• our business strategy,

• estimated quantities of oil and gas reserves,

• uncertainty of commodity prices in oil and gas,

• disruption of credit and capital markets,

• our financial position,

• our cash flow and liquidity,

• replacing our oil and gas reserves,

• our inability to retain and attract key personnel,

• uncertainty regarding our future operating results,

• uncertainties in exploring for and producing oil and gas,

• high costs, shortages, delivery delays or unavailability of drilling rigs, equipment, labor or other services,

• disruptions to, capacity constraints in or other limitations on the pipeline systems which deliver our gas and other processing and transportation considerations,

• our inability to obtain additional financing necessary to fund our operations and capital expenditures and to meet our other obligations,

• competition in the oil and gas industry,

• marketing of oil, gas and natural gas liquids,

• exploitation of our current asset base or property acquisitions,

• the effects of government regulation and permitting and other legal requirements,

• plans, objectives, expectations and intentions contained in this report that are not historical, and

• other factors discussed in our 2008 Annual Report on Form 10-K and subsequent filings, including this Quarterly Report on Form 10-Q.

Overview
We are an independent energy company engaged in the exploration, development, production and acquisition of natural gas and oil properties. We have assembled leasehold interests aggregating approximately 302,484 gross (201,267 net) acres as of September 30, 2009. We operate in Texas, Kentucky and New Mexico and have non-operated interests in British Columbia.
At December 31, 2008, we had estimated proved reserves of approximately 211.1 Bcfe. At September 30, 2009, we owned working interests in 473 producing oil and gas wells. Production for the third quarter of 2009 was 21.8 MMcfe/d. Our estimated production for the month of October 2009 was 21.1 MMcfe/d. In December 2008, we announced a capital expenditure budget of $43.8 million for 2009. Due to the extended decline of oil and natural gas prices, however, in March 2009 we announced that we would not extend the contracts for our two remaining drilling rigs after March 31, 2009, and we released these rigs during the first week of April 2009.
We have resumed drilling and currently are operating two rigs in Cinco Terry. We also have begun 3-D seismic operations in Cinco Terry. We plan to move one rig into Ozona Northeast in November 2009 to begin drilling. Given the anticipated increase in activity during the remainder of 2009, we currently expect that our capital expenditures for the year ending December 31, 2009, including these projects but excluding any acquisitions, will not exceed $30 million. We intend to fund remaining 2009 capital expenditures, excluding any acquisitions, with internally-generated cash flows.

Our Board of Directors has approved a capital expenditure budget of up to $53 million for 2010. The 2010 capital expenditure budget provides for us to operate two rigs in Cinco Terry and one rig in Ozona Northeast until mid-year 2010, when we plan to operate four rigs in Cinco Terry and two rigs in Ozona Northeast.
Our financial results depend upon many factors, particularly the price of oil and gas. Commodity prices are affected by changes in market demand, which is impacted by overall economic activity, weather, pipeline capacity constraints, estimates of inventory storage levels, commodity price differentials and other factors. As a result, we cannot accurately predict future oil and gas prices, and therefore, we cannot determine what effect increases or decreases will have on our capital program, production volumes and future revenues. A substantial or extended decline in oil and gas prices could have a material adverse effect on our business, financial condition, results of operations, quantities of oil and gas reserves that may be economically produced and liquidity that may be accessed through our borrowing base under our revolving credit facility and through the capital markets. We enter into financial swaps and collars to partially mitigate the risk of market price fluctuations related to future oil and gas production. See Note 7 to our consolidated financial statements in this report for information regarding our commodity derivatives positions at September 30, 2009.
In addition to production volumes and commodity prices, finding and developing sufficient amounts of oil and gas reserves at economical costs are critical to our long-term success. Future finding and development costs are subject to changes in the industry, including the costs of acquiring, drilling and completing our projects. We focus our efforts on increasing oil and gas reserves and production while controlling costs at a level that is appropriate for long-term operations. Our future cash flow from operations will depend on our ability to manage our overall cost structure.
Like all oil and gas production companies, we face the challenge of natural production declines. Oil and gas production from a given well naturally decreases over time. Additionally, our reserves have a rapid initial decline. We generally will attempt to overcome this natural decline by drilling to develop and identify additional reserves, farm-ins or other joint drilling ventures, and by acquisitions. However, during times of severe price declines, we may from time to time reduce current capital expenditures and curtail drilling operations in order to preserve liquidity. See "Capital expenditures for 2009." A material reduction in capital expenditures and drilling activities could materially reduce our production volumes and revenues from pre-2009 levels and increase future expected costs necessary to develop existing reserves. As discussed above, due to the extended decline of oil and natural gas prices, we released our remaining rigs during the first week of April 2009. The natural decline of our tight gas fields and reduced drilling activity has caused a decline in our average daily production since the three months ended March 31, 2009. Notwithstanding these periods of reduced capital expenditures or curtailed production, our future growth will depend upon our ability over the long term to continue to add oil and gas reserves in excess of production at a reasonable cost. We intend to maintain our focus on the costs of adding reserves through drilling and acquisitions as well as the costs necessary to produce such reserves.
We also face the challenge of financing future acquisitions. We believe we have adequate unused borrowing capacity under our revolving credit facility for possible acquisitions, temporary working capital needs and expansion of our drilling program. However, funding for future acquisitions also may require additional sources of financing, which may not be available.

Results of operations

                                                  Three Months Ended                Nine Months Ended
                                                    September 30,                     September 30,
                                                 2009             2008            2009             2008

Revenues (in thousands):
Gas                                           $    5,001        $ 14,456        $  16,936        $ 47,900
Oil                                                2,490           5,973            7,700          13,223
NGLs                                               1,296           1,586            4,131           4,054

Total oil and gas sales                            8,787          22,015           28,767          65,177

Realized gain (loss) on commodity
derivatives                                        4,271            (195 )         11,896            (676 )

Total oil and gas sales including
derivative impact                             $   13,058        $ 21,820        $  40,663        $ 64,501


Production:
Gas (MMcf)                                         1,505           1,588            4,900           4,927
Oil (MBbls)                                           39              54              155             120
NGLs (MBbls)                                          44              28              164              75

Total (MMcfe)                                      2,003           2,080            6,817           6,097
Total (MMcfe/d)                                     21.8            22.6             25.0            22.3

Average prices:
Gas (per Mcf)                                 $     3.32        $   9.10        $    3.46        $   9.72
Oil (per Bbl)                                      63.49          110.61            49.53          110.19
NGLs (per Bbl)                                     29.72           56.64            25.18           54.05

Total (per Mcfe)                              $     4.39        $  10.58        $    4.22        $  10.69

Realized gain (loss) on commodity
derivatives (per Mcfe)                              2.13           (0.09 )           1.75           (0.11 )

Total including derivative impact (per
Mcfe)                                         $     6.52        $  10.49        $    5.97        $  10.58

Costs and expenses (per Mcfe):
Lease operating                               $     0.95        $   0.89        $    0.88        $   0.84
Severance and production taxes                      0.23            0.47             0.20            0.47
Exploration                                         0.27               -             0.08            0.24
General and administrative                          1.12            0.92             1.07            0.93
Depletion, depreciation and amortization            2.79            2.41             2.75            2.67

Glossary
Bbl. One stock tank barrel, of 42 U.S. gallons liquid volume, used herein to reference oil, condensate or NGLs.
Bcf. Billion cubic feet of natural gas.
Bcfe. Billion cubic feet equivalent, determined using the ratio of six Mcf of natural gas to one Bbl of oil, condensate or NGLs. MBbl. Thousand barrels of oil, condensate or NGLs. Mcf. Thousand cubic feet of natural gas.
Mcfe. Thousand cubic feet equivalent, determined using the ratio of six Mcf of natural gas to one Bbl of oil, condensate or NGLs. MMBtu. Million British thermal units.
MMcf. Million cubic feet of natural gas.
MMcfe. Million cubic feet equivalent, determined using the ratio of six Mcf of natural gas to one Bbl of oil, condensate or NGLs. NGLs. Natural gas liquids.
/d. "Per day" when used with volumetric units or dollars.

Three months ended September 30, 2009 compared to three months ended September 30, 2008
Oil and gas production. Production for the three months ended September 30, 2009 totaled 2.0 Bcfe (21.8 MMcfe/d), compared to 2.1 Bcfe (22.6 MMcfe/d) produced in the prior year period, a decrease of 3.7%. Production for the three months ended September 30, 2009 was 75% natural gas and 25% oil and NGLs, compared to 76% natural gas and 24% oil and NGLs in prior year period. Tight gas sands are unconventional natural gas reservoirs. Production from these reservoirs has a high initial rate of decline in the early life of the well. The natural decline of our tight gas fields and reduced drilling activity has caused a decline in our average daily production from the three months ended September 30, 2008 to the three months ended September 30, 2009. Production declined at a faster rate in our Cinco Terry field than Ozona Northeast, which we believe is typical given its earlier stage of development. Production declined at a slower rate in Ozona Northeast due to the later stage of development of the field.
Oil and gas sales. Oil and gas sales decreased $13.2 million, or 60.1%, for the three months ended September 30, 2009 to $8.8 million from $22.0 million for the three months ended September 30, 2008. The decrease in oil and gas sales principally resulted from sharp decreases in the price we received for our natural gas, oil and NGL production. The average price we received for our production, before the effect of commodity derivatives, decreased from $10.58 per Mcfe to $4.39 per Mcfe as oil and gas prices decreased significantly between the two periods. Of the $13.2 million decrease in revenues, approximately $12.5 million was attributable to a decrease in oil and gas prices and approximately $749,000 was attributable to a reduction in production volumes. Commodity derivative activities. Realized gains and losses from our commodity derivative activity resulted in a gain of $4.3 million and a loss of $195,000 for the three months ended September 30, 2009 and 2008, respectively. Our average realized price, including the effect of commodity derivatives, was $6.52 per Mcfe for the three months ended September 30, 2009, compared to $10.49 per Mcfe for the three months ended September 30, 2008. Realized gains and losses on commodity derivatives are derived from the relative movement of gas prices in relation to the range of prices in our collars or the fixed notional pricing in our price swaps for the applicable periods. The unrealized loss on commodity derivatives was $6.4 million for the three months ended September 30, 2009, and the unrealized gain on commodity derivatives was $18.6 million for the three months ended September 30, 2008. As natural gas commodity prices increase, the fair value of the open portion of those positions decreases. As natural gas commodity prices decrease, the fair value of the open portion of those positions increases. Historically, we have not designated our derivative instruments as cash-flow hedges. We record our open derivative instruments at fair value on our consolidated balance sheets as either unrealized gains or losses on commodity derivatives. We record changes in such fair value in earnings on our consolidated statements of operations under the caption entitled "unrealized
(loss) gain on commodity derivatives." Lease operating expenses. Our lease operating expenses, or LOE, were relatively constant with an increase of $52,000, or 2.8%, for the three months ended September 30, 2009 to $1.9 million ($0.95 per Mcfe) from $1.8 million ($0.89 per Mcfe) for the three months ended September 30, 2008. The increase in LOE per Mcfe over the prior year period was due primarily to increases in pumping and supervision, well related repairs and maintenance, compression and water hauling, certain of which are fixed costs, partially offset by lower ad valorem taxes and workover expenses. The following is a summary of LOE (per Mcfe):

                                          Three Months Ended
                                             September 30,
                                          2009           2008       Change       % Change

   Compression and gas treating         $    0.26       $  0.24     $  0.02            8.3 %
   Water hauling, insurance and other        0.18          0.16        0.02           12.5
   Pumping and supervision                   0.18          0.13        0.05           38.5
   Ad valorem taxes                          0.18          0.21       (0.03 )        (14.3 )
   Well repairs and maintenance              0.14          0.11        0.03           27.3
   Workovers                                 0.01          0.04       (0.03 )        (75.0 )

   Total                                $    0.95       $  0.89     $  0.06            6.7 %

Severance and production taxes. Our production taxes decreased $513,000, or 53.0%, for the three months ended September 30, 2009 to $455,000 from $968,000 for the three months ended September 30, 2008. The decrease in production taxes was a function of the decrease in oil and gas sales between the two periods. Severance and production taxes amounted to approximately 5.2% and 4.4% of oil and gas sales for the respective periods.
Exploration. We recorded $534,000 of exploration expense for the three months ended September 30, 2009. Exploration expense in the 2009 period resulted primarily from the expiration of leases for approximately 2,300 net acres in our Ozona Northeast and North Bald Prairie fields. We recorded no exploration expense for the three months ended September 30, 2008.
General and administrative. Our general and administrative, or G&A, expenses increased $314,000, or 16.3%, to $2.2 million ($1.12 per Mcfe) for the three months ended September 30, 2009 from $1.9 million ($0.92 per Mcfe) for the three months ended September 30, 2008. The increase in G&A expenses was principally due to increased staffing and share-based compensation. Following is a summary of G&A expenses (in millions and per Mcfe):

                                       Three Months Ended
                                          September 30,
                                     2009               2008                 Change
                               $MM       Mcfe       $MM       Mcfe       $MM       Mcfe       % Change
   Salaries and benefits      $ 1.0     $ 0.48     $ 0.8     $ 0.40     $ 0.2     $ 0.08           20.0 %
   Share-based compensation     0.4       0.21       0.3       0.15       0.1       0.06           40.0
   Professional fees            0.3       0.15       0.3       0.15         -          -              -
   Other                        0.5       0.28       0.5       0.22         -       0.06           27.3

   Total                      $ 2.2     $ 1.12     $ 1.9     $ 0.92     $ 0.3     $ 0.20           21.7 %

Depletion, depreciation and amortization. Our depletion, depreciation and amortization, or DD&A, expense increased $579,000, or 11.5%, to $5.6 million for the three months ended September 30, 2009 from $5.0 million for the three months ended September 30, 2008. Our DD&A expense per Mcfe increased by $0.38, or 15.8%, to $2.79 per Mcfe for the three months ended September 30, 2009, compared to $2.41 per Mcfe for the three months ended September 30, 2008. The increase in DD&A expense was primarily attributable to an increase in capitalized costs, partially offset by a decrease in production over the prior year period. Interest expense, net. Our interest expense, net, increased $28,000, or 6.6%, to $451,000 for the three months ended September 30, 2009 from $423,000 for the three months ended September 30, 2008. This increase was substantially the result of our higher average debt level in the 2009 period, partially offset by lower interest rates in the 2009 period.
Income taxes. Our income taxes decreased $11.8 million to a benefit of $1.4 million for the three months ended September 30, 2009, from a provision of $10.4 million for the three months ended September 30,

2008. The decrease in income tax provision was due to the decrease in our income before taxes. Our effective income tax rate for the three months ended September 30, 2009 was 30.5%, compared with 34.4% for the three months ended September 30, 2008. The decrease in the effective tax rate relates primarily to the increased impact of permanent differences between book and taxable income. Nine months ended September 30, 2009 compared to nine months ended September 30, 2008
Oil and gas production. Production for the nine months ended September 30, 2009 totaled 6.8 Bcfe (25.0 MMcfe/d), compared to 6.1 Bcfe (22.3 MMcfe/d) produced in the prior year period, an increase of 11.8%. Production for the nine months ended September 30, 2009 was 72% natural gas and 28% oil and NGLs, compared to 81% natural gas and 19% oil and NGLs in prior year period.
Oil and gas sales. Oil and gas sales decreased $36.4 million, or 55.9%, for the nine months ended September 30, 2009 to $28.8 million from $65.2 million for the nine months ended September 30, 2008. The decrease in oil and gas sales principally resulted from sharp decreases in the price we received for our natural gas, oil and NGL production. The decrease in oil and gas sales was partially offset by a 1.1 MMcfe increase in production from the continued development of our Cinco Terry field. The average price we received for our production, before the effect of commodity derivatives, decreased from $10.69 per Mcfe to $4.22 per Mcfe as oil and gas prices decreased significantly between the two periods. Of the $36.4 million decrease in revenues, approximately $40.3 million was attributable to a decrease in oil and gas prices, which was partially offset by approximately $3.9 million attributable to growth in production volume from the continued development in Cinco Terry.
Commodity derivative activities. Realized gains and losses from our commodity derivative activity resulted in a gain of $11.9 million and a loss of $676,000 for the nine months ended September 30, 2009 and 2008, respectively. Our average realized price, including the effect of commodity derivatives, was $5.97 per Mcfe for the nine months ended September 30, 2009, compared to $10.58 per Mcfe for the nine months ended September 30, 2008. Realized gains and losses on commodity derivatives are derived from the relative movement of gas prices in relation to the range of prices in our collars or the fixed notional pricing in our price swaps for the applicable periods. The unrealized loss on commodity derivatives was $8.6 million for the nine months ended September 30, 2009, and the unrealized gain on commodity derivatives was $4.1 million for the nine months ended September 30, 2008. As natural gas commodity prices increase, the fair value of the open portion of those positions decreases. As natural gas commodity prices decrease, the fair value of the open portion of those positions increases. Historically, we have not designated our derivative instruments as cash-flow hedges. We record our open derivative instruments at fair value on our consolidated balance sheets as either unrealized gains or losses on commodity derivatives. We record changes in such fair value in earnings on our consolidated statements of operations under the caption entitled "unrealized
(loss) gain on commodity derivatives." Lease operating expenses. Our LOE increased $921,000, or 18.1%, for the nine months ended September 30, 2009 to $6.0 million ($0.88 per Mcfe) from $5.1 million ($0.84 per Mcfe) for the nine months ended September 30, 2008. The increase in LOE per Mcfe over the prior year period was due in part to increases in compression and pumping and supervision, partially offset by lower well-related repair and maintenance, ad valorem taxes and workover expenses. The following is a summary of LOE (per Mcfe):

                                           Nine Months Ended
                                             September 30,
                                           2009           2008      Change       % Change
    Compression and gas treating         $    0.30       $ 0.24     $  0.06           25.0 %
    Water hauling, insurance and other        0.16         0.14        0.02           14.3
    Ad valorem taxes                          0.16         0.17       (0.01 )         (5.9 )
    Pumping and supervision                   0.15         0.13        0.02           15.4
    Well repairs and maintenance              0.10         0.13       (0.03 )        (23.1 )
    Workovers                                 0.01         0.03       (0.02 )        (66.7 )

    Total                                $    0.88       $ 0.84     $  0.04            4.8 %

Severance and production taxes. Our production taxes decreased $1.5 million, or 51.9%, for the nine months ended September 30, 2009 to $1.4 million from $2.9 million for the nine months ended September 30, 2008. The decrease in production taxes was a function of the decrease in oil and gas sales between the two periods. Severance and production taxes amounted to approximately 4.8% and 4.4% of oil and gas sales for the respective periods.
Exploration. We recorded $534,000 and $1.5 million of exploration expense for the nine months ended September 30, 2009 and 2008, respectively. Exploration expense in the 2009 period resulted primarily from the expiration of leases for approximately 2,300 net acres in our Ozona Northeast and North Bald Prairie . . .