form10k.htm


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, 2009

OR

o
Transition Report Pursuant To Section 13 Or 15(d) of The Securities Exchange Act of 1934
 

 
Commission File Number: 000-51801


 
ROSETTA RESOURCES INC.
(Exact name of registrant as specified in its charter)
 
Delaware
43-2083519
(State or other jurisdiction of incorporation or organization)
(I.R.S. Employer Identification No.)
   
717 Texas, Suite 2800, Houston, TX
77002
(Address of principal executive offices)
(Zip Code)
   
Registrant's telephone number, including area code: (713) 335-4000



Securities Registered Pursuant to Section 12(b) of the Act:
 
The Nasdaq Stock Market LLC
Common Stock, $.001 Par Value
(Nasdaq Global Select Market)
(Title of Class)
(Name of Exchange on which registered)

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.  
Yes o  No x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act.  
Yes o  No x

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes o  No o

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 the 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. o


 
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. 
 
 
Large accelerated filer o
 
Accelerated filer x
       
 
Non-Accelerated filer o
 
Smaller Reporting Company o
       
 
(Do not check if a smaller reporting company)

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

The aggregate market value of the voting and non-voting common equity held by Non-affiliates of the registrant as of June 30, 2009 was approximately $446.9 million based on the closing price of $8.76 per share on the Nasdaq Global Select Market.

The number of shares of the registrant’s Common Stock, $.001 par value per share outstanding as of February 24, 2010 was 52,589,439.

Documents Incorporated By Reference

Portions of the definitive proxy statement relating to the 2010 annual meeting of stockholders to be filed with the Securities and Exchange Commission are incorporated by reference in answer to Part III of this Form 10-K.

2

 
 
Table of Contents
 
     
     
Part I –
Page
 
4
 
15
 
22
 
23
 
23
Part II –
 
 
24
 
25
 
26
 
42
 
44
 
79
 
79
 
79
Part III –
 
 
80
 
80
 
80
 
80
 
80
Part IV –
 
 
81

 
CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

This Form 10-K contains forward-looking statements regarding factors that we believe may affect our performance in the future. Such statements typically are identified by terms expressing our future expectations or projections of revenues, earnings, earnings per share, cash flow, market share, capital expenditures, effects of operating initiatives, gross profit margin, debt levels, interest costs, tax benefits and other financial items. All forward-looking statements are based on assumptions about future events and are therefore inherently uncertain, and actual results may differ materially from those expected or projected. Important factors that may cause our actual results to differ materially from expectations or projections include those described under the heading “Risk Factors” in Item 1A of this Form 10-K. Forward-looking statements speak only as of the date of this report, and we undertake no obligation to update or revise such statements to reflect new circumstances or unanticipated events as they occur.
 
For a glossary of oil and natural gas terms, see page 85.
 
Part I
 
Items 1 and 2. Business and Properties
 
General
 
We are an independent oil and gas company engaged in the exploration, development, acquisition and production of oil and gas properties.  Our operations are concentrated in the core areas of the Sacramento Basin of California, the Rockies, and South Texas.  In addition, we have non-core positions in the State Waters of Texas and the Gulf of Mexico.  We are a Delaware corporation based in Houston, Texas.  Our headquarters are located at 717 Texas, Suite 2800, Houston, Texas 77002, where we sublease two floors of office space from Calpine and lease a third floor. We also maintain a division office in Denver, Colorado, where we were assigned a lease by Calpine and now deal directly with the landlord.  We also have field offices in Laredo, Texas, Rio Vista, California and Wray, Colorado. All office leases were negotiated at market prices applicable to their respective location.
 
Rosetta Resources Inc. (together with our consolidated subsidiaries, the “Company” or “Rosetta”) was formed in June 2005 to acquire the domestic oil and natural gas business formerly owned by Calpine Corporation and its affiliates (“Calpine”).   We have subsequently acquired numerous other oil and natural gas properties.  We have grown our existing property base by developing and exploring our acreage, purchasing new undeveloped leases, and acquiring oil and gas producing properties and drilling prospects from third parties.  We operate in one business segment.  See Item 8. “Financial Statements and Supplementary Data, Note 15 - Operating Segments.”
 
 We sell a significant portion of our gas to Calpine pursuant to certain gas purchase and sales contracts, including the gas sales agreement for the dedicated California production which was amended and restated in connection with the parties’ settlement agreement dated October 22, 2008. These original gas purchase and sales contracts and the amended and restated gas purchase and sales contract for the dedicated California production are discussed further under Part I. Items 1 and 2. ”Business and Properties - Marketing and Customers.”

Our Strategy
 
Our strategy is to increase stockholder value by delivering visible and sustainable growth from unconventional onshore domestic basins.  This strategy represents a shift in our business model that is consistent with our goal to become a successful resource player with sufficient project inventory to drive growth.  We recognize that there may be cycles, such as the current economic downturn, that could impact our ability to fully execute this strategy on a short-term basis.  However, we believe our strategy is fundamentally sound and emphasizes (i) identifying and developing inventory in existing core properties, (ii) establishing and testing positions in new resource plays, (iii) efficiently exploring and exploiting our assets, (iv) pursuing selective acquisitions and divestitures, (v) applying technological expertise, (vi) focusing on cost control and (vii) maintaining financial flexibility.  We seek to implement our strategy while working to protect stockholder interests by focusing on sound stewardship, managing our capital resources wisely, monitoring emerging trends, minimizing liabilities through governmental compliance and protecting the environment.  Below is a discussion of the key elements of our strategy:
 
Identifying and Developing Inventory in Existing Core Properties. Project inventory is a key to our strategy and we believe our legacy assets have significant remaining inventory potential.  We have designated the Sacramento Basin of California, the Rockies and South Texas as core areas and intend to expand our asset base in these areas through additional leasing and acquisitions, where applicable, in order to build inventory.  As importantly, we intend to further develop the upside potential of these core properties by conducting thorough resource assessments of our existing assets, working over existing wells, drilling in-fill locations, drilling step-out wells to expand known field outlines, testing and implementing downspacing potential, recompleting and testing behind pipe pays, lowering field line pressures through compression and optimizing for additional reserve recovery.  We believe that applying an “unconventional lens” to these assets will generate inventory to fuel future growth.

 
Establishing and Testing Positions in New Resource Plays.  We intend to extend our operational footprint into new core areas within North America that are characterized by a significant presence of resource potential that can be exploited utilizing our technological expertise.  We strive to minimize the cost of entry into these plays by being disciplined in our leasehold acquisition activities and prudently paced during the testing phase.
 
Efficiently Exploring and Exploiting our Assets.   We intend to generate growth in existing and new areas by applying our technological and operational expertise to our inventory of projects.  We believe that this is a key to creating value from resource plays.
 
Pursuing Selective Acquisitions and Divestitures. We regularly evaluate possible acquisitions of producing properties, undeveloped acreage and drilling prospects in our existing core areas, as well as areas where we believe we can establish new core areas with resource potential.  We focus on opportunities with identified inventory where we believe our reservoir management and operational expertise will enhance the value and performance of the acquired properties through repeatable drilling programs.  Periodically, we also evaluate possible divestitures of non-core properties that we believe have limited future potential or that do not fit our risk profile.  In 2009, we sold certain non-core assets for a total of approximately $20 million.
 
Applying Technological Expertise. We intend to maintain, further develop and apply the technological expertise that helped us achieve a net drilling success rate of 83% for the year ended December 31, 2009 and helped us maximize field recoveries.  Our definition of drilling success is a well that is producing or capable of production, including natural gas wells awaiting pipeline connections to commence deliveries and oil wells awaiting connection to production facilities. We use advanced geological and geophysical technologies, detailed petrophysical analyses, advanced reservoir engineering and sophisticated drilling, completion and stimulation techniques to grow our reserves, production and project inventory.
 
Focusing on Cost Control. We manage all elements of our cost structure including drilling and operating costs as well as overhead costs. We strive to minimize our drilling and operating costs by concentrating our activities within existing and new resource play areas where we can achieve efficiencies through economies of scale.
 
Maintaining Financial Flexibility. As of December 31, 2009, we had drawn $190.0 million and had $160.0 million available for borrowing under our revolving line of credit. Additionally, we expect internally generated cash flow to provide additional financial flexibility.  We intend to continue to actively manage our exposure to commodity price risk in the marketing of our oil and natural gas production. As part of this strategy, we entered into natural gas fixed-price swaps for a portion of our expected production through 2011.  As of December 31, 2009, 13% and 13% of our expected natural gas production was hedged using swaps and costless collars, respectively, with settlement in 2010, and 5% and 23% of our expected natural gas production was hedged using swaps and costless collars, respectively, with settlement in 2011.  The swaps to settle in 2010 have an average price of $7.46 per MMBtu and the collars have floor and ceiling prices of $5.75 per MMBtu and $7.40 per MMBtu, respectively.  The swaps to settle in 2011 have an average price of $5.72 per MMBtu and the collars have floor and ceiling prices of $5.80 per MMBtu and $7.58 per MMBtu, respectively.   In January 2010, we entered into additional costless collar transactions to hedge 10,000 MMBtu/d of our expected production for July 2010 through December 2012.  The costless collars have a floor price of $5.75 per MMBtu and a ceiling price of $6.50 per MMBtu through 2011 and $7.15 per MMBtu in 2012.  In February 2010, we entered into natural gas fixed-price swaps to hedge 10,000 MMBtu/d of our expected production for July 2010 through December 2011 at an average price of $5.91 per MMBtu.  We also entered into a series of interest rate swap agreements during 2009 to hedge the change in variable interest rates associated with our debt under our credit facility through December 2010.  

Our Strengths

Our business strategy and our goal to become a successful resource player are not proprietary.  However, we believe we possess several strengths that could differentiate our performance over time.  We believe our key strengths are as follows:

High Quality Asset Base. We own what we believe is a unique asset base in key onshore hydrocarbon basins.  Approximately 85% of our reserves are natural gas and, except for some minor non-core properties, most of our assets are located in our core areas of the Sacramento Basin of California, the Rockies, and South Texas.  Thus, we are both relatively concentrated, yet geographically diverse.  Our concentration allows us to achieve scale, while the geographic diversity exposes us to different commodity pricing locations, including some premium markets.  In addition, a significant portion of our legacy asset base requires relatively low levels of maintenance capital, which enhances our flexibility to allocate capital.  In combination with our new resource plays, our asset base is capable of yielding growth from a large and growing inventory of projects.  We also believe our current asset base provides a strong platform for additional acquisitions.
 
Resource Assessment Capability and Inventory Generation. We have established multi-disciplinary teams that are skilled at conducting comprehensive resource assessments on a field and regional basis.  This work helps us indentify and catalog an inventory of low to moderate risk opportunities that provide us with multiple years of drilling projects.   We expect to continue to add to our diversified portfolio of non-proved resource inventory over time from both our legacy properties, as well as from our emerging resource plays.   

Operational Control. We operate approximately 87% of our estimated proved reserves, which allows us to more effectively manage expenses and control the timing of capital spending on our exploration and development activities.  In addition, we have a very high working interest in most of our properties and a high percentage of acreage that is held by production.  These factors also give us greater flexibility over our activities.

 
Experienced Management Team. Our executive management team has an average of 30 years of experience in the energy industry with specific experience in the areas where our core properties are located. In November 2007, Randy L. Limbacher became our President and Chief Executive Officer (“CEO”). In February 2010, Mr. Limbacher became our Chairman of the Board. Mr. Limbacher has more than 29 years of experience in the energy industry, most recently serving as President, Exploration and Production - Americas for ConocoPhillips. Since coming to Rosetta, Mr. Limbacher has continued to hire personnel with technical and commercial experience in unconventional resource plays.
 
Proven Technical and Land Personnel with Access to Technological Resources. Our technical staff includes 57 geologists, geophysicists, landmen, engineers and technicians with an average of over 14 years of relevant technical experience. Our staff has experience in analyzing complex structural and stratigraphic plays using 3-D geophysical expertise, producing and optimizing low pressure natural gas reservoirs, detecting low contrast, low permeability pay opportunities, drilling, completing and fracing of deep tight natural gas reservoirs, operating in complex basins and managing coalbed methane operations. These core competencies helped us to achieve a net drilling success rate of 83% for the year ended December 31, 2009 and helped maximize recovery from our reservoirs.   

Our Operating Areas

We own core producing and non-producing oil and natural gas properties in proven or prospective basins that are primarily located in California, the Rockies, and South Texas.  We also have non-core positions in the State Waters of Texas and the Gulf of Mexico.   For the year ended December 31, 2009, we drilled 43 gross and 36 net wells, with a net success rate of 83%. The following is a summary of our major operating areas.
  
California
 
Historically, the Sacramento Basin is one of California’s most prolific gas producing areas, containing a majority of the state’s largest gas fields.  It is located near the Northern California natural gas markets and has an established natural gas gathering and pipeline infrastructure.  We are one of the largest producers and leaseholders in the basin.
 
As of December 31, 2009, we owned approximately 60,000 net acres in the Rio Vista Field and other fields in the Sacramento Basin areas.  We believe our acreage in the basin holds significant low-risk, low-cost reserves, and numerous workover and recompletion opportunities.  Additional reserve potential exists in gathering system optimization projects, fracture stimulation opportunities in lower permeability, low contrast pays, and deeper gas bearing sands.
 
For the year ended December 31, 2009, our average net daily production from the Rio Vista Field and surrounding fields in the Sacramento Basin was 42.4 MMcfe/d.  In 2009, we drilled one gross well which was successful.   
 
Rio Vista Field. The Rio Vista Gas Unit and a significant portion of the deep rights below the Rio Vista Gas Unit, which together constitute the greater Rio Vista Field, is the largest onshore natural gas field in California and one of the 15 largest natural gas fields in the United States. The field has produced a cumulative 3.7 Tcfe of natural gas reserves to date since its discovery in 1936. We currently produce from or have behind-pipe reserves in multiple zones at depths ranging from 2,000 feet to 11,000 feet in the field. The Rio Vista Field is a faulted, downthrown rollover anticline, elongated to the northwest. The current productive area is approximately ten miles long and nine miles wide. We completed a successful low cost, by-passed pay recompletion program during 2009.  Our 2009 recompletion program consisted of 40 projects with a total combined capital cost of $2.1 million.

As of December 31, 2009, there was one workover rig currently working on our wells in the Rio Vista area.   We plan to conduct approximately 20 workovers, recompletions or reactivation operations on field wells during 2010.  Moreover, a majority of our time and effort in 2010 will be devoted to resource assessments within the Rio Vista Gas Field.  The resource assessments are expected to generate future drilling and recompletion inventory for 2011 and beyond.
  
Rockies
 
As of December 31, 2009, we owned approximately 160,000 net acres in the Rockies and had approximately 230,000 net acres under an exploration option in the Alberta Basin of Montana.  Our production is concentrated in three basins: the DJ Basin, San Juan Basin and Greater Green River Basin.  Our average net daily production for the year ended December 31, 2009 was 19.0 MMcfe/d.  In 2009, we drilled five gross wells, all of which were successful.  

DJ Basin, Colorado. As of December 31, 2009, we had a majority working interest in approximately 94,000 net acres with 154 square miles of 3-D seismic data.  In 2009, due to low commodity prices, we chose to not drill and focused our efforts on resource assessment.  For the year ended December 31, 2009, our average net daily production from the DJ Basin was 7.9 MMcfe/d.  We commenced a 105-well drilling program in the first quarter of 2010 and expect to be completed by mid-year.  This program is matched with favorable hedges in the Rockies that will improve project returns.

 
San Juan Basin, New Mexico. The San Juan Basin is the second most prolific gas basin in North America, with significant contribution coming from the Fruitland Coal Bed Methane (“CBM”) trend. There is CBM production from depths of 1,600 feet surrounding our leasehold. As of December 31, 2009, we had a 100% working interest in approximately 16,000 net acres.   In 2009, we drilled 3 CBM wells, all of which were successful.  For the year ended December 31, 2009, our average net daily production from the San Juan Basin was 5.0 MMcfe/d.  

Pinedale, Wyoming.  On December 11, 2008, we purchased a 90% working interest in 1,280 acres of the Pinedale field from Pinedale Energy LLC, a subsidiary of Constellation Energy Group, Inc.  We purchased 28 productive natural gas wells and one salt water disposal well.  On February 4, 2009, we purchased the remaining 10% working interest in the 1,280 acres in the Pinedale field from Nielsen & Associates, Inc. and obtained operatorship of the properties.  Detailed resource assessment work commenced in the fourth quarter of 2009, which led to the implementation of three recompletions before year end.  As assessment work continues in 2010, it is anticipated that new drilling and recompletion inventory will be identified.  For the year ended December 31, 2009, our average net daily production from Pinedale was 6.0 MMcfe/d.

Alberta Basin, Montana.  The Alberta Basin play is a westward analog of the industry’s Bakken and Three Forks plays of the Williston Basin of Montana and North Dakota.  On December 24, 2008, Rosetta received approval from the Bureau of Indian Affairs to option approximately 200,000 net acres located on the Blackfeet Indian Reservation in Western Montana.  In 2009, we initiated the technical assessment of our acreage position by drilling two test wells, of which one was vertical and one was horizontal.  We also continued land acquisition and consolidation efforts through fee and allottee leasing.  As of year-end, our acreage position increased to approximately 240,000 net acres, including approximately 230,000 net acres under exploration option agreements.

South Texas
 
As of December 31, 2009, we owned approximately 170,000 net acres in South Texas.  Our production in South Texas comes from the Lobo, Olmos, and Perdido sand trends and the Eagle Ford Shale trend and averaged 55.7 MMcfe/d for the year ended December 31, 2009.  In 2009, we drilled 31 gross wells, of which 25 were successful.  Additionally, we have significantly expanded our acreage holdings in the rapidly developing Eagle Ford Shale trend, and we maintain a significant position in the emerging Dinn Sand trend.

Lobo Trend.  We are a significant producer in the South Texas Lobo Trend, with 470 square miles of 3-D seismic and 255 operated producing wells.  Our working interests range from 50% to 100%, but most of our acreage is 100% owned and operated.   In 2009, we shot a new proprietary 3-D seismic survey covering 112 square miles of our Lobo acreage.  The data has been processed and is being evaluated to identify additional drilling locations.  For the year ended December 31, 2009, our average net daily production from the Lobo trend was 44.1 MMcfe/d.   In 2009, we drilled 27 gross wells, of which 21 were successful.

Discovered in 1973, the Lobo trend of South Texas is a complex, highly faulted sand that has produced over 8 Tcf of natural gas. The Lobo trend produces from tight sands with low permeabilities and high pressures at depths from 7,500 to 10,000 feet.

Eagle Ford Shale Trend.  The Eagle Ford Shale trend has emerged as a focus area for Rosetta in South Texas.  In 2009, we continued to acquire additional sizable acreage tracts with potential in this evolving shale gas play.  Since 2008, we have accumulated approximately 53,000 net acres in the Eagle Ford Shale trend.  Most of this acreage also has potential in the Austin Chalk and Edwards formations, as well as the newly emerging Pearsall Shale gas trend.  In 2009, we drilled four gross wells to gather and evaluate the shale with core and log data.  We then took two wells horizontal, completing both wells, each having approximately 4,000 foot laterals, with 10-stage hydraulic fracture treatments.  For the quarter ended December 31, 2009, our average net daily production was 4.3 MMcfe/d.

Olmos Trend.  On December 23, 2008, we closed on the acquisition of a 70% non-operated working interest in 231 gross producing Olmos wells in the Olmos trend of South Texas.  Production from these wells averaged 3.8 MMcfe/d for the year ended December 31, 2009.

Perdido Sand Trend. We own a 50% non-operated working interest in the South Texas Perdido Sand trend. The Perdido Sands are comprised of tight natural gas sands and are in isolated fault blocks that are stratigraphically trapped below the Upper Wilcox structures at approximately 8,000 to 9,500 feet.  We plan to continue to coordinate with the operator to improve horizontal and vertical drilling techniques to lower cost and increase performance.  For the year ended December 31, 2009, our average net daily production was 6.5 MMcfe/d from 37 producing wells (24 horizontal and 13 vertical).

Dinn Sand Trend.  In 2008, we acquired a significant acreage position with approximately 100% operated working interest adjacent to our existing Perdido development trend.   This leasehold acquisition has potential in the intermediate depth Dinn Sand trend.  The Dinn Sand has been sparsely developed with vertical wells, and has potential for additional horizontal and vertical well development over most of the leasehold.  Additionally, much of the leasehold has potential for extending the Perdido Sand trend horizontal development from our adjacent non-operated 50% working interest acreage to this operated 100% working interest leasehold.

 
Other Onshore
 
In the Other Onshore region, we currently have approximately 12,000 net acres under lease with an average non-operated working interest of 47%.  Some of these properties are potential divestiture candidates in the future.    
 
Texas State Waters
 
 We own a 50% operated working interest through a joint venture in Sabine Lake, within Texas State Waters of Jefferson County and Louisiana State Waters of Cameron Parish, and additional non-operated properties in Texas State Waters near Nueces Bay.  During 2009, we drilled three gross wells which were successful.  Net production averaged 5.4 MMcfe/d during 2009.   As of December 31, 2009, we held interests in approximately 4,000 net acres with 72 square miles of 3-D seismic data.  These properties are considered to be non-core and are likely divestiture candidates.

Gulf of Mexico

Federal Waters.  We own working interests in 12 offshore blocks ranging from 20% to 100% working interest with approximately 28,000 net acres.  For the year ended December 31, 2009, our average net daily production from these blocks was 6.4 MMcfe/d.  These properties are considered to be non-core and are likely divestiture candidates.

Title to Properties

Our properties are subject to customary royalty interests, liens incident to operating agreements, liens for current taxes and other burdens, including other mineral encumbrances and restrictions as well as mortgage liens on at least 80% of our proved reserves in accordance with our credit facilities. We do not believe that any of these burdens materially interfere with our use of the properties in the operation of our business.
 
We believe that we generally have satisfactory title to or rights in all of our producing properties. As is customary in the oil and natural gas industry, we make minimal investigation of title at the time we acquire undeveloped properties. We make title investigations and receive title opinions of local counsel only before we commence drilling operations. We believe that we have satisfactory title to all of our other assets. Although title to our properties is subject to encumbrances in certain cases, we believe that none of these burdens will materially detract from the value of our properties or from our interest therein or will materially interfere with our use in the operation of our business.

Crude Oil and Natural Gas Operations
 
Production by Operating Area

The following table presents certain information with respect to our production data for the period presented:

   
For the Year Ended December 31, 2009
 
   
Natural Gas
(Bcf)
   
NGLs
(MBbls)
   
Oil
(MBbls)
   
Equivalents
(Bcfe)
 
California
    15.3       -       28.3       15.5  
Rockies
    6.8       -       19.8       6.9  
South Texas
    16.3       548.4       117.0       20.3  
Other Onshore
    2.8       33.8       94.0       3.6  
Texas State Waters
    1.5       21.1       62.3       2.0  
Gulf of Mexico
    1.8       16.8       72.5       2.3  
Total
    44.5       620.1       393.9       50.6  
 
For additional information regarding our oil and gas production, production prices and production costs see Item 7.  “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Operating Expenses.”

Proved Reserves

There are a number of uncertainties inherent in estimating quantities of proved reserves, including many factors beyond our control, such as commodity pricing. Therefore, the reserve information in this report represents only estimates. Reserve engineering is a subjective process of estimating underground accumulations of oil and natural gas that cannot be measured in an exact manner. The accuracy of any reserve estimate is a function of the quality of available data and of engineering and geological interpretation and judgment. As a result, estimates of different engineers may vary. In addition, results of drilling, testing and production subsequent to the date of an estimate may justify revising the original estimate. Accordingly, initial reserve estimates are often different from the quantities of oil and natural gas that are ultimately recovered. The meaningfulness of such estimates depends primarily on the accuracy of the assumptions upon which they were based. Except to the extent that we acquire additional properties containing proved reserves or conduct successful exploration and development activities, or both, our proved reserves will decline as reserves are produced.

 
As of December 31, 2009, we had an estimated 351.1 Bcfe of proved oil and natural gas reserves, including 296.8 Bcf of natural gas, 3,825 MBbls of oil and condensate and 5,221 MBbls of NGLs,  of which 75% was proved developed.  As of December 31, 2009 and based on the 2009 twelve-month first day of the month historical average referenced prices as adjusted for basis and quality differentials, our reserves had an estimated standardized measure of discounted future net cash flows of $465 million.  In December 2008, the Securities and Exchange Commission (“SEC”) issued its final rule, Modernization of Oil and Gas Reporting (Release No. 33-8995), which is effective for reporting 2009 reserve information.  The primary impacts of the SEC’s final rule on our reserve estimates include:

 
·
the use of the twelve-month first day of the month historical average prices adjusted for basis and quality differentials for West Texas Intermediate oil of $57.65 per Bbl and Henry Hub natural gas of $3.87 per MMBtu compared to the use of year-end prices adjusted for basis and quality differentials for West Texas Intermediate oil of $76.00 per Bbl and Henry Hub natural gas of $5.79 per MMBtu at December 31, 2009 as previously required under SEC guidelines;

 
·
the requirement that all proved undeveloped locations be developed within five years.  As of December 31, 2009, we did not have any proved undeveloped locations to be developed beyond five years and we have the intent to develop all of our proved undeveloped locations within this five year timeframe; and

 
·
the inclusion of proved undeveloped locations beyond one-offset is allowed if there is reasonable certainty of economic producibility.  A few of our undeveloped locations are beyond one-offset and current production data, logs, microseismic, and geologic data supports reasonable certainty of economic producibility.

Under the SEC’s final rule, prior period reserves were not restated.  

The following table sets forth, by operating area, a summary of our estimated net proved reserve information as of December 31, 2009:

   
Estimated Proved Reserves at December 31, 2009 (1)(2)
 
   
Developed
   
Undeveloped
             
   
Natural Gas
(Bcf)
   
NGLs
(MMBbls)
   
Oil
(MMBbls)
   
Total
(Bcfe)
   
Natural Gas
(Bcf)
   
NGLs
(MMBbls)
   
Oil
(MMBbls)
   
Total
(Bcfe)
   
Total
(Bcfe)
   
Percent of Total
Reserves
 
California
    74.88       -       0.05       75.17       14.55       -       0.01       14.60       89.8       26 %
Rockies
    64.80       -       0.25       66.27       3.86       -       -       3.86       70.1       20 %
South Texas
    69.72       2.06       0.52       85.17       40.21       2.84       1.47       66.07       151.3       43 %
Other Onshore
    13.63       0.00       0.52       16.75       -       -       -       -       16.7       5 %
Texas State Waters
    4.10       0.24       0.27       7.16       -       -       -       -       7.2       2 %
Gulf of Mexico
    9.48       0.05       0.72       14.10       1.54       0.03       0.02       1.89       16.0       4 %
Total
    236.61       2.35       2.33       264.62       60.16       2.87       1.50       86.42       351.1       100 %
___________________________________

 
(1)
These estimates are based upon a reserve report prepared using internally developed reserve estimates and criteria in compliance with the SEC guidelines and audited by Netherland Sewell & Associates, Inc. (hereafter “NSAI”), independent petroleum engineers.  See Item 7.  “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Policies and Estimates” and Item 8. “Financial Statements and Supplementary Data - Supplemental Oil and Gas Disclosures.”  NSAI’s report is attached as Exhibit 99.1 to this Form 10-K.
 
(2)
The reserve volumes and values were determined under the method prescribed by the SEC, which for 2009 requires the use of an average price, calculated as the twelve-month first day of the month historical average price for the twelve-month period prior to the end of the reporting period, unless prices are defined by contractual arrangements, excluding escalations based upon future conditions.  For years prior to 2009, the SEC rules required the use of year-end prices.

All of our proved undeveloped reserves are scheduled for development within five years and at December 31, 2009, we did not have any proved undeveloped reserves greater than five years.

As of December 31, 2009, we had proved undeveloped reserves of 86.4 Bcfe, an increase of 15.6 Bcfe relative to December 31, 2008.  Significant additions to proved undeveloped reserves resulted primarily from additional proved undeveloped locations in our Eagle Ford Shale acreage.

In accordance with SEC guidelines, the reserve engineers’ estimates of future net revenues from our properties, and the present value of the properties, are made using the twelve-month first day of the month historical average oil and gas prices for the December 31, 2009 reserves and oil and gas sales prices in effect as of the end of the period of such estimates for prior periods, and are held constant throughout the life of the properties, except where the guidelines permit alternate treatment, including the use of fixed and determinable contractual price escalations.  Historically, the prices for oil and gas have been volatile and are likely to continue to be volatile in the future.



The table below sets forth our proved reserves calculated according to prior SEC guidelines using the year-end oil and natural gas prices adjusted for basis and quality differentials rather than the twelve-month first day of the month historical average prices adjusted for basis and quality differentials:

   
Proved Reserves
 
   
Natural Gas
(Bcf)
   
NGLs
(MMBbls)
   
Oil
(MMBbls)
   
Total
(Bcfe)
 
                         
Price Scenario 1 (1)
    355.7       5.6       3.7       411.6  
___________________________________

 
(1)
Price Scenario 1 assumes a West Texas Intermediate oil price adjusted for basis and quality differentials of $76.00 per Bbl and a Henry Hub natural gas price adjusted for basis and quality differentials of $5.79 per MMBtu at December 31, 2009.

Internal Control

The preparation of our reserve estimates are completed in accordance with our prescribed internal control procedures, which include verification of input data into a reserve forecasting and economic evaluation software, as well as management review.  The Company’s primary reserves estimator is the Company’s Chief Engineer and Operations General Manager who has twenty-two years of experience in the petroleum industry with 18 years of experience in the evaluation of reserves and income attributable to oil and gas properties. She holds a Bachelor of Science in Petroleum Engineering, a Bachelor of Science in Geosciences and a Master of Business Administration from the University of Tulsa.  She also holds a Master of Science in Petroleum Engineering from the University of Houston.  She obtained a Doctor of Jurisprudence from South Texas College of Law and is a member of Phi Delta Phi honorary law society and the Society of Petroleum Engineers.

Our corporate reservoir engineering department reports to our Chief Engineer and Operations General Manager who maintains oversight and compliance responsibility for the internal reserve estimate process and provides appropriate data to independent third party engineers for the annual audit of our year-end reserves. The management of our corporate reservoir engineering group, including the Chief Engineer, consists of two degreed petroleum engineers, with an average of 26 years of industry experience in reservoir engineering/management.

Qualifications of Third Party Engineers

The technical personnel responsible for preparing the reserve estimates at NSAI meet the requirements regarding qualifications, independence, objectivity, and confidentiality set forth in the Standards Pertaining to the Estimating and Auditing of Oil and Gas Reserves Information promulgated by the Society of Petroleum Engineers.  NSAI is an independent firm of petroleum engineers, geologists, geophysicists, and petrophysicists; it does not own an interest in our properties and is not employed on a contingent fee basis.  NSAI’s President and Chief Operating Officer is a licensed professional engineer with more than 30 years of experience and the geoscientist charged with the audit is a licensed professional with 25 years of experience.

2009 Capital Expenditures

The following table summarizes information regarding our development and exploration capital expenditures for the years ended December 31, 2009, 2008 and 2007:

   
Year Ended December 31,
 
   
2009
   
2008
   
2007
 
   
(In thousands)
 
Capital Expenditures by Operating Area:
                 
California
  $ 7,453     $ 42,429     $ 58,493  
Rockies
    17,227       25,015       23,904  
South Texas
    59,547       94,567       105,301  
Other Onshore
    2,974       12,927       29,796  
Texas State Waters
    4,545       8,541       27,000  
Gulf of Mexico (1)
    (2,788 )     422       28,523  
Leasehold
    22,066       17,883       8,838  
Acquisitions
    3,624       115,074       38,656  
Delay rentals
    1,683       1,451       1,409  
Geological and geophysical/seismic
    8,558       4,571       4,422  
Total capital expenditures (2)
  $ 124,889     $ 322,880     $ 326,342  

___________________________________

 
(1)
During the first quarter of 2009, a capital expenditure accrual for approximately $3.6 million was removed from capitalized costs.  The accrued capital expenditure related to a property for which we had a non-operating interest.  The well was drilled and operated by a third party prior to 2009.  During the latter part of 2008, the operator sold their interest to a different third party and it was determined that there were to be no future capital obligations to the original operator.  As such, the accrued capital expenditure was removed.  Actual capital expenditures in the Gulf of Mexico during 2009 totaled approximately $0.8 million and were primarily related to drilling and completion costs and plug and abandonment costs.
 
(2)
Capital expenditures for the year ended December 31, 2009 exclude capitalized internal costs directly identified with acquisition, exploration and development activities of $4.8 million, capitalized interest of $1.2 million and corporate other capital costs of $4.1 million.  Capital expenditures for the year ended December 31, 2008 exclude capitalized internal costs directly identified with acquisition, exploration and development activities of $7.1 million, capitalized interest of $1.4 million and corporate other capital costs of $3.0 million. Capital expenditures for the year ended December 31, 2007 exclude capitalized internal costs directly identified with acquisition, exploration and development activities of $5.5 million, capitalized interest of $2.4 million and corporate other capital costs of $1.8 million.  Corporate other capital costs consist of costs related to IT software/hardware, office furniture and fixtures and license transfer fees.  
 
Productive Wells and Acreage
 
The following table sets forth our interest in undeveloped acreage, developed acreage and productive wells in which we own a working interest as of December 31, 2009.  “Gross” represents the total number of acres or wells in which we own a working interest.  “Net” represents our proportionate working interest resulting from our ownership in the gross acres or wells. Productive wells are wells in which we have a working interest and that are capable of producing oil or natural gas.

                           
Productive Wells (1)
 
   
Undeveloped Acres
   
Developed Acres
   
Gross
   
Net
 
   
Gross
   
Net
   
Gross
   
Net
   
Natural Gas
   
Oil
   
Natural Gas
   
Oil
 
California
    23,712       16,178       53,671       44,188       158       -       147       -  
Rockies (2)
    148,714       131,200       36,016       28,527       264       2       232       1  
South Texas
    113,315       99,902       103,229       69,546       531       2       411       2  
Other Onshore
    9,379       3,260       29,259       9,034       236       15       30       6  
Texas State Waters
    4,913       2,456       4,800       1,302       1       -       1       -  
Gulf of Mexico
    7,500       5,000       35,752       22,513       2       1       1       1  
Total
    307,533       257,996       262,727       175,110       1,192       20       822       10  
 ___________________________________
 
 
(1)
Offshore productive wells are based on intervals rather than well bores.
 
(2)
Excludes 230,000 net undeveloped acres under exploration option in the Alberta Basin of Montana.

Of our productive wells listed above, there were 13 and 14 multiple completions in Texas and California, respectively.

The following table shows our interest in undeveloped acreage as of December 31, 2009 that is subject to expiration in 2010, 2011, 2012 and thereafter:

2010
 
2011
 
2012
 
Thereafter
Gross
 
Net
 
Gross
 
Net
 
Gross
 
Net
 
Gross
 
Net
127,466
 
111,294
 
87,863
 
76,050
 
47,812
 
40,088
 
44,392
 
30,564

Drilling Activity

The following table sets forth the number of gross exploratory and development wells we drilled or in which we participated during the last three fiscal years. The number of wells drilled refers to the number of wells completed at any time during the respective fiscal year.  Productive wells are either producing wells or wells capable of commercial production.

   
Gross Wells
 
   
Exploratory
   
Development
 
   
Productive
   
Dry
   
Total
   
Productive
   
Dry
   
Total
 
2009
    7.0       -       7.0       30.0       6.0       36.0  
2008
    3.0       1.0       4.0       160.0       20.0       180.0  
2007
    11.0       7.0       18.0       149.0       28.0       177.0  



The following table sets forth, for each of the last three fiscal years, the number of net exploratory and net development wells drilled by us based on our proportionate working interest in such wells.

   
Net Wells
 
   
Exploratory
   
Development
 
   
Productive
   
Dry
   
Total
   
Productive
   
Dry
   
Total
 
2009
    6.1       -       6.1       23.4       6.0       29.4  
2008
    1.9       1.0       2.9       132.7       15.9       148.6  
2007
    7.5       5.1       12.6       130.2       26.5       156.7  

As of December 31, 2009, we had one well in process.  This well is located in the Alberta Basin and we own a 100% working interest in this well.

Marketing and Customers

We have entered into a natural gas purchase and sales contract with Calpine Energy Services (“CES”) for the dedicated California production, which runs through December 2019.  Under the terms of this agreement, we are obligated to sell all our existing and future production from our California leases in production as of May 1, 2005 based on market prices.   For the month of December 2009, this dedicated California production comprised approximately 33% of our overall daily equivalent production.

Under the terms of the purchase and sales contract with CES, cash payment for all natural gas volumes that are contractually sold to CES on the previous day are deposited into our bank account. If the funds are not deposited one business day in arrears in accordance with our contracts, we are not obligated to continue to sell our production to CES and these sales may cease immediately. We would then be in a position to market this natural gas production to other parties. CES has 60 days to pay amounts owed to us, at which time, provided CES has fully cured such payment default, we are obligated under the contract to resume natural gas sales to CES.

We may market our remaining natural gas production in California to parties other than CES.  All of our other production (other than our dedicated California production being sold to CES, as described above) is sold to various purchasers, including CES, at market rates.  We market all of our oil and gas production and have expanded our internal capabilities in this regard, both by hiring experienced personnel and implementing our own licensed systems.
 
Major Customers
 
For the year ended December 31, 2009, we had one major customer, CES, which accounted for approximately 57% of our consolidated annual revenue.
 
Competition
 
The oil and natural gas industry is highly competitive, and we compete with a substantial number of other companies that have greater resources than we do. Many of these companies explore for, produce and market oil and natural gas, carry on refining operations and market the resulting products on a worldwide basis. The primary areas in which we encounter substantial competition are in locating and acquiring desirable leasehold acreage for our drilling and development operations, locating and acquiring attractive producing oil and natural gas properties, and obtaining purchasers and transporters of the oil and natural gas we produce. There is also competition between producers of oil and natural gas and other industries producing alternative energy and fuel. Furthermore, competitive conditions may be substantially affected by various forms of energy legislation and/or regulation considered from time to time by the federal, state and local government.  It is not possible to predict the nature of any such legislation or regulation that may ultimately be adopted or its effects upon our future operations. Such legislation and regulations may, however, substantially increase the costs of exploring for, developing, producing or marketing natural gas and oil and may prevent or delay the commencement or continuation of a given operation. The effect of these risks cannot be accurately predicted.
 
Seasonal Nature of Business
 
Generally, but not always, the demand for natural gas decreases during the summer months and increases during the winter months.  Seasonal anomalies such as mild winters or abnormally hot summers sometimes lessen this fluctuation. In addition, certain natural gas users utilize natural gas storage facilities and purchase some of their anticipated winter requirements during the summer. This can also lessen seasonal demand fluctuations. Seasonal weather conditions and lease stipulations can limit our drilling and producing activities and other oil and natural gas operations in certain areas. These seasonal anomalies can increase competition for equipment, supplies and personnel during the spring and summer months, which could lead to shortages and increase costs or delay our operations.

 
Government Regulation
 
 The oil and gas industry is subject to extensive laws that are subject to change.  These laws have a significant impact on oil and gas exploration, production and marketing activities, and increase the cost of doing business, and consequently, affect profitability. Some of the legislation and regulation affecting the oil and gas industry carry significant penalties for failure to comply. While there can be no assurance that we will not incur fines or penalties, we believe we are currently in material compliance with the applicable federal, state and local laws.  Because enactment of new laws affecting the oil and gas business is common and because existing laws are often amended or reinterpreted, we are unable to predict the future cost or impact of complying with such laws.  We do not expect that any of these laws would affect us in a materially different manner than any other similarly sized oil and gas company operating in the United States.  The following are significant types of legislation affecting our business.
 
Exploration and Production Regulation
 
Oil and natural gas production is regulated under a wide range of federal, state and local statutes, rules, orders and regulations, including laws related to location of wells, drilling and casing of wells, well production limitations; spill prevention plans; surface use and restoration; platform, facility and equipment removal; the calculation and disbursement of royalties; the plugging and abandonment of wells; bonding; permits for drilling operations; and production, severance and ad valorem taxes. Oil and gas companies can encounter delays in drilling from the permitting process and requirements.  Our operations are subject to regulations governing operation restrictions and conservation matters, including provisions for the unitization or pooling of oil and natural gas properties, the establishment of maximum rates of production from oil and natural gas wells, and prevention of flaring or venting of natural gas. The conservation laws have the effect of limiting the amount of oil and gas we can produce from our wells and limit the number of wells or the locations at which we can drill.
 
Environmental Regulation
 
General.  Our operations are subject to extensive environmental, health and safety regulation by federal, state and local agencies.  These requirements govern the handling, generation, storage and management of hazardous substances, including how these substances are released or discharged into the air, water, surface and subsurface. These laws and regulations often require permits and approvals from various agencies before we can commence or modify our operations or facilities, and on occasion (especially on federally-managed land) require the preparation of an environmental impact assessment or study (which can result in the imposition of various conditions and mitigation measures) prior to or in connection with obtaining such permits.  In connection with releases of hydrocarbons or hazardous substances into the environment, we may be responsible for the costs of remediation even if we did not cause the release or were not otherwise at fault, under applicable laws.  These costs can be substantial and we evaluate them regularly as part of our environmental and asset retirement programs.  Failure to comply with applicable laws, permits or regulations can result in project or operational delays, civil or in some cases criminal fines and penalties and remedial obligations.

Sacramento and San Joaquin Rivers Delta.  In November 2009, the California State legislature enacted and the governor signed a package of four bills, as well as an $11.14 billion bond measure to be voted on by the California voters in the November 2010 election.  These bills promise to restore and maintain the delta resulting from the confluence of the Sacramento and San Joaquin rivers, while simultaneously sending needed water to the farmers in the western San Joaquin Valley and to urban and farming water users to the south.  The Company currently produces about one third of its natural gas in this delta. We are involved in monitoring and providing comments to the anticipated plans, rules and regulations to be proposed by the State committees responsible for implementing this legislation.  To the extent that the State elects to proceed with a peripheral canal, certain of the proposed options for the route of such a canal have the potential to impact some of our land and access rights in our Rio Vista Gas Field.  In addition, proposed habitat restoration goals under the regulatory programs may be significant, and may include reduced or discontinued maintenance of certain existing levees to allow marshlands to return to their natural state.  As a result, the implementation of this legislation and associated regulatory programs (and any potential peripheral canal) may increase significantly the Company’s costs to maintain certain levees, and may affect our operations in the Rio Vista Gas Field.

Climate Change.  Current and future regulatory initiatives directed at climate change may increase our operating costs and may, in the future, reduce the demand for some of our produced materials.   The United States Congress is currently considering legislation on climate change.  In June 2009, the U.S. House of Representatives passed a comprehensive clean energy and climate bill (H.R. 2454, also known as “Waxman-Markey”).  In the Senate, the Boxer-Kerry climate bill has been reported out of the Senate Environment and Public Works Committee.  These bills have a variety of provisions and differences, but in substance they both propose a “cap and trade” approach to greenhouse gas regulation.  Under such an approach, companies would be required to hold sufficient emission allowances to cover their greenhouse gas emissions.  Over time, the total number of allowances would be reduced or expire, thereby relying on market-based incentives to allocate investment in emission reductions across the economy.  As the number of available allowances declines, the cost would presumably increase.  In addition to the prospect of federal legislation, several states have adopted or are in the process of adopting greenhouse gas reporting or cap-and-trade programs.  Therefore, while the outcome of the federal and state legislative processes is currently uncertain, if such an approach were adopted (either by domestic legislation, international treaty obligation or domestic regulation), we would expect our operating costs to increase as we buy additional allowances or embark on emission reduction programs.

 
Even without further federal legislation, the United States Environmental Protection Agency (EPA) may act to regulate greenhouse gas emissions.  In April 2007, the United States Supreme Court concluded that greenhouse gas emissions from automobiles were “air pollutants” within the meaning of the applicable provisions of the federal Clean Air Act.  Relying in part on that precedent, in December 2009, the EPA released an Endangerment and Cause or Contribute Findings for Greenhouse Gases, which became effective in January 2010.  This regulatory finding sets the foundation for future EPA greenhouse gas regulation under the Clean Air Act.  The EPA also promulgated a new greenhouse gas reporting rule, which became effective in December 2009, and which requires facilities that emit more than 25,000 tons per year of carbon dioxide-equivalent emissions to prepare and file certain emission reports.  The portion of the rule pertaining to fugitive and vented methane emissions from the oil and gas sector has not yet been incorporated into the final rule and remains proposed.  If this portion of the proposed rule is ultimately promulgated, some of our facilities may be subject to the reporting requirements.  Finally, in September 2009, the EPA proposed a new regulation, subject to public comment and not yet effective, which would impose additional permitting requirements on certain stationary sources.  Depending on the final outcome of this rulemaking, some of our facilities may be subject to additional operating and other permit requirements. As a result of these regulatory initiatives, our operating costs may increase in compliance with these programs, although we are not situated differently in this respect from our competitors in the industry.

Hydraulic Fracturing.  Congress is also considering legislation that would repeal the current exemption in the Safe Drinking Water Act’s underground injection control program for hydraulic fracturing.  We and our competitors use hydraulic fracturing in our shale gas operations.  If this legislation is passed, it would impose additional requirements on our hydraulic fracturing operations, we would face additional requirements, including permitting requirements, financial assurances, public disclosure obligations, monitoring and reporting requirements.  Such a result could increase our operating costs.  The disclosure requirements also could increase the possibility of third-party or government legal challenges to hydraulic fracturing.  Even without such legislation, hydraulic fracturing has come under increased regulatory scrutiny in certain locations, such as New York, although our operations have not yet been affected.
 
Wyoming Air Permit.  On February 12, 2010, we received a Notice of Violation (“Notice”) from the Wyoming Department of Environmental Quality (“Wyoming DEQ”) regarding a multiple wellsite facility for wet gas/condensate production and six associated wells located in Sublette County, Wyoming (collectively, the “Wellsite”).  The Notice alleges that we did not obtain a construction permit prior to constructing the Wellsite, and that we operated the Wellsite in violation of applicable regulations by allegedly having failed to control air emissions from six associated wells. The Notice threatens referral of this matter to the Wyoming Attorney General for “appropriate penalties,” which could include civil penalties or injunctive relief.  We have responded to the Notice, are in the process of implementing corrective action and have agreed with the Wyoming DEQ to discuss possible settlement of this matter. If we do not reach a settlement, we will contest any associated litigation. No civil penalties have been imposed nor has the Wyoming DEQ yet requested a specific civil penalty amount, although the maximum daily penalty for such violations is $10,000 per violation per day.  Given the preliminary stage of this matter and the inherent uncertainty of enforcement actions of this nature, the Company is presently unable to predict the ultimate outcome of this enforcement action.
 
Insurance Matters
 
As is common in the oil and natural gas industry, we do not insure fully against all risks associated with our business either because such insurance is unavailable or because premium costs are considered prohibitive. A loss not fully covered by insurance could have a materially adverse effect on our financial position, results of operations or cash flows.  We maintain insurance at industry customary levels to limit our financial exposure in the event of a substantial environmental claim resulting from sudden, unanticipated and accidental discharges of certain prohibited substances into the environment.  Such insurance might not cover the complete amount of such a claim and would not cover fines or penalties for a violation of an environmental law.  In analyzing our operations and insurance needs, and in recognition that we have a large number of individual well locations with varied geographical distribution, we compared premium costs to the likelihood of material loss of production. Based on this analysis, we have elected, at this time, not to carry loss of production or business interruption insurance for our operations. We carry limited property insurance for loss or damage caused by earthquakes and our energy package insurance, including property insurance, is limited to $4 million in the aggregate for any single named windstorm with a $2.5 million retention.

Filings of Reserve Estimates with Other Agencies
 
We annually file estimates of our oil and gas reserves with the United States Department of Energy (“DOE”) for those properties which we operate.  During 2009, we filed estimates of our oil and gas reserves as of December 31, 2008 with the DOE, which differ by five percent or less from the reserve data presented in the Annual Report on Form 10-K for the year ended December 31, 2008.    For information concerning proved natural gas and crude oil reserves, refer to Item 8. Financial Statements and Supplementary Data, Supplemental Oil and Gas Disclosures.
 
Employees
 
As of February 22, 2010, we had 203 full time employees. We also contract for the services of consultants involved in land, regulatory, accounting, financial, legal and other disciplines, as needed.  As of February 22, 2010, we had contracted approximately 22 consultants.  None of our employees are represented by labor unions or covered by any collective bargaining agreement. We believe that our relations with our employees are satisfactory.
 
Available Information
 
Through our website, http://www.rosettaresources.com, you can access, free of charge, our filings with the SEC, including our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act, our proxy statements, our Code of Business Conduct and Ethics, Nominating and Corporate Governance Committee Charter, Audit Committee Charter, and Compensation Committee Charter.  You may also read and copy any materials that we file with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Room 1580, Washington, D.C. 20549.  You may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. In addition, the SEC maintains a website that contains reports, proxy and information statements and other information that is filed electronically with the SEC. The website can be accessed at http://www.sec.gov.

 
Item 1A. Risk Factors

Broad industry or economic factors may adversely affect the timing of and extent to which we can effectively implement our strategy shift to an onshore unconventional resource player.

Our strategy shift is an important element of positioning us for more predictable, sustainable future performance.  In conjunction with pursuing this shift, we recognize that several factors could impact our ability to execute the shift, including: (i) a sustained downturn of commodity prices, (ii) a lack of inventory potential within existing assets, (iii) an inability to attract and retain the personnel necessary to implement an unconventional resource business model, and (iv) a lack of access to credit.  We have processes in place to track and monitor these trends on an ongoing basis.  At this time, we believe the rationale and the goals for the strategy shift are intact; however, current market conditions could impact the pace of the planned shift.

Adverse capital and credit market conditions may significantly affect our ability to meet liquidity needs, access to capital and cost of capital.

While there are signs that the economy may be improving, the potential remains for further volatility and disruption in the capital and credit markets.  During 2009, the markets produced downward pressure on stock prices and credit capacity for certain issuers without regard to those issuers’ underlying financial strength.  If these levels of market disruption and volatility return, our business, financial condition and results of operations, as well as our ability to access capital, may all be negatively impacted.
 
The deterioration in the credit markets, combined with a decline in commodity prices, may impact our capital expenditure level and also our counterparty risk.

While we seek to fund our capital expenditures primarily from cash flows from operating activities, we have in the past also drawn on unused capacity under our existing revolving credit facility for capital expenditures.  While we have not received any indication from our lenders that our ability to draw on our existing revolving credit facility has been restricted, it is possible that our borrowing base, which is based on our oil and gas reserves and is subject to review and adjustment on a semi-annual basis, with the next review scheduled to begin on April 1, 2010, and other interim adjustments, may be reduced when it is reviewed.  In the event that our borrowing base is reduced, outstanding borrowings in excess of the revised base will be due immediately.  As we do not have a substantial amount of unpledged property, we may not have the financial resources to make the mandatory prepayments.  A reduction in our ability to borrow under our existing revolving credit facility, combined with a reduction in cash flow from operating activities resulting from a decline in commodity prices, may require us to reduce our capital expenditures further, which may in turn adversely affect our ability to carry out our business plan. Furthermore, if we lack the resources to dedicate sufficient capital expenditures to our existing oil and gas leases, we may be unable to produce adequate quantities of oil and gas to retain these leases and they may expire due to a lack of production.  The loss of leases could have a material adverse effect on our results of operations.

The impairment of financial institutions or counterparty credit default could adversely affect us.

We have exposure to different counterparties, and we have entered into transactions with counterparties in the financial services industry, including commercial banks, investment banks, insurance companies, other investment funds and other institutions.  These transactions expose us to credit risk in the event of default by our counterparties.  Further deterioration in the credit markets may impact the credit ratings of our current and potential counterparties and affect their ability to fulfill their existing obligations to us and their willingness to enter into future transactions with us.  We have exposure to these financial institutions in the form of oil and gas derivative contracts, which protect our cash flows when commodity prices decline.  During periods of low oil and gas prices, we may have significant exposure to our derivative counterparties and the value of our derivative positions may provide a significant amount of cash flow.  We also maintain insurance policies with insurance companies to protect us against certain risks inherent in our business.  In addition, if any lender under our credit facility is unable to fund its commitment, our liquidity will be reduced by an amount up to the aggregate amount of such lender’s commitment under our credit facility.  Currently, no single lender in our credit facility has commitments representing more than 13% of our total commitments.  However, if banks continue to consolidate, we may experience a more concentrated credit risk.
 
Oil and natural gas prices are volatile, and a decline in oil and natural gas prices would significantly affect our financial results and impede our growth.  Additionally, our results are subject to commodity price fluctuations related to seasonal and market conditions and reservoir and production risks.

Our revenue, profitability and cash flow depend substantially upon the prices and demand for oil and natural gas. The markets for these commodities are volatile, and even relatively modest drops in prices can significantly affect our financial results and impede our growth. Prices for oil and natural gas fluctuate widely in response to relatively minor changes in the supply and demand for oil and natural gas, market uncertainty and a variety of additional factors beyond our control, such as:

 
 
Domestic and foreign supply of oil and natural gas;
 
 
Price and quantity of foreign imports;
 
 
Actions of the Organization of Petroleum Exporting Countries and state-controlled oil companies relating to oil price and production controls;
 
 
Consumer demand;
 
 
Conservation of resources;
 
 
Regional price differentials and quality differentials of oil and natural gas;
 
 
Domestic and foreign governmental regulations, actions and taxes;
 
 
Political conditions in or affecting other oil producing and natural gas producing countries, including the current conflicts in the Middle East and conditions in South America and Russia;
 
 
Weather conditions and natural disasters;

 
Technological advances affecting oil and natural gas consumption;
 
 
Overall U.S. and global economic conditions;
 
 
Price and availability of alternative fuels;

 
Seasonal variations in oil and natural gas prices;
 
 
Variations in levels of production; and
 
 
The completion of exploration and production projects.
 
Further, oil and natural gas prices do not necessarily fluctuate in direct relationship to each other. Because the majority of our estimated proved reserves are natural gas reserves, our financial results are more sensitive to movements in natural gas prices. Lower oil and natural gas prices may not only decrease our revenues on a per unit basis but also may reduce the amount of oil and natural gas that we can produce economically. Thus, a continued weakness in commodity prices may result in our having to make substantial downward adjustments to our estimated proved reserves and could have a material adverse effect on our financial position, results of operations and cash flows.
 
Development and exploration drilling activities do not ensure reserve replacement and thus our ability to produce revenue.
 
Development and exploration drilling and strategic acquisitions are the main methods of replacing reserves. However, development and exploration drilling operations may not result in any increases in reserves for various reasons. Development and exploration drilling operations may be curtailed, delayed or cancelled as a result of:
 
 
Lack of acceptable prospective acreage;
 
 
Inadequate capital resources;
 
 
Weather conditions and natural disasters;
 
 
Title problems;
 
 
Compliance with governmental regulations;
 
 
Mechanical difficulties; and
 
 
Unavailability or high cost of equipment, drilling rigs, supplies or services.

Our future oil and natural gas production depends on our success in finding or acquiring additional reserves. If we fail to replace reserves through drilling or acquisitions, our level of production and cash flows will be affected adversely. In general, production from oil and natural gas properties declines as reserves are depleted, with the rate of decline depending on reservoir characteristics. Our total proved reserves decline as reserves are produced. Our ability to make the necessary capital investment to maintain or expand our asset base of oil and natural gas reserves would be impaired to the extent cash flow from operations is reduced and external sources of capital become limited or unavailable. We may not be successful in exploring for, developing or acquiring additional reserves.

 
We sell a significant amount of our production to one customer.

We have a natural gas purchase and sale contract with CES, which runs through December 2019. Under this contract, we are obligated to sell all of our existing and future production from our California leases in production as of May 1, 2005 at market prices. For the month of December 2009, this dedicated California production comprised approximately 33% of our overall production based on an equivalent unit basis. Additionally, under separate monthly spot agreements, we may sell some of our natural gas production to Calpine, which could increase our credit exposure to Calpine. Under the terms of our contract with CES and spot agreements with CES, all natural gas volumes that are contractually sold to CES are collateralized by CES making margin payments one business day in arrears to our collateral account equal to the previous day’s natural gas sales. In the event of a default by CES, we could be exposed to the loss of up to four days of natural gas sales revenue under these contracts, which at prices and volumes in effect as of December 31, 2009 would be approximately $1.0 million. 
 
We will require additional capital to fund our future activities. If we fail to obtain additional capital, we may not be able to implement fully our business plan, which could lead to a decline in reserves.
 
Future projects and acquisitions will depend on our ability to obtain financing beyond our cash flow from operations. We may finance our business plan and operations primarily with internally generated cash flow, bank borrowings and sales of common stock.  In the future, we will require substantial capital to fund our business plan and operations. Sufficient capital may not be available on acceptable terms or at all. If we cannot obtain additional capital resources, we may curtail our drilling, development and other activities or be forced to sell some of our assets on unfavorable terms.
 
The terms of our credit facilities contain a number of covenants.  If we are unable to comply with these covenants, our lenders could accelerate the repayment of our indebtedness.
 
The terms of our credit facilities subject us to a number of covenants that impose restrictions on us, including our ability to incur indebtedness and liens, make loans and investments, make capital expenditures, sell assets, engage in mergers, consolidations and acquisitions, enter into transactions with affiliates, enter into sale and leaseback transactions and pay dividends on our common stock. We are also required by the terms of our credit facilities to comply with financial covenant ratios.  A more detailed description of our credit facilities is included in Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations  - Liquidity and Capital Resources” and the footnotes to the Consolidated Financial Statements.
 
A breach of any of the covenants imposed on us by the terms of our indebtedness, including the financial covenants under our credit facilities, could result in a default under such indebtedness. In the event of a default, the lenders for our revolving credit facility could terminate their commitments to us, and they and the lenders of our second lien term loan could accelerate the repayment of all of our indebtedness. In such case, we may not have sufficient funds to pay the total amount of accelerated obligations, and our lenders under the credit facilities could proceed against the collateral securing the facilities, which is substantially all of our assets. Any acceleration in the repayment of our indebtedness or related foreclosure could adversely affect our business.
 
Properties we acquire may not produce as expected, and we may be unable to determine reserve potential, identify liabilities associated with the properties or obtain protection from sellers against such liabilities.
 
We continually review opportunities to acquire producing properties, undeveloped acreage and drilling prospects; however, such reviews are not capable of identifying all potential conditions. Generally, it is not feasible to review in depth every individual property involved in each acquisition. Ordinarily, we will focus our review efforts on higher value properties or properties with known adverse conditions and will sample the remainder.
 
However, even a detailed review of records and properties may not necessarily reveal existing or potential problems or permit a buyer to become sufficiently familiar with the properties to assess fully their condition, any deficiencies, and development potential. Inspections may not always be performed on every well, and environmental problems, such as ground water contamination are not necessarily observable even when an inspection is undertaken.

We believe we have good and defensible title to all our properties, including those held by production. As is customary in the industry, before we drill our exploration and development wells, we secure external legal opinions on our legal title for the properties involved.  We also may perform curative work with respect to significant defects to title. We are typically responsible for curing any title defects at our expense. This curative work may include the acquisition of additional property rights in order to perfect our ownership for development and production of the mineral estate. We also may be required to respond to claims regarding possible threats to our title to our properties, including clouds on our title, concerning which, if we are unsuccessful could result in the worst case, to the loss of our title.  In those situations, we are subject to increased costs in defending our title against possible claims and if we are unsuccessful in this regard, possible damages, including amounts of revenues from prior production during those time periods for which a claim for revenue may be brought.

 
Our exploration and development activities may not be commercially successful.
 
Exploration activities involve numerous risks, including the risk that no commercially productive oil or natural gas reservoirs will be discovered. In addition, the future cost and timing of drilling, completing and producing wells is often uncertain. Furthermore, drilling operations may be curtailed, delayed or cancelled as a result of a variety of factors, including:
 
 
Unexpected drilling conditions; pressure or irregularities in formations; equipment failures or accidents;
 
 
Adverse weather conditions, including hurricanes, which are common in the Gulf of Mexico during certain times of the year; compliance with governmental regulations; unavailability or high cost of drilling rigs, equipment or labor;

 
Possible federal, state, regional and municipal regulatory moratoriums on new permits, delays in securing new permits, changes to existing permitting requirements without “grandfathering” of existing permits and possible prohibition and limitations with regard to certain completion activities;
 
 
Reductions in oil and natural gas prices; and
 
 
Limitations in the market for oil and natural gas.
 
Our decisions to purchase, explore, develop and exploit prospects or properties depend in part on data obtained through geophysical and geological analyses, production data and engineering studies, the results of which are often uncertain. Even when used and properly interpreted, 3-D seismic data and visualization techniques only assist geoscientists in identifying subsurface structures and hydrocarbon indicators. They do not allow the interpreter to know conclusively if hydrocarbons are present or producible economically. In addition, the use of 3-D seismic and other advanced technologies requires greater pre-drilling expenditures than traditional drilling strategies. Because of these factors, we could incur losses as a result of exploratory drilling expenditures. Poor results from exploration activities could have a material adverse effect on our future financial position, results of operations and cash flows.
 
Numerous uncertainties are inherent in our estimates of oil and natural gas reserves and our estimated reserve quantities and present value calculations may not be accurate. Any material inaccuracies in these reserve estimates or underlying assumptions will affect materially the estimated quantities and present value of our reserves.
 
Estimates of proved oil and natural gas reserves and the future net cash flows attributable to those reserves are prepared by our engineers and audited by independent petroleum engineers and geologists.  There are numerous uncertainties inherent in estimating quantities of proved oil and natural gas reserves and cash flows attributable to such reserves, including factors beyond our engineers' control. Reserve engineering is a subjective process of estimating underground accumulations of oil and natural gas that cannot be measured in an exact manner. The accuracy of an estimate of quantities of reserves, or of cash flows attributable to such reserves, is a function of the available data, assumptions regarding future oil and natural gas prices, expenditures for future development and exploration activities, engineering and geological interpretation and judgment. Additionally, reserves and future cash flows may be subject to material downward or upward revisions, based upon production history, development and exploration activities and prices of oil and natural gas. As an example, our internally generated reserve report for year end 2009 includes the downward revision of 60.5 Bcfe of proved reserves due to the use of the twelve-month first day of the month historical average price compared to year-end commodity prices, or approximately 15% of previously estimated reserves.  Actual future production, revenue, taxes, development expenditures, operating expenses, underlying information, quantities of recoverable reserves and the value of cash flows from such reserves may vary significantly from the assumptions and underlying information set forth herein. In addition, different reserve engineers may make different estimates of reserves and cash flows based on the same available data. The present value of future net revenues from our proved reserves referred to in this report is not necessarily the actual current market value of our estimated oil and natural gas reserves. In accordance with SEC requirements, we base the estimated discounted future net cash flows from our proved reserves on fixed prices and costs as of the date of the estimate.  Our reserves as of December 31, 2009 were based on the twelve-month first day of the month historical average West Texas Intermediate oil prices adjusted for basis and quality differentials of $57.65 per Bbl and the twelve-month first day of the month historical average Henry Hub gas prices adjusted for basis and quality differentials of $3.87 per MMbtu compared to the year-end prices adjusted for basis and quality differentials of $41.00 per Bbl and $5.71 per MMBtu, respectively, at December 31, 2008.  Actual future prices and costs fluctuate over time and may differ materially from those used in the present value estimate. In addition, discounted future net cash flows are estimated assuming royalties to the Minerals Management Service, royalty owners and other state and federal regulatory agencies with respect to our affected properties, and will be paid or suspended during the life of the properties based upon oil and natural gas prices as of the date of the estimate. Since actual future prices fluctuate over time, royalties may be required to be paid for various portions of the life of the properties and suspended for other portions of the life of the properties.
 
The timing of both the production and expenses from the development and production of oil and natural gas properties will affect both the timing of actual future net cash flows from our proved reserves and their present value. In addition, the 10% discount factor that we use to calculate the net present value of future net cash flows for reporting purposes in accordance with the SEC’s rules may not necessarily be the most appropriate discount factor. The effective interest rate at various times and the risks associated with our business or the oil and natural gas industry, in general, will affect the appropriateness of the 10% discount factor in arriving at an accurate net present value of future net cash flows.

 
We are subject to the full cost ceiling limitation which has resulted in a write-down of our estimated net reserves and may result in a write-down in the future if commodity prices continue to decline.
 
Under the full cost method, we are subject to quarterly calculations of a “ceiling” or limitation on the amount of our oil and gas properties that can be capitalized on our balance sheet. If the net capitalized costs of our oil and gas properties exceed the cost ceiling, we are subject to a ceiling test write-down of our estimated net reserves to the extent of such excess. If required, it would reduce earnings and impact stockholders’ equity in the period of occurrence and result in lower amortization expense in future periods. The discounted present value of our proved reserves is a major component of the ceiling calculation and represents the component that requires the most subjective judgments.  The current ceiling calculation utilizes a twelve-month first day of the month historical average price and does not allow for us to re-evaluate the calculation subsequent to the end of the period if prices increase.  It also dictates that costs in effect as of the last day of the quarter are held constant.  Prior to December 31, 2009, ceiling calculation guidance dictated that prices in effect as of the last day of the quarter or annual period be used and allowed a write-down to be reduced or avoided if prices increased subsequent to the end of a quarter or annual period but prior to the issuance of our financial statements in which a write-down might otherwise be required.  As of December 31, 2009, the use of the recovery of prices after the end of the period is no longer permitted.  The risk that we will be required to write down the carrying value of oil and natural gas properties increases when natural gas and crude oil prices are depressed or volatile.  In addition, a write-down of proved oil and natural gas properties may occur if we experience substantial downward adjustments to our estimated proved reserves.  Expense recorded in one period may not be reversed in a subsequent period even though higher natural gas and crude oil prices may have increased the ceiling applicable in the subsequent period.
 
For the year ended December 31, 2009, we recognized a non-cash, pre-tax ceiling test impairment of $379.5 million in the first quarter.  For the year ended December 31, 2008, we recognized a non-cash, pre-tax ceiling test impairment of $205.7 million and $238.7 million in the third and fourth quarters, respectively.  Due to the volatility of commodity prices, should natural gas prices continue to decline in the future, it is possible that additional write-downs could occur.  

In addition, write-downs of proved oil and natural gas properties may occur if we experience substantial downward adjustments to our estimated proved reserves.  For example, we recognized a downward revision to our proved reserves in the third and fourth quarters of 2008.   As we are continuing to evaluate and test our asset base, it is possible that we may recognize additional revisions to our proved reserves in the future.

See Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Policies and Estimates” for further information.
 
Government laws and regulations can change.
 
Our activities are subject to federal, state, regional and local laws and regulations. Extensive laws, regulations and rules relate to activities and operations in the oil and gas industry.   Some of the laws, regulations and rules contain provisions for significant fines and penalties for non-compliance.  Changes in laws and regulations could affect our costs of operations and our profitability.  Changes in laws and regulations could also affect production levels, royalty obligations, price levels, environmental requirements, and other matters affecting our business.  We are unable to predict changes to existing laws and regulations or additions to laws and regulations.  Such changes could significantly impact our business, results of operations, cash flows, financial position and future growth.
 
Our business requires a sufficient level of staff with technical expertise, specialized knowledge and training and a high degree of management experience.
 
Our success is largely dependent upon our ability to attract and retain personnel with the skills and experience required for our business. An inability to sufficiently staff our operations or the loss of the services of one or more members of our senior management or of numerous employees with technical skills could have a negative effect on our business, financial position, results of operations, cash flows and future growth.

Market conditions or transportation impediments may hinder our access to oil and natural gas markets or delay our production.
 
Market conditions, the unavailability of satisfactory oil and natural gas processing and transportation or the remote location of certain of our drilling operations may hinder our access to oil and natural gas markets or delay our production. The availability of a ready market for our oil and natural gas production depends on a number of factors, including the demand for and supply of oil and natural gas and the proximity of reserves to pipelines or trucking and terminal facilities. In the Gulf of Mexico operations, the availability of a ready market depends on the proximity of and our ability to tie into existing production platforms owned or operated by others and the ability to negotiate commercially satisfactory arrangements with the owners or operators.  Under interruptible or short term transportation agreements, the transportation of our gas may be interrupted due to capacity constraints on the applicable system, for maintenance or repair of the system or for other reasons specified by the particular agreements.  We may be required to shut in natural gas wells or delay initial production for lack of a market or because of inadequacy or unavailability of natural gas pipelines or gathering system capacity. When that occurs, we are unable to realize revenue from those wells until the production can be tied to a gathering system. This can result in considerable delays from the initial discovery of a reservoir to the actual production of the oil and natural gas and realization of revenues.

 
Competition in the oil and natural gas industry is intense, and many of our competitors have resources that are greater than ours.

We operate in a highly competitive environment for acquiring prospects and productive properties, marketing oil and natural gas and securing equipment and trained personnel. Many of our competitors, major and large independent oil and natural gas companies, possess and employ financial, technical and personnel resources substantially greater than our resources. Those companies may be able to develop and acquire more prospects and productive properties than our financial or personnel resources permit. Our ability to acquire additional prospects and discover reserves in the future will depend on our ability to evaluate and select suitable properties and consummate transactions in a highly competitive environment. Also, there is substantial competition for capital available for investment in the oil and natural gas industry. Larger competitors may be better able to withstand sustained periods of unsuccessful drilling and absorb the burden of changes in laws and regulations more easily than we can, which would adversely affect our competitive position. We may not be able to compete successfully in the future in acquiring prospective reserves, developing reserves, marketing hydrocarbons, attracting and retaining quality personnel and raising additional capital.
 
The unavailability or high cost of drilling rigs, equipment, supplies, personnel and oil field services could adversely affect our ability to execute our exploration and development plans on a timely basis and within our budget.
 
Our industry is cyclical and, from time to time, there is a shortage of drilling rigs, equipment, supplies or qualified personnel. During these periods, the costs and delivery times of rigs, equipment and supplies are substantially greater. In addition, the demand for, and wage rates of, qualified drilling rig crews rise as the number of active rigs in service increases. If oil and gas prices increase in the future, increasing levels of exploration and production could result in response to these stronger prices, and as a result, the demand for oilfield services could rise, and the costs of these services could increase, while the quality of these services may suffer. If the unavailability or high cost of drilling rigs, equipment, supplies or qualified personnel were particularly severe in Texas, California and the Rockies, we could be materially and adversely affected because our operations and properties are concentrated in those areas.
 
Operating hazards, natural disasters or other interruptions of our operations could result in potential liabilities, which may not be fully covered by our insurance.
 
The oil and natural gas business involves certain operating hazards such as:
 
 
Well blowouts;
 
 
Cratering;
 
 
Explosions;
 
 
Uncontrollable flows of oil, natural gas, or well fluids;
 
 
Fires;

 
Hurricanes, tropical storms, earthquakes, mud slides, and flooding;

 
Pollution; and

 
Releases of toxic gas.

The occurrence of one of the above may result in injury, loss of life, property damage, suspension of operations, environmental damage and remediation and/or governmental investigations and penalties.

In addition, our operations in California are especially susceptible to damage from natural disasters such as earthquakes and fires and involve increased risks of personal injury, property damage and marketing interruptions. Any of these operating hazards could cause serious injuries, fatalities or property damage, which could expose us to liabilities. The payment of any of these liabilities could reduce, or even eliminate, the funds available for exploration, development, and acquisition, or could result in a loss of our properties. Our insurance policies provide limited coverage for losses or liabilities relating to pollution, with broader coverage for sudden and accidental occurrences. Our insurance might be inadequate to cover our liabilities. For example, we are not fully insured against earthquake risk in California because of high premium costs. Insurance covering earthquakes or other risks may not be available at premium levels that justify its purchase in the future, if at all. In addition, we are subject to energy package insurance coverage limitations related to any single named windstorm. The insurance market in general and the energy insurance market in particular have been difficult markets over the past several years. Insurance costs could increase over the next few years and we may decrease coverage and retain more risk to mitigate future cost increases. If we incur substantial liability and the damages are not covered by insurance or are in excess of policy limits, or if we incur a liability at a time when we are not able to obtain liability insurance, then our business, financial position, results of operations and cash flows could be materially adversely affected.  Because of the expense of the associated premiums and the diversification of risk, we do not have any insurance coverage for any loss of production as may be associated with these operating hazards.

 
Environmental matters and costs can be significant.

The oil and natural gas business is subject to various federal, state, and local laws and regulations relating to discharge of materials into, and protection of, the environment.  Such laws and regulations may impose liability on us for pollution clean-up, remediation, restoration and other liabilities arising from or related to our operations. Any noncompliance with these laws and regulations could subject us to material administrative, civil or criminal penalties or other liabilities. Additionally, our compliance with these laws may, from time to time, result in increased costs to our operations or decreased production.  We also may be liable for environmental damages caused by the previous owners or operators of properties we have purchased or are currently operating. The cost of future compliance is uncertain and is subject to various factors, including future changes to laws and regulations.  We have no assurance that future changes in or additions to the environmental laws and regulations will not have a significant impact on our business, results of operations, cash flows, financial condition and future growth.

Possible regulations related to global warming and climate change could have an adverse effect on our operations and the demand for oil and natural gas.

Recent scientific studies have suggested that emissions of certain gases, commonly referred to as "greenhouse gases," may be contributing to the warming of the Earth's atmosphere.  Methane, a primary component of natural gas, and carbon dioxide, a byproduct of the burning of refined oil products and natural gas, are examples of greenhouse gases.  The U.S. Congress is considering climate-related legislation to reduce emissions of greenhouse gases.  In addition, at least 20 states have developed measures to regulate emissions of greenhouse gases, primarily through the planned development of greenhouse gas emissions inventories and/or regional greenhouse gas cap and trade programs.  The U.S. Environmental Protection Agency has adopted regulations requiring reporting of greenhouse gas emissions from certain facilities and is considering additional regulation of greenhouse gases as "air pollutants" under the existing federal Clean Air Act.  Passage of climate change legislation or other regulatory initiatives by Congress or various states, or the adoption of regulations by the EPA or analogous state agencies, that regulate or restrict emissions of greenhouse gases (including methane or carbon dioxide) in areas in which we conduct business could have an adverse effect on our operations and the demand for oil and natural gas.

Our acquisition strategy could fail or present unanticipated problems for our business in the future, which could adversely affect our ability to make acquisitions or realize anticipated benefits of those acquisitions.

Our growth strategy includes acquiring oil and natural gas businesses and properties if favorable economics and strategic objectives can be served. We may not be able to identify suitable acquisition opportunities or finance and complete any particular acquisition successfully.
 
Furthermore, acquisitions involve a number of risks and challenges, including:
 
 
Diversion of management’s attention;

 
Ability or impediments to conducting thorough due diligence activities;
 
 
The need to integrate acquired operations;
 
 
Potential loss of key employees of the acquired companies;
 
 
Potential lack of operating experience in a geographic market of the acquired business; and
 
 
An increase in our expenses and working capital requirements.
 
Any of these factors could adversely affect our ability to achieve anticipated levels of cash flows from the acquired businesses and properties or realize other anticipated benefits of those acquisitions.

We are vulnerable to risks associated with operating in the Gulf of Mexico and inland waters region.

Our operations and financial results could be significantly impacted by unique conditions in the Gulf of Mexico and inland waters region because we explore and produce in that area. As a result of this activity, we are vulnerable to the risks associated with operating in the Gulf of Mexico and inland waters region, including those relating to:

 
 
Adverse weather conditions and natural disasters;

 
Availability of required performance bonds and insurance;

 
Oil field service costs and availability;

 
Compliance with environmental and other laws and regulations;

 
Remediation and other costs resulting from oil spills or releases of hazardous materials; and

 
Failure of equipment or facilities.

Further, production of reserves from reservoirs in the Gulf of Mexico and inland waters region generally decline more rapidly than from fields in many other producing regions of the world. This results in recovery of a relatively higher percentage of reserves from properties during the initial years of production, and as a result, our reserve replacement needs from new prospects may be greater there than for our operations elsewhere. Also, our revenues and return on capital will depend significantly on prices prevailing during these relatively short production periods.
 
Hedging transactions may limit our potential revenue, result in financial losses or reduce our income.
 
We have entered into natural gas price hedging arrangements with respect to a portion of our expected production through 2011. As of December 31, 2009, 13% and 13% of our expected natural gas production was hedged using swaps and costless collars, respectively, with settlement in 2010, and 5% and 23% of our expected natural gas production was hedged using swaps and costless collars, respectively, with settlement in 2011, based on anticipated future gas production.  The swaps to settle in 2010 have an average price of $7.46 per MMBtu and the collars have floor and ceiling prices of $5.75 per MMBtu and $7.40 per MMBtu, respectively.  The swaps to settle in 2011 have an average price of $5.72 per MMBtu and the collars have floor and ceiling prices of $5.80 per MMBtu and $7.58 per MMBtu, respectively.  In January 2010, we entered into additional costless collar transactions to hedge 10,000 MMBtu/d of our expected production for July 2010 through December 2012.  The costless collars have a floor price of $5.75 per MMBtu and a ceiling price of $6.50 per MMBtu through 2011 and $7.15 per MMBtu in 2012.  In February 2010, we entered into natural gas fixed-price swaps to hedge 10,000 MMBtu/d of our expected production for July 2010 through December 2011 at an average price of $5.91 per MMBtu.  Such transactions may limit our potential revenue if oil and natural gas prices were to rise substantially over the price established by the hedge. In addition, such transactions may expose us to the risk of 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, or the counterparties to our hedging agreements fail to perform under the contracts.  Our current hedge positions are with counterparties that are lenders in our credit facilities. Our lenders are comprised of banks and financial institutions that could default or fail to perform under our contractual agreements. A default under any of these agreements could negatively impact our financial performance.
 
We have also entered into a series of interest rate swap agreements to hedge the change in the variable interest rates associated with our debt under our credit facility.  If interest rates should fall below the rate established in the hedge, we will not receive the benefit of the lower interest rates.
 
Certain federal income tax deductions currently available with respect to oil and gas exploration and development may be eliminated as a result of future legislation.

Among the changes contained in the President’s Fiscal Year 2011 budget proposal, released by the White House on February 1, 2010, is the elimination or deferral of certain key U.S. federal income tax deductions currently available to oil and gas exploration and production companies. Such changes include, but are not limited to, (i) the repeal of the percentage depletion allowance for oil and gas properties; (ii) the elimination of current deductions for intangible drilling and development costs; (iii) the elimination of the deduction for certain U.S. production activities; and (iv) an extension of the amortization period for certain geological and geophysical expenditures. Additionally, the Senate version of the Oil Industry Tax Break Repeal Act of 2009, introduced on April 23, 2009, the Senate version of the Energy Fairness for America Act, introduced on May 20, 2009 and the President’s Fiscal Year 2010 budget proposal, released on February 26, 2009, include many of the proposals outlined in the President’s Fiscal Year 2011 budget proposal. It is unclear, however, whether any such changes will be enacted or how soon such changes could be effective.  The passage of any legislation as a result of the budget proposal, either Senate bill or any other similar change in U.S. federal income tax law could eliminate or defer certain tax deductions within the industry that are currently available with respect to oil and gas exploration and development, and any such change could negatively affect our financial condition and results of operations.

Item 1B. Unresolved Staff Comments
 
None

 
Item 3. Legal Proceedings

Wyoming Air Permit.  On February 12, 2010, we received a Notice of Violation (“Notice”) from the Wyoming Department of Environmental Quality (“Wyoming DEQ”) regarding a multiple wellsite facility for wet gas/condensate production and six associated wells located in Sublette County, Wyoming (collectively, the “Wellsite”).  The Notice alleges that we did not obtain a construction permit prior to constructing the Wellsite, and that we operated the Wellsite in violation of applicable regulations by allegedly having failed to control air emissions from six associated wells. The Notice threatens referral of this matter to the Wyoming Attorney General for “appropriate penalties,” which could include civil penalties or injunctive relief.  We have responded to the Notice, are in the process of implementing corrective action and have agreed with the Wyoming DEQ to discuss possible settlement of this matter. If we do not reach a settlement, we will contest any associated litigation. No civil penalties have been imposed nor has the Wyoming DEQ yet requested a specific civil penalty amount, although the maximum daily penalty for such violations is $10,000 per violation per day.  Given the preliminary stage of this matter and the inherent uncertainty of enforcement actions of this nature, the Company is presently unable to predict the ultimate outcome of this enforcement action.

We are party to various other oil and natural gas litigation matters arising out of the ordinary course of business.  While the outcome of these proceedings cannot be predicted with certainty, we do not expect these other matters to have a material adverse effect on the consolidated financial statements.
 
Item 4. Submission of Matters to a Vote of Security Holders
 
No matters were submitted to a vote of our security holders during the fourth quarter of 2009.

 
Part II

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

Trading Market

Our common stock is listed on The NASDAQ Global Select Market® under the symbol “ROSE”.  The following table sets forth for the 2009 and 2008 periods indicated the high and low sale prices of our common stock:

2009
 
2008
 
   
High
   
Low
     
High
   
Low
 
January 1 - March 31
  $ 8.37     $ 3.52  
January 1 - March 31
  $ 21.42     $ 16.20  
April 1 - June 30
    10.17       4.81  
April 1 - June 30
    29.65       19.15  
July 1 - September 30
    15.60       7.08  
July 1 - September 30
    29.20       16.67  
October 1 - December 31
    20.62       12.35  
October 1 - December 31
    18.23       5.97  

The number of shareholders of record on February 24, 2010 was approximately 10,500. However, we estimate that we have a significantly greater number of beneficial shareholders because a substantial number of our common shares are held of record by brokers or dealers for the benefit of their customers.
 
We have not paid a cash dividend on our common stock and currently intend to retain earnings to fund the growth and development of our business. Any future change in our policy will be made at the discretion of our board of directors in light of our financial condition, capital requirements, earnings prospects and any limitations imposed by our lenders or investors, as well as other factors the Board of Directors may deem relevant.  Our Senior Secured Revolving Line of Credit agreement restricts our ability to pay cash dividends on our common stock.  See Item 8. “Financial Statements and Supplementary Data Note 10 – Long-Term Debt.”
 
The following table sets forth certain information with respect to repurchases of our common stock during the three months ended December 31, 2009:
 
Period
 
Total Number of Shares Purchased (1)
   
Average Price Paid per Share
   
Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs
   
Maximum Number (or Approximate Dollar Value) of Shares that May yet Be Purchased Under the Plans or Programs
 
October 1 - October 31
    2,700     $ 14.46       -       -  
November 1 - November 30
    10,043       13.77       -       -  
December 1 - December 31
    351       16.47       -       -  
___________________________________

 
(1)
All of the shares were surrendered by our employees to pay tax withholding upon the vesting of restricted stock awards.  These repurchases were not part of a publicly announced program to repurchase shares of our common stock, nor do we have a publicly announced program to repurchase shares of common stock.
 
Stock Performance Graph
 
The following performance graph and related information shall not be deemed “soliciting material” or to be “filed” with the Securities and Exchange Commission, nor shall such information be incorporated by reference into any future filing under the Securities Act of 1933 or Securities Exchange Act of 1934, each as amended, except to the extent that the Company specifically incorporates it by reference into such filing.

The following common stock performance graph shows the performance of Rosetta Resources Inc. common stock up to December 31, 2009.  As required by applicable rules of the SEC, the performance graph shown below was prepared based on the following assumptions:

 
·
A $100 investment was made in Rosetta Resources Inc. common stock at the opening trade price of $19.00 per share on February 13, 2006 (the first full trading day following the Company’s initial public offering of its common stock), and $100 was invested in each of the Standard & Poor’s 500 Index (S&P 500) and the Standard & Poor’s MidCap 400 Oil & Gas Exploration & Production Index (S&P 400 E&P) at the opening price on February 13, 2006.
 
·
All dividends are reinvested for each measurement period.

 
The S&P 400 E&P Index is widely recognized in our industry and includes a representative group of independent peer companies (weighted by market capital) that are engaged in comparable exploration, development and production operations.
 
Total Return Among Rosetta Resources Inc., the S&P 500 Index and the S&P 400 O&G E&P Index


   
2/13/2006 (1)
   
12/31/2006
   
12/31/2007
   
12/31/2008
   
12/31/2009
 
ROSE
  $ 100.00     $ 98.26     $ 104.37     $ 37.26     $ 104.84  
S&P 500
    100.00       113.86       120.12       75.67       95.70  
S&P 400 E&P
    100.00       103.24       149.13       67.84       120.86  
___________________________________
(1) February 13, 2006 was the first full trading day following the effective date of our registration statement filed in connection with our initial public offering.
 
Item 6. Selected Financial Data
 
The following table sets forth our selected financial data.  For the years ended December 31, 2009, 2008, 2007 and 2006 and the six months ended December 31, 2005 (Successor), the financial data has been derived from the consolidated financial statements of Rosetta Resources Inc.  For the six months ended June 30, 2005 (Predecessor), the financial data was derived from the combined financial statements of the domestic oil and natural gas properties of Calpine and are presented on a carve-out basis to include the historical operations of the domestic oil and natural gas business.  You should read the following selected historical consolidated/combined financial data in connection with Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the audited Consolidated Financial Statements and related notes included elsewhere in this Form 10-K.
 
Additionally, the historical financial data reflects successful efforts accounting for oil and natural gas properties for the Predecessor periods described above and the full cost method of accounting for oil and natural gas properties effective July 1, 2005 for the Successor periods.  In addition, on January 1, 2003, Calpine adopted authoritative guidance regarding the accounting for stock-based compensation to measure the cost of employee services received in exchange for an award of equity instruments, whereas we adopted the intrinsic value method of accounting for stock options and stock awards pursuant to authoritative guidance regarding stock issued to employees effective July 2005, and as required, have subsequently adopted the guidance for stock-based compensation under the most recent authoritative guidance for share-based payments effective January 1, 2006.

 
   
Successor-Consolidated
   
Predecessor - Combined
 
   
Year Ended
December 31,
   
Six Months Ended
December 31,
   
Six Months Ended
June 30,
 
   
2009 (1)
   
2008 (1)
   
2007
   
2006
   
2005
   
2005
 
                                     
Operating Data:
                                   
Total revenue
  $ 293,951     $ 499,347     $ 363,489     $ 271,763     $ 113,104     $ 103,831  
Net income (loss)
    (219,176 )     (188,110 )     57,205       44,608       17,535       18,681  
Income (loss) per share:
                                               
Net income (loss)
                                               
Basic
    (4.30 )     (3.71 )     1.14       0.89       0.35       0.37  
Diluted
    (4.30 )     (3.71 )     1.13       0.88       0.35       0.37  
Cash dividends declared per common share
    -       -       -       -       -       -  
Balance Sheet Data (At the end of the Period)
                                               
Total assets
    879,584       1,154,378       1,357,214       1,219,405       1,119,269       -  
Long-term debt
    288,742       300,000       245,000       240,000       240,000       -  
Stockholders' equity
    493,095       726,372       872,955       822,289       715,423       -  
____________________________________

 
(1)
Includes a $379.5 million and a $444.4 million non-cash, pre-tax impairment charge for the years ended December 31, 2009 and 2008, respectively.
 
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
Overview
 
During the past two years, Rosetta significantly transformed itself as a company. The actions taken to affect this business shift were underpinned by a relatively straightforward goal: to position the Company for visible and sustainable future growth. We believe that achieving this goal is essential in order for Rosetta to create long-term shareholder value. As part of our transformation, we took many steps to improve the underlying fundamentals of virtually every aspect of our business. Most notably, we committed to building a portfolio of high quality unconventional assets with significant project inventory potential. In addition, we sought to establish the technical and organizational competencies required for executing a resource-driven business model. These asset and competency efforts were matched with a fiscal approach that maintained relative conservatism and a focus on cost control and efficiency. While we will continue to evolve and optimize each of these areas over time, we believe we made significant progress in transforming Rosetta into a “resource-player” since the effort began in early 2008.

We believe that our 2009 performance offers tangible evidence that our strategy shift is yielding success. Against one of the most challenging business climates in years, we lived within our means while delivering results from our activities in new and legacy asset programs.  Of significance, we note the following highlights with respect to our performance in 2009:

 
·
We tested two new shale plays, namely the Eagle Ford Shale in South Texas and the Alberta Basin Bakken Shale in Montana. In the Eagle Ford, we grew our acreage position and drilled four wells in the play. We completed two wells, both of which were discoveries. The discoveries set up the potential for a significant future development effort that will start in 2010.
 
·
In the Alberta Basin Bakken Shale, we drilled two wells on our large exploratory acreage position. We drilled and completed one horizontal well and drilled one additional vertical well. We acquired core samples and ran extensive log suites in both wells to obtain important geologic and reservoir data about the play. Since we consider this early stage exploration, we intend to fully analyze and evaluate our drilling, completion and logging results in order to optimize our 2010 program activity.
 
·
In addition to testing our new shale plays, we advanced the studies of our legacy assets using an “unconventional lens” approach.  Under this approach, our assets are thoroughly analyzed and re-engineered to identify remaining resource potential.  We believe our legacy onshore assets, especially the DJ Basin and the Sacramento Basin, contain significant remaining resource potential that was overlooked under a historical exploitation approach that utilized conventional techniques. We believe the project inventory potential of our legacy assets is a competitive advantage for Rosetta.
 
·
We identified assets for possible sale and established an ongoing process to divest of non-core assets. During 2009, we designated our Gulf of Mexico, Texas State Waters and several small assets as “non-core” given that they do not have the unconventional resource characteristics we seek. We generated approximately $20 million of proceeds from sales of a portion of our non-core assets in 2009.
 
·
In addition to asset sales, we took other measures to ensure our financial flexibility during the year. We monitored capital program results on a continuous basis and shifted or adjusted spending as necessary. We refinanced our existing debt and extended our maturities. We hedged selectively during the latter part of 2009 into a period of relative commodity price strength.

 
In 2009, our portfolio actions, in combination with prudent fiscal measures, strengthened our ability to deliver on the visible and sustainable growth that we are striving for as a resource player. Accordingly, we believe we enter 2010 at an inflection point on performance. We believe that we are in the relatively early stages of creating value from our meaningful positions in the new Eagle Ford and Alberta Basin Bakken shale plays. With success in either or both of these plays, we could recognize significant reserve and production upside to our current levels. Furthermore, success in either or both of these plays could shift our product mix toward a higher percentage of oil, which would provide attractive diversification for Rosetta. Finally, we believe the inventory potential from our legacy onshore assets provides a high-value base of production and reserves with relatively low capital intensity. In combination with our new shale plays, we believe Rosetta possesses a unique combination of assets for a company of our size.
 
Our business goals for 2010 are predicated on an announced 2010 capital program of $280 million, subject to program results and timing. We expect to initiate development activities in the Eagle Ford, where our efforts will likely focus in the condensate-prone area surrounding our 2009 Gates Ranch discovery. We expect to continue testing our Alberta Basin Bakken position, as well as conduct modest programs in several legacy assets. We intend to continue our effort to build lease positions in existing core areas, if possible, but also to pursue entry into new basins of interest. We prefer organic opportunities, but we are also expanding our capability to evaluate and pursue acquisition opportunities that fit our business model. We believe this balanced approach is appropriate for long-term success; however, it is not our intention or desire to pursue acquisitions solely for the sake of growth, but rather that fit our strategic and economic objectives.  

We recognize that, despite what we believe was a successful year in 2009, the operating environment for our industry continues to be somewhat uncertain and Rosetta’s success in 2010 or beyond is not assured. Commodity prices, particularly for natural gas, continue to be impacted by anemic demand and the lack of a meaningful supply response to lower prices in 2009. Access to some oilfield services are starting to tighten. Attractive acquisitions or leasing opportunities remain extremely competitive. Finally, given the early stage of the Eagle Ford and Alberta Basin Bakken plays, there is still significant risk to those programs. We attempt to manage these risks by carefully monitoring the environment, working closely with our suppliers and vendors, staying abreast of the marketplace, and moving at a deliberative pace in our new play programs. Nevertheless, regardless of how effectively we manage these risks, they represent threats to our ability to achieve our growth goals and build our asset base.

In approving our 2010 capital budget of $280 million, we indicated that the program could be funded from internally generated cash flows plus cash on hand at an average gas price of roughly $6 per Mcf and an average oil price of roughly $70 per Bbl. In that price environment, we believe that we have sufficient liquidity and operational flexibility at this time to fund and actively manage our stated capital expenditures program. We monitor our liquidity situation continuously. We intend to maintain a position in which we can execute prudent and timely decisions should commodity prices, services costs, or market conditions change.  In the event that we encounter a situation in which we do not have sufficient internal funds to execute our planned capital program, fund incremental organic opportunities or pursue attractive acquisitions, we would consider curtailing our capital spending, drawing on the unused capacity under our existing revolving credit facility or accessing capital markets. As of December 31, 2009, we had $160.0 million of available borrowing capacity under our revolving credit facility.  We have not received any indication from our lenders that draws under the credit facility are restricted below current availability at this time and we are proactively communicating with them on a routine basis. We affirmed our borrowing base in the third quarter of 2009 at $350.0 million and the next redetermination is scheduled to begin in March 2010. Our ability to raise additional capital depends on the current state of the financial markets, which are subject to general economic and industry conditions.  Therefore, the availability and price of capital in the financial markets could negatively affect our liquidity position and cost of borrowed money.  

In order to ensure that Rosetta preserves the necessary financial flexibility, we work closely with our lenders to stay abreast of market and creditor conditions. Of note, our capital expenditures are primarily in areas where Rosetta acts as operator and has high working interests. As a result, we do not believe we have significant exposure to joint interest partners who may be unable to fund their portion of any capital program, but we monitor partner situations routinely.  
 
Financial Highlights
 
Our consolidated financial statements reflect total revenue of $294.0 million on total volumes of 50.6 Bcfe for the year ended December 31, 2009.  Operating loss for the year ended December 31, 2009 was $326.7 million and included depreciation, depletion and amortization (“DD&A”) expense of $121.0 million, a non-cash, pre-tax full cost ceiling test impairment charge of $379.5 million, lease operating expense of $60.8 million and $7.5 million of compensation expense for stock-based compensation granted to employees included in General and administrative costs. Total net other income for the year ended December 31, 2009 was comprised of interest expense (net of capitalized interest) on our long-term debt offset by interest income on short-term cash investments.

 
Results of Operations

The following table summarizes the components of our revenues for the periods indicated, as well as each period’s production volumes and average prices:

   
Year Ended December 31,
 
   
2009
   
2008
   
2007
 
   
(In thousands, except per unit amounts)
 
Revenues:
                 
Natural gas sales
  $ 250,684     $ 398,268     $ 295,644  
Oil sales
    21,763       55,736       40,148  
NGL sales
    21,504       45,343       27,697  
Total revenues
  $ 293,951     $ 499,347     $ 363,489  
                         
Production:
                       
Gas (Bcf)
    44.5       47.7       39.1  
Oil (MBbls)
    393.9       546.4       561.2  
NGLs (MBbls)
    620.1       440.8       557.0  
Total equivalents (Bcfe)
    50.6       53.6       45.8  
                         
$ per unit:
                       
Avg. gas price per Mcf
  $ 5.63     $ 8.35     $ 7.56  
Avg. gas price per Mcf excluding hedging
    3.91       8.74       6.97  
Avg. oil price per Bbl
    55.25       102.00       71.54  
Avg. NGL price per Bbl
    34.68       102.87       49.73  
Avg. revenue per Mcfe
    5.81       9.32       7.94  

Revenues
 
Our revenues are derived from the sale of our oil and natural gas production, which includes the effects of qualifying commodity hedge contracts.  Our revenues may vary significantly from period to period as a result of changes in commodity prices or volumes of production sold.
 
Year Ended December 31, 2009 Compared to the Year Ended December 31, 2008

Total revenue for the year ended December 31, 2009 was $294.0 million, which is a decrease of $205.4 million, or 41%, from the year ended December 31, 2008.  Approximately 85% of revenue was attributable to natural gas sales.
 
Natural Gas.  For the year ended December 31, 2009, natural gas revenue decreased by 37%, or $147.6 million, including the realized impact of derivative instruments, from the comparable period in 2008, to $250.7 million.  Of this decrease, $27.1 million is attributable to decreased volumes and $120.5 million is attributable to lower average realized prices in 2009.  The average realized natural gas price including the effects of hedging decreased 33%, or $2.72, to $5.63 per Mcf for the year ended December 31, 2009 as compared to $8.35 per Mcf for the same period in 2008. In 2009, the Henry Hub natural gas spot price averaged $3.87 per Mcf compared to the 2008 average of $9.13 per Mcf.  The effect of gas hedging activities on natural gas revenue for the year ended December 31, 2009 was an increase of $76.6 million, or an increase of $1.72 per Mcf, as compared to a decrease of $18.7 million, or a decrease of $0.39 per Mcf, for the year ended December 31, 2008.  Production volumes decreased overall by 7%, or 3.2 Bcf for the year ended December 31, 2009, primarily due to natural decline in our non-core Gulf of Mexico properties as well as the suspension of drilling programs during 2009 in areas where we were active during 2008 as well as the suspension of non-essential workover and recompletion activity in all areas for a portion of 2009 for the purpose of cash management during the industry downturn.      
 
Crude Oil.  For the year ended December 31, 2009, oil revenue decreased by 61%, or $34.0 million, primarily due to the decrease of $46.75 per Bbl in the average oil price from $102.00 per Bbl for the year ended December 31, 2008 as compared to $55.25 per Bbl for the year ended December 31, 2009.   Oil volumes also decreased by 28%, or 152.5 MBbls, to 393.9 MBbls for the year ended December 31, 2009 from 546.4 MBbls for the year ended December 31, 2008.  The decrease in oil production volumes was due to natural decline in our non-core Gulf of Mexico and Texas State Waters properties.

NGLs.  For the year ended December 31, 2009, NGL revenue decreased by 53%, or $23.8 million, primarily due to the decrease of $68.19 per Bbl in the average NGL price from $102.87 per Bbl for the year ended December 31, 2008 as compared to $34.68 per Bbl for the year ended December 31, 2009.  NGL volumes increased by 41%, or 179.3 MBbls, to 620.1 MBbls for the year ended December 31, 2009 from 440.8 MBbls for the year ended December 31, 2008.  The increase in NGL production volumes was due to the recognition in 2009 of processed liquid volumes for the first time from our Lobo trend properties.

 
Year Ended December 31, 2008 Compared to the Year Ended December 31, 2007
 
Total revenue for the year ended December 31, 2008 was $499.3 million, which is an increase of $135.9 million, or 37%, from the year ended December 31, 2007.  Approximately 80% of revenue was attributable to natural gas sales.
 
Natural Gas.  For the year ended December 31, 2008, natural gas revenue increased by 35%, or $102.6 million, including the realized impact of derivative instruments, from the comparable period in 2007, to $398.3 million.  Of this increase, $37.6 million is attributable to increased volumes and $65.0 million is attributable to favorable average realized prices in 2008.  Production volumes for the year ended December 31, 2008 increased by 22%, or 8.6 Bcf, primarily due to the increase in the number of productive wells during 2008.  Net productive wells increased from 606 in 2007 to 825 in 2008.  The effect of gas hedging activities on natural gas revenue for the year ended December 31, 2008 was a decrease of $18.7 million, or a decrease of $0.39 per Mcf, as compared to an increase of $22.9 million, or an increase of $0.59 per Mcf, for the year ended December 31, 2007.  The average realized natural gas price including the effects of hedging increased 10% or $0.79 per Mcf to $8.35 per Mcf for the year ended December 31, 2008 as compared to the same period in 2007 of $7.56 per Mcf. In 2008, the Henry Hub natural gas spot price averaged $9.13 per Mcf compared to the 2007 average of $7.17 per Mcf.
 
Crude Oil.  For the year ended December 31, 2008, oil revenue increased by 39%, or $15.6 million, primarily due to the increase of $30.46 per Bbl in the average oil price from $71.54 per Bbl for the year ended December 31, 2007 as compared to $102.00 per Bbl for the year ended December 31, 2008.  At December 31, 2008, the West Texas Intermediate price for oil was $41.00 per Bbl compared to $92.50 per Bbl at December 31, 2007. Oil volumes decreased by 3%, or 14.8 MBbls, to 546.4 MBbls for the year ended December 31, 2008 from 561.2 MBbls for the year ended December 31, 2007.  The decrease in oil production volumes in 2008 was associated with decreased production in the Gulf of Mexico primarily due to the effects of Hurricane Ike and Sabine Lake well work in September 2008 as well as lower production in Other Onshore.

NGLs. For the year ended December 31, 2008, NGL revenue increased by 64%, or $17.6 million, primarily due to the increase of $53.14 per Bbl in the average NGL price from $49.73 per Bbl for the year ended December 31, 2007 as compared to $102.87 per Bbl for the year ended December 31, 2008.  NGL volumes decreased by 21%, or 116.2 MBbls, to 440.8 MBbls for the year ended December 31, 2008 from 557.0 MBbls for the year ended December 31, 2007.  The decrease in NGL production volumes was associated with the effects of Hurricane Ike in the Gulf of Mexico and Sabine Lake.

Operating Expenses
 
The following table summarizes our production costs and operating expenses for the periods indicated:
 
   
Year Ended December 31,
 
   
2009
   
2008
   
2007
 
   
(In thousands, except per unit amounts)
 
Lease operating expense
  $ 60,773     $ 55,694     $ 47,044  
Production taxes
    6,131       13,528       6,417  
Depreciation, depletion and amortization
    121,042       198,862       152,882  
Impairment of oil and gas properties
    379,462       444,369       -  
General and administrative costs
    46,993       52,846       43,867  
                         
$ per unit:
                       
Avg. lease operating expense per Mcfe
  $ 1.20     $ 1.04     $ 1.03  
Avg. production taxes per Mcfe
    0.12       0.25       0.14  
Avg. DD&A per Mcfe
    2.39       3.71       3.34  
Avg. production costs per Mcfe (1)
    3.59       4.75       4.36  
Avg. G&A per Mcfe
    0.93       0.99       0.96  
____________________________________

 
(1)
Production costs per Mcfe include lease operating expense and DD&A.

Year Ended December 31, 2009 Compared to the Year Ended December 31, 2008

Lease Operating Expense.  Lease operating expense increased $5.1 million for the year ended December 31, 2009 as compared to the same period for 2008. This overall increase is primarily due to the 2008 South Texas Constellation, Pinedale and Petroflow acquisitions as 2009 was the first full year of recording expenses.   Lease operating expense includes workover costs of $0.08 per Mcfe, ad valorem taxes of $0.29 per Mcfe and insurance of $0.03 per Mcfe for the year ended December 31, 2009 as compared to workover costs of $0.14 per Mcfe, ad valorem taxes of $0.21 per Mcfe and insurance of $0.03 per Mcfe for the same period in 2008.

Production Taxes.  Production taxes as a percentage of oil and natural gas sales were 2.1% for the year ended December 31, 2009 as compared to 2.7% for the year ended December 31, 2008.  This decrease is the result of decreased production and prices for the year ended December 31, 2009 as compared to the same period for 2008.

 
Depreciation, Depletion, and Amortization.  DD&A expense decreased $77.8 million for the year ended December 31, 2009 as compared to the same period for 2008.  The decrease is due to a 6% decrease in total production and a lower DD&A rate for 2009 compared to 2008 due to the full cost ceiling test impairment charges recognized during the second half of 2008 and during the first quarter of 2009, which decreased the full cost pool.  The DD&A rate for the year ended December 31, 2009 was $2.39 per Mcfe while the rate for the year ended December 31, 2008 was $3.71 per Mcfe.

Impairment of Oil and Gas Properties.  Based upon the quarterly ceiling test computations using hedge adjusted market prices during the year ended December 31, 2009, at March 31, 2009, the net capitalized costs of oil and natural gas properties exceeded the cost center ceiling and a pre-tax, non-cash impairment expense of $379.5 million was recorded.  There was no impact on the ceiling test of applying the new SEC guidance.  Whereas based upon the quarterly ceiling test computations using hedge adjusted market prices during the year ended December 31, 2008, the net capitalized costs of oil and natural gas properties exceeded the cost center ceiling and a pre-tax, non-cash impairment expense of $444.4 million was recorded.
 
General and Administrative Costs.  General and administrative costs, net of capitalized exploration and development overhead costs of $4.8 million, decreased by $5.9 million for the year ended December 31, 2009 as compared to the same period for 2008.  The decrease in general and administrative costs incurred in the current period is primarily related to decreases of $12.1 million in legal fees related to the Calpine litigation, which settled during 2008, and an increase of $1.4 million in billable field personnel offset by a $3.1 million decrease in capitalizable geological and geophysical expenses, a $2.2 million increase in salaries and wages resulting from the additional technical personnel hired during 2009 and a $2.7 million increase in bonus expense.

Year Ended December 31, 2008 Compared to the Year Ended December 31, 2007
 
Lease Operating Expense.  Lease operating expense increased $8.7 million for the year ended December 31, 2008 as compared to the same period for 2007. This overall increase is primarily due to the increase in the number of productive wells as well as increased production of 17% for 2008 which led to higher costs for equipment rentals, maintenance and repairs, and costs associated with non-operated properties.  Lease operating expense includes workover costs of $0.14 per Mcfe, ad valorem taxes of $0.21 per Mcfe and insurance of $0.03 per Mcfe for the year ended December 31, 2008 as compared to workover costs of $0.11 per Mcfe, ad valorem taxes of $0.26 per Mcfe and insurance of $0.05 per Mcfe for the same period in 2007.

Production Taxes.  Production taxes as a percentage of oil and natural gas sales were 2.7% for the year ended December 31, 2008 as compared to 1.8% for the year ended December 31, 2007.  This increase is the result of increased production in areas that do not qualify for tax credits for the year ended December 31, 2008 as compared to the same period for 2007.  
 
Depreciation, Depletion, and Amortization.  DD&A expense increased $46.0 million for the year ended December 31, 2008 as compared to the same period for 2007.  The increase is due to a 17% increase in total production and a higher DD&A rate for 2008 due to the decrease in oil and natural gas reserves as compared to 2007.  The DD&A rate for the year ended December 31, 2008 was $3.71 per Mcfe while the rate for the year ended December 31, 2007 was $3.34 per Mcfe due to the increase in finding costs.  

Impairment of Oil and Gas Properties.  Based upon the quarterly ceiling test computations using hedge adjusted market prices during the year ended December 31, 2008, and in conjunction with the downward revisions of a portion of our reserves in the third and fourth quarters of 2008, the net capitalized costs of oil and natural gas properties exceeded the cost center ceiling and a pre-tax, non-cash impairment expense of $444.4 million was recorded.  There were no ceiling test impairments during the year ended December 31, 2007.
  
General and Administrative Costs.  General and administrative costs, net of capitalized exploration and development overhead costs of $7.1 million, increased by $9.0 million for the year ended December 31, 2008 as compared to the same period for 2007, with capitalized exploration and development overhead costs of $5.5 million.  The increase in costs incurred in 2008 were primarily related to increases in legal fees related to the Calpine litigation of $6.9 million and increases in payroll expenses of $2.1 million resulting from increased headcount and a $1.3 million accrual related to the severance of a former executive officer, as well as the absence of approximately $5.0 million in CEO transition costs that were incurred in 2007 but not 2008.  

Total Other Expense
 
Other expense includes interest expense, interest income and other income/expense, net which decreased $7.3 million for the year ended December 31, 2009 as compared to the same period in 2008.  The decrease in other expense is primarily the result of a $12.4 million charge related to the settlement of litigation with Calpine in 2008 for which there were no related expenses during 2009 offset by a $4.6 million increase in interest expense due to higher interest rates on the restated credit facilities and increased amortization of deferred loan fees and original issue discount related to the restated credit facilities during the first quarter of 2009.

Other expense increased $10.2 million for the year ended December 31, 2008 to $25.6 million as compared to $15.4 million in the same period in 2007.  The increase in other expense was the result of a $12.4 million charge related to the Calpine Settlement partially offset by $3.0 million decrease in interest expense in 2008.

 
Provision for Income Taxes
 
Our 2009 income tax benefit of $125.8 million was primarily due to the first quarter ceiling test write-down.  For the year ended December 31, 2009, the effective tax rate was 36.5% compared to the effective tax rate of 37.5% for the year ended December 31, 2008 and 37.3% for the year ended December 31, 2007.  The provision for income taxes differs from the taxes computed at the federal statutory income tax rate primarily due to the effect of state taxes, a tax shortfall arising from our deferred compensation plans, and other permanent differences.

We provide for deferred income taxes on the difference between the tax basis of an asset or liability and its carrying amount in our financial statements in accordance with authoritative guidance for accounting for income taxes.  This difference will result in taxable income or deductions in future years when the reported amount of the asset or liability is recovered or settled, respectively. Considerable judgment is required in determining when these events may occur and whether recovery of an asset is more likely than not.  Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized.  At December 31, 2009, we have a deferred tax asset of approximately $169.7 million resulting primarily from the difference between the book basis and tax basis of our oil and natural gas properties compared to a deferred tax asset of approximately $42.7 million at December 31, 2008.  We have concluded that it is more likely than not that this deferred tax asset will be realized through future taxable income generated by the production of our oil and natural gas properties.

Liquidity and Capital Resources
 
Our primary source of liquidity and capital is our operating cash flow. We also maintain a revolving line of credit, which can be accessed as needed to supplement operating cash flow.
 
Operating Cash Flow.  Our cash flows depend on many factors, including the price of oil and natural gas and the success of our development and exploration activities as well as future acquisitions. We actively manage our exposure to commodity price fluctuations by executing derivative transactions to hedge the change in prices of a portion of our production, thereby mitigating our exposure to price declines, but these transactions may also limit our earnings potential in periods of rising natural gas prices. The effects of these derivative transactions on our natural gas sales are discussed above under “Results of Operations – Natural Gas.”  The majority of our capital expenditures is discretionary and could be curtailed if our cash flows decline from expected levels.  Current economic conditions and lower commodity prices could adversely affect our cash flow and liquidity. We will continue to monitor our cash flow and liquidity and, if appropriate, we may consider adjusting our capital expenditure program.
 
Senior Secured Revolving Line of Credit.  On April 9, 2009, we amended and restated our revolving credit agreement (the “Restated Revolver”) with BNP Paribas, as Administrative Agent, and the other lenders identified therein to provide for a senior secured revolving line of credit in the amount of up to $600.0 million and to extend its term until July 1, 2012. Availability under the Restated Revolver is restricted to the borrowing base, which is subject to review and adjustment on a semi-annual basis and other interim adjustments, including adjustments based on our hedging arrangements.  Our borrowing base is dependent on a number of factors, including our level of reserves as well as the pricing outlook at the time of the redetermination. A reduction in capital spending could result in a reduced level of reserves thus causing a reduction in the borrowing base. After the redetermination in October 2009, the borrowing base under the Restated Revolver is $350.0 million.  Amounts outstanding under the Restated Revolver bear interest at specified margins over the London Interbank Offered Rate (LIBOR) of 2.25% to 3.00%. Borrowings under the Restated Revolver are collateralized by perfected first priority liens and security interests on substantially all of our assets, including a mortgage lien on oil and natural gas properties having at least 80% of the pre-tax SEC PV-10 reserve value, a guaranty by all of our domestic subsidiaries, and a pledge of 100% of the membership interests of domestic subsidiaries. These collateralized amounts under the mortgages are subject to semi-annual reviews based on updated reserve information. We are subject to the financial covenants of a minimum current ratio of not less than 1.0 to 1.0 as of the end of each fiscal quarter and a maximum leverage ratio of not greater than 3.5 to 1.0, calculated at the end of each fiscal quarter for the four fiscal quarters then ended, measured quarterly after giving pro forma effect to acquisitions and divestitures.  At December 31, 2009, our current ratio was 4.3 and the leverage ratio was 1.6.  In addition, we are subject to covenants limiting dividends and other restricted payments, transactions with affiliates, incurrence of debt, changes of control, asset sales, and liens on properties. We were in compliance with all covenants at December 31, 2009.   As of February 26, 2010, we had $190.0 million outstanding, which is due and payable on July 1, 2012, with $160.0 million available for borrowing under the Restated Revolver.

Second Lien Term Loan.   On April 9, 2009, we also amended and restated our term loan (the “Restated Term Loan”) with BNP Paribas, as Administrative Agent, and other lenders and extended its term until October 2, 2012. Borrowings under the Restated Term Loan were initially set at $75.0 million and bear interest at LIBOR plus 8.5% with a LIBOR floor of 3.5%. The Restated Term Loan had an option to increase fixed and floating rate borrowings by up to $25.0 million to $100.0 million prior to May 9, 2009. We exercised this option on April 21, 2009, and the increased borrowings consisted of $5.0 million of floating rate borrowings and $20.0 million of fixed rate borrowings at 13.75%. The loan is collateralized by second priority liens on substantially all of our assets. We are subject to the financial covenants of a minimum asset coverage ratio of not less than 1.5 to 1.0 and a maximum leverage ratio of not more than 4.0 to 1.0, calculated at the end of each fiscal quarter for the four fiscal quarters then ended, measured quarterly after giving pro forma effect to acquisitions and divestitures.  At December 31, 2009, our asset coverage ratio was 2.7 and the leverage ratio was 1.6.  In addition, we are subject to covenants limiting dividends and other restricted payments, transactions with affiliates, incurrence of debt, changes of control, asset sales, and liens on properties. We were in compliance with all covenants at December 31, 2009.  As of December 31, 2009, we had $80.0 million of variable rate borrowings and $20.0 million of fixed rate borrowings outstanding under the Restated Term Loan.  At December 31, 2009, the principal balance of the Restated Term Loan was due and payable on October 2, 2012.    We have the right to prepay the Restated Term Loan at any time on or after the first anniversary of the effective date (April 10, 2010), in whole or in part, from April 10, 2010 to April 10, 2011 with a premium equal to 2% of such amount prepaid or subsequent to April 10, 2011 without premium or penalty provided that each prepayment is in an amount that is an integral multiple of $1.0 million and not less than $1.0 million, or if such amount is less than $1.0 million, the outstanding principal amount.

 
Working Capital
 
At December 31, 2009, we had a working capital surplus of $45.7 million as compared to a working capital surplus of $28.6 million at December 31, 2008.  Our working capital is affected primarily by fluctuations in the fair value of our commodity derivative instruments, deferred taxes associated with hedging activities, cash and cash equivalents balance and our capital spending program.  The surplus for 2009 was largely caused by the increases in our cash balance.  As of December 31, 2009, the working capital asset balances of our cash and cash equivalents and derivative instruments were approximately $61.3 million and $9.0 million, respectively, and there was no balance for current deferred tax assets.  In addition, the associated working capital liability balances for accrued liabilities were approximately $37.1 million as of December 31, 2009.

Cash Flows
 
   
Year Ended December 31,
 
   
2009
   
2008
   
2007
 
   
(In thousands)
 
Cash flows provided by operating activities
  $ 160,501     $ 374,719     $ 257,307  
Cash flows used in investing activities
    (123,865 )     (393,070 )     (322,041 )
Cash flows (used in) provided by financing activities
    (18,235 )     57,990       5,170  
Net increase (decrease) in cash and cash equivalents
  $ 18,401     $ 39,639     $ (59,564 )

Operating Activities. Key drivers of net cash provided by operating activities are commodity prices, production volumes and costs and expenses, which primarily include operating costs, taxes other than income taxes, transportation and general and administrative expenses.  Net cash provided by operating activities continued to be a primary source of liquidity and capital used to finance our capital expenditures for the year ended December 31, 2009.

Cash flows provided by operating activities decreased by $214.2 million for the year ended December 31, 2009 as compared to the same period for 2008. This decrease is largely due to lower oil and natural gas prices and production during 2009 compared to 2008.   For the year ended December 31, 2009, we had net losses of $219.2 million with a decrease in production of 6% as compared to the year ended December 31, 2008 with net losses of $188.1 million.

Cash flows provided by operating activities increased by $117.4 million for the year ended December 31, 2008 as compared to the same period for 2007. This increase is largely due to higher oil and natural gas prices during 2008 compared to 2007.   For the year ended December 31, 2008, we had net losses of $188.1 million with an increase of production of 17% as compared to the year ended December 31, 2007 with net income of $57.2 million.

Investing Activities.  The primary driver of cash used in investing activities is capital spending.
 
Cash flows used in investing activities decreased by $269.2 million for the year ended December 31, 2009 as compared to the same period for 2008, which primarily reflected reduced expenditures for the acquisition and development of oil and gas properties and drilling.  Acquisitions of oil and gas properties decreased $159.3 million and purchases of oil and gas assets decreased $87.4 million from 2008 to 2009 as a result of our decision to exercise prudence and caution with our capital spending in order to preserve our liquidity and maximize our financial position during a period of low commodity prices and reduced demand for natural gas.  For the year ended December 31, 2009, we incurred approximately $135.0 million in capital expenditures as compared to $334.4 million for the year ended December 31, 2008.  During the year ended December 31, 2009, we participated in the drilling of 43 gross wells as compared to the drilling of 184 gross wells for the year ended December 31, 2008.

Cash flows used in investing activities increased by $71.0 million for the year ended December 31, 2008 as compared to the same period for 2007, which reflected expenditures for the acquisition and development of oil and gas properties and drilling.  The Company acquired the Petroflow properties in the San Juan Basin for $29.0 million, the Pinedale and South Texas properties for approximately $55.0 million, and the Calpine non-consent properties as part of the Calpine Settlement for $30.9 million.  Additionally, acquisition costs for the year ended December 31, 2008 include a non-cash purchase price adjustment of $36.7 million related to the release of suspended revenues and non-consent liabilities associated with non-consent properties as part of the settlement of litigation with Calpine, as well as an $8.0 million reduction in accrued capital costs.  For the year ended December 31, 2008, we incurred approximately $334.4 million in capital expenditures as compared to $336.1 million for the year ended December 31, 2007.  During the year ended December 31, 2008, we participated in the drilling of 184 gross wells as compared to the drilling of 195 gross wells for the year ended December 31, 2007.

 
Financing Activities.  The primary driver of cash used in financing activities is equity transactions and issuance and repayments of debt.

Cash flows provided by financing activities decreased by $76.2 million for the year ended December 31, 2009 as compared to the same period for 2008.  The net decrease is primarily related to payments of $40.0 million made in 2009 against the Restated Revolver and $5.9 million of deferred loan fees related to the restated credit facilities netted with $28.4 million of borrowings in 2009 compared to $55.0 million of borrowings in 2008.  In addition, there was a decrease of approximately $3.6 million in the stock options exercised for the year ended December 31, 2009 compared to 2008.

Cash flows provided by financing activities increased by $52.8 million for the year ended December 31, 2008 as compared to the same period for 2007.  The net increase is primarily related to net borrowings of $55.0 million made in 2008 against the Revolver.  In addition, there was an increase of approximately $3.0 million in the stock options exercised for the year ended December 31, 2008 compared to 2007.  
 
Commodity Price Risk, Interest Rate Risk and Related Hedging Activities

The energy markets have historically been very volatile, and there can be no assurance that oil and natural gas prices will not be subject to wide fluctuations in the future. To mitigate our exposure to changes in commodity prices, management hedges oil and natural gas prices from time to time primarily through the use of certain derivative instruments including fixed price swaps, basis swaps, costless collars and put options. Although not risk free, we believe these activities will reduce our exposure to commodity price fluctuations and thereby achieve a more predictable cash flow. Consistent with this policy, we have entered into a series of natural gas fixed-price swaps and costless collars, which are intended to establish a fixed price or an average floor and ceiling price for 13% to 23% of our expected natural gas production through 2011. The fixed-price swap agreements we have entered into require payments to (or receipts from) counterparties based on the differential between a fixed price and a variable price for a notional quantity of natural gas without the exchange of underlying volumes. The notional amounts of these financial instruments were based on expected proved production from existing wells at inception of the hedge instruments.

Borrowings under our Restated Revolver and Restated Term Loan mature on July 1, 2012 and October 2, 2012, respectively, and bear interest at a LIBOR-based rate. This exposes us to risk of earnings loss due to increases in market interest rates. To mitigate this exposure, we have entered into a series of interest rate swap agreements through December 2010. If we determine the risk may become substantial and the costs are not prohibitive, we may enter into additional interest rate swap agreements in the future.
 
The following table sets forth the results of commodity and interest rate swap hedging transaction settlements:

   
For the Year Ended December 31,
 
   
2009
   
2008
 
Natural Gas
           
Quantity settled (MMBtu)
    20,856,465       26,684,616  
Increase (decrease) in natural gas sales revenue (In thousands)
  $ 76,567     $ (18,669 )
Interest Rate Swaps
               
Increase in interest expense (In thousands)
  $ (1,289 )   $ (1,158 )

In accordance with the authoritative guidance for derivatives, all derivative instruments, not designated as a normal purchase sale, are recorded on the balance sheet at fair market value and changes in the fair market value of the derivatives are recorded each period in current earnings or other comprehensive income, depending on whether a derivative is designated as a hedge transaction, and depending on the type of hedge transaction. Our derivative contracts are cash flow hedge transactions in which we are hedging the variability of cash flow related to a forecasted transaction. Changes in the fair market value of these derivative instruments are reported in other comprehensive income and reclassified as earnings in the period(s) in which earnings are impacted by the variability of the cash flow of the hedged item. We assess the effectiveness of hedging transactions on a quarterly basis, consistent with documented risk management strategy for the particular hedging relationship. Changes in the fair market value of the ineffective portion of cash flow hedges, if any, are included in other income (expense).
 
As of December 31, 2009, our commodity and interest rate hedge positions were with counterparties that were also lenders in our credit facilities. This allows us to secure any margin obligation resulting from a negative change in the fair market value of the derivative contracts in connection with our credit obligations and eliminate the need for independent collateral postings.  As of December 31, 2009, we had no deposits for collateral.

 
Capital Requirements
 
The historical capital expenditures summary table is included in Items 1 and 2. Business and Properties and is incorporated herein by reference.
 
Our capital expenditures for the year ended December 31, 2009 were $135.0 million, including capitalized internal costs directly identified with acquisition, exploration and development activities of $4.8 million, capitalized interest of $1.2 million and corporate and other capital costs of $4.1 million.  We have plans to carefully execute an organic capital program in 2010 that can be funded from internally generated cash flows and available cash in a $6 per Mcf and a $70 per Bbl price environment.  We also have the discretion to use our available borrowing base and proceeds from divestitures to fund capital expenditures, including acquisitions.  

Commitments and Contingencies
 
As is common within the industry, we have entered into various commitments and operating agreements related to the exploration and development of and production from proved oil and natural gas properties. It is management’s belief that such commitments will be met without a material adverse effect on our financial position, results of operations or cash flows.
 
Contractual Obligations. At December 31, 2009, the aggregate amounts of our contractually obligated payment commitments for the next five years are as follows:

   
Payments Due By Period
 
   
Total
   
2010
   
2011 to 2012
   
2013 to 2014
   
2015 & Beyond
 
 
(In thousands)
 
Senior secured revolving line of credit
  $ 190,000     $ -     $ 190,000     $ -     $ -  
Second lien term loan
    100,000       -       100,000       -       -  
Operating leases
    12,872       3,025       6,204       3,643       -  
Interest payments on long-term debt (1)
    48,875       18,264       30,611       -       -  
Rig commitments
    3,542       3,542       -       -       -  
Total contractual obligations
  $ 355,289     $ 24,831     $ 326,815     $ 3,643     $ -  
___________________________________

(1) Future interest payments were calculated based on interest rates and amounts outstanding at December 31, 2009.
 
Asset Retirement Obligation. We also had total liabilities of $28.9 million related to asset retirement obligations recorded in Accrued liabilities and Other long-term liabilities at December 31, 2009 that are excluded from the table above. Due to the nature of these obligations, we cannot determine precisely when the payments will be made to settle these obligations. See Item 8. “Financial Statements and Supplementary Data, Note 9 - Asset Retirement Obligation.”

Contingencies
 
We are party to various litigation matters arising out of the normal course of business. Although the ultimate outcome of each of these matters cannot be absolutely determined, and the liability we may ultimately incur with respect to any one of these matters in the event of a negative outcome may be in excess of amounts currently accrued with respect to such matters, management does not believe any such matters will have a material adverse effect on our financial position, results of operation or cash flows.

Critical Accounting Policies and Estimates
 
The discussion and analysis of our financial condition and results of operations are based upon the Consolidated Financial Statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, related disclosure of contingent assets and liabilities and proved oil and gas reserves. Certain accounting policies involve judgments and uncertainties to such an extent that there is reasonable likelihood that materially different amounts could have been reported under different conditions, or if different assumptions had been used. We evaluate our estimates and assumptions on a regular basis. We base our estimates on historical experience and various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates and assumptions used in preparation of our financial statements. Below, we have provided expanded discussion of our more significant accounting policies, estimates and judgments for our financial statements. We believe these accounting policies reflect the more significant estimates and assumptions used in preparation of the financial statements.
 
We also describe the most significant estimates and assumptions we make in applying these policies.  See Item 8. “Financial Statements and Supplementary Data, Note 2 - Summary of Significant Accounting Policies,” for a discussion of additional accounting policies and estimates made by management.

 
Principles of Consolidation  

The accompanying consolidated financial statements as of December 31, 2009, 2008 and 2007, contain the accounts of the Company and its majority owned subsidiaries after eliminating all significant intercompany balances and transactions.
 
Oil and Gas Activities
 
Accounting for oil and gas activities is subject to special, unique rules. Two generally accepted methods of accounting for oil and gas activities are the successful efforts method and the full cost method. The most significant differences between these two methods are the treatment of exploration costs and the manner in which the carrying value of oil and gas properties are amortized and evaluated for impairment. The successful efforts method requires certain exploration costs to be expensed as they are incurred while the full cost method provides for the capitalization of these costs. Both methods generally provide for the periodic amortization of capitalized costs based on proved reserve quantities. Impairment of oil and gas properties under the successful efforts method is based on an evaluation of the carrying value of individual oil and gas properties against their estimated fair value.  The assessment for impairment under the full cost method requires an evaluation of the carrying value of oil and gas properties included in a cost center against the net present value of future cash flows from the related proved reserves using a twelve-month average price computed as an average of first day of the month prices, period-end costs and a 10% discount rate.  Prior to December 31, 2009, the assessment for impairment under the full cost method required the use of period-end pricing when evaluating the carrying value of oil and gas properties against the net present value of future cash flows from the related proved reserves.
 
Full Cost Method
 
We use the full cost method of accounting for our oil and gas activities. Under this method, all costs incurred in the acquisition, exploration and development of oil and gas properties are capitalized into a cost center (the amortization base), whether or not the activities to which they apply are successful.  As all of our operations are located in the U.S., all of our costs are included in one cost pool.  Such amounts include the cost of drilling and equipping productive wells, dry hole costs, lease acquisition costs and delay rentals. Capitalized costs also include salaries, employee benefits, costs of consulting services and other expenses that directly relate to our oil and gas activities.  Interest costs related to unproved properties are also capitalized.  Costs associated with production and general corporate activities are expensed in the period incurred. The capitalized costs of our oil and gas properties, plus an estimate of our future development and abandonment costs, are amortized on a unit-of-production method based on our estimate of total proved reserves. Unevaluated costs are excluded from the full cost pool and are periodically considered for impairment.  Upon evaluation, these costs are transferred to the full cost pool and amortized.  Our financial position and results of operations would have been significantly different had we used the successful efforts method of accounting for our oil and gas activities, since we generally reflect a higher level of capitalized costs as well as a higher DD&A rate on our oil and natural gas properties.
 
Proved Oil and Gas Reserves
 
Our engineering estimates of proved oil and gas reserves directly impact financial accounting estimates, including DD&A expense and the full cost ceiling limitation. Proved oil and gas reserves are the estimated quantities of oil and gas reserves that geological and engineering data demonstrate with reasonable certainty to be recoverable in future years from known reservoirs under period-end economic and operating conditions. The process of estimating quantities of proved reserves is very complex, requiring significant subjective decisions in the evaluation of all geological, engineering and economic data for each reservoir.  Accordingly, our reserve estimates are developed internally and subsequently, provided to NSAI who then performs an annual year-end reserve report audit. The data for a given reservoir may change substantially over time as a result of numerous factors including additional development activity, evolving production history and continual reassessment of the viability of production under varying economic conditions. Changes in oil and gas prices, operating costs and expected performance from a given reservoir also will result in revisions to the amount of our estimated proved reserves.  The estimate of proved oil and natural gas reserves primarily impact property, plant and equipment amounts in the consolidated balance sheet and the DD&A amounts in the consolidated statement of operations.  Current guidance dictates the use of a twelve-month first day of the month historical average price adjusted for basis and quality differentials for oil and natural gas and holds costs in effect as of the last day of the quarter or annual period constant in calculating reserves.  Prior to 2009, the guidance dictated that year-end prices adjusted for basis and quality differentials and costs be used in calculating reserves.  For more information regarding reserve estimation, including historical reserve revisions, refer to Item 8. “Financial Statements and Supplementary Data - Supplemental Oil and Gas Disclosures.”

 
Full Cost Ceiling Limitation
 
Under the full cost method, we are subject to quarterly calculations of a “ceiling” or limitation on the amount of costs associated with our oil and gas properties that can be capitalized on our balance sheet.  This ceiling limits such capitalized costs to the present value of estimated future cash flows from proved oil and natural gas reserves (including the effect of any related hedging activities) reduced by future operating expenses, development expenditures, abandonment costs (net of salvage values) to the extent not included in oil and gas properties pursuant to authoritative guidance, and estimated future income taxes thereon.  If net capitalized costs exceed the applicable cost center ceiling, we are subject to a ceiling test write-down to the extent of such excess. If required, it would reduce earnings and stockholders’ equity in the period of occurrence and result in lower DD&A expense in future periods. The discounted present value of our proved reserves is a major component of the ceiling calculation and represents the component that requires the most subjective judgments. The current ceiling calculation utilizes a twelve-month first day of the month historical average price.  The costs in effect as of the last day of the quarter or annual period are held constant.  Prior to December 31, 2009, ceiling calculation guidance dictated that prices in effect as of the last day of the quarter or annual period be used and allowed a write-down to be reduced or avoided if prices increased subsequent to the end of a quarter but prior to the issuance of our financial statements in which a write-down might otherwise be required.  As of December 31, 2009, the use of the recovery of prices after the end of the period is no longer permitted.  The full cost ceiling test impairment calculations also take into consideration the effects of hedging contracts that are designated for hedge accounting. Given the fluctuation of natural gas and oil prices, it is reasonably possible that the estimated discounted future net cash flows from our proved reserves will change in the near term. If natural gas and oil prices decline, or if we have downward revisions to our estimated proved reserves, it is possible that write-downs of our oil and gas properties could occur in the future.  For more information regarding the full cost ceiling limitation, refer to Item 8. “Financial Statements and Supplementary Data, Note 2 – Summary of Significant Accounting Policies.”

Depreciation, Depletion and Amortization
 
The quantities of estimated proved oil and gas reserves are a significant component of our calculation of depletion expense and revisions in such estimates may alter the rate of future depletion expense. Holding all other factors constant, if reserves are revised upward, earnings would increase due to lower depletion expense. Likewise, if reserves are revised downward, earnings would decrease due to higher depletion expense or due to a ceiling test write-down.  A five percent positive or negative revision to proved reserves would decrease or increase the DD&A rate by approximately $0.09 to $0.10 per Mcfe.  This estimated impact is based on current data at December 31, 2009 and actual events could require different adjustments to DD&A.
 
Costs Withheld From Amortization  

Costs associated with unevaluated properties are excluded from our amortization base until we have evaluated the properties. The costs associated with unevaluated leasehold acreage wells currently drilling and capitalized interest are initially excluded from our amortization base. Leasehold costs are either transferred to our amortization base with the costs of drilling a well on the lease or are assessed quarterly for possible impairment.  In addition, a portion of incurred (if not previously included in the amortization base) and future estimated development costs associated with qualifying major development projects may be temporarily excluded from amortization. To qualify, a project must require significant costs to ascertain the quantities of proved reserves attributable to the properties under development (e.g., the installation of an offshore production platform from which development wells are to be drilled). Incurred and estimated future development costs are allocated between completed and future work. Any temporarily excluded costs are included in the amortization base upon the earlier of when the associated reserves are determined to be proved or impairment is indicated.

Our decision to withhold costs from amortization and the timing of the transfer of those costs into the amortization base involve a significant amount of judgment and may be subject to changes over time based on several factors, including our drilling plans, availability of capital, project economics and results of drilling on adjacent acreage. At December 31, 2009, our full cost pool had approximately $42.3 million of costs excluded from the amortization base.
 
Future Development and Abandonment Costs
 
Future development costs include costs incurred to obtain access to proved reserves such as drilling costs and the installation of production equipment and such costs are included in the calculation of DD&A expense. Future abandonment costs include costs to dismantle and relocate or dispose of our production platforms, gathering systems and related structures and restoration costs of land and seabed. We develop estimates of these costs for each of our properties based upon the property’s geographic location, type of production structure, well depth, currently available procedures and ongoing consultations with construction and engineering consultants. Because these costs typically extend many years into the future, estimating these future costs is difficult and requires management to make judgments that are subject to future revisions based upon numerous factors, including changing technology and the political and regulatory environment. We review our assumptions and estimates of future development and future abandonment costs on an annual basis.
 
We provide for future abandonment costs in accordance with authoritative guidance for accounting for asset retirement obligations. This guidance requires that a liability for the discounted fair value of an asset retirement obligation be recorded in the period in which it is incurred and the corresponding cost capitalized by increasing the carrying amount of the related long-lived asset. The liability is accreted to its present value each period, and the capitalized cost is depreciated over the useful life of the related asset.  Holding all other factors constant, if our estimate of future abandonment and development costs is revised upward, earnings would decrease due to higher DD&A expense. Likewise, if these estimates are revised downward, earnings would increase due to lower DD&A expense.

 
Derivative Transactions and Hedging Activities
 
We enter into derivative transactions to hedge against changes in oil and natural gas prices and changes in interest rates related to outstanding debt under our credit agreements primarily through the use of fixed price swap agreements, basis swap agreements, costless collars and put options. Consistent with our hedge policy, we entered into a series of derivative transactions to hedge a portion of our expected natural gas production through 2011.  As of December 31, 2009, 13% and 13% of our expected natural gas production was hedged using swaps and costless collars, respectively, with settlement in 2010 and 5% and 23% of our expected natural gas production was hedged using swaps and costless collars, respectively, with settlement in 2011, based on our annual reserve report. We also entered into a series of interest rate swap agreements to hedge the change in interest rates associated with our variable rate debt through December of 2010.  These transactions are recorded in our financial statements in accordance with authoritative guidance for accounting for derivative instruments and hedging activities.  Although not risk free, we believe this policy will reduce our exposure to commodity price fluctuations and changes in interest rates and thereby achieve a more predictable cash flow. We do not enter into derivative agreements for trading or other speculative purposes.
 
In accordance with amended guidance, all derivative instruments, unless designated as normal purchase and normal sale, are recorded on the balance sheet at fair market value and changes in the fair market value of the derivatives are recorded each period in current earnings or other comprehensive income, depending on whether a derivative is designated as a hedge transaction, and depending on the type of hedge transaction. Our derivative contracts are cash flow hedge transactions in which we are hedging the variability of cash flows related to a forecasted transaction. Changes in the fair market value of these derivative instruments are reported in other comprehensive income and reclassified as earnings in the period(s) in which earnings are impacted by the variability of the cash flow of the hedged item. We assess the effectiveness of hedging transactions quarterly, consistent with our documented risk management strategy for the particular hedging relationship. Changes in the fair market value of the ineffective portion of cash flow hedges are included in Other (income) expense on the Consolidated Statement of Operations.
 
Fair Value Measurements

In September 2006, the Financial Accounting Standards Board (“FASB”) issued authoritative guidance regarding fair value measurements.  This guidance defined fair value, established a framework for measuring fair value, expanded the related disclosure requirements and was effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those years.  This guidance did not require any new fair value measurements; however, it did require some entities to change their measurement practices.  In February 2008, the FASB issued additional guidance which delayed the effective date of fair value accounting for nonfinancial assets and liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually), until fiscal years beginning after November 15, 2008.  Effective January 1, 2008, we implemented the guidance for measuring the fair value of financial assets and liabilities.  Beginning January 1, 2009, we implemented the guidance for nonfinancial assets and liabilities.  The adoption of this guidance did not have an impact on our consolidated financial position, results of operations or cash flows.  In October 2008, the FASB issued guidance on determining the fair value of a financial asset when the market for that asset is not active.  This guidance clarifies the application of fair value accounting in a market that is not active and provides an example to illustrate key considerations in determining the fair value of a financial asset when the market for that financial asset is not active.  This guidance was effective upon issuance, including prior periods for which financial statements have not been issued.  We applied this guidance to financial assets measured at fair value on a recurring basis at September 30, 2009.  The adoption of this guidance did not have a significant impact on our consolidated financial position, results of operations or cash flows.  In April 2009, the FASB issued authoritative guidance to provide additional application guidance and enhance disclosures regarding fair value measurements and impairments of securities.  This guidance provides guidelines for making fair value measurements for assets and liabilities for which the volume and level of activity for the asset or liability have significantly decreased or for transactions that are not orderly more consistent with the principles presented in earlier guidance, enhances consistency in financial reporting by increasing the frequency of fair value disclosures, and provides additional guidance designed to create greater clarity and consistency in accounting for and presenting impairment losses on securities for other-than-temporary impairments.  This guidance is effective for interim and annual periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009.  We applied this guidance for the period ended June 30, 2009 and the adoption did not have a significant impact on the Company’s consolidated financial position, results of operations or cash flows.  See Item 8. “Financial Statements and Supplementary Data, Note 7 - Fair Value Measurements.”

Stock-Based Compensation
 
We account for stock-based compensation in accordance with authoritative guidance regarding the accounting for stock-based compensation. Under the provisions of this guidance, stock-based compensation cost for options is estimated at the grant date based on the award’s fair value as calculated by the Black-Scholes option-pricing model and is recognized as expense over the requisite service period. The Black-Scholes model requires various highly judgmental assumptions including volatility, forfeiture rates and expected option life. If any of the assumptions used in the Black-Scholes model change significantly, stock-based compensation expense for future grants may differ materially from that recorded in the current period.  Stock-based compensation cost for restricted stock is estimated at the grant date based on the award’s fair value which is equal to the average high and low common stock price on the date of grant and is recognized as expense over the requisite service period.  Stock-based compensation for performance share units (“PSUs”) is measured at the end of each reporting period through the settlement date using the quarter-end closing common stock prices for awards that are solely based on performance conditions or a Monte Carlo model for awards that contain market conditions to reflect the current fair value.  Compensation expense is recognized ratably over the performance period based on our estimated achievement of the established metrics.  Compensation expense for awards with performance conditions will only be recognized for those awards for which it is probable that the performance conditions will be achieved and which are expected to vest.  The compensation expense will be estimated based upon an assessment of the probability that the performance metrics will be achieved, current and historical forfeitures, and the Board’s anticipated vesting percentage.  Compensation expense for awards with market conditions is measured at the end of each reporting period based on the fair value derived from the Monte Carlo model which incorporates a risk-neutral valuation approach to value these awards.  The Monte Carlo model requires various highly judgmental assumptions to determine the fair value of the awards.  This model samples paths of ours and the S&P 400 O&G E&P Industry Index (the “Index”)’s stock price and calculates the resulting change in cash flow multiple at the end of the forecasted performance period.   This model iterates these randomly forecasted results until the distribution of results converge on a mean or estimated fair value.  The five primary inputs for the Monte Carlo model are the risk-free rate, independent analyst cash flow per share estimates for the Index and us, volatility of the equities of the Index and us, expected dividends, where applicable, and various historical market data. The risk-free rate was generated from Bloomberg for United States Treasuries with a two-year tenor.  Volatility was set equal to the annualized daily volatility measured over a historic 400-day period ending on the reporting date for the Index and us.   No forfeiture rate is assumed for this type of award.  Expense related to these awards can be volatile based on the Company’s comparative performance at the end of each quarter.  If any of the assumptions used in the Monte Carlo model change significantly, stock-based compensation expense may differ materially in the future from that recorded in the current period.  See Item 8. “Financial Statements and Supplementary Data, Note 12 – Stock-based Compensation”.  

 
Revenue Recognition
 
We use the sales method of accounting for the sale of our natural gas.   When actual natural gas sales volumes exceed our delivered share of sales volumes, an over-produced imbalance occurs. To the extent an over-produced imbalance exceeds our share of the remaining estimated proved natural gas reserves for a given property, we record a liability.  
 
Since there is a ready market for natural gas, crude oil and natural gas liquids (“NGLs”), we sell our products soon after production at various locations at which time title and risk of loss pass to the buyer. Revenue is recorded when title passes based on our net interest or nominated deliveries of production volumes. We record our share of revenues based on production volumes and contracted sales prices. The sales price for natural gas, NGLs and crude oil are adjusted for transportation cost and other related deductions. The transportation costs and other deductions are based on contractual or historical data and do not require significant judgment. Subsequently, these deductions and transportation costs are adjusted to reflect actual charges based on third party documents once received by us. Historically, these adjustments have been insignificant. In addition, natural gas and crude oil volumes sold are not significantly different from our share of production.
 
We pay royalties on natural gas, crude oil and NGLs in accordance with the particular contractual provisions of the lease.  Royalty liabilities are recorded in the period in which the natural gas, crude oil or NGLs are produced and are included in Royalties Payable on our Consolidated Balance Sheet.
 
Income Taxes
 
We provide for deferred income taxes on the difference between the tax basis of an asset or liability and its carrying amount in our financial statements in accordance with authoritative guidance for accounting for income taxes.  This difference will result in taxable income or deductions in future years when the reported amount of the asset or liability is recovered or settled, respectively. Considerable judgment is required in determining when these events may occur and whether recovery of an asset is more likely than not.  Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized.

Estimating the amount of the valuation allowance is dependent on estimates of future taxable income, alternative minimum tax income and change in stockholder ownership that would trigger limits on use of net operating losses under the Internal Revenue Code Section 382.  We have a significant deferred tax asset associated with our oil and gas properties.  We have concluded that it is more likely than not that we will realize this deferred tax asset in future years and therefore, we have not recorded a valuation allowance as of December 31, 2009.  See Item 8. “Financial Statements and Supplementary Data, Note 13 - Income Taxes.”
 
Additionally, our federal and state income tax returns are generally not filed before the consolidated financial statements are prepared, therefore we estimate the tax basis of our assets and liabilities at the end of each period as well as the effects of tax rate changes, tax credits and net operating and capital loss carryforwards and carrybacks. Adjustments related to differences between the estimates we used and actual amounts we reported are recorded in the period in which we file our income tax returns. These adjustments and changes in our estimates of asset recovery could have an impact on our results of operations. A one percent change in our effective tax rate would have affected our calculated income tax expense (benefit) by approximately $3.5 million for the year ended December 31, 2009.
 
Authoritative guidance for accounting for uncertainty in income taxes requires that we recognize the financial statement benefit of a tax position only after determining that the relevant tax authority would more likely than not sustain the position following an audit.  For tax positions meeting the more likely than not threshold, the amount recognized in the financial statements is the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement with the relevant tax authority.

 
Recent Accounting Developments

The following recently issued accounting developments have been applied or may impact the Company in future periods.

Business Combinations. In December 2007, the FASB revised the authoritative guidance for business combinations, extending its applicability to all transactions and other events in which one entity obtains control over one or more other businesses.  The revised guidance broadens the fair value measurement and recognition of assets acquired, liabilities assumed, and interests transferred as a result of business combinations and requires that acquisition-related costs incurred prior to the acquisition be expensed.  The revised guidance also expands the definition of what qualifies as a business, and this expanded definition could include prospective oil and gas purchases.  This could cause us to expense transaction costs for future oil and gas property purchases that we have historically capitalized.  Additionally, this guidance expands the required disclosures to improve the financial statement users’ abilities to evaluate the nature and financial effects of business combinations.  This guidance is effective for business combinations for which the acquisition date is on or after January 1, 2009.  The adoption of the revised guidance did not have a significant impact on our consolidated financial position, results of operations or cash flows.

Noncontrolling Interests in Consolidated Financial Statements.   In December 2007, the FASB issued authoritative guidance which improves the relevance, comparability and transparency of the financial information that a reporting entity provides in its consolidated financial statements by establishing accounting and reporting standards for the non-controlling interest in a subsidiary and for the deconsolidation of a subsidiary.  This guidance is effective for fiscal years beginning after December 15, 2008.  The adoption of this guidance did not have a significant impact on our consolidated financial position, results of operations or cash flows. 
 
Disclosures about Derivative Instruments and Hedging Activities.   In March 2008, the FASB issued authoritative guidance related to disclosures about derivative instruments and hedging activities, which is intended to improve financial reporting about derivative instruments and hedging activities by requiring enhanced disclosures.  This guidance is effective for fiscal years beginning after November 15, 2008.  We adopted the disclosure requirements beginning January 1, 2009.  See Item 8. “Financial Statements and Supplementary Data, Note 6 - Commodity Hedging Contracts and Other Derivatives.”

Fair Value Measurements.  In February 2008, the FASB issued authoritative guidance which delayed the effective date of fair value accounting for nonfinancial assets and liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually), until fiscal years beginning after November 15, 2008.  Beginning January 1, 2009, we implemented the guidance for nonfinancial assets and liabilities.  The adoption of this guidance did not have an impact on our consolidated financial position, results of operations or cash flows.  In October 2008, the FASB issued guidance on determining the fair value of a financial asset when the market for that asset is not active.  This guidance clarifies the application of fair value accounting in a market that is not active and provides an example to illustrate key considerations in determining the fair value of a financial asset when the market for that financial asset is not active.  This guidance was effective upon issuance, including prior periods for which financial statements have not been issued.  We applied this guidance to financial assets measured at fair value on a recurring basis at September 30, 2009.  See Item 8. “Financial Statements and Supplementary Data, Note 5 - Fair Value Measurements.” The adoption of this guidance did not have a significant impact on our consolidated financial position, results of operations or cash flows.

In April 2009, the FASB issued authoritative guidance to provide additional application guidance and enhance disclosures regarding fair value measurements and impairments of securities.  This guidance provides guidelines for making fair value measurements for assets and liabilities for which the volume and level of activity for the asset or liability have significantly decreased or for transactions that are not orderly more consistent with the principles presented in earlier guidance, enhances consistency in financial reporting by increasing the frequency of fair value disclosures, and provides additional guidance designed to create greater clarity and consistency in accounting for and presenting impairment losses on securities for other-than-temporary impairments.  This guidance is effective for interim and annual periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009.  We applied this guidance for the period ended June 30, 2009 and the adoption did not have a significant impact on our consolidated financial position, results of operations or cash flows.

In January 2010, the FASB issued authoritative guidance related to improving disclosures about fair value measurements. This guidance requires separate disclosures of the amounts of transfers in and out of Level 1 and Level 2 fair value measurements and a description of the reason for such transfers. In the reconciliation for Level 3 fair value measurements using significant unobservable inputs, information about purchases, sales, issuances and settlements shall be presented separately. These disclosures will be required for interim and annual reporting periods effective January 1, 2010, except for the disclosures related to the purchases, sales, issuances and settlements in the roll forward activity of Level 3 fair value measurements, which are effective on January 1, 2011. This guidance will require additional disclosures but will not impact our consolidated financial position, results of operations or cash flows.

Subsequent Events.  In May 2009, the FASB issued authoritative guidance on subsequent events to incorporate accounting guidance that originated as auditing standards into the body of authoritative literature issued by the FASB.  This guidance requires the evaluation of subsequent events through the date the financial statements are issued or are available for issue and the disclosure of the date through which subsequent events were evaluated and the basis for that date.  This guidance is effective for interim and annual financial periods ending after June 15, 2009.  We adopted the requirements of this guidance for the period ended June 30, 2009 and the adoption did not have a significant impact on our consolidated financial position, results of operations or cash flows.  On February 25, 2010, the FASB amended this guidance to remove the requirement to disclose the date through which an entity has evaluated subsequent events. See Item 8. “Financial Statements and Supplementary Data, Note 16 – Subsequent Events.”

 
Variable Interest Entities. In June 2009, the FASB issued authoritative guidance related to variable interest entities which changes how a reporting entity determines when an entity that is insufficiently capitalized or is not controlled through voting rights should be consolidated and modifies the approach for determining the primary beneficiary of a variable interest entity. This guidance will require a reporting entity to provide additional disclosures about its involvement with variable interest entities and any significant changes in risk exposure due to that involvement. The guidance related to variable interest entities will be effective on January 1, 2010 and will not have an impact on our consolidated financial position, results of operations or cash flows.

 FASB Codification.  In July 2009, the FASB issued guidance making the FASB Accounting Standards Codification the single source of authoritative nongovernmental U.S. GAAP.  The Codification is not intended to change GAAP, however, it will represent a significant change in researching issues and referencing U.S. GAAP in financial statements and accounting policies.  This guidance is effective for financial statements issued for interim and annual periods ending after September 15, 2009.  We applied this guidance as of the period ended September 30, 2009.

Oil and Gas Reporting Requirements.  In December 2008, the SEC issued Release No. 33-8995, “Modernization of Oil and Gas Reporting” (the “Release”).  The disclosure requirements under this Release require reporting of oil and gas reserves using an average price based upon the prior twelve-month period rather than year-end prices and the use of new technologies to determine proved reserves if those technologies have been demonstrated to result in reliable conclusions about reserves volumes.  Companies will also be allowed, but not required, to disclose probable and possible reserves in SEC filings.  In addition, companies will be required to report the independence and qualifications of its reserves preparer or auditor and file reports when a third party is relied upon to prepare reserves estimates or conduct a reserves audit.  The new disclosure requirements become effective beginning with our annual report on Form 10-K for the year ending December 31, 2009.   In October 2009, the SEC issued Staff Accounting Bulletin (“SAB”) No. 113 to bring existing SEC guidance into conformity with the Release.  The principle revisions of the guidance include changing the price used in determining quantities of oil and gas reserves, as noted above; eliminating the option to use post-quarter-end prices to evaluate write-offs of excess capitalized costs under the full cost method of accounting; removing the exclusion of unconventional methods used in extracting oil and gas from oil sands or shale as an oil and gas producing activity; and removing certain questions and interpretative guidance which are no longer necessary.   In January 2010, the FASB issued its guidance on oil and gas reserve estimation and disclosure, aligning their requirements with the SEC’s final rule.  The Company applied this guidance at December 31, 2009 as a change in accounting principle that is inseparable from a change in accounting estimate.  This methodology was different than that applied at December 31, 2008 and March 31, 2009, each of which resulted in a ceiling test write-down.  The effect of the adoption at December 31, 2009 was not significant to our financial statements. The adoption of the new rule will result in future amounts recorded for depreciation, depletion and amortization and ceiling limitations being different from what would have been recorded if the new rules would not have been mandated.  See Item 8. “Financial Statements and Supplementary Data, Supplemental Oil and Gas Disclosures.”

Off-Balance Sheet Arrangements
 
At December 31, 2009 and 2008, we did not have any off-balance sheet arrangements.
 
Forward-Looking Statements
 
This report includes forward-looking information regarding Rosetta that is intended to be covered by the “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. All statements other than statements of historical fact included or incorporated by reference in this report are forward-looking statements, including without limitation all statements regarding future plans, business objectives, strategies, expected future financial position or performance, expected future operational position or performance, budgets and projected costs, future competitive position, or goals and/or projections of management for future operations. In some cases, you can identify a forward-looking statement by terminology such as “may,” “will,” “could,” “should,” “expect,” “plan,” “project,” “intend,” “anticipate,” “believe,” “estimate,” “predict,” “potential,” “pursue,” “target” or “continue,” the negative of such terms or variations thereon, or other comparable terminology.
 
The forward-looking statements contained in this report are largely based on our expectations for the future, which reflect certain estimates and assumptions made by our management. These estimates and assumptions reflect our best judgment based on currently known market conditions, operating trends, and other factors. Although we believe such estimates and assumptions to be reasonable, they are inherently uncertain and involve a number of risks and uncertainties that are beyond our control. As such, management’s assumptions about future events may prove to be inaccurate. For a more detailed description of the risks and uncertainties involved, see Item 1A. “Risk Factors” in Part I. of this report.  We do not intend to publicly update or revise any forward-looking statements as a result of new information, future events, changes in circumstances, or otherwise. These cautionary statements qualify all forward-looking statements attributable to us, or persons acting on our behalf. Management cautions all readers that the forward-looking statements contained in this report are not guarantees of future performance, and we cannot assure any reader that such statements will be realized or that the events and circumstances they describe will occur. Factors that could cause actual results to differ materially from those anticipated or implied in the forward-looking statements herein include, but are not limited to:  

 
the supply and demand for natural gas and oil;
 
the price of oil and natural gas;

general economic conditions, either internationally, nationally or in jurisdictions affecting our business;

conditions in the energy and economic markets;

our ability to access the capital markets on favorable terms or at all;

our ability to obtain credit and/or capital in desired amounts and/or on favorable terms;

the ability and willingness of our current or potential counterparties or vendors to enter into transactions with us and/or to fulfill their obligations to us;

failure of our joint interest partners to fund any or all of their portion of any capital program;

the occurrence of property acquisitions or divestitures;

reserve levels;

inflation;

competition in the oil and natural gas industry;

the availability and cost of relevant raw materials, goods and services;

the availability and cost of processing and transportation;

changes or advances in technology;

potential reserve revisions;  
 
future processing volumes and pipeline throughput;
 
developments in oil-producing and natural gas-producing countries;
 
drilling and exploration risks;

several possible new legislative initiatives and regulatory changes potentially adversely impacting our business and industry, including, but not limited to,  national healthcare, cap and trade, hydraulic fracturing, state and federal corporate income taxes, retroactive royalty or production tax regimes, changes in environmental regulations, environmental risks and liability under federal, state and local environmental laws and regulations;

effects of the application of applicable laws and regulations, including changes in such regulations or the interpretation thereof;

present and possible future claims, litigation and enforcement actions;

lease termination due to lack of activity or other disputes with mineral lease and royalty owners, whether regarding calculation and payment of royalties or otherwise;

the weather, including the occurrence of any adverse weather conditions and/or natural disasters affecting our business; and

any other factors that impact or could impact the exploration of oil or natural gas resources, including but not limited to the geology of a resource, the total amount and costs to develop recoverable reserves, legal title, regulatory, natural gas administration, marketing and operational factors relating to the extraction of oil and natural gas.

 
Item 7A.  Quantitative and Qualitative Disclosures about Market Risk
 
The primary objective of the following information is to provide forward-looking quantitative and qualitative information about our potential exposure to market risks. The term “market risk” refers to the risk of loss arising from adverse changes in oil and natural gas prices and interest rates. The disclosures are not meant to be precise indicators of expected future losses, but rather indicators of reasonable possible losses. This forward-looking information provides indicators of how we view and manage our ongoing market risk exposures. All of our market risk sensitive instruments were entered into for purposes other than speculative trading.  See Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Commodity Price Risk, Interest Rate Risk and Related Hedging Activities.”
 
Commodity Price Risk. Our major market risk exposure is in the pricing of our oil and natural gas production. Realized pricing is primarily driven by the prevailing worldwide price for crude oil and spot market prices applicable to our U.S. natural gas production. Pricing for oil and natural gas production has been volatile and unpredictable for several years, and we expect this volatility to continue in the future. The prices we receive for production depend on many factors outside of our control.
 
Our fixed-price swap agreements are used to fix the sales price for our anticipated future oil and natural gas production. Upon settlement, we receive a fixed price for the hedged commodity and pay our counterparty a floating market price, as defined in each instrument. These instruments are settled monthly. When the floating price exceeds the fixed price for a contract month, we pay our counterparty. When the fixed price exceeds the floating price, our counterparty is required to make a payment to us. We have designated these swaps as cash flow hedges.

We use derivative transactions to manage exposure to changes in commodity prices and interest rates. Our objective for holding derivative instruments is to achieve a consistent level of cash flow to support a portion of our planned capital spending. Our use of derivative transactions for hedging activities could materially affect our results of operations, in particular quarterly or annual periods since such instruments can limit our ability to benefit from favorable interest rate movements. We do not enter into derivative instruments for speculative purposes.
 
We believe the use of derivative transactions, although not free of risk, allows us to reduce our exposure to oil and natural gas sales price fluctuations and interest rates and thereby achieve a more predictable cash flow. While the use of derivative instruments limits the downside risk of adverse price movements, their use may also limit future revenues from favorable price movements. Moreover, our derivative contracts generally do not apply to all of our production or variable rate debt and thus provide only partial price protection against declines in commodity prices or rising interest rates. We expect that the amount of our derivative contracts will vary from time to time.

On December 31, 2009, we had open natural gas derivative hedges in an asset position with a fair value of $7.4 million.  A 10 percent increase in natural gas prices would reduce the fair value by approximately $10.3 million, while a 10 percent decrease in natural gas prices would increase the fair value by approximately $10.5 million.  The effects of these derivative transactions on our natural gas sales are discussed above under “Results of Operations – Natural Gas”.  These fair value changes assume volatility based on prevailing market parameters at December 31, 2009.  In addition, the majority of our capital expenditures is discretionary and could be curtailed if our cash flows decline from expected levels.

Our current cash flow hedge positions are with counterparties who are lenders in our credit facilities.  Based upon communications with these counterparties, we expect the obligations under these transactions to continue to be met. We evaluated nonperformance risk using current credit default swap values and default probabilities for each counterparty and recorded a downward adjustment to the fair value of our derivative assets in the amount of $0.01 million at December 31, 2009.  We currently know of no circumstances that would limit access to our credit facility or require a change in our debt or hedging structure.
 
At December 31, 2009, we had the following financial fixed price swap and costless collar positions outstanding with average underlying prices that represent hedged prices of commodities at various market locations:

 
Settlement
Period
Derivative
Instrument
Hedge
Strategy
 
Notional Daily Volume
MMBtu
   
Total of Notional Volume
MMBtu
   
Average Floor/Fixed Prices per
MMBtu
   
Average Ceiling Prices per MMBtu
   
Natural Gas Production Hedged (1)
   
Fair Market Value
Asset/(Liability)
(In thousands)
 
2010
Swap
Cash flow
    15,000       5,475,000     $ 7.46     $ -       13 %   $ 8,834  
2010
Costless Collar
Cash flow
    15,041       5,490,000       5.75       7.40       13 %     548  
2011
Swap
Cash flow
    5,000       1,825,000       5.72               5 %     (408 )
2011
Costless Collar
Cash flow
    25,000       9,125,000       5.80       7.58       23 %     (1,552 )
                  21,915,000                             $ 7,422  
____________________________________

 
(1)
Estimated based on anticipated future gas production.

 
In January 2010, we entered into additional costless collar transactions to hedge 10,000 MMBtu/d of our expected production for July 2010 through December 2012.  The costless collars have a floor price of $5.75 per MMBtu and a ceiling price of $6.50 per MMBtu through 2011 and $7.15 per MMBtu in 2012.  In February 2010, we entered into natural gas fixed-price swaps to hedge 10,000 MMBtu/d of our expected production for July 2010 through December 2011 at an average price of $5.91 per MMBtu. 

Interest Rate Risks. We have entered into a series of fixed rate swap agreements for a portion of our variable rate debt.  Our fixed-rate swap agreements are used to fix the interest rate we pay under our variable rate credit facilities. The fixed-rate swaps are freestanding financial agreements that require us and the counterparty to net cash settle our gains and losses on a monthly basis.  Upon settlement, we receive a floating market LIBOR rate and pay our counterparty a fixed interest rate, as defined in each instrument. When the floating rate exceeds the fixed rate for a contract month, our counterparty pays us. When the fixed price exceeds the floating price, we are required to make a payment to our counterparty. We have designated these swaps as cash flow hedges.  At December 31, 2009, we had open interest rate swap hedges in a liability position of $0.6 million.  A 10 percent increase in interest rates would increase the fair value by approximately $0.06 million, while a 10 percent decrease in interest rates would decrease the fair value by approximately $0.06 million.  These fair value changes assume volatility based on prevailing market parameters at December 31, 2009.

We have hedged the interest rates on $100.0 million of our variable rate debt through December 31, 2010.  At December 31, 2009 we had the following financial fixed interest rate swap positions outstanding:

Settlement
Period
Derivative
Instrument
Hedge
Strategy
 
Average Fixed Rate
   
Fair Market Value
Asset/(Liability)
(In thousands)
 
January 1 - December 31, 2010
Swap
Cash Flow
    1.24 %   $ (635 )

 
Item 8.  Financial Statements and Supplementary Data

Index to Financial Statements

 
Page
Report of Independent Registered Public Accounting Firm
45
Consolidated Balance Sheet at December 31, 2009 and 2008
46
Consolidated Statement of Operations for the years ended December 31, 2009, 2008 and 2007
47
Consolidated Statement of Cash Flows for the years ended December 31, 2009, 2008 and 2007
48
Consolidated Statement of Stockholders' Equity for the years ended December 31, 2009, 2008 and 2007
49
Notes to Consolidated Financial Statements
50

 
Report of Independent Registered Public Accounting Firm



To the Board of Directors
and Stockholders of Rosetta Resources Inc.
 
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, of cash flows and of stockholders' equity present fairly, in all material respects, the financial position of Rosetta Resources Inc. and its subsidiaries (the "Company") at December 31, 2009 and 2008, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2009 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, 2009, 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 Annual Report on Internal Control Over Financial Reporting appearing under Item 9A.  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.
 
As discussed in Note 2, at December 31, 2009 the Company changed the manner in which its oil and gas reserves are estimated as well as the manner in which prices are determined to calculate the ceiling limit on capitalized oil and gas costs.

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.
 
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
 
February 26, 2010
Houston, Texas

 
Item 8.  Financial Statements and Supplementary Data

Rosetta Resources Inc.
Consolidated Balance Sheet
(In thousands, except share amounts)

   
December 31,
 
   
2009
   
2008
 
Assets
           
Current assets:
           
Cash and cash equivalents
  $ 61,256     $ 42,855  
Restricted cash
    -