006. Upon the consummation of the sale, we will cease to have any natural gas distribution operations.


Revenues and Operating Income

Gas distribution revenues fluctuate due to the effects of weather on demand for natural gas and the pass-through of gas supply cost changes. Because of the corresponding changes in purchased gas costs, the revenue effect of the pass-through of gas cost changes has not materially affected operating income. Revenues for 2007 increased 1% to $174.5 million compared to the prior year and revenues for 2006 decreased 4% to $172.2 million compared to the prior year. The increase in 2007 gas distribution revenues was due to an increase in volumes delivered and a rate increase implemented in August 2007. The decrease in 2006 gas distribution revenues was primarily due to lower sales volumes as a result of warmer weather, partially offset by a rate increase implemented in October 2005.


Operating income for our Natural Gas Distribution segment increased 123% in 2007 compared to the prior year and decreased 9% in 2006 compared to the prior year. The increase in 2007 operating income resulted primarily from the increase in revenues and decreased operating costs and expenses. The decrease in 2006 operating income resulted primarily from the decrease in revenues and increased operating costs and expenses. Weather during 2007 in the utility's service territory was 9% warmer than normal and 8% colder than the prior year. Weather during 2006 in the utility's service territory was 17% warmer than normal and 8% warmer than the prior year.

Deliveries and Rates

In 2007, AWG sold 15.0 Bcf to its customers at an average rate of $11.07 per Mcf, compared to 13.4 Bcf at $12.30 per Mcf in 2006 and 14.4 Bcf at $11.85 per Mcf in 2005. Additionally, AWG transported 8.6 Bcf in 2007, compared to 8.4 Bcf in 2006 and 8.8 Bcf in 2005 for its end-use customers. The increase in deliveries in 2007 compared to 2006 was primarily due to colder weather. The decrease in volumes sold in 2006 compared to 2005 primarily resulted from warmer than normal weather. The average sales rate per Mcf decreased in 2007 due to changes in natural gas prices and the impact of incremental volumes delivered. Deliveries in recent years have also been impacted by customer conservation brought about by higher gas prices.


Our utility segment hedged 4.0 Bcf of derivative gas purchases during 2007 which had the effect of increasing its total gas supply cost by $7.5 million. Our utility hedged 3.1 Bcf and 4.2 Bcf of its 2006 and 2005 gas purchases,



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respectively, which had the effect of increasing its total gas supply costs by $7.7 million and $2.4 million, respectively.  Additionally, our utility segment has hedges in place on 2.0 Bcf of gas purchases at an average purchase price of $8.61 per Mcf for the 2007-2008 winter season. We refer you to “Quantitative and Qualitative Disclosures about Market Risk” and Note 9 to the consolidated financial statements for additional information.


AWG has a transportation contract with Ozark Gas Transmission System for approximately 66,900 MMBtu per day of firm capacity that expires in 2014. Deliveries are made by the pipeline to portions of AWG’s distribution systems and to the interstate pipelines with which it interconnects.


Operating Costs and Expenses

The changes in purchased gas costs for the Natural Gas Distribution segment reflect volumes purchased, prices paid for supplies and the mix of purchases from various gas supply contracts (base load, swing and no-notice). Operating costs and expenses, net of purchased gas costs, decreased in 2007 to $53.2 million from $54.8 million in 2006. The decrease was primarily due to lower general and administrative expenses that resulted from a decrease in corporate expenses allocated to the Natural Gas Distribution segment. Operating costs and expenses for 2006 increased to $54.8 million from $52.7 million in 2005 primarily due to an increase in general and administrative expenses that resulted from increased salaries and incentive compensation costs.


Inflation impacts our Natural Gas Distribution segment by generally increasing our operating costs and the costs of our capital additions. Additionally, delays inherent in the rate-making process prevent us from obtaining immediate recovery of increased operating costs of our Natural Gas Distribution segment. Although general rates of inflation have been relatively low in recent years, the effects of inflation on the utility's operations may be intensified by higher inflation rates related to certain items such as steel, fuel, right-of-way acquisition costs and qualified labor.

Regulatory Matters

AWG’s rates and operations are regulated by the APSC and it operates through municipal franchises that are perpetual by virtue of state law. These franchises, however, may not be exclusive within a geographic area. Although its rates for gas delivered to its retail customers are not regulated by the FERC, its transmission and gathering pipeline systems are subject to the FERC’s regulations concerning open access transportation.

 

On January 12, 2006, the APSC initiated a notice of inquiry regarding a rulemaking for developing and implementing energy efficiency programs.  Following a collaborative process, the APSC issued energy efficiency rules on January 11, 2007.  These rules require all gas and electric utilities, excluding electric cooperatives, to file energy efficiency plans and programs with the APSC.  AWG has filed and received approval for its initial energy efficiency plan, and is in the process of implementing Quick Start programs.  Comprehensive programs are to be implemented in 2009.  AWG will recover the costs of these programs from its customers.  In AWG’s most recent rate case, the APSC approved a Billing Determinant Adjustment Mechanism to mitigate the effects of lost revenues associated with energy efficiency programs.

 

On December 19, 2006, the APSC issued affiliate transactions rules.  In January 2007, AWG and other utilities requested a rehearing of these rules.  On February 16, 2007, the APSC issued an order granting rehearing and staying the implementation of the affiliate transaction rules pending further review.  The APSC subsequently revised the rules to address concerns expressed by the parties to the rulemaking proceeding.  AWG has filed Affiliate Transactions Compliance Procedures required by the rules, and we do not expect the final rules to have a material effect on its operations.


In July 2007, the APSC approved a rate increase for our utility segment totaling $5.8 million annually, exclusive of costs to be recovered through the utility’s purchase gas adjustment clause. The rate increase became effective for billings rendered on or after August 1, 2007. The APSC order provided for an allowed return on equity of 9.5% and an assumed capital structure of 55% debt and 45% equity.


Transportation

In 2006, we sold our 25% partnership interest in NOARK Pipeline System, Limited Partnership (NOARK) to Atlas Pipeline Partners, L.P. for $69.0 million and recognized a pre-tax gain of approximately $10.9 million ($6.7 million after-tax) relating to the transaction. We recorded pre-tax income from operations related to our investment in NOARK of $0.9 million in 2006 and $1.6 million in 2005. Income from operations and the gain on the sale in the second quarter of 2006 were recorded in other income in our statements of operations.



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Other Revenues

In 2007, 2006 and 2005, other revenues included pre-tax gains of $6.4 million, $4.0 million and $3.1 million, respectively, related to the sale of gas-in-storage inventory.

Interest Expense and Interest Income

Interest costs, net of capitalization, increased to $23.9 million in 2007 due primarily to increased debt levels resulting from our increased level of capital investments. Interest expense decreased 95% to $0.7 million in 2006, as compared to the prior year, due to decreased debt levels resulting from our equity offering in September 2005 and increased capitalized interest. We refer you to “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources — Financing Requirements” and Note 3 to the consolidated financial statements for further discussion of our debt. Interest capitalized increased to $13.8 million in 2007, up from $11.8 million in 2006 and $6.0 million in 2005. Changes in capitalized interest are primarily due to the level of investment in unevaluated properties in our E&P segment and the capitalization of interest during the construction phase of our drilling rigs in 2006 and 2005. Costs excluded from amortization in the E&P segment increased to $372.4 million at December 31, 2007, compared to $166.8 million at December 31, 2006. Total capital investments for our E&P segment were $1.38 billion in 2007, up from $861.0 million in 2006.

During 2007, 2006 and 2005, we earned interest income of $0.1 million, $6.3 million and $3.4 million, respectively, related to our cash investments. These amounts are recorded in other income.

Income Taxes

Our provision for deferred income taxes was an effective rate of 38.1% for 2007, compared to 37.9% in 2006 and 36.9% in 2005. Any changes in the provision for deferred income taxes recorded each period result primarily from the level of income before income taxes, adjusted for permanent differences.

Pension Expense

We incurred pension costs of $5.3 million in 2007 for our pension and other postretirement benefit plans, compared to $4.0 million in 2006 and $2.7 million in 2005. The increase was primarily the result of an increase in our number of employees. The amount of pension expense recorded is determined by actuarial calculations and is also impacted by the funded status of our plans. During 2007, we contributed $6.5 million to our pension plans and $0.4 million to our other postretirement plans, compared to $3.4 million and $0.4 million, respectively, in 2006. For further discussion of our pension plans, we refer you to Note 5 to the consolidated financial statements and “Critical Accounting Policies” below.  

Stock-Based Compensation Expense

We recognized expense of $5.4 million and capitalized $2.6 million to the full cost pool for stock-based compensation in 2007, compared to $5.2 million expensed and $1.7 million capitalized to the full cost pool for 2006 and $1.8 million expensed and $0.8 million capitalized to the full cost pool for 2005. We refer you to Note 10 to the consolidated financial statements for additional discussion of our equity-based compensation plans.  Additionally in 2007, we recorded expense of $0.9 million and capitalized $0.6 million to the full cost pool related to the valuation of company shares held in our non-qualified deferred compensation plan.

Adoption of Accounting Principles

During the first quarter of 2007, we adopted FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (FIN 48). FIN 48 provides guidance for recognizing and measuring uncertain tax positions, as defined in FAS 109. FIN 48 prescribes a threshold condition that a tax position must meet to be recognized in the financial statements. Guidance is also provided regarding de-recognition, classification and disclosure of these uncertain tax positions. FIN 48 was effective for fiscal years beginning after December 15, 2006. The adoption of FIN 48 had no material impact on our results of operations and financial condition.  The income tax years 2004-2007 remain open to examination by the major taxing jurisdictions to which we are subject.


In September 2006, the Financial Accounting Standards Board issued SFAS No. 157, “Fair Value Measurements” (FAS 157).  FAS 157 defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. Prior to this statement, there were different definitions of fair value and limited guidance for

 


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applying those definitions in GAAP.  In developing FAS 157, FASB considered the need for increased consistency and comparability in fair value measurements and for expanded disclosures about fair value measurements. This statement applies to other accounting pronouncements that require or permit fair value measurements. FAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007.  We will adopt FAS 157 in the first quarter of 2008 and will make additional required disclosures for financial instruments that are currently measured at fair value. In addition to required disclosures, FAS 157 also requires companies to evaluate current measurement techniques.  We have not yet determined if any of its current fair value measurement methodology will change and, therefore, have not yet determined the impact FAS 157 may have on our results of operations or financial condition.


In February 2007, the Financial Accounting Standards Board issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (FAS 159). FAS 159 permits entities to choose to measure many financial instruments and certain other items at fair value and applies to other accounting pronouncements that require or permit fair value measurements. FAS 159 is effective for financial statements issued for fiscal years beginning after November 15, 2007. We have not yet determined the impact FAS 159 may have on our results of operations or financial condition.


In December 2007, the Financial Accounting Standards Board issued SFAS No. 160, “Noncontrolling Interest in Consolidated Financial Statements, an amendment of ARB No. 51” (FAS 160). FAS 160 will change the financial accounting and reporting of noncontrolling (or minority) interests in consolidated financial statements, and is effective for financial statements issued for fiscal years beginning after December 15, 2008.  FAS 160 could impact the presentation of our balance sheet line item “Minority Interest” related to our Overton partnership (see Note 1 for discussion), but is expected to have no impact on the results of operations.


In December 2007, the Financial Accounting Standards Board issued SFAS No. 141(R), “Business Combinations” (FAS 141R). FAS 141R provides greater consistency in the accounting and financial reporting of business combinations. It requires the acquiring entity in a business combination to recognize all assets acquired and liabilities assumed in the transaction, establishes the acquisition-date fair value as the measurement objective for all assets acquired and liabilities assumed, and requires the acquirer to disclose the nature and financial effect of the business combination. FAS 141R is effective for fiscal years beginning after December 15, 2008. We have not yet determined the impact FAS 141R may have on our results of operations or financial condition.


LIQUIDITY AND CAPITAL RESOURCES


We depend primarily on internally-generated funds, our unsecured revolving credit facility (discussed below under “Financing Requirements”) and funds accessed through debt and equity markets as our primary sources of liquidity. We may borrow up to $1.0 billion under our revolving credit facility from time to time. The amount available under our revolving credit facility may be increased up to $1.25 billion at any time upon our agreement with our existing or additional lenders. As of December 31, 2007, we had $842.2 million outstanding under our revolving credit facility. At December 31, 2006, we had no indebtedness outstanding under our revolving credit facility. During 2008, we expect to draw on a portion of the funds available under our credit facility to fund our planned capital investments (discussed below under “Capital Investments”), which are expected to exceed the net cash generated by our operations.


On January 16, 2008, we consummated a private placement offering of $600 million of 7.5% Senior Notes due 2018 (discussed below under “Financing Requirements”). Net proceeds of approximately $591 million from the offering were used to pay down outstanding indebtedness under our revolving credit facility. On January 2, 2008, we entered into a $200 million short-term line of credit which was cancelled subsequent to the $600 million private placement offering. As of February 22, 2008, we had $328.2 million outstanding under our revolving credit facility.


Net cash provided by operating activities increased 45% to $622.7 million in 2007, compared to a 41% increase in 2006 to $429.9 million. The primary components of cash generated from operations are net income, depreciation, depletion and amortization, the provision for deferred income taxes and changes in operating assets and liabilities. Cash from operating activities increased in 2007 and 2006 due mainly to increased net income, adjusted for non-cash expenses. For 2007, requirements for our capital investments were met primarily by our revolving credit facility and cash provided by operating activities. Net cash from operating activities provided 41% of our cash requirements for capital investments in 2007, 46% in 2006 and 63% in 2005.


At December 31, 2007, our capital structure consisted of 37% debt and 63% equity. We believe that our operating cash flow, borrowings under our revolving credit facility and the expected proceeds from the sale of AWG and certain E&P asset divestitures will be adequate to meet our capital and operating requirements for 2008.


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Our cash flow from operating activities is highly dependent upon the market prices that we receive for our gas and oil production. The price received for our production is also influenced by our commodity hedging activities, as more fully discussed in Note 9 to the consolidated financial statements included in this Form 10-K and Item 7A, “Quantitative and Qualitative Disclosures about Market Risk.” Natural gas and oil prices are subject to wide fluctuations. As a result, we are unable to forecast with certainty our future level of cash flow from operations. We adjust our discretionary uses of cash dependent upon available cash flow.

Capital Investments

Our capital investments increased 59% to $1.5 billion in 2007 and increased 95% in 2006 to $942.4 million. Capital investments include a reduction of $20.6 million in 2007 and increases of $88.9 million and $28.1 million for 2006 and 2005, respectively, related to the change in accrued expenditures between years. Our E&P segment investments in 2007 were $1.38 billion, up from $861.0 million in 2006. Capital investments for 2006 and 2005 included $93.6 million and $35.1 million, respectively, for drilling rigs and related equipment which were subsequently sold and leased back in December 2006.

 

 

2007

 

2006

 

2005

 

 

(in thousands)

 

Exploration and production

           

Exploration and development

$1,375,204

$   767,400

$    416,161

Drilling rigs and related equipment

4,453

93,641

35,128

 

1,379,657

861,041

451,289

Midstream services

107,363

 

48,660

 

15,840

 

Natural gas distribution

11,375

 

11,232

 

10,908

 

Other

4,743

 

21,474

 

5,014

 
 

$1,503,138

 

$    942,407

 

$    483,051

 


Our capital investments for 2008 are planned to be $1.46 billion, consisting of $1.33 billion for E&P, $101 million for Midstream Services and $25 million for Natural Gas Distribution improvements and general purposes. We expect to allocate approximately $1.0 billion of our 2008 E&P capital to our Fayetteville Shale play, up from approximately $960 million in 2007. Our planned level of capital investments in 2008 will allow us to accelerate our drilling activity in the Fayetteville Shale, continue the development of our properties in East Texas, continue our conventional drilling in the Arkoma Basin, maintain our present markets, explore and develop other existing gas and oil properties, generate new drilling prospects, and provide for improvements necessary due to normal customer growth in our Natural Gas Distribution segment through the closing date of the pending sale. As discussed above, our 2008 capital investment program is expected to be funded through cash flow from operations, borrowings under our credit facility and the expected proceeds from the sale of AWG and certain E&P assets. We may adjust the level of 2008 capital investments dependent upon our level of cash flow generated from operations and our ability to borrow under our credit facility.

Financing Requirements

Our total debt outstanding was $978.8 million at December 31, 2007, and $137.8 million at December 31, 2006. On October 12, 2007, we amended our unsecured revolving credit facility to, among other things, increase the current borrowing capacity to $1 billion. Pursuant to the amendment, the amount available under the revolving credit facility may be increased to $1.25 billion at any time upon our agreement with our existing or additional lenders. At December 31, 2007, we had $842.2 million outstanding under our revolving credit facility. As discussed more fully below, in January 2008, we issued $600 million of 7.5% Senior Notes due 2018, the net proceeds of which were used to repay amounts outstanding under our revolving credit facility. There were no borrowings under our revolving credit facility at December 31, 2006. The interest rate on the credit facility is calculated based upon our public debt rating and is currently 87.5 basis points over LIBOR. The revolving credit facility is currently guaranteed by our subsidiaries, Southwestern Energy Production Company, SEECO, Inc. and Southwestern Energy Services Company and requires additional subsidiary guarantors if certain guaranty coverage levels are not satisfied. Our publicly traded notes were downgraded on August 1, 2006 by Standard and Poor’s to BB+ with a stable outlook from BBB- with a negative outlook. We have a Corporate Family Rating of Ba2 by Moody’s. Our 7.5% Senior Notes were rated BB+ by Standard and Poor’s and Ba2 by Moody’s. Any future downgrades in our public debt ratings could increase our cost of funds under the credit facility.

 


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Our revolving credit facility contains covenants which impose certain restrictions on us. Under the credit agreement, we may not issue total debt in excess of 60% of our total capital, must maintain a certain level of stockholders’ equity and must maintain a ratio of EBITDA to interest expense of 3.5 or above. Additionally, there are certain limitations on the amount of indebtedness that may be incurred by our subsidiaries. We were in compliance with all of the covenants of our credit agreement at December 31, 2007. Although we do not anticipate any violations of our financial covenants, our ability to comply with those covenants is dependent upon the success of our exploration and development program and upon factors beyond our control, such as the market prices for natural gas and oil. If we are unable to borrow under our credit facility, we would have to decrease our capital investment plans.


On January 16, 2008, we issued $600 million of 7.5% Senior Notes due 2018 in a private placement. The 7.5% notes are redeemable at our election, in whole or in part, at any time at a redemption price equal to the greater of: (i) 100% of the principal amount of the notes to be redeemed then outstanding; and (ii) the sum of the present values of the remaining scheduled payments of principal and interest on the notes to be redeemed as determined in accordance with the indenture, plus 50 basis points. Any redemption is also subject to payment of accrued and unpaid interest to the date of redemption. In addition, if we undergo a “change of control” as defined in the indenture, holders of the 7.5% Senior Notes will have the option to require us to purchase all or any portion of the notes at a purchase price equal to 101% of the principal amount of the notes to be purchased plus any accrued and unpaid interest to, but excluding, the change of control date. The 7.5% Senior Notes are currently guaranteed by our subsidiaries, SEECO, Inc., Southwestern Energy Production Company and Southwestern Energy Services Company, which guarantees may be unconditionally released in certain circumstances. The indentures governing the 7.5% Senior Notes and our other existing notes contain covenants that, among other things, restrict the ability of us and/or our subsidiaries to incur liens, to engage in sale and leaseback transactions and to merge, consolidate or sell assets.


At December 31, 2007, our capital structure consisted of 37% debt and 63% equity. Stockholders’ equity in the December 31, 2007 balance sheet includes an accumulated other comprehensive gain of $24.6 million related to our hedging activities that is required to be recorded under the provisions of Statement on Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities” (FAS 133), and a loss of $11.3 million related to changes in our pension liability and the adoption of Statement on Financial Accounting Standards No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans” (FAS 158). The amount recorded for FAS 133 is based on current market values of our hedges at December 31, 2007, and does not necessarily reflect the value that we will receive or pay when the hedges ultimately are settled, nor does it take into account revenues to be received associated with the physical delivery of sales volumes hedged. Our credit facility’s financial covenants with respect to capitalization percentages exclude the effects of non-cash entries that result from FAS 133 and FAS 158 and the non-cash impact of any full cost ceiling write-downs. Our capital structure at December 31, 2007, would remain at 37% debt and 63% equity without consideration of the accumulated other comprehensive gains and losses related to FAS 133 and FAS 158.

 

As part of our strategy to ensure a certain level of cash flow to fund our operations, we have hedged approximately 70% of our expected 2008 gas production. The amount of long-term debt we incur will be dependent upon commodity prices, our capital investment plans and the actual proceeds from the sale of our utility or any E&P asset divestitures. If commodity prices remain at or near their current levels throughout 2008, assuming that we do not complete the sale of AWG or the divestitures of any E&P assets, our long-term debt would significantly increase in 2008. If commodity prices significantly decrease, we may decrease and/or reallocate our planned capital investments.


Off-Balance Sheet Arrangements

In December 2006, we entered into a sale and leaseback transaction pursuant to which we sold 13 operating drilling rigs, two rigs yet to be delivered and related equipment and then leased such drilling rigs and equipment for an initial term of eight years commencing January 1, 2007, with aggregate annual rental payments of approximately $19.6 million. Subject to certain conditions, we have options to purchase the rigs and related equipment from the lessors at the end of the 84th month of the lease term at an agreed upon price or at the end of the lease term for the then fair market value.  Additionally, we have the option to renew each lease for a negotiated renewal term at a periodic rental equal to the fair market rental value of the rigs as determined at the time of renewal. In 2007, we sold and leased back additional drilling rig equipment receiving proceeds of $3.1 million, and leased an additional $5.9 million of drilling rig equipment, under similar terms as the 2006 transaction. We will incur additional annual rental payments of $1.4 million related to the 2007 transactions.

 


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Contractual Obligations and Contingent Liabilities and Commitments


We have various contractual obligations in the normal course of our operations and financing activities. Significant contractual obligations at December 31, 2007, were as follows:


Contractual Obligations:

Payments Due by Period

 

Total

 

Less than

1 Year

 

1 to 3 Years

 

3 to 5 Years

 

More than

5 Years

(in thousands)

Long-term debt (1)

$   978,800 

 

$      1,200 

 

$    62,400 

 

$   844,600 

 

$    70,600 

Interest on senior notes (2)

57,213 

 

10,054 

 

12,240 

 

10,358 

 

24,561 

Operating leases (3)

62,795 

 

10,801 

 

19,667 

 

16,118 

 

16,209 

Compression services (4)

47,205 

 

13,146 

 

21,886 

 

12,173 

 

Unconditional purchase

   obligations (5)

 

 

 

 

Operating agreements (6)

52,354 

 

37,345 

 

15,009 

 

 

Demand charges (7)

101,251 

 

32,146 

 

25,983 

 

21,960 

 

21,162 

Rig leases (8)

146,678 

 

20,954 

 

41,908 

 

41,908 

 

41,908 

Other obligations (9)

29,053 

 

28,693 

 

360 

 

 

 

$1,475,349 

 

$  154,339 

 

$  199,453 

 

$   947,117 

 

$  174,440 


(1)

Debt includes $842.2 million borrowings outstanding under our revolving credit facility with a floating interest rate (5.87% at December 31, 2007) and $36.6 million of 7.15% Notes due 2018 which requires semi-annual principal payments of $0.6 million. On January 16, 2008, we issued $600 million of 7.5% Senior Notes, the proceeds of which were utilized to reduce the outstanding borrowings on our revolving credit facility.

(2)  Interest on the senior notes includes interest through 2009 on the $60 million notes that are due in 2027 and putable at the holder’s option in 2009.

(3)  Operating leases include costs for compressors, aircraft, office space and equipment under non-cancelable operating leases expiring through 2018.

(4)  Our Midstream Services segment has commitments for approximately $39.3 million and our E&P segment has commitments for approximately $7.9 million for compression services associated primarily with our Fayetteville Shale play and our Overton operations.

(5)  Our Natural Gas Distribution segment has volumetric commitments for the purchase of gas under non-cancelable competitive bid packages and non-cancelable wellhead contracts. Volumetric purchase commitments at December 31, 2007, totaled 0.9 Bcf, comprised of 0.8 Bcf in less than one year, 0.1 Bcf in one to three years and less than 0.1 Bcf in three to five years. Our volumetric purchase commitments are priced primarily at regional gas indices set at the first of each future month. These costs are recoverable from the utility’s end-use customers.  Upon the consummation of the sale of AWG, we will cease to have these volumetric commitments.

(6)  Our E&P segment has commitments for up to $41.1 million in termination fees related to rig operator agreements.  Additionally, our E&P segment has secured rig moving services by committing monthly take-or-pay amounts of $938,000, expiring in December 2008.

(7)  Our Midstream Services segment has commitments for demand transportation charges of approximately $22.9 million related to the Fayetteville Shale play and approximately $5.2 million related to Angelina. Our Natural Gas Distribution segment has commitments for approximately $71.4 million of demand charges on non-cancelable firm gas purchase and firm transportation agreements. These costs are recoverable from the utility’s end-use customers. Our E&P segment has commitments for approximately $1.8 million of demand transportation charges.

(8)  Our E&P segment has commitments related to the leasing of 15 drilling rigs and related equipment through 2014.

(9)  Our other significant contractual obligations include approximately $14.4 million related to seismic services, approximately $7.9 million for funding of benefit plans and approximately $1.9 million for various information technology support and data subscription agreements.  Additionally, our E&P segment has committed up to $3.9 million in termination fees to a gravel company.


We refer you to Note 3 to the consolidated financial statements for a discussion of the terms of our long-term debt.

Contingent Liabilities and Commitments

We have the following commitments and contingencies that could create liabilities for us or increase or accelerate our contingent liabilities. Substantially all of our employees are covered by defined benefit and postretirement benefit plans. Our return on the assets of these plans, when combined with other factors including an increase in employees, resulted in an increase in pension expense and our required funding of the plans for 2007, 2006 and 2005. At December 31, 2007, we recognized a liability of $14.6 million as a result of the underfunded status of our pension and other postretirement benefit plans, compared to a liability of $13.8 million at December 31, 2006. As a result of actuarial data, and assuming the closing of the sale of AWG by mid-year, we expect to record expenses of $4.8 million for these plans in 2008. See Note 5 to the consolidated financial statements and “Critical Accounting Policies” below for additional information.

 

 

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In 2006, our Midstream Services segment entered into a three-year firm transportation agreement with Ozark Gas Transmission System to transport volumes increasing to 220,000 MMBtu per day in the latter stage of the contract.  Additionally, in January 2007, our Midstream Services segment entered into a separate two-year firm transportation agreement with Ozark Gas Transmission System to transport volumes of 50,000 MMBtu per day.


In December 2006, one of our Midstream Services subsidiaries entered into a precedent agreement pursuant to which we will contract for firm gas transportation services on two newly-proposed pipeline laterals and related facilities of Texas Gas Transmission, LLC (Texas Gas), a subsidiary of Boardwalk Pipeline Partners, LP. We will be a “Foundation Shipper” for the project and will use the proposed laterals and related facilities primarily to deliver gas volumes produced from Southwestern’s operations in its Fayetteville Shale play in central Arkansas. Depending on regulatory approvals, the expected in-service date for both laterals is January 1, 2009. The first lateral line (Fayetteville Lateral) will originate in Conway County, Arkansas, and connect to Texas Gas’ mainline system in Coahoma County, Mississippi. The Fayetteville Lateral will be a minimum of 36” in diameter and would have an estimated ultimate capacity of up to 1.1 Bcf per day. The second lateral (Greenville Lateral) will originate at the Texas Gas mainline system near Greenville, Mississippi, and extend eastward to interconnect with various interstate pipelines. The firm transportation agreements entered into by us pursuant to the precedent agreement will have an initial term of ten years and, over time, will enable us to transport up to 500,000 MMBtu per day on the Fayetteville Lateral and up to 400,000 MMBtu per day on the Greenville Lateral. We will also have the option to acquire up to 300,000 MMBtu per day of additional capacity on the Fayetteville Lateral and up to 240,000 MMBtu per day of additional capacity on the Greenville Lateral. Upon execution and delivery of the firm transportation agreements contemplated by the precedent agreement, our Midstream Services segment would have additional demand charges of $503.5 million that would be payable over the ten-year term of the agreements.


We are subject to litigation and claims (including with respect to environmental matters) that arise in the ordinary course of business. Management believes, individually or in aggregate, such litigation and claims will not have a material adverse impact on our financial position or our results of operations, but these matters are subject to inherent uncertainties and management's view may change in the future. If an unfavorable final outcome were to occur, there exists the possibility of a material impact on our financial position and the results of operations for the period in which the effect becomes reasonably estimable.


Working Capital

We maintain access to funds that may be needed to meet capital requirements through our revolving credit facility described above. We had negative working capital of $67.6 million at the end of 2007 and negative working capital of $55.0 million at the end of 2006. Current assets at December 31, 2007, increased $49.3 million, compared to current assets at December 31, 2006, due to increases in accounts receivable related to gas marketing sales and sales of oil and gas production, partially offset by a $42.0 million decrease in cash equivalents. Current liabilities increased $52.0 million at December 31, 2007, due primarily to an increase in accounts payable related to our level of drilling activity, partially offset by a decrease in our current hedging liability.

CRITICAL ACCOUNTING POLICIES

Natural Gas and Oil Properties

We utilize the full cost method of accounting for costs related to the exploration, development and acquisition of natural gas and oil reserves. Under this method, all such costs (productive and nonproductive), including salaries, benefits and other internal costs directly attributable to these activities are capitalized and amortized on an aggregate basis over the estimated lives of the properties using the units-of-production method. These capitalized costs are subject to a ceiling test that limits such pooled costs to the aggregate of the present value of future net revenues attributable to proved natural gas and oil reserves discounted at 10 percent (standardized measure) plus the lower of cost or market value of unproved properties. Any costs in excess of the ceiling are written off as a non-cash expense. The expense may not be reversed in future periods, even though higher natural gas and oil prices may subsequently increase the ceiling. Full cost companies must use the prices in effect at the end of each accounting quarter, including the impact of derivatives qualifying as hedges, to calculate the ceiling value of their reserves.  However, commodity price increases subsequent to the end of a reporting period but prior to the release of periodic reports may be utilized to calculate the ceiling value of reserves. At December 31, 2007, 2006 and 2005, our unamortized costs of natural gas and oil properties did not exceed this ceiling amount. At December 31, 2007, the ceiling value of our reserves was calculated based upon quoted market prices of $6.80 per Mcf for Henry Hub gas and $92.50 per barrel for West Texas Intermediate oil, adjusted for market differentials. Cash flow hedges of gas production in place at December 31, 2007, increased the calculated ceiling value by approximately $163 million (net of tax). We had approximately 181.0 Bcf of future gas production hedged at December 31, 2007. At December 31, 2006,

 

 


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the ceiling value of our reserves was calculated based upon quoted market prices of $5.64 per Mcf for Henry Hub gas and $57.25 per barrel for West Texas Intermediate oil, and at December 31, 2005, the ceiling value of our reserves was calculated based upon quoted market prices of $10.08 per Mcf for Henry Hub gas and $61.04 per barrel for West Texas Intermediate oil. Decreases in market prices from December 31, 2007 levels, as well as changes in production rates, levels of reserves, the evaluation of costs excluded from amortization, future development costs, and service costs could result in future ceiling test impairments.


The risk that we will be required to write-down the carrying value of our natural gas and oil properties increases when natural gas and oil prices are depressed or if there are substantial downward revisions in estimated proved reserves. Under the SEC’s full cost accounting rules, our reserves are required to be priced using prices in effect at the end of the reporting period. Application of these rules during periods of relatively low natural gas or oil prices due to seasonality or other reasons, even if temporary, increases the probability of a ceiling test write-down. Natural gas pricing has historically been unpredictable and any declines could result in a ceiling test write-down in subsequent quarterly or annual reporting periods.


Natural gas and oil reserves used in the full cost method of accounting cannot be measured exactly. Our estimate of natural gas and oil reserves requires extensive judgments of reservoir engineering data and is generally less precise than other estimates made in connection with financial disclosures. Our reservoir engineers prepare our reserve estimates under the supervision of our management.  Reserve estimates are prepared for each of our properties annually by the reservoir engineers assigned to the asset management team in the geographic locations in which the property is located.  These estimates are reviewed by senior engineers who are not part of the asset management teams and the president of our E&P subsidiaries.  Final authority over the estimates of our proved reserves rests with our Board of Directors.  In each of the past three years, performance revisions to our proved reserve estimates represented no greater than 8% of our total proved reserve estimates, which we believe is indicative of the effectiveness of our internal controls. Proved developed reserves generally have a higher degree of accuracy in this estimation process, when compared to proved undeveloped and proved non-producing reserves, as production history and pressure data over time is available for the majority of our proved developed properties. Proved developed reserves account for 64% of our total reserve base at December 31, 2007. Assigning monetary values to such estimates does not reduce the subjectivity and changing nature of such reserve estimates. The uncertainties inherent in the reserve estimates are compounded by applying additional estimates of the rates and timing of production and the costs that will be incurred in developing and producing the reserves.  We cannot assure you that our internal controls sufficiently address the numerous uncertainties and risks that are inherent in estimating quantities of natural gas and oil reserves and projecting future rates of production and timing of development expenditures as many factors are beyond our control.  We refer you to “Although our estimated natural gas and oil reserve data is independently audited, our estimates may still prove to be inaccurate.” in Item 1A, “Risk Factors,” of Part I of this Form 10-K for a more detailed discussion of these uncertainties, risks and other factors.

We engage the services of Netherland, Sewell & Associates, Inc., an independent petroleum engineering firm, or NSA, to audit our reserves as estimated by our reservoir engineers. Netherland, Sewell & Associates, Inc. reports the results of the reserves audit to our Board of Directors.  In conducting its audit, the engineers and geologists of Netherland, Sewell & Associates study our major properties in detail and independently develop reserve estimates.  NSA’s audit consists primarily of substantive testing, which includes a detailed review of major properties that account for approximately 81% of present worth of the company's total proved reserves.  NSA’s audit process consists of sorting all fields by descending present value order and selecting the fields from highest value to descending value until the selected fields account for more than 80% of the present worth of our reserves.  The properties in the bottom 20% of the total present worth are the lowest value properties and are not reviewed in the audit.  The fields included in approximately the top 81% present value as of December 31, 2007, accounted for approximately 85% of our total proved reserves and approximately 90% of our proved undeveloped reserves.  In the conduct of its audit, NSA did not independently verify the data we provided to them with respect to ownership interests, oil and gas production, well test data, historical costs of operation and development, product prices, or any agreements relating to current and future operations of the properties and sales of production.  NSA has advised us that if, in the course of its audit, something came to its attention that brought into question the validity or sufficiency of any such information or data, NSA did not rely on such information or data until it had satisfactorily resolved any questions relating thereto or had independently verified such information or data. For the year-ended December 31, 2007, Netherland, Sewell & Associates issued its audit opinion as to the reasonableness of our reserve estimates, stating that our estimated proved oil and gas reserves are, in the aggregate, reasonable and have been prepared in accordance with generally accepted petroleum engineering and evaluation principles.


A decline in gas and oil prices used to calculate the discounted future net revenues of our reserves affects both the present value of cash flows and the quantity of reserves reported. Our reserve base is 96% natural gas, therefore changes in oil prices used do not have as significant an impact as gas prices on cash flows and reported reserve quantities. Reported discounted cash flows and reserve quantities at December 31, 2007, were $2,015.2 million and 1,450.3 Bcfe. An assumed

 


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decrease of $1.00 per Mcf in the December 31, 2007 gas price used to price our reserves would have resulted in an approximate $350 million decline in our future cash flows discounted at 10%, adjusted for the effects of commodity hedges, and an approximate decrease of 14 Bcfe of our reported reserves. The decline in reserve quantities, assuming this decrease in gas price, would have the impact of increasing our unit of production amortization of the full cost pool. The unit of production rate for amortization is adjusted quarterly based on changes in reserve estimates and capitalized costs.

Hedging

We use natural gas and crude oil swap agreements and options and interest rate swaps to reduce the volatility of earnings and cash flow due to fluctuations in the prices of natural gas and oil and in interest rates. Our policies prohibit speculation with derivatives and limit swap agreements to counterparties with appropriate credit standings to minimize the risk of uncollectability. In recent years, we have hedged 70% to 80% of our annual production. The primary market risks related to our derivative contracts are the volatility in market prices and basis differentials for natural gas and crude oil. However, the market price risk is offset by the gain or loss recognized upon the related sale or purchase of the natural gas or sale of the oil that is hedged.


Our derivative instruments are accounted for under FAS 133, as amended by FAS 138 and FAS 149, and are recorded at fair value in our financial statements. We have established the fair value of derivative instruments using data provided by our counterparties in conjunction with assumptions evaluated internally using established index prices and other sources. These valuations are recognized as assets or liabilities in our balance sheet and, to the extent an open position is an effective cash flow hedge on equity production or interest rates, the offset is recorded in other comprehensive income. Results of settled commodity hedging transactions are reflected in natural gas and oil sales or in gas purchases. Results of settled interest rate hedges are reflected in interest expense. Any derivative not qualifying for hedge accounting treatment or any ineffective portion of a properly designated hedge is recognized immediately in earnings. For the year ended December 31, 2007, we recorded an unrealized gain of $6.0 million related to basis differential swaps that did not qualify for hedge accounting in addition to a $1.0 million gain related to the change in estimated ineffectiveness of our commodity cash flow hedges. Future market price volatility could create significant changes to the hedge positions recorded in our financial statements. We did not enter into any interest rate swaps in 2007, 2006 or 2005.  We refer you to “Quantitative and Qualitative Disclosures about Market Risk” in Item 7A of Part II of this Form 10-K for additional information regarding our hedging activities.

Regulated Utility Operations

Our utility operations are subject to the rate regulation and accounting requirements of the APSC. Allocations of costs and revenues to accounting periods for ratemaking and regulatory purposes may differ from those generally applied by non-regulated operations. Such allocations to meet regulatory accounting requirements are considered generally accepted accounting principles for regulated utilities provided that there is a demonstrated ability to recover any deferred costs in future rates.


During the ratemaking process, the APSC may require a utility to defer recognition of certain costs to be recovered through rates over time as opposed to expensing such costs as incurred. This allows the utility to stabilize rates over time rather than passing such costs on to the customer for immediate recovery. This causes certain expenses to be deferred as a regulatory asset and amortized to expense as they are recovered through rates. The APSC has not required any unbundling of services, although large industrials are free to contract for their own gas supply. There are no pending regulations relating to unbundling of services; however, should such regulation be proposed and adopted, certain of these assets may no longer meet the criteria for deferred recognition and, accordingly, a write-off of regulatory assets and stranded costs could be required.

Pension and Other Postretirement Benefits

We record our prepaid or accrued benefit cost, as well as our periodic benefit cost, for our pension and other postretirement benefit plans using measurement assumptions that we consider reasonable at the time of calculation (see Note 5 to the consolidated financial statements for further discussion and disclosures regarding these benefit plans). Two of the assumptions that affect the amounts recorded are the discount rate, which estimates the rate at which benefits could be effectively settled, and the expected return on plan assets, which reflects the average rate of earnings expected on the funds invested. For the December 31, 2007, benefit obligation and the periodic benefit cost to be recorded in 2008, the discount rate assumed is 6.0%. For the 2008 periodic benefit cost, the expected return assumed is 7.75%. This compares to a discount rate of 6.0% and an expected return of 8.0% used in 2007.  

 

 


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Using the assumed rates discussed above, we recorded pension expense of $5.3 million in 2007, $4.0 million in 2006 and $2.7 million in 2005 related to our pension and other postretirement benefit plans. At December 31, 2007, we recognized a liability of $14.6 million, compared to $13.8 million at December 31, 2006, related to our pension and other postretirement benefit plans. During 2007, we also funded $6.9 million to our pension and other postretirement benefit plans. In 2008, we expect to fund $7.9 million to our pension and other postretirement benefit plans and recognize pension expense of $4.2 million and a postretirement benefit expense of $0.6 million, assuming the sale of the Natural Gas Distribution segment closes mid-year. Assuming a 1% change in the 2007 rates (lower discount rate and lower rate of return), we would have recorded pension expense of $5.9 million in 2007.

Gas in Underground Storage

We record our gas stored in inventory that is owned by the E&P segment at the lower of weighted average cost or market. Gas expected to be cycled within the next 12 months is recorded in current assets with the remaining stored gas reflected as a long-term asset. The quantity and average cost of gas in storage was 10.1 Bcf at $4.05 per Mcf at December 31, 2007, compared to 9.6 Bcf at $3.89 per Mcf at December 31, 2006.


The gas in inventory for the E&P segment is used primarily to supplement production in meeting the segment's contractual commitments, including delivery to customers of AWG, especially during periods of colder weather. As a result, demand fees paid by AWG to our E&P subsidiaries, which are passed through to the utility’s customers, are a part of the realized price of the gas in storage. In determining the lower of cost or market for storage gas, we utilize the gas futures market in assessing the price we expect to be able to realize for our gas in inventory. A significant decline in the future market price of natural gas could result in a write-down of our gas in storage carrying cost.


See further discussion of our significant accounting policies in Note 1 to the consolidated financial statements.


CAUTIONARY STATEMENT ABOUT FORWARD-LOOKING STATEMENTS


All statements, other than historical fact or present financial information, may be deemed to be 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 that address activities, outcomes and other matters that should or may occur in the future, including, without limitation, statements regarding the financial position, business strategy, production and reserve growth and other plans and objectives for our future operations, are forward-looking statements. Although we believe the expectations expressed in such forward-looking statements are based on reasonable assumptions, such statements are not guarantees of future performance. We have no obligation and make no undertaking to publicly update or revise any forward-looking statements, except as may be required by law.


Forward-looking statements include the items identified in the preceding paragraph, information concerning possible or assumed future results of operations and other statements in this Form 10-K identified by words such as “anticipate,” “project,” “intend,” “estimate,” “expect,” “believe,” “predict,” “budget,” “projection,” “goal,” “plan,” “forecast,” “target” or similar expressions.


You should not place undue reliance on forward-looking statements. They are subject to known and unknown risks, uncertainties and other factors that may affect our operations, markets, products, services and prices and cause our actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by the forward-looking statements. In addition to any assumptions and other factors referred to specifically in connection with forward-looking statements, risks, uncertainties and factors that could cause our actual results to differ materially from those indicated in any forward-looking statement include, but are not limited to:

 

·

the timing and extent of changes in market conditions and prices for natural gas and oil (including regional basis differentials);

·

the timing and extent of our success in discovering, developing, producing and estimating reserves;

·

the economic viability of, and our success in drilling, our large acreage position in the Fayetteville Shale play, overall as well as relative to other productive shale gas plays;

·

our ability to fund our planned capital investments;

·

our ability to determine the most effective and economic fracture stimulation for the Fayetteville Shale formation;

·

the impact of federal, state and local government regulation, including any increase in severance taxes;



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·

the costs and availability of oilfield personnel services and drilling supplies, raw materials, and equipment and services, including pressure pumping equipment and crews in the Arkoma basin;

·

our future property acquisition or divestiture activities;

·

the effects of weather;

·

increased competition;

·

the financial impact of accounting regulations and critical accounting policies;

·

the comparative cost of alternative fuels;

·

conditions in capital markets and changes in interest rates, and;

·

any other factors listed in the reports we have filed and may file with the SEC.


We caution you that forward-looking statements contained in this Form 10-K are subject to all of the risks and uncertainties, many of which are beyond our control, incident to the exploration for and development, production and sale of natural gas and oil. These risks include, but are not limited to, commodity price volatility, third-party interruption of sales to market, inflation, lack of availability of goods and services, environmental risks, drilling and other operating risks, regulatory changes, the uncertainty inherent in estimating proved natural gas and oil reserves and in projecting future rates of production and timing of development expenditures and the other risks described in Item 1A of Part I of this Form 10-K.


Estimates of our proved natural gas and oil reserves and the estimated future net revenues from such reserves in this Form 10-K are based upon various assumptions, including assumptions required by the SEC relating to natural gas and oil prices, drilling and operating expenses, capital investments, taxes and availability of funds. The process of estimating natural gas and oil reserves is complex. This process requires significant decisions and assumptions in the evaluation of available geological, geophysical, engineering and economic data for each reservoir. Therefore, those estimates are inherently imprecise.


Actual future production, natural gas and oil prices, revenues, taxes, development investments, operating expenses and quantities of recoverable natural gas and oil reserves will most likely vary from those estimated. Such variances may be material. Any significant variance could materially affect the estimated quantities and present value of reserves set forth in this Form 10-K. Our properties may also be susceptible to hydrocarbon drainage from production by other operators on adjacent properties. In addition, we may adjust estimates of proved reserves to reflect production history, results of exploration and development, prevailing natural gas and oil prices and other factors, many of which are beyond our control.

At December 31, 2007, approximately 36% of our estimated proved reserves were proved undeveloped and 4% were proved developed non-producing. Proved undeveloped reserves and proved developed non-producing reserves, by their nature, are less certain than proved developed producing reserves. Estimates of reserves in the non-producing categories are nearly always based on volumetric calculations rather than the performance data used to estimate producing reserves. Recovery of proved undeveloped reserves requires significant capital expenditures and successful drilling operations. Recovery of proved developed non-producing reserves requires capital expenditures to recomplete into the zones behind pipe and is subject to the risk of a successful recompletion. Production revenues from proved undeveloped and proved developed non-producing reserves will not be realized, if at all, until sometime in the future.

The reserve data assumes that we will make significant capital investments to develop our reserves. Although we have prepared estimates of our natural gas and oil reserves and the costs associated with these reserves in accordance with industry standards, we cannot assure you that the estimated costs are accurate, that development will occur as scheduled or that the actual results will be as estimated.

You should not assume that the present value of future net cash flows referred to in this Form 10-K is the current fair value of our estimated natural gas and oil reserves. In accordance with SEC requirements, the estimated discounted future net cash flows from proved reserves are generally based on prices and costs as of the date of the estimate. Actual future prices and costs may be materially higher or lower than the prices and costs as of the date of the estimate. Any changes in consumption by gas purchasers or in governmental regulations or taxation could also affect actual future net cash flows. The timing of both the production and the expenses from the development and production of natural gas and oil properties will affect the timing of actual future net cash flows from proved reserves and their present value. In addition, the 10% discount factor, which is required by the SEC to be used in calculating discounted future net cash flows for reporting purposes, is not necessarily the most accurate discount factor for our company.

 


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Should one or more of the risks or uncertainties described above or elsewhere in this Form 10-K occur, or should underlying assumptions prove incorrect, our actual results and plans could differ materially from those expressed in any forward-looking statements. 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 us are expressly qualified in their entirety by this cautionary statement.



ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK


Market risks relating to our operations result primarily from the volatility in commodity prices, basis differentials and interest rates, as well as credit risk concentrations. We use natural gas and crude oil swap agreements and options and interest rate swaps to reduce the volatility of earnings and cash flow due to fluctuations in the prices of natural gas and oil and in interest rates. Our Board of Directors has approved risk management policies and procedures to utilize financial products for the reduction of defined commodity price and interest rate risks. These policies prohibit speculation with derivatives and limit swap agreements to counterparties with appropriate credit standings.


Credit Risk


Our financial instruments that are exposed to concentrations of credit risk consist primarily of trade receivables and derivative contracts associated with commodities trading. Concentrations of credit risk with respect to receivables are limited due to the large number of our customers and their dispersion across geographic areas. No single customer accounted for greater than 5% of accounts receivable at December 31, 2007.  In addition, please see the discussion of credit risk associated with commodities trading below.


Interest Rate Risk


The following table provides information on our financial instruments that are sensitive to changes in interest rates. The table presents the principal cash payments for our debt obligations and related weighted-average interest rates by expected maturity dates. At December 31, 2007, we had $842.2 million borrowings outstanding under our revolving credit facility with a floating interest rate (5.87% at December 31, 2007). Our policy is to manage interest rates through use of a combination of fixed and floating rate debt. Interest rate swaps may be used to adjust interest rate exposures when appropriate. We do not have any interest rate swaps in effect currently.

 

     

Fair

 

Expected Maturity Date

 

Value

  2008 2009 2010 2011 2012 Thereafter Total   12/31/07
 

($ in millions)

 
Fixed Rate

$

1.2

$

61.2

$

1.2

$

1.2

$

1.2

$

70.6

$

136.6

$

134.2

Average Interest Rate

7.15%

7.62%

7.15%

7.15%

7.15%

7.18%

7.38%

 

-   

 
Variable Rate

$

-   

$

-   

$

-   

$

-   

$

842.2

$

-   

$

842.2

$

842.2

Average Interest Rate

-   

-   

-   

-   

5.87%

-   

5.87%

 

-   


Commodities Risk


We use over-the-counter natural gas and crude oil swap agreements and options to hedge sales of our production, to hedge activity in our Midstream Services segment and to hedge the purchase of gas in our Natural Gas Distribution segment against the inherent price risks of adverse price fluctuations or locational pricing differences between a published index and the NYMEX futures market. These swaps and options include (1) transactions in which one party will pay a fixed price (or variable price) for a notional quantity in exchange for receiving a variable price (or fixed price) based on a published index (referred to as price swaps), (2) transactions in which parties agree to pay a price based on two different indices (referred to as basis swaps), and (3) the purchase and sale of index-related puts and calls (collars) that provide a “floor” price below which the counterparty pays (production hedge) or receives (gas purchase hedge) funds equal to the amount by which the price of the commodity is below the contracted floor, and a “ceiling” price above which we pay to (production hedge) or receive from (gas purchase hedge) the counterparty the amount by which the price of the commodity is above the contracted ceiling.

 

 

 

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The primary market risks relating to our derivative contracts are the volatility in market prices and basis differentials for natural gas and crude oil. However, the market price risk is offset by the gain or loss recognized upon the related sale or purchase of the natural gas or sale of the oil that is hedged. Credit risk relates to the risk of loss as a result of non-performance by our counterparties. The counterparties are primarily major investment and commercial banks which management believes present minimal credit risks. The credit quality of each counterparty and the level of financial exposure we have to each counterparty are periodically reviewed to limit our credit risk exposure.


Exploration and Production


The following table provides information about our financial instruments that are sensitive to changes in commodity prices and that are used to hedge prices for gas production. The table presents the notional amount in Bcf, the weighted average contract prices and the fair value by expected maturity dates. At December 31, 2007, the fair value of our financial instruments related to natural gas production and underground storage sales was a $47.6 million asset.

 

Volume Weighted Average Price to be Swapped ($) Weighted Average Floor Price ($) Weighted Average Ceiling Price ($) Weighted Average Basis Differential ($) Fair Value at Dec 31, 2007 ($ in millions)

Natural Gas (Bcf):

                     
                       

Fixed Price Swaps:

                     

   2008 (1)

55.7 

 

8.27 

 

 

 

-  

 

25.6 

   2009

56.0 

 

8.20 

 

 

 

-  

 

(10.8)

                       

Costless Collars:

 

 

 

             

 

   2008

48.0 

 

 

7.92 

 

11.60 

 

-  

 

30.5 

   2009

23.0 

 

 

8.09 

 

10.91 

 

-  

 

2.9 

                       

Basis Swaps:

                     

   2008

63.2 

 

 

 

 

(0.45) 

 

(0.5)

   2009

3.6 

 

 

 

 

(0.44) 

 

(0.2)

                       

Matched-Basis Swaps:

 

                 

 

   2008

8.0 

 

 

 

 

(0.73) 

 

0.1 


(1)

Includes fixed-price swaps for 1.7 Bcf relating to future sales from our underground storage facility that have a fair value asset of $2.3 million.


At December 31, 2007, we had outstanding fixed-price basis differential swaps on 8.0 Bcf of 2008 gas production that qualified for hedge treatment.  At December 31, 2007, we also had outstanding fixed-price basis differential swaps on 63.2 Bcf of 2008 and 3.6 Bcf of 2009 gas production that did not qualify for hedge accounting treatment.  Changes in the fair value of derivatives that do not qualify as cash flow hedges are recorded in gas and oil sales. For the year ended December 31, 2007, we recorded an unrealized gain of $6.0 million related to the differential swaps that did not qualify for hedge accounting treatment and a $1.0 million gain related to the change in estimated ineffectiveness of our cash flow hedges. Typically, our ineffectiveness results from changes at the end of a reporting period in the price differentials between the index price of the derivative contract, which is primarily a NYMEX price, and the index price for the point of sale for the cash flow that is being hedged.


At December 31, 2006, we had outstanding natural gas price swaps on total notional volumes of 32.5 Bcf in 2007 and 13.0 Bcf in 2008 for which we will receive fixed prices ranging from $6.20 to $12.06 per MMBtu. At December 31, 2006, we had outstanding fixed price basis differential swaps on 40.4 Bcf of 2007 and 2008 gas production that qualified for hedge treatment and outstanding fixed price basis differential swaps on 62.0 Bcf of 2007 and 2008 gas production that did not qualify for hedge treatment.


At December 31, 2006, we had collars in place on notional volumes of 34.0 Bcf in 2007 and 22.0 Bcf in 2008.  The 34.0 Bcf in 2007 had an average floor and ceiling price of $6.93 and $12.34 per MMBtu, respectively. The 22.0 Bcf in 2008 had an average floor and ceiling price of $7.92 and $13.15 per MMBtu, respectively.


Subsequent to December 31, 2007 and prior to February 22, 2008, we hedged 16.0 Bcf of 2008, 17.0 Bcf of 2009 and 16.0 Bcf of 2010 gas production under fixed price swaps with average prices of $8.99, $8.53 and $8.55 per Mcf, respectively.  In addition, we hedged 8.0 Bcf of 2009 and 2.0 Bcf of 2010 gas production using costless collars. The collars relating to 2009 production have a weighted average floor and ceiling price of $8.00 and $10.05 per Mcf, respectively; and

 

 


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the collars relating to 2010 production have a weighted average floor and ceiling price of $8.50 and $10.20 per Mcf, respectively. We have also basis protected an additional 2.1 Bcf of 2008 gas production with an average differential price of $0.26 below NYMEX spot rates for our respective basis locations.


Midstream Services


At December 31, 2007, our Midstream Services segment had outstanding fair value hedges in place on 1.0 Bcf of gas.  These hedges are a mixture of fixed-price swap purchases and sales relating to our gas marketing activities. These hedges have contract months from January 2008 through December 2008 and have fair value asset of $0.8 million as of December 31, 2007.  A liability of $0.7 million was recognized at December 31, 2007, as an offset to these hedges for physical gas purchases and sales commitments relating specifically to the hedged transactions.


Natural Gas Distribution


At December 31, 2007, our Natural Gas Distribution segment had outstanding hedges in place on 2.0 Bcf of gas.  These hedges are fixed-price swap purchases that relate to the utility’s planned and discretionary hedging program for the winter heating season.  These hedges have contract months from January 2008 through March 2008, and have a fair value liability of $2.4 million as of December 31, 2007.  Hedging gains and losses for our Natural Gas Distribution segment are a component of the overall gas cost paid by the utility’s customers.


ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA


INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

 

 

Page

 

Management’s Report on Internal Control Over Financial Reporting

58

 

Report of Independent Registered Public Accounting Firm

58

 

Statements of Operations for the years ended December 31, 2007, 2006 and 2005

60

 

Balance Sheets as of December 31, 2007 and 2006

61

 

Statements of Cash Flows for the years ended December 31, 2007, 2006 and 2005

62

 

Statements of Changes in Stockholders’ Equity and Comprehensive Income (Loss) for the years ended December 31, 2007, 2006 and 2005

63

 

Notes to Consolidated Financial Statements, December 31, 2007, 2006 and 2005

65

 





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Management's Report on Internal Control Over Financial Reporting


Our management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rule 13a-15(f) under the Exchange Act.  We have performed an evaluation under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of our internal control over financial reporting.  Our management assessed the effectiveness of our internal control over financial reporting as of December 31, 2007.  Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements.  Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies and procedures may deteriorate.


Our management used the criteria set forth in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) to perform its assessment. Based on this assessment, our management, including our Chief Executive Officer and our Chief Financial Officer, concluded, that as of December 31, 2007, our internal control over financial reporting was effective based on those criteria.   


The effectiveness of our internal control over financial reporting as of December 31, 2007 has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in their report below.



Report of Independent Registered Public Accounting Firm


To the Board of Directors and Shareholders of Southwestern Energy Company:


In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Southwestern Energy Company and its subsidiaries at December 31, 2007 and 2006, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2007 in conformity with accounting principles generally accepted in the United States of America.  Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).  The Company's management is responsible for these financial statements, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in Management’s Report on Internal Control Over Financial Reporting appearing in Item 8.  Our responsibility is to express opinions on these financial statements and on the Company's internal control over financial reporting based on our integrated audits.  We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States).  Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects.  Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation.  Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk.  Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.


A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.  A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.



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Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements.  Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.


/s/ PricewaterhouseCoopers LLP


PricewaterhouseCoopers LLP

Tulsa, Oklahoma

February 28, 2008



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STATEMENTS OF OPERATIONS

Southwestern Energy Company and Subsidiaries

 

 

For the years ended December 31,

   

2007

 

2006

 

2005

(in thousands, except share/per share amounts)

Operating revenues:

   

   

   

Gas sales

$

870,047 

$

572,354 

$

503,111 

Gas marketing

   

316,912 

136,698 

132,690 

Oil sales

42,434 

40,742 

30,026 

Gas gathering, transportation and other

   

25,738 

13,318 

10,502 

     

1,255,131 

763,112 

676,329 

Operating costs and expenses:

   

   

   

Gas purchases - midstream services

   

306,336 

128,387 

124,730 

Gas purchases - gas distribution

   

85,445 

79,363 

82,689 

Operating expenses

85,826 

66,579 

52,850 

General and administrative expenses

   

80,269 

66,112 

48,650 

Depreciation, depletion, and amortization

   

293,914 

151,290 

96,211 

Taxes, other than income taxes

   

21,875 

25,109 

25,279 

 

   

873,665 

516,840 

430,409 

Operating income

   

381,466 

246,272 

245,920 

Interest expense:

   

   

   

Interest on long-term debt

36,191 

11,099 

19,791 

Other interest charges

1,474 

1,402 

1,254 

Interest capitalized

   

(13,792)

(11,822)

(6,005)

     

23,873 

679 

15,040 

Other income (expense)

   

(219)

17,079 

4,784 

           

Income before income taxes and minority interest

   

357,374 

262,672 

235,664 

Minority interest in partnership

   

(345)

(637)

(1,473)

Income before income taxes

   

357,029 

262,035 

234,191 

Provision for income taxes:

   

   

   

Current

   

-  

-  

-  

Deferred

   

135,855 

99,399 

86,431 

     

135,855 

99,399 

86,431 

 

   

   

   

Net income

  $

221,174 

  $

162,636 

  $

147,760 

                   

Basic earnings per share

   

$1.31 

   

$0.97 

   

$0.98 

       

Diluted earnings per share

   

$1.27 

   

$0.95 

   

$0.95 

       

Weighted average common shares outstanding:

   

   

   

Basic

169,476,723 

167,303,141 

150,892,602 

Effect of:

     

Stock options

4,012,099 

3,476,701 

4,512,564 

Restricted stock awards

232,508 

507,908 

903,873 

Diluted

   

173,721,330 

   

171,287,750 

   

156,309,039 



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



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BALANCE SHEETS

Southwestern Energy Company and Subsidiaries

 

December 31,

2007

2006

(in thousands)

ASSETS

 

 

 

 

 

 

Current assets

           

Cash and cash equivalents

  $

727 

  $

42,867 

Accounts receivable

 

 

177,680 

 

 

100,139 

Inventories, at average cost

33,034 

25,981 

Hedging asset - FAS 133

64,472 

64,082 

Current assets held for sale (see Note 2)

58,877 

67,395 

Other

 

 

28,551 

 

 

13,620 

Total current assets

363,341 

314,084 

Property, plant and equipment, at cost

Gas and oil properties, using the full cost method, including $372.4 million

 

 

in 2007 and $166.8 million in 2006 excluded from amortization

 

 

4,020,448 

 

 

2,651,427 

Gathering systems

158,604 

51,836 

Gas in underground storage

 

 

13,349 

 

 

13,349 

Other

85,983 

75,282 

 

 

 

4,278,384 

 

 

2,791,894 

Less: Accumulated depreciation, depletion and amortization

1,200,754 

913,233 

 

 

 

3,077,630 

 

 

1,878,661 

Assets held for sale (see Note 2)

143,234 

139,523 

Other assets

38,511 

46,801 

 

$

3,622,716 

 

$

2,379,069 

LIABILITIES AND STOCKHOLDERS' EQUITY

 

 

 

 

 

 

Current liabilities

 

 

 

 

 

 

Current portion of long-term debt

$

1,200 

$

1,200 

Accounts payable

 

 

313,070 

 

 

261,177 

Taxes payable

 

 

5,087 

 

 

10,271 

Advances from partners

32,005 

25,048 

Hedging liability - FAS 133

8,598 

15,799 

Current deferred income taxes

 

 

20,909 

 

 

19,162 

Current liabilities associated with assets held for sale (see Note 2)

 

 

39,118 

 

 

37,732 

Other

10,908 

8,471 

Total current liabilities

 

 

430,895 

 

 

378,860 

Long-term debt

977,600 

136,600 

Other liabilities

 

 

 

 

 

 

Deferred income taxes

479,196 

354,702 

Long-term hedging liability

15,186 

4,902 

Pension liability

12,268 

11,697 

Liabilities associated with assets held for sale (see Note 2)

15,417 

16,621 

Other

 

 

35,084 

 

 

30,010 

557,151 

417,932 

Commitments and contingencies

           

Minority interest in partnership

 

 

10,570 

 

 

11,034 

Stockholders' equity

 

 

 

 

 

 

Common stock, $0.01 par value; authorized 540,000,000 shares,

 

 

 

 

 

 

issued 170,790,836 in 2007 and 168,953,893 in 2006

 

 

1,708 

 

 

1,690 

Additional paid-in capital

 

 

754,077 

 

 

740,609 

Retained earnings

882,031 

660,857 

Accumulated other comprehensive income

 

 

13,348 

 

 

31,487 

Common stock in treasury, 111,387 shares in 2007

 

 

(4,664)

 

 

-  

1,646,500 

1,434,643 

 

$

3,622,716 

 

$

2,379,069 



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


 

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STATEMENTS OF CASH FLOWS

Southwestern Energy Company and Subsidiaries

 

 

For the years ended December 31,

   

2007

 

2006

 

2005

(in thousands)

Cash flows from operating activities

   

   

   

Net income

$

221,174 

$

162,636 

$

147,760 

Adjustments to reconcile net income to net cash provided by operating activities:

   

   

   

Depreciation, depletion and amortization

295,332 

152,519 

97,652 

Deferred income taxes

   

135,855 

   

99,399 

   

86,431 

Unrealized (gain) loss on derivatives

   

(7,103)

   

5,579 

(9,666)

Stock-based compensation expense

   

6,377 

   

5,164 

   

1,906 

Minority interest in partnership

   

(465)

   

(579)

   

(245)

Gain on sale of investment in partnership and other property

-  

(10,285)

(445)

Equity in income of NOARK partnership

   

-  

   

(925)

   

(1,635)

Change in assets and liabilities:

   

   

   

Accounts receivable

(76,136)

(2,422)

(42,680)

Inventories

(10,800)

(12,975)

(17,265)

Under/over-recovered purchased gas costs

   

5,709 

   

3,258 

   

5,911 

Accounts payable

   

61,284 

   

20,742 

   

32,837 

Advances from partners and customer deposits

   

7,615 

   

24,317 

   

1,513 

Other assets and liabilities

(16,107)

(16,491)

2,408 

Net cash provided by operating activities

   

622,735 

   

429,937 

   

304,482 

Cash flows from investing activities

   

   

   

Capital investments

   

(1,519,433)

   

(850,910)

   

(453,859)

Proceeds from sale and leaseback of drilling rigs and related equipment

3,066 

127,288 

-  

Proceeds from sale of investment in partnership and other property

2,725 

92,465 

1,519 

Other items

145 

1,151 

(578)

Net cash used in investing activities

   

(1,513,497)

   

(630,006)

   

(452,918)

Cash flows from financing activities

   

   

   

Issuance of common stock

   

-  

   

-  

   

579,956 

Debt retirement

(1,200)

(1,200)

(125,000)

Payments on revolving long-term debt

(916,550)

(267,700)

(563,800)

Borrowings under revolving long-term debt

   

1,758,750 

   

267,700 

   

463,800 

Debt issuance costs

(2,000)

-  

(1,180)

Excess tax benefit for stock-based compensation

   

-  

   

14,609 

   

-  

Change in bank drafts outstanding

5,193 

2,009 

11,860 

Proceeds from exercise of common stock options

   

5,474 

   

3,873 

   

5,270 

Net cash provided by financing activities

   

849,667 

   

19,291 

   

370,906 

Increase (decrease) in cash and cash equivalents

   

(41,095)

   

(180,778)

   

222,470 

Cash and cash equivalents at beginning of year

42,927 

223,705 

1,235 

Cash and cash equivalents at end of year

  $

1,832 

  $

42,927 

  $

223,705 



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


 

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STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY AND COMPREHENSIVE INCOME (LOSS)


Southwestern Energy Company and Subsidiaries

 

Common Stock(1)

Additional Paid-In Capital(1)

Retained Earnings

Accumulated Other Comprehensive Income (Loss)

Common Stock in Treasury

Unamortized Restricted Stock Awards

Total

Shares Issued

Amount

 

(in thousands)

Balance at December 31, 2004

148,902 

  $

14,890 

 

$

117,586 

  $

350,461 

  $

(19,816)

  $

 (9,156)

  $

 (6,288)

  $

447,677 

Comprehensive income: