COSTILLA ENERGY INC, PRES14A, 1998-10-16

COSTILLA ENERGY INC
PRES14A, 1998-10-16
CRUDE PETROLEUM & NATURAL GAS

Previous: BAMCO INC /NY/, SC 13D/A, 1998-10-16

Next: MARQUEE GROUP INC, 8-K/A, 1998-10-16

<PAGE> 1

SCHEDULE 14A INFORMATION

PROXY STATEMENT PURSUANT TO SECTION 14(a) OF THE SECURITIES
EXCHANGE ACT OF 1934 (AMENDMENT NO. )

Filed by the Registrant [X]
Filed by a Party other than the Registrant [ ]
Check the appropriate box:
[X] Preliminary Proxy Statement
[ ] Confidential, for use of the Commission
Only (as permitted by Rule 14a-6(e)(2))
[ ] Definitive Proxy Statement
[ ] Definitive Additional Materials
[ ] Soliciting Material Pursuant to sec. 240.14a-11(c) or sec. 240.14a-12

COSTILLA ENERGY, INC.
- --------------------------------------------------------------------------------
(Name of Registrant as Specified in its Charter)

COSTILLA ENERGY, INC.
- --------------------------------------------------------------------------------
(Name of Person(s) Filing Proxy Statement)

Payment of Filing Fee (Check the appropriate box):
[X] No fee required.
[ ] Fee computed on table below per Exchange Act Rules 14a-6(i)(1) and
0-11.

1) Title of each class of securities to which transaction applies:

- --------------------------------------------------------------------------------
2) Aggregate number of securities to which transaction applies:

- --------------------------------------------------------------------------------
3) Per unit price or other underlying value of transaction computed
pursuant to Exchange Act Rule 0-11 (Set forth the amount on which the filing fee
is calculated and state how it was determined):

- --------------------------------------------------------------------------------
4) Proposed maximum aggregate value of transaction:

- --------------------------------------------------------------------------------
5) Total fee paid:

- --------------------------------------------------------------------------------

[ ] Fee paid previously with preliminary materials.

[ ] Check box if any part of the fee is offset as provided by Exchange Act
Rule 0-11(a)(2) and identify the filing for which the offsetting fee was paid
previously. Identify the previous filing by registration statement number, or
the Form or Schedule and the date of its filing.

1) Amount Previously Paid:

- --------------------------------------------------------------------------------
2) Form, Schedule or Registration Statement No.:

- --------------------------------------------------------------------------------
3) Filing Party:

- --------------------------------------------------------------------------------
4) Date Filed:

- --------------------------------------------------------------------------------
<PAGE> 2

PRELIMINARY COPY

COSTILLA ENERGY, INC.
400 WEST ILLINOIS, SUITE 1000
MIDLAND, TEXAS 79701

, 1998

Dear Stockholder:

You are cordially invited to attend a Special Meeting of Stockholders of
Costilla Energy, Inc. ("Costilla"), which will be held at the Petroleum Club,
501 West Wall Avenue, Midland, Texas at 10:00 a.m., local time, on ,
1998.

At the Special Meeting, you will be asked to approve certain matters
related to the proposed acquisition by Costilla of oil and gas properties and
associated assets (the "Acquisition") from Pioneer Natural Resources USA, Inc.
Please note that stockholder approval of the Acquisition is not required and is
not being requested; however, the Company's ability to consummate the
Acquisition may depend upon stockholder approval of the following matters which
you will be asked to approve:

(1) an amendment to Costilla's Certificate of Incorporation (the
"Charter Amendment") to increase its authorized Common Stock from 20
million shares to 100 million shares;

(2) the issuance of up to 250,000 shares of Convertible Preferred
Stock (the "New Preferred Stock") and up to 35 million shares of Common
Stock, the net cash proceeds of which will be used to fund a portion of the
Acquisition purchase price, and the potential issuance of an indeterminable
number of shares of Common Stock which may be issued in payment of
dividends on, or upon conversion of, the New Preferred Stock (collectively,
the "Stock Issuance"); and

(3) an amendment to the Company's 1996 Stock Option Plan (the "Option
Plan") to increase the number of shares of Common Stock reserved and
authorized under the plan from 1,250,000 shares to 4,000,000 shares (the
"Plan Amendment").

Your approval of these proposals will assist Costilla in completing the
Acquisition and permit further use of the Option Plan to provide incentives to
the Company's officers and employees. The Charter Amendment, Stock Issuance and
Plan Amendment are described in the accompanying Proxy Statement, together with
a description of the properties to be acquired and certain other information
relating to the Acquisition.

THE BOARD OF DIRECTORS OF COSTILLA HAS DETERMINED THAT THE ACQUISITION IS
IN THE BEST INTERESTS OF THE HOLDERS OF SHARES OF COMMON STOCK. ACCORDINGLY, THE
BOARD HAS UNANIMOUSLY APPROVED THE ACQUISITION, THE CHARTER AMENDMENT, THE STOCK
ISSUANCE AND PLAN AMENDMENT, AND RECOMMENDS THAT YOU VOTE IN FAVOR OF THE
CHARTER AMENDMENT, THE STOCK ISSUANCE AND PLAN AMENDMENT AT THE SPECIAL MEETING.

Your vote is very important. Please mark, date, sign and return the
enclosed proxy in the enclosed postage prepaid envelope as soon as possible,
regardless of whether you plan to attend the meeting.

Thank you. We look forward to seeing you at the meeting.

Sincerely,

COSTILLA ENERGY, INC.

By:
----------------------------------
Michael J. Grella, President
<PAGE> 3

PRELIMINARY COPY

COSTILLA ENERGY, INC.

400 WEST ILLINOIS, SUITE 1000
MIDLAND, TEXAS 79701

NOTICE OF SPECIAL MEETING OF STOCKHOLDERS
TO BE HELD ON , 1998

Dear Stockholder:

A Special Meeting of Stockholders of Costilla Energy, Inc. ("Costilla")
will be held at the Petroleum Club, 501 West Wall Avenue, Midland, Texas at
10:00 a.m., local time, on , 1998 to consider and vote upon the
following matters in connection with the acquisition by Costilla of oil and gas
properties and related assets (the "Acquisition") from Pioneer Natural Resources
USA, Inc.:

(1) an amendment to Costilla's Certificate of Incorporation (the
"Charter Amendment") to increase its authorized Common Stock from 20
million shares to 100 million shares;

(3) an amendment to the Company's 1996 Stock Option Plan to increase
the number of shares of Common Stock reserved and authorized under the plan
from 1,250,000 to 4,000,000 shares (the "Plan Amendment"); and

(4) the transaction of such other business, if any, as may properly
come before the Special Meeting or any adjournments or postponements
thereof.

The approval of the Charter Amendment requires the affirmative vote of a
majority of the outstanding shares of Costilla Common Stock. The approval of the
Stock Issuance and the Plan Amendment each requires the affirmative vote of a
majority of the shares of Common Stock represented at the Meeting in person or
by proxy and entitled to vote thereon, so long as a quorum is present at the
Meeting. Approval of the creation and issuance of the New Preferred Stock also
requires the affirmative vote of a majority of the outstanding shares of
Costilla's currently outstanding 7% (8% Paid in Kind) Series A Cumulative
Convertible Preferred Stock.

YOUR VOTE IS VERY IMPORTANT. PLEASE MARK, DATE AND SIGN THE ENCLOSED PROXY
CARD AND RETURN IT PROMPTLY IN THE ENCLOSED POSTAGE PREPAID RETURN ENVELOPE,
REGARDLESS OF WHETHER YOU EXPECT TO ATTEND THE MEETING. IF YOU SIGN AND RETURN
YOUR PROXY CARD WITHOUT SPECIFYING HOW YOU WOULD LIKE YOUR SHARES VOTED, YOUR
SHARES WILL BE VOTED FOR THE CHARTER AMENDMENT, THE STOCK ISSUANCE AND THE PLAN
AMENDMENT. YOU MAY REVOKE YOUR PROXY BY SIGNING AND RETURNING A LATER DATED
PROXY WITH RESPECT TO THE SAME SHARES, BY FILING WITH THE SECRETARY OF COSTILLA
A DULY EXECUTED REVOCATION, OR BY ATTENDING THE SPECIAL MEETING AND VOTING IN
PERSON (ALTHOUGH ATTENDANCE AT THE SPECIAL MEETING WILL NOT IN AND OF ITSELF
CONSTITUTE A REVOCATION OF YOUR PROXY).

By order of the Board of Directors

Bobby W. Page
Secretary
<PAGE> 4

PRELIMINARY COPY

COSTILLA ENERGY, INC.

PROXY STATEMENT

This Proxy Statement is being furnished to stockholders (the
"Stockholders") of Costilla Energy, Inc., a Delaware corporation (together with
its predecessors and subsidiaries as the context may require, the "Company" or
"Costilla"), in connection with the solicitation of proxies by the Company's
Board of Directors for use at a Special Meeting of Stockholders (the "Special
Meeting" or the "Meeting") to be held at the Petroleum Club, 501 West Wall
Avenue, Midland, Texas on , 1998 at 10:00 a.m., local time, and at any
adjournments or postponements thereof.

At the Special Meeting, the Stockholders will be asked to approve certain
matters related to the proposed acquisition (the "Acquisition") by Costilla of
oil and gas properties and associated assets from Pioneer Natural Resources
U.S.A., Inc. ("Pioneer") for a purchase price of $410 million. Specifically, the
Stockholders will be asked to consider and vote upon the following matters:

(1) An amendment to Costilla's Certificate of Incorporation to
increase its authorized Common Stock, $0.10 par value (the "Common Stock"),
from 20 million shares to 100 million shares (the "Charter Amendment");

(2) The issuance of up to 250,000 shares of Convertible Preferred
Stock (the "New Preferred Stock") and up to 35 million shares of Common
Stock (the "Acquisition Common"), the net cash proceeds of which will be
used to fund a portion of the Acquisition purchase price, and the potential
issuance of an indeterminable number of shares of Common Stock which may be
issued in payment of dividends on (the "Dividend Common"), or upon
conversion of (the "Conversion Common"), the New Preferred Stock pursuant
to the terms thereof (collectively, the "Stock Issuance");

(3) An amendment to the Company's 1996 Stock Option Plan (the "Option
Plan") to increase the number of shares of Common Stock reserved and
authorized under the Option Plan from 1,250,000 shares to 4,000,000 shares
(the "Plan Amendment"); and

(4) Such other business, if any, as may properly come before the
Special Meeting or any adjournments or postponements thereof.

Approval of such matters is required pursuant to certain provisions of the
Delaware General Corporation Law and the listing requirements of the Nasdaq
National Market. Approval of the Acquisition by the Stockholders is not
required, and the Stockholders are not being asked to consider and vote on the
Acquisition itself. However, the Company's ability to consummate the Acquisition
may depend upon Stockholder approval of the Charter Amendment and the Stock
Issuance.

This Proxy Statement and the accompanying form of proxy are first being
mailed to Stockholders on or about , 1998.
---------------------

The Date of This Proxy Statement is , 1998.

1
<PAGE> 5

AVAILABLE INFORMATION

The Company is subject to the reporting requirements of the Securities
Exchange Act of 1934, as amended (the "Exchange Act"), and, in accordance
therewith, files reports, proxy statements and other information with the
Securities and Exchange Commission (the "Commission"). Such reports, proxy
statements and other information can be inspected and copied at the Public
Reference Room maintained by the Commission at 450 Fifth Street, N.W.,
Washington, D.C. 20549 and at its Regional Offices at Seven World Trade Center,
Suite 1300, New York, NY 10048 and the CitiCorp Center, 500 West Madison Street,
Suite 1400, Chicago, IL 60661. Copies of such material also may be obtained by
mail at prescribed rates from the Public Reference Section of the Commission,
450 Fifth Street, N.W., Washington, D.C. 20549. Information on the operation of
the Public Reference Room may be obtained by calling the Commission at
1-800-SEC-0330. In addition, information that the Company and other registrants
have filed electronically with the Commission is available on the Internet
through the Commission's EDGAR data base at http://www.sec.gov.

Certain information is also available from the Company by request to its
principal offices at 400 West Illinois, Suite 1000, Midland, Texas 79701, Attn:
Corporate Secretary (telephone number 915-683-3092).

2
<PAGE> 6

TABLE OF CONTENTS

<TABLE>
<CAPTION>
PAGE
----
<S> <C>
Available Information....................................... 2
Summary
General................................................... 5
The Acquisition........................................... 5
The Stock Issuance........................................ 6
The Meeting............................................... 6
Intent of Certain Insiders and Affiliates................. 7
Summary Financial Information............................. 8
Summary Reserve Data...................................... 9
Summary Operating Data.................................... 9
Cautionary Statement Regarding Forward-Looking Statements... 10
Potential Effects of Stockholder Vote....................... 10
Potential Effects of Consummating the Transactions........ 10
Potential Effects of Not Consummating the Transactions.... 12
The Meeting................................................. 13
General................................................... 13
Purposes of Meeting....................................... 13
Record Date and Voting.................................... 13
Vote Required............................................. 13
Solicitation of Proxies................................... 14
Stockholder Proposals and Other Matters................... 14
The Charter Amendment....................................... 14
The Stock Issuance.......................................... 15
General................................................... 15
Terms of New Preferred Stock.............................. 15
Terms of Stock Agreement.................................. 16
Registration Rights....................................... 17
The Plan Amendment.......................................... 18
The Acquisition............................................. 19
General................................................... 19
The Acquisition Agreement................................. 19
The Acquisition Properties................................ 20
Funding the Acquisition................................... 22
Certain Federal Income Tax Consequences................... 22
Accounting Treatment...................................... 22
The Company................................................. 23
General................................................... 23
Business and Properties................................... 23
Oil and Gas Reserves...................................... 24
Marketing Arrangements.................................... 25
Exploration and Development Activities.................... 25
Productive Well Summary................................... 26
Acreage................................................... 26
Competition and Markets................................... 26
Regulation................................................ 27
Environmental Matters..................................... 27
Employees................................................. 28
Legal Proceedings......................................... 28
Title to Properties....................................... 29
Operational Hazards and Insurance......................... 29
</TABLE>

3
<PAGE> 7

<TABLE>
<CAPTION>
PAGE
----
<S> <C>
Price Range of Common Stock and Dividend Policy............. 29
Pro Forma Condensed Financial Statements.................... 31
Selected Financial Information.............................. 39
Management's Discussion and Analysis of Financial Condition
and Results of Operations................................. 40
Security Ownership of Certain Beneficial Owners and
Management................................................ 50
Ownership Table........................................... 50
Potential Change of Control............................... 51
Executive Compensation...................................... 52
Summary Compensation Table................................ 52
Employment Agreements..................................... 53
Option Grants in Last Fiscal Year......................... 53
Aggregated Option Exercises and Year-End Option Values.... 54
Compensation Committee Interlocks and Insider
Participation.......................................... 55
Description of Certain Indebtedness......................... 55
New Credit Facility....................................... 55
Senior Notes.............................................. 55
Auditors.................................................... 56
Petroleum Engineers......................................... 56
Glossary.................................................... 57
Index to Financial Statements............................... F-1
</TABLE>

4
<PAGE> 8

SUMMARY

The following is a summary of certain information contained elsewhere in
this Proxy Statement. This summary does not contain a complete statement of all
material information relating to the Charter Amendment, the Stock Issuance, the
Plan Amendment, the Acquisition and other matters discussed herein, and is
subject to, and qualified in its entirety by, more detailed information and
financial statements contained elsewhere in this Proxy Statement.

For purposes of pro forma information and other estimates related to the
Stock Issuance included in this Proxy Statement, it is assumed that (1) 155,000
shares of New Preferred Stock, with an initial conversion rate of $9.375 per
share, will be issued as part of the Stock Issuance, 105,000 of which will be
sold for $1,000 per share for an aggregate purchase price of $105 million and
50,000 of which will be exchanged for the 50,000 outstanding shares of the
Company's 7% (8% Paid in Kind) Series A Cumulative Convertible Preferred Stock
(the "Outstanding Preferred Stock"), (2) 20,666,667 shares of Acquisition Common
will be issued as part of the Stock Issuance and sold for $7.50 per share for an
aggregate purchase price of $155 million, (3) 16,533,333 shares of Conversion
Common will initially be authorized and reserved for issuance upon conversion of
the New Preferred Stock and (4) no shares of Dividend Common Stock will be
issued. The foregoing assumptions are for illustrative purposes. The exact
number of shares of New Preferred Stock up to 250,000 shares and the exact
number of shares of Acquisition Common up to 35 million shares, as well as the
terms of the Stock Issuance, will be determined by the Company in its
discretion.

GENERAL

Costilla is an independent oil and gas company engaged in the exploration,
acquisition and development of oil and gas properties. The Company's primary
operations are in the South/East Texas region, the Rocky Mountain region and the
Permian Basin area of Texas and New Mexico. The Company's strategy has focused
on utilizing current and developing technological advancements to increase
reserves through a targeted exploration program, strategic property acquisitions
and development of producing properties.

The Company began active efforts to acquire and develop oil and gas
properties in 1993 and, from January 1, 1993 to June 30, 1998, closed nine
acquisitions for an aggregate purchase price of approximately $149 million. The
Acquisition is a continuation of the Company's strategy of growth through
strategic negotiated property acquisitions.

THE ACQUISITION

On September 4, 1998, Costilla and Pioneer entered into a Purchase and Sale
Agreement with respect to the Acquisition (the "Acquisition Agreement"),
culminating several weeks of arms-length negotiations between the parties. Upon
execution of the Acquisition Agreement, Costilla paid a $25 million performance
deposit to Pioneer which may be subject to forfeiture if the Acquisition is not
consummated. See "Potential Effects of Stockholder Vote -- Potential Effects of
Not Consummating the Transactions -- Termination of Acquisition Agreement."
Pursuant to and subject to the terms and conditions of the Acquisition Agreement
(which are more fully described under "The Acquisition -- The Acquisition
Agreement"), the Company will purchase from Pioneer (1) producing oil and gas
properties located primarily in the Permian Basin, the South/East Texas region,
and the Mid-Continent region, (2) approximately 11 million gross undeveloped
mineral acres, (3) approximately 210,000 gross undeveloped leasehold acres, (4)
a license to use seismic data related to certain of the foregoing oil and gas
properties and (5) gas plants, pipelines and processing facilities
(collectively, the "Acquisition Properties"). The purchase price for the
Acquisition Properties is $410 million, subject to adjustment as provided in the
Acquisition Agreement. See "The Acquisition -- General." The Company expects
that, as a result of such adjustments, the adjusted purchase price will be
approximately $390 million (the "Estimated Purchase Price"). The Company intends
to fund the Estimated Purchase Price through the net cash proceeds from the
Stock Issuance and borrowings under the New Credit Facility (as defined under
"Description of Certain Indebtedness -- New Credit Facility").

5
<PAGE> 9

The Company estimates that the Acquisition Properties include, at October
1, 1998, proved reserves of approximately 436 Bcfe, with a PV-10 value of
approximately $275 million, which will more than double the Company's proved
reserves. The Company believes that the Acquisition Properties will complement
the Company's core assets, enhance the Company's operating cash flow and provide
additional opportunities for development of proved reserves. The Acquisition
Properties include approximately 210,000 gross undeveloped leasehold acres and
11 million gross undeveloped mineral acres which will provide additional
exploration opportunities for the Company. The Company anticipates that the
Acquisition will have the further benefit of diversifying Costilla's oil and gas
reserves, making the Company less dependent upon the success or failure of
individual prospects and spreading its opportunities and risks over a more
geographically and geologically diversified portfolio of properties. See "The
Acquisition -- The Acquisition Properties."

THE STOCK ISSUANCE

The Stock Issuance will consist of (1) the sale to a limited number of
institutional accredited investors of up to 35 million shares of Acquisition
Common and up to 250,000 shares of New Preferred Stock for an aggregate cash
purchase price of approximately $260 million, in a private placement exempt from
registration under state and federal securities laws; (2) an exchange of the
Outstanding Preferred Stock, which is held by two institutional investors and
has a liquidation value of $50 million, for shares of New Preferred Stock; and
(3) the potential issuance of the Dividend Common and the Conversion Common. The
cash investors in the Stock Issuance and the holders of the Outstanding
Preferred Stock are referred to collectively herein as the "New Investors." The
exact number of shares of each of the New Preferred Stock and Acquisition Common
which will be issued in the Stock Issuance will be determined by the Company in
its discretion. While the Company anticipates that the Stock Issuance will be
made to not more than 10 New Investors (each of whom will make a minimum
investment of $15 million) on the terms described under "The Stock Issuance,"
the Company is seeking Stockholder approval and authorization of the Stock
Issuance to such investors and on such terms as the Company may determine in its
discretion in order to consummate the Stock Issuance. The terms of the New
Preferred Stock and other matters related to the Stock Issuance described herein
are, therefore, subject to change without further notice to or approval of the
Stockholders. See "The Stock Issuance."

The net cash proceeds from the Stock Issuance will be used to fund a
portion of the Estimated Purchase Price. Consequently, the Company's ability to
consummate the Acquisition may be dependent upon Stockholder approval of the
Stock Issuance. See "Potential Effects of Stockholder Vote -- Potential Effects
of Not Consummating the Transactions -- Inability to Obtain Alternative
Financing." The Company believes that utilizing the Stock Issuance as a means of
funding a portion of the Estimated Purchase Price will benefit the Company not
only by providing funding for the Acquisition, but also by reducing Costilla's
balance sheet leverage through a reduction in its debt to capitalization ratio.
The Company believes that such a leverage reduction will enhance its overall
financial condition, and provide increased financial flexibility to take
advantage of future acquisition, exploration and development opportunities.

THE MEETING

The Special Meeting has been called for the Stockholders to consider and
vote upon the following matters: (1) the Charter Amendment to increase the
number of shares of authorized Common Stock; (2) the Stock Issuance to approve
the issuance of the Acquisition Common and the New Preferred Stock, and to
approve the potential issuance of an indeterminable number of shares of the
Dividend Common and the Conversion Common; (3) the Plan Amendment to increase
the number of shares of Common Stock reserved and authorized under the Option
Plan; and (4) such other matters as may be properly brought before the Meeting
or any adjournments or postponements thereof. See "The Meeting," "The Charter
Amendment," "The Stock Issuance" and "The Plan Amendment."

and entitled to vote thereon, so long as a quorum is present at the Meeting.
Approval of the creation and issuance of the New Preferred Stock also requires
the affirmative vote of a majority of the outstanding shares of the Outstanding
Preferred Stock, voting separately as a class. Any other matters properly coming
before the Meeting will be decided by the affirmative vote of a majority of the
shares of Common Stock represented at the Meeting in person or by proxy and
entitled to vote on such matters, except as otherwise required by law or by the
Company's Certificate of Incorporation or Bylaws. The holders of Common Stock
are not entitled to dissenters' or appraisal rights in connection with the
Charter Amendment, the Stock Issuance, the Plan Amendment or the Acquisition.

INTENT OF CERTAIN INSIDERS AND AFFILIATES

Three of the Company's executive officers and principal stockholders,
Cadell S. Liedtke, Michael J. Grella and Henry G. Musselman, have entered into
an agreement with Pioneer pursuant to the Acquisition Agreement which provides,
among other things, that they will vote at the Special Meeting in favor of the
actions necessary for consummation of the Acquisition. Messrs. Liedtke, Grella
and Musselman currently own in the aggregate approximately 49% of the
outstanding Common Stock. In addition, the Company anticipates that the two
holders of the Outstanding Preferred Stock will agree to approve the creation
and issuance of the New Preferred Stock in connection with their exchange of
shares of Outstanding Preferred Stock for shares of New Preferred Stock. See
"The Meeting -- Vote Required" and "The Stock Issuance -- Terms of Stock
Agreement -- Exchange of Outstanding Preferred Stock for New Preferred Stock."

7
<PAGE> 11

SUMMARY FINANCIAL INFORMATION

The following table sets forth certain summary historical and pro forma
financial data of the Company. The historical information should be read in
conjunction with the Consolidated Financial Statements and the notes thereto
included elsewhere in this Proxy Statement. The Company acquired significant
producing oil and gas properties in certain of the periods presented which
affect the comparability of the historical financial and operating data for the
periods presented. The pro forma information should be read in conjunction with
the Pro Forma Condensed Statement of Operations and notes thereto included
elsewhere in this Proxy Statement. Neither the historical results nor the pro
forma results are necessarily indicative of the Company's future operations or
financial results.

<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31, SIX MONTHS ENDED JUNE 30,
---------------------------------------- ------------------------------
HISTORICAL PRO HISTORICAL PRO
----------------------------- FORMA ------------------- FORMA
1995 1996 1997 1997(1) 1997 1998 1998(1)
------- -------- -------- -------- -------- -------- --------
(IN THOUSANDS, EXCEPT RATIOS)
<S> <C> <C> <C> <C> <C> <C> <C>
STATEMENT OF OPERATIONS DATA:
Revenues................................ $21,816 $ 55,026 $ 76,501 $234,019 $ 35,812 $ 32,712 $ 89,107
Expenses:
Oil and gas production................ 10,355 21,774 30,029 75,460 14,163 14,226 33,448
General and administrative............ 3,571 5,238 8,407 10,527 3,370 5,070 5,570
Compensation related to option
settlement.......................... 656 -- -- -- -- -- --
Exploration and abandonment........... 1,652 2,550 6,588 6,788 3,115 5,228 5,228
Depreciation, depletion and
amortization........................ 5,958 12,430 26,409 74,909 9,720 14,364 36,713
Impairment of oil and gas
properties.......................... -- -- 28,189 28,189 -- -- --
------- -------- -------- -------- -------- -------- --------
Total Operating Expenses.......... 22,192 41,992 99,622 195,873 30,368 38,888 80,959
------- -------- -------- -------- -------- -------- --------
Operating income (loss)................... (376) 13,034 (23,121) 38,146 5,444 (6,176) 8,148
Interest expense.......................... 4,591 11,281 12,979 26,653 5,516 9,833 15,665
Income (loss) from continuing
operations.............................. (4,970) 535 (36,252) 7,471 (134) (16,009) (4,886)
Net income (loss)......................... (4,970) (4,440) (36,471) 7,471 (134) (16,308) (4,886)
Cumulative preferred stock dividend....... -- -- -- 10,850 -- 307 5,732
STATEMENT OF CASH FLOWS DATA:
Net cash provided by (used in):
Operating activities.................... $ 6,366 $ 12,350 $ 25,032 $ 14,572 $ (2,976)
Investing activities.................... (62,467) (64,129) (92,597) (34,453) (45,813)
Financing activities.................... 58,830 61,531 58,562 13,268 62,262
OTHER FINANCIAL DATA:
Adjusted EBITDA(2)...................... $ 7,234 $ 27,108 $ 38,065 $148,032 $ 18,279 $ 13,416 $ 50,089
Interest charges(3)..................... 4,591 10,253 12,461 36,521 5,262 9,541 20,905
Adjusted EBITDA(2)/interest
charges(3)............................ 1.6x 2.6x 3.1x 4.1x 3.5x 1.4x 2.4x
BALANCE SHEET DATA (AS OF PERIOD END):
Working capital (deficit)............... $ 2,654 $ 10,320 $(11,511) $ (2,167) $ 4,277 $ 4,277
Total assets............................ 87,367 162,790 194,088 178,171 238,258 630,258
Total debt, less current maturities..... 71,494 100,262 163,087 114,826 182,441 323,241
Redeemable predecessor capital.......... 11,576 -- -- -- -- --
Predecessor capital..................... (7,445) -- -- -- -- --
Stockholders' equity.................... -- 40,569 410 39,202 30,218 281,418
</TABLE>

- ---------------

(1) Assumes that the Ballard Acquisition (as defined under "The
Company -- Business and Properties"), the Acquisition and the Stock Issuance
and the application of net proceeds therefrom had taken place as of January
1, 1997 for purposes of Statement of Operations Data and Other Financial
Data.

(2) Adjusted EBITDA is presented because of its wide acceptance as a financial
indicator of a company's ability to service or incur debt. Adjusted EBITDA
(as used herein) is calculated by adding interest, income taxes,
depreciation, depletion and amortization, impairment of oil and gas
properties, exploration and abandonment costs and extraordinary loss
resulting from extinguishment of debt to net income (loss). Adjusted EBITDA
should not be considered as an alternative to earnings (loss), or operating
earnings (loss), as defined by generally accepted accounting principles, as
an indicator of the Company's financial performance or to cash flow as a
measure of liquidity.

(3) Represents cumulative preferred stock dividends paid in cash and interest
expense, net of deferred charges amortization.

8
<PAGE> 12

SUMMARY RESERVE DATA

<TABLE>
<CAPTION>
AS OF JANUARY 1, 1998 AS OF OCTOBER 1, 1998(3)
---------------------- -------------------------
PRO PRO
COSTILLA(1) FORMA(2) COSTILLA FORMA
----------- -------- ----------- -----------
<S> <C> <C> <C> <C>
ESTIMATED PROVED RESERVES(4):
Oil (Mbbls)..................................... 14,952 44,262 11,168 36,640
Gas (Mmcf)...................................... 148,637 473,672 164,597 447,336
Total (Mmcfe)................................... 238,349 739,244 231,605 667,176
Percent of proved developed reserves............ 62.4% 75.7% 65.2% 77.5%
Present value of estimated future net cash flow,
before income taxes, discounted at 10% (in
thousands)................................... $196,678 $558,109 $179,631 $455,015
</TABLE>

- ---------------

(1) Estimates of net proved oil and gas reserves for Costilla at January 1, 1998
were prepared by the Company, of which approximately 72% were reviewed by
Williamson Petroleum Consultants, Inc., independent petroleum engineers. See
"Petroleum Engineers."

(2) Estimates of net proved oil and gas reserves for the Acquisition Properties
at January 1, 1998 were prepared by the Company.

(3) The reserve estimates at October 1, 1998 for both Costilla and the
Acquisition Properties were prepared by the Company.

(4) Average oil and gas prices used to determine proved reserves and the present
value of estimated future net cash flow (a) at January 1, 1998 were $15.29
per Bbl and $2.20 per Mcf for Costilla and $15.96 per Bbl and $1.91 per Mcf
pro forma; and (b) at October 1, 1998 were $13.26 per Bbl and $1.99 per Mcf
for Costilla and $14.12 per Bbl and $1.80 per Mcf pro forma. Estimates of
oil and gas reserves are subject to interpretation and uncertainty. See "The
Company -- Oil and Gas Reserves."

SUMMARY OPERATING DATA

<TABLE>
<CAPTION>
YEAR ENDED SIX MONTHS ENDED
DECEMBER 31, 1997 JUNE 30, 1998
------------------- -------------------
PRO PRO
COSTILLA FORMA(1) COSTILLA FORMA(1)
-------- -------- -------- --------
<S> <C> <C> <C> <C>
PRODUCTION DATA:
Oil (Mbbls)........................................... 2,175 5,318 1,049 2,547
Gas (Mmcf)............................................ 14,698 55,730 7,562 25,552
Total (Mmcfe)......................................... 27,750 87,638 13,856 40,833
AVERAGE SALES PRICE PER UNIT(2):
Oil (per Bbl)......................................... $17.77 $18.46 $15.39 $14.10
Gas (per Mcf)......................................... 2.29 2.34 2.10 2.01
COSTS PER MCFE:
Production costs, including severance taxes........... $ 1.08 $ 0.86 $ 1.03 $ 0.82
Depreciation, depletion and amortization.............. 0.95 0.85 1.04 0.90
</TABLE>

- ---------------

(1) Gives effect to the Ballard Acquisition and the Acquisition as if such
acquisitions had occurred as of January 1, 1997.

(2) Before deduction of production taxes and including hedging results.

9
<PAGE> 13

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

This Proxy Statement includes certain statements that may be deemed to be
"forward-looking statements" within the meaning of Section 27A of the Securities
Act of 1933, as amended (the "Securities Act"), and Section 21E of the Exchange
Act. All statements, other than statements of historical facts, included in this
Proxy Statement that address activities, events or developments that the Company
expects, projects, believes or anticipates will or may occur in the future,
including such matters as oil and gas reserves, future drilling and operations,
future production of oil and gas, future net cash flows, future capital
expenditures and other such matters, are forward-looking statements. These
statements are based on certain assumptions and analysis made by management of
the Company in light of its experience and its perception of historical trends,
current conditions, expected future developments and other factors it believes
are appropriate in the circumstances. Such statements are subject to a number of
assumptions, risks and uncertainties, including, without limitation, the
potential effects of the Stock Issuance and the Acquisition discussed herein,
reserve replacement risk, uncertainty of estimates of proved reserves and future
net cash flows, general economic and business conditions, prices of oil and gas,
the business opportunities (or lack thereof) that may be presented to and
pursued by the Company, changes in laws or regulations or other factors, many of
which are beyond the control of the Company. Stockholders are cautioned that any
such statements are not guarantees of future performance and that actual results
or developments may differ materially from those projected in the
forward-looking statements.

POTENTIAL EFFECTS OF STOCKHOLDER VOTE

The following is a brief summary of certain of the potential effects which
may result from the Stockholders either approving or not approving the Charter
Amendment and the Stock Issuance (collectively with the Acquisition, the
"Transactions"). Because the Company's ability to consummate the Acquisition may
be conditioned upon the results of Stockholder voting, the following discussion
also describes certain effects of consummating or not consummating the
Acquisition. This summary of potential effects is subject to and qualified in
its entirety by the more detailed information set forth elsewhere in this Proxy
Statement. Stockholders should carefully consider all such information together
with other publicly available information concerning the Company, and are
encouraged to seek the advice of their financial and legal advisors, in
assessing such effects. See "Summary" for certain assumptions with respect to
the securities to be issued and reserved for issuance as part of the Stock
Issuance.

POTENTIAL EFFECTS OF CONSUMMATING THE TRANSACTIONS

Significant Dilution of Ownership of Current Stockholders. Upon
consummation of the Stock Issuance, a total of 30,331,782 shares of Common Stock
will be outstanding, compared with 9,665,115 shares of Common Stock outstanding
as of September 30, 1998. The difference consists entirely of the Acquisition
Common to be issued to the New Investors. Unless a Stockholder is also a New
Investor, that Stockholder's percentage ownership of the Company will be reduced
by approximately 68% even though the Stockholder continues to own the same
number of shares after the Stock Issuance as before the Stock Issuance.
Additional dilution to current Stockholders will occur upon issuance of any
Conversion Common or Dividend Common. Conversion of all shares of the New
Preferred Stock to be issued would result in a total of 46,865,115 shares of
Common Stock being outstanding, causing total reduction in the percentage
ownership of the current Stockholders of approximately 80%. See "Security
Ownership of Certain Beneficial Owners and Management."

Change in Principal Stockholders and Interest of Management; Influence of
New Investors. Messrs. Liedtke, Grella and Musselman, executive officers and
principal stockholders of the Company (the "Current Management"), currently own
in the aggregate approximately 49% of the outstanding shares of Common Stock and
hold three of the seven positions on the Company's Board of Directors. Upon
consummation of the Stock Issuance, Current Management (assuming no change in
the number of shares of Common Stock owned by them) will own, in the aggregate,
approximately 16% (10% assuming the conversion of all of the New Preferred
Stock) of the outstanding shares of Common Stock, and the New Investors will

10
<PAGE> 14

own, in the aggregate, approximately 68% (80% assuming conversion of all of the
New Preferred Stock) of the outstanding shares of Common Stock. Therefore, the
New Investors will become the principal stockholders of the Company and the
proportionate stock ownership interests of Current Management will be
significantly reduced. See "Security Ownership of Certain Beneficial Owners and
Management."

While the Company expects that the New Investors will agree not to form,
join in or in any other way participate in a partnership, pooling agreement,
syndicate, voting trust or other group with respect to the Company's Common
Stock, or enter into any agreement or arrangement or otherwise act in concert
with any person for the purpose of acquiring, holding, voting or disposing of
the Common Stock, the New Investors could independently cast identical votes
which would control the approval or rejection of a proposal presented to the
Company's Stockholders or control an election of the Company's directors. In
addition, it is anticipated that the holders of the New Preferred Stock will be
entitled to initial representation on the Company's Board of Directors upon
consummation of the Stock Issuance, and may, under certain circumstances, be
entitled to additional representation on the Board. As a result, the New
Investors will have significant influence over the management and direction of
the Company due to the level of their stock ownership and through Board
representation.

Shares Eligible for Future Sale; Registration Rights. Future sales, or the
availability for sale, of a substantial number of additional shares of Common
Stock in the public market following the Stock Issuance could adversely affect
the market price of the Common Stock. Following the Stock Issuance, there will
be a total of 30,331,782 (46,865,115 in the event of conversion of all of the
New Preferred Stock) shares of Common Stock outstanding, compared to 9,665,115
shares outstanding at September 30, 1998. While the shares of Common Stock
issued in the Stock Issuance (including the Dividend Common and the Conversion
Common) will not be registered under the Securities Act, and therefore will be
restricted securities under the Securities Act, the New Investors have been
granted certain registration rights with respect to such Common Stock which
would allow for the resale of a significant amount of such stock at the election
of the New Investors under an effective registration statement. See "The Stock
Issuance -- Registration Rights."

Indenture Issues. The Indenture (the "Indenture") governing the Company's
10 1/4% Senior Notes due 2006 (the "Notes") provides that the Company must offer
to redeem all of the Notes (with a total current principal amount of $180
million) in the event of a change of control of the Company. Under the terms of
the Indenture, a "change of control" is deemed to have occurred if, among other
things, any person or group (other than Current Management) acquires beneficial
ownership of 50% or more of the outstanding shares of Common Stock or upon
certain changes in the majority of the members of the Company's Board of
Directors. The Company anticipates that the New Investors will be prohibited
from individually acquiring 50% or more of the outstanding Common Stock and from
acting as a group, and will agree not to enter into any agreement or arrangement
with respect to the voting of their stock. However, the New Investors could
independently vote in an election of directors in a manner that would cause a
change in the Board of Directors resulting in a change of control under the
Indenture. The Company would then be required to make an offer to purchase all
of the Notes, requiring significant capital resources which may not be available
to the Company. Furthermore, such events may create a default under the New
Credit Facility creating additional adverse financial consequences for the
Company.

Significant Increase in Operations. The Acquisition is expected to (1) more
than double the Company's estimated proved oil and gas reserves, (2) increase
the Company's operated oil and gas properties by 134%, (3) increase the
Company's total oil and gas properties by 154%, and (4) increase the Company's
leasehold acreage by 167% (not including the approximately 11 million gross
undeveloped mineral acres to be acquired). The Company will encounter
significant challenges in managing this larger enterprise and no assurance can
be given of the time required for the Company to assimilate the Acquisition
Properties and realize its strategy of exploiting the value it believes exists
in the Acquisition Properties. The Company anticipates that certain of the
Acquisition Properties will require workovers, recompletions and other remedial
activities which may result in initially increased lease operating expenses,
without realizing increased production and revenue, if any, resulting from such
efforts until subsequent periods.

11
<PAGE> 15

Assumed Liabilities in the Acquisition. Under the Acquisition Agreement,
Costilla assumes responsibility for all duties, claims and liabilities related
to the Acquisition Properties regardless of when such duties, claims or
liabilities arose (except for certain claims related to payment of royalties by
Pioneer). In addition, Costilla has agreed to indemnify Pioneer with respect to
all such duties, claims and liabilities. Costilla also becomes responsible and
liable for certain litigation related to the Acquisition Properties. Because
many of the assumed liabilities are unknown at this time, the Company is not
able to estimate the effects the assumption of such obligations may have. See
"The Acquisition -- The Acquisition Agreement -- Assumed Liabilities."

Terms of New Preferred Stock. The New Preferred Stock is expected to rank
senior to all other classes and series of Costilla capital stock, including the
Common Stock, with respect to the payment of dividends or any distributions upon
liquidation. It is anticipated that the New Preferred Stock will also have the
right to initial representation on the Company's Board of Directors upon
consummation of the Stock Issuance, and under certain circumstances may be
entitled to additional representation on the Board. See "The Stock
Issuance -- Terms of New Preferred Stock."

POTENTIAL EFFECTS OF NOT CONSUMMATING THE TRANSACTIONS

Inability to Obtain Alternative Financing. If the Stock Issuance is not
consummated or the New Credit Facility is not closed, the Company will be
required to obtain alternative sources of financing to consummate the
Acquisition or risk termination of the Acquisition Agreement and the
consequences resulting therefrom. See "-- Termination of Acquisition Agreement."
The Company does not currently have arrangements or commitments for such
alternative financing and will have a limited time to make such arrangements
prior to the proposed Acquisition closing date of December 15, 1998 (as that
date may be extended under the Acquisition Agreement) in order to avoid
termination of the Acquisition Agreement. See "The Acquisition -- The
Acquisition Agreement -- General." The Indenture and the Company's present bank
credit facility limit the Company's ability to incur debt as a means of funding
the Acquisition. There can be no assurance that the Company will be able to
obtain alternative sources of financing in the event the Stock Issuance is not
consummated.

Termination of Acquisition Agreement. In the event the Company is unable to
obtain financing to consummate the Acquisition or breaches any provision of the
Acquisition Agreement, Pioneer may terminate the Acquisition Agreement. Upon
such termination, Costilla would forfeit the $25 million deposit and all
interest accrued thereon and be liable to Pioneer for an additional $16 million
in liquidated damages plus the costs and expenses of recovering such amount.
Because the $25 million deposit was funded through borrowing under the Company's
present bank credit facility, a forfeiture of such amount upon termination of
the Acquisition Agreement by Pioneer due to a breach by the Company would
increase the amount of Costilla's long term debt without providing value in
return, thereby increasing the Company's leverage position. The Company does not
currently have available, either in cash or under its present bank credit
facility, the funds to pay the additional $16 million in liquidated damages in
the event of such termination. The Company has not made arrangements to finance
such payment and may not be able to obtain such financing, which could result in
a sale of assets to fund the payment. The Company's ability to obtain the funds
necessary to carry out its operating plans could be significantly affected if
the Acquisition Agreement is terminated.

12
<PAGE> 16

THE MEETING

GENERAL

This Proxy Statement and related proxy are being mailed to Stockholders on
or about , 1998, in connection with the solicitation by the Company of
proxies to be used at the Special Meeting to be held at the Petroleum Club, 501
West Wall Ave., Midland, Texas on , 1998 at 10:00 a.m., local time,
and at all adjournments or postponements thereof.

PURPOSES OF MEETING

The Special Meeting has been called to consider and vote upon the following
matters.

(1) The Charter Amendment, which is an amendment to Costilla's Certificate
of Incorporation to increase its authorized Common Stock from 20
million shares to 100 million shares.

(2) The Stock Issuance, which consists of the issuance of up to 250,000
shares of New Preferred Stock and up to 35 million shares of
Acquisition Common, and the potential issuance of an indeterminable
number of shares of Dividend Common and Conversion Common.

(3) The Plan Amendment, which is an amendment to the Option Plan to
increase the number of shares of Common Stock reserved and authorized
under the Option Plan from 1,250,000 shares to 4,000,000 shares.

(4) The transaction of such other business, if any, as may properly come
before the Special Meeting or any adjournments or postponements
thereof.

RECORD DATE AND VOTING

Stockholders of record at the close of business on , 1998 are
entitled to notice of and to vote at the Meeting. At the close of business on
such date, the Company had shares of Common Stock outstanding, each share
being entitled to one vote on all matters properly coming before the Meeting;
and 50,000 shares of Outstanding Preferred Stock outstanding, each share being
entitled to one vote only on the creation and issuance of the New Preferred
Stock, voting separately as a class. Properly executed proxies will be voted in
accordance therewith. If no direction is indicated thereon, a properly executed
proxy will be voted (1) in favor of the Charter Amendment, (2) in favor of the
Stock Issuance, (3) in favor of the Plan Amendment, and (4) in the discretion of
proxy holders on any other business properly coming before the Meeting.

Any person giving a proxy has the power to revoke it at any time before it
is voted by filing with the Secretary of the Company an instrument revoking the
proxy, by delivering a properly executed proxy of a later date or by attending
the Special Meeting and voting in person (mere attendance at the meeting will
not, by itself, constitute revocation of a proxy).

VOTE REQUIRED

The approval of the Charter Amendment requires the affirmative vote of a
majority of the outstanding shares of Common Stock. The approval of each of the
Stock Issuance and the Plan Amendment requires the affirmative vote of a
majority of the shares of Common Stock represented at the Meeting in person or
by proxy and entitled to vote thereon, so long as a quorum is present at the
Meeting. The approval of the creation and issuance of the New Preferred Stock
also requires the affirmative vote of a majority of the outstanding shares of
the Outstanding Preferred Stock, voting separately as a class. All other matters
properly coming before the Meeting will be decided by the affirmative vote of a
majority of the shares of Common Stock represented at the Meeting in person or
by proxy and entitled to vote on such matters, except as otherwise required by
law or by the Company's Certificate of Incorporation or bylaws.

Messrs. Liedtke, Grella and Musselman have entered into an agreement with
Pioneer pursuant to the Acquisition Agreement which provides that they will vote
the shares of Common Stock owned by them in
13
<PAGE> 17

favor of the actions necessary for the Company to consummate the Acquisition.
Messrs. Liedtke, Grella and Musselman currently own, in the aggregate,
approximately 49% of the outstanding shares of Common Stock, representing
substantially all of the shares of Common Stock required for approval of the
proposals to be presented at the Meeting. In addition, the Company anticipates
that the holders of all of the Outstanding Preferred Stock will agree to approve
the creation and issuance of the New Preferred Stock in connection with the
exchange of the Outstanding Preferred Stock for New Preferred Stock, which
agreement would assure the required approval of such matters by the Outstanding
Preferred Stock as a class.

The votes will be counted by one or more inspectors appointed by the Board
of Directors, who will determine, among other things, whether a quorum (being a
majority of the outstanding shares of Common Stock and Outstanding Preferred
Stock entitled to vote at the Meeting) is present at the Meeting in person or by
proxy, the number of votes necessary for the Stockholders to take action in
accordance with the foregoing requirements and the abstentions and votes cast
for and against each matter. All properly executed proxies and ballots,
regardless of the nature of the vote or the absence of a vote indication (but
not including broker non-votes), are counted in determining the number of shares
represented at the Meeting. Neither broker non-votes nor abstentions are counted
as affirmative votes, in whole or in part. An abstention arises when a proxy is
properly executed and the "abstain" box is properly marked as to a proposal. A
properly executed proxy with no voting selections made thereon is not an
abstention and will be voted as set forth under "-- Record Date and Voting."

SOLICITATION OF PROXIES

This solicitation of proxies is being made by the Company and the Company
will bear the costs of this solicitation. The Company may also reimburse persons
holding stock in their names or in those of their nominees for their reasonable
expenses in sending proxy material to their principals and obtaining their
proxies. The solicitation is being made by mail and may also be made by
telephone or telecopy by officers, directors and regular employees of the
Company, who will receive no additional compensation therefor. Total expenses of
the solicitation are expected to be nominal.

STOCKHOLDER PROPOSALS AND OTHER MATTERS

For inclusion in the Company's 1999 annual meeting proxy statement, all
stockholder proposals made under the rules of the Commission for consideration
at the Annual Meeting of Stockholders of the Company to be held in 1999 must be
received at the Company's principal executive offices, 400 W. Illinois, Suite
1000, Midland, Texas 79701, Attention: Bobby W. Page, by December 28, 1998.
Proposals made other than under the rules of the Commission will be untimely if
received by the Company after March 14, 1999.

The Company has been advised that a representative of KPMG Peat Marwick
LLP, the Company's independent auditors, will be present at the Special Meeting.
The representative will have an opportunity to make a statement at the Meeting
and to respond to appropriate questions raised at the Meeting.

THE CHARTER AMENDMENT

PROPOSAL NO. 1

The Stockholders are being asked to consider and vote on the Charter
Amendment, which consists of an amendment to the Company's Certificate of
Incorporation to increase the number of shares of authorized Common Stock from
20 million to 100 million. This increase in the authorized Common Stock is
necessary, in part, to have sufficient authorized Common Stock to effectuate the
Stock Issuance, and the Company believes that such increase is further desirable
to allow the flexibility of issuing Common Stock in connection with the granting
and exercise of employee stock options and for future transactions. The Company
has no present intention to issue or reserve any of these additionally
authorized shares other than those being issued and reserved in the Stock
Issuance and the Plan Amendment. Except as required by applicable law and the
listing requirements of the Nasdaq National Market, the Board of Directors may
approve the issuance of the newly authorized Common Stock without further
stockholder approval.
14
<PAGE> 18

THE STOCK ISSUANCE

PROPOSAL NO. 2

GENERAL

The Stockholders are being asked to consider and vote on the Stock
Issuance, which consists of (1) the issuance of up to 250,000 shares of New
Preferred Stock and up to 35 million shares of Acquisition Common for the
aggregate cash purchase price of approximately $260 million, (2) the issuance of
shares of New Preferred Stock in exchange for all of the outstanding shares of
Outstanding Preferred Stock, and (3) the potential issuance of an indeterminable
number of shares of Dividend Common and Conversion Common. The exact number of
shares of each of the New Preferred Stock and Acquisition Common which will be
issued in, and all other terms of, the Stock Issuance will be determined by the
Company in its discretion. The Company intends to use the net cash proceeds from
the Stock Issuance to fund a portion of the Estimated Purchase Price. Costilla
and the New Investors expect to enter into a Stock Purchase Agreement (the
"Stock Agreement") with respect to the Stock Issuance. The Stock Agreement is
expected to provide that the Stock Issuance will close on the day before or the
day of the closing of the Acquisition, subject to stockholder approval and other
closing conditions. While the Company anticipates that the Stock Issuance will
be consummated pursuant to the Stock Agreement and on the terms described
herein, the Company is seeking Stockholder approval and authorization of the
Stock Issuance to such investors and on such terms as the Company may determine
in its discretion in order to consummate the Stock Issuance. The terms of the
New Preferred Stock, the Stock Agreement and other matters related to the Stock
Issuance described herein are, therefore, subject to change without further
notice to or approval of the Stockholders. See "Summary" for certain assumptions
with respect to the securities to be issued and reserved for issuance as part of
the Stock Issuance.

The Dividend Common and Conversion Common may be issuable in the future
upon certain payments of dividends on, or upon conversion of, the New Preferred
Stock pursuant to the terms thereof. The Company is seeking approval for the
potential issuance of shares of Dividend Common and Conversion Common. If such
approval is obtained, the Company will not be required to seek further
stockholder approval of any such issuance of Dividend Common or Conversion
Common under the listing requirements of the Nasdaq National Market and will not
seek such further stockholder approval unless required by applicable law. See
"Potential Effects of Stockholder Vote -- Potential Effects of Consummating the
Transactions -- Significant Dilution of Ownership of Current Stockholders."

TERMS OF NEW PREFERRED STOCK

The New Preferred Stock is expected to have a purchase price of $1,000 per
share and carry a 7% cumulative annual cash dividend, payable quarterly. If
Costilla cannot legally, or pursuant to the terms of the Indenture or the New
Credit Facility, pay cash dividends, it is anticipated that Costilla will be
allowed to pay such dividends in shares of Dividend Common at a rate of 8% per
annum (the "PIK Dividend"). For purposes of determining the number of shares in
a PIK Dividend, the price of the Common Stock will be equal to the market price
of the Common Stock at the time the PIK Dividend is paid.

The Company anticipates that the New Preferred Stock will be convertible
into shares of Conversion Common at any time at the option of the holders of the
New Preferred Stock, with each holder of New Preferred Stock entitled to receive
that number of shares of Conversion Common equal to the quotient of $1,000 per
share of New Preferred Stock divided by 125% of the average volume-weighted
closing sales price of the Common Stock as reported by the Nasdaq National
Market for the 20 trading days prior to the date which is three days prior to
the closing of the sale of the New Preferred Stock (the "Conversion Price"). A
total of 16,533,333 shares of Conversion Common will initially be reserved for
issuance upon conversion of the New Preferred Stock.

It is anticipated that the shares of New Preferred Stock will not be
redeemable by Costilla until the third annual anniversary of the date of
issuance. It is further expected that following the expiration of such period,
Costilla will have the right, at its option, upon not less than 60 days prior
written notice, but subject to the

15
<PAGE> 19

rights of the holders of the New Preferred Stock to convert their shares of New
Preferred Stock into shares of Common Stock, to redeem the shares of New
Preferred Stock if the average closing sales price for shares of the Common
Stock as reported by the Nasdaq National Market for 20 of the 30 trading days
immediately preceding the date on which notice of redemption is given is at
least 150% of the Conversion Price; and if Costilla exercises its redemption
option, the purchase price would be (1) during year four, 107% of the
liquidation value; (2) during year five, 103.5% of the liquidation value; (3)
during year six, 101.75% of the liquidation value; and (4) thereafter, 100% of
the liquidation value; plus, in each case, any then accrued and unpaid dividends
on the New Preferred Stock.

Costilla anticipates that the New Preferred Stock will rank senior to all
other classes and series of Costilla stock as to liquidation preference and
dividend rights.

It is expected that holders of the New Preferred Stock will be entitled to
vote their shares of New Preferred Stock as a class, with respect to: (1) any
sale of all or substantially all of the assets of Costilla; (2) certain actions
affecting the terms of the New Preferred Stock; (3) any proposed issuance of
capital stock of Costilla that ranks senior to or pari passu with the New
Preferred Stock; and (4) any merger or business combination transaction pursuant
to which the Stockholders of Costilla prior to the consummation of such
transaction do not own at least 51% of the outstanding capital stock of the
surviving entity in such transaction or in which the members of the Board of
Directors of Costilla prior to the consummation of the transaction do not
comprise at least a majority of the members of the Board of Directors of the
surviving entity in such transaction.

Upon closing of the Stock Issuance it is anticipated that holders of the
New Preferred Stock will be entitled to initial representation on Costilla's
Board of Directors, and may be entitled to additional representation under
certain circumstances.

TERMS OF STOCK AGREEMENT

General. The Company anticipates that it will sell, pursuant to the Stock
Agreement, an aggregate of 105,000 shares of New Preferred Stock and 20,666,667
shares of Acquisition Common to a limited number of New Investors at a purchase
price of $1,000 per share for New Preferred Stock and $7.50 per share for
Acquisition Common, for an aggregate cash purchase price of approximately $260
million. In addition, the two holders of the Outstanding Preferred Stock, which
has a stated liquidation value of $50 million, are expected to agree to exchange
their 50,000 shares of Outstanding Preferred Stock for 50,000 shares of New
Preferred Stock. The Company believes that there will be a total of not more
than 10 New Investors, each of whom will be an institutional accredited investor
making a minimum investment of $15 million.

Exchange of Outstanding Preferred Stock for New Preferred Stock. The
holders of all of the Outstanding Preferred Stock are expected to exchange such
stock for New Preferred Stock (the "Exchange"). The New Preferred Stock is
expected to be identical to the Outstanding Preferred Stock in all material
respects other than the conversion rate, which is $12.39 for the Outstanding
Preferred Stock as compared to the $9.375 assumed conversion rate for the New
Preferred Stock. The terms of Outstanding Preferred Stock provide that the
holders thereof must approve the creation and issuance of any capital stock of
the Company senior to or in parity with such stock, such as the New Preferred
Stock. The Exchange will be the result of arms-length negotiations between the
Company and the holders of the Outstanding Preferred Stock in which the Company
anticipates that it will receive such holders' agreement to approve the creation
and issuance of the New Preferred Stock and such holders will receive the
opportunity to obtain stock with a more attractive conversion rate. One of the
Company's directors, Mr. Timothy J. Detmering, is also affiliated with the
holders of the Outstanding Preferred Stock. Mr. Detmering's interest in the
Exchange due to such affiliation has been fully disclosed to the Company's Board
of Directors, and his vote as a director of the Company will not be counted
toward approval by the Board of matters related to the Exchange. As a result of
the Exchange, no shares of Outstanding Preferred Stock are expected to remain
outstanding after consummation of the Stock Issuance.

Representations and Warranties. It is anticipated that the Stock Agreement
will contain customary representations and warranties of the Company with
respect to the Company and its subsidiaries relating to, among other things: (1)
organization, standing and qualification to do business; (2) the authorization,
16
<PAGE> 20

execution, delivery, performance and enforceability of the Stock Agreement; (3)
the Company's capital structure; (4) non-contravention with organizational
documents, agreements, contracts and governmental regulations; (5) the absence
of certain changes or events since the date of the most recent Company financial
statements filed with the Commission, including material adverse changes with
respect to the Company; and (6) the accuracy of information contained in the
Proxy Statement, as well as in all other filings with the Commission.

The Stock Agreement is also expected to contain customary representations
and warranties of the New Investors relating to, among other things: (1)
organization, standing and other corporate matters; (2) the authorization,
execution, delivery, performance and enforceability of the Stock Agreement and
related matters; (3) broker's fees and expenses; and (4) investment intent.

Covenants. The Company believes that the Stock Agreement will contain
covenants which will affect the Company's actions on and after the date of
closing of the Stock Agreement, all of which the Company believes to be
customary for transactions of this type. These covenants are expected to relate
to, among other things: (1) the use of cash proceeds from the Stock Issuance to
consummate the Acquisition; (2) the obligation of the Company and its
subsidiaries to maintain their corporate existence; (3) requirements that the
Company continue to comply with applicable laws and maintain their material
properties and permits; (4) requirements that the Company keep reserved a
sufficient number of shares of Common Stock to permit the conversion of New
Preferred Stock into Common Stock; and (5) that the Company comply with all
necessary requirements to maintain the quotation of its Common Stock on the
Nasdaq National Market.

Conditions to Closing. Consummation of the transactions contemplated by the
Stock Agreement are expected to occur on the day following the Special Meeting;
provided, however, that the obligation of the New Investors to consummate the
Stock Agreement will likely be subject to certain conditions, including: (1) the
absence of any injunction or other legal restraint or prohibition preventing the
consummation of the Stock Agreement; (2) the receipt of all regulatory and
Stockholder approvals necessary for the consummation of the Stock Agreement; and
(3) no material adverse change having occurred with respect to the Company's
operations or financial conditions.

Termination. It is anticipated that the Stock Agreement may be terminated
at any time, subject to its terms and conditions: (1) by the mutual written
consent of the Company and New Investors; or (2) by the Company, on the one
hand, or the New Investors, on the other hand, if there shall have been a breach
by the other party of any of the covenants contained therein or if a
representation or warranty made by any other party is untrue in any material
respect.

Standstill Restrictions; Acquisition of Company Voting Securities. The
Company expects that the Stock Agreement will restrict the New Investors'
trading activities in the Common Stock and prohibit the conversion of the New
Preferred Stock for a reasonable and customary time period. It is also
anticipated that the Stock Agreement will prohibit the New Investors from
individually acquiring 50% or more of the outstanding Common Stock and from
acting as a group in ownership of the Company's securities.

Restrictions Upon Voting Agreements. It is anticipated that the New
Investors will agree not to form, join in or in any other way participate in a
partnership, pooling agreement, syndicate, voting trust or other group with
respect to the Common Stock. The New Investors are also expected to agree not to
enter into any agreement or arrangement or otherwise act in concert with any
person for the purpose of acquiring, holding, voting or disposing of the Common
Stock.

REGISTRATION RIGHTS

The Company anticipates that it will agree, subject to existing contractual
rights, to certain registration rights in connection with the Stock Issuance.
Such rights are expected to provide that after 180 days following consummation
of the Stock Issuance, the New Investors holding not less than 50% of the shares
of Acquisition Common and any shares of Dividend Common or Conversion Common
(collectively, the "Registerable Securities") may, on up to three occasions,
make written demand ("Demand Registrations") upon Costilla for the registration
of all or part of their Registerable Securities. Such rights are also expected
to

17
<PAGE> 21

provide that at any time Costilla proposes to file a registration statement
under the Securities Act with respect to an offering of Common Stock by Costilla
for its own account or for the account of any other security holders, the New
Investors will be entitled to, subject to certain restrictions, register their
Registerable Securities as part of such registration (the "Piggyback
Registration"). In the event the Company is not able to fulfill all requests for
Registerable Securities to be included in a Demand Registration or a Piggyback
Registration, the New Investors may be entitled to certain priorities over other
holders to have their Registerable Securities included in such registrations. It
is anticipated that all registration expenses (other than underwriters'
commissions) will be payable by Costilla, and that Costilla will also provide
customary securities law indemnification to any party who participates in any
registration effected under the registration rights agreement.

THE PLAN AMENDMENT

PROPOSAL NO. 3

The Stockholders are being asked to consider and vote on the Plan
Amendment, which is an amendment to the Option Plan to increase the shares of
Common Stock reserved and authorized under the Option Plan from 1,250,000 shares
to 4,000,000 shares, subject to certain adjustments to reflect changes in
capitalization. A summary of the Option Plan, including certain tax matters, is
set forth herein under "Executive Compensation -- Aggregated Option Exercises
and Fiscal Year-End Option Values."

Of the 1,250,000 shares of Common Stock available under the Option Plan,
695,250 are subject to currently outstanding options granted under the Option
Plan, leaving 554,750 shares available for future option grants. The 1,250,000
shares of Common Stock reserved and authorized under the Option Plan currently
represent approximately 13% of the outstanding Common Stock. Upon issuance of
the Acquisition Common, this percentage will be diluted to approximately 4% (3%
assuming conversion of all of the New Preferred Stock).

The Board of Directors has determined that it is in the best interest of
the Company to increase the number of shares of Common Stock available under the
Option Plan so that additional options can be granted to fulfill the purpose of
attracting, retaining, rewarding and providing long term stock ownership
incentives to the officers and employees of the Company as provided in the
Option Plan. Toward this end, the Board has adopted, subject to stockholder
approval, an amendment to the Option Plan to increase the number of shares of
Common Stock authorized and reserved under the Option Plan from 1,250,000 to
4,000,000 shares. The Company intends to file a Registration Statement on Form
S-8 with respect to the Option Plan to register such additional shares of Common
Stock pursuant to the Securities Act as soon as practicable after the amendment
is approved by the Stockholders.

The effect of the amendment to the Option Plan on the benefits available to
the officers and employees of the Company cannot be specifically determined at
this time. Generally, the amendment will allow additional options to be granted
to such persons under the Option Plan, but the benefits to such persons will be
unknown until such additional options are granted. Likewise, it is not possible
to determine the benefits which such persons may have received as a result of
the amendment if the amendment had been in effect in 1997 because it is unknown
whether any additional options would have been granted if more authorized and
reserved shares had been available. The benefits and amounts of options already
granted to certain executive officers under the Option Plan are set forth herein
under "Executive Compensation."

18
<PAGE> 22

THE ACQUISITION

GENERAL

On September 4, 1998, Costilla entered into the Acquisition Agreement with
Pioneer to purchase the Acquisition Properties for the cash purchase price of
$410 million (subject to adjustment as provided in the Acquisition Agreement).
The Acquisition Agreement resulted from several weeks of arms-length
negotiations between Costilla and Pioneer. The Acquisition Properties include
(1) properties that constituted three divestiture packages which were widely
marketed by Pioneer, and (2) properties that were not a part of those packages
and were selected by Costilla for inclusion in the transaction, such as
approximately 11 million gross undeveloped mineral acres, approximately 210,000
gross undeveloped leasehold acres, a license to use seismic data, offshore
properties in the Gulf of Mexico, and additional oil and gas properties in the
Permian Basin and elsewhere. The Acquisition purchase price was based upon
several factors, including the prior marketing of certain of the Acquisition
Properties, Costilla's review of selected data provided by Pioneer and
negotiations as to value. The Acquisition Agreement provides an effective date
of the transaction of October 1, 1998. As a result, Costilla will be entitled to
the operating income from the Acquisition Properties on or after October 1,
1998. Costilla estimates that the receipt of these funds through closing will
reduce the Acquisition purchase price to the Estimated Purchase Price of $390
million. The Company intends to fund the Estimated Purchase Price through the
net cash proceeds from the Stock Issuance and borrowings under the New Credit
Facility. Costilla and Pioneer do not believe that any governmental approvals
are required in connection with the Acquisition other than those which are
customarily obtained post-closing relating to leases of federal lands.

The Company estimates that the Acquisition Properties include, as of
October 1, 1998, proved reserves of approximately 436 Bcfe, with a PV-10 value
of approximately $275 million, which will be more than double the Company's
proved reserves. The Company believes that the Acquisition Properties complement
its current core assets, and have the further benefit of diversifying the
Company's properties, making the Company less dependent upon the success or
failure of individual prospects and spreading its opportunities and risks over a
more geographically and geologically diversified portfolio of properties. The
Company anticipates that the current production from the Acquisition Properties
will significantly enhance its cash flow while providing additional
opportunities for development of proved reserves as well as additional
exploration opportunities.

Pioneer is an independent oil and gas company with its principal offices at
1400 Williams Square West, 5205 North O'Conner Blvd., Irving, Texas 75039,
telephone number (972) 444-9001. Pioneer placed the Acquisition Properties on
the market pursuant to its publicly-announced plan to strategically refocus its
efforts on selected core properties in the United States and abroad. Pioneer has
publicly reported that the proved reserves attributable to the Acquisition
Properties represent about 10% of its year-end 1997 total proved reserves.
Costilla previously acquired oil and gas properties from a predecessor to
Pioneer in each of 1995 and 1996. See "The Company -- General" and "Management's
Discussion and Analysis of Financial Condition and Results of Operations." Other
than the Acquisition, there are no current arrangements or agreements between
Costilla and Pioneer, and other than certain limited agreements in the
Acquisition Agreement which survive closing of the Acquisition, Costilla and
Pioneer do not presently have any arrangements or agreements which extend into
the future.

THE ACQUISITION AGREEMENT

The following is only a brief summary of certain terms and conditions set
forth in the Acquisition Agreement. This discussion is subject to and qualified
in its entirety by other descriptions of the Acquisition Agreement set forth
herein and by the full text of the Acquisition Agreement which will be filed
with the Commission as an exhibit to the Company's Quarterly Report on Form 10-Q
for the period ended September 30, 1998.

General. The Acquisition Agreement was entered into by Costilla and Pioneer
on September 4, 1998 and provides for a closing date of December 15, 1998, with
an effective date of October 1, 1998. The Closing Date may be extended by
Pioneer for up to 30 days for any reason and for up to an additional 15 days for
Pioneer to respond to any notice of defects given by Costilla. Costilla has the
right to extend the Closing Date

19
<PAGE> 23

for up to 30 days under certain circumstances in order to obtain Stockholder
approvals related to the Acquisition; provided, however, that upon any such
extension by Costilla, interest will accrue on the Acquisition purchase price
for the period between December 15, 1998 and the date of closing, at a rate
expected to be approximately $60,000 per day. Upon execution of the Acquisition
Agreement, Costilla paid a performance deposit to Pioneer in the amount of $25
million. The deposit, plus interest thereon, will be applied to the Estimated
Purchase Price upon closing of the Acquisition or may be forfeited to Pioneer or
returned to Costilla upon termination of the Acquisition Agreement as discussed
below. All disputes between the parties with respect to the Acquisition
Agreement must be arbitrated, except that Pioneer may, in its sole discretion,
choose not to arbitrate certain specified disputes.

Assumed Liabilities. Under the Acquisition Agreement, Costilla assumes
responsibility for all duties, claims and liabilities related to the Acquisition
Properties regardless of when such duties, claims or liabilities arose or arise.
Costilla has agreed to indemnify Pioneer with respect to all such duties, claims
and liabilities. Upon closing of the Acquisition, Costilla also becomes
responsible and liable for certain litigation associated with the Acquisition
Properties, although Costilla believes that such litigation is not material.
Costilla is conducting a due diligence review of the Acquisition Properties in
part to identify the assumed liabilities. However, due to the number of
Acquisition Properties and the scope of the assumed liabilities, there may be
significant obligations which are unknown prior to closing the Acquisition. Such
unknown liabilities may have a material adverse effect on the future financial
condition of the Company. In addition, Costilla is obligated under the
Acquisition Agreement to interview and evaluate certain identified field
personnel of Pioneer, and pay certain severance benefits of any such employees
that Costilla decides not to employ. Pioneer does not provide any indemnity to
Costilla under the Acquisition Agreement for any claims or liabilities, except
certain limited claims relating to the payment of royalties by Pioneer. Costilla
is not assuming any indebtedness currently secured by the Acquisition
Properties, and such properties will be acquired free and clear of liens and
encumbrances. However, the Acquisition Properties will be pledged by the Company
to secure the New Credit Facility immediately upon closing of the Acquisition.
See "Description of Certain Indebtedness -- New Credit Facility."

Termination. Pioneer has the right to terminate the Acquisition Agreement
upon customary defaults and breaches by Costilla or if: (1) Costilla asserts
title defects, environmental defects and certain other claims with a total value
in excess of 10% of the Acquisition purchase price, (2) all adjustments for such
defects would result in the Acquisition purchase price being reduced by more
than 10%, (3) Costilla asserts any environmental defect and Pioneer determines
that the defect actually exists, (4) the parties cannot agree on the amount of
an adjustment to the Acquisition purchase price for a title or environmental
defect, or (5) preferential rights are exercised on Acquisition Properties
aggregating more than 80% of the Acquisition purchase price. Costilla has the
right to terminate the Acquisition Agreement if (a) the mutually agreed upon
adjustments for defects, casualty losses and condemnation takings exceed 20% of
the Acquisition purchase price, (b) preferential rights are exercised on assets
aggregating more than 80% of the Acquisition purchase price, or (c) Pioneer has
not satisfied certain conditions to closing (which are customary in transactions
of this type). If the Acquisition Agreement is terminated by Costilla due to a
breach by Pioneer, Costilla may enforce any or all of its legal or equitable
rights and remedies, including specific performance, seeking a refund of the
deposit and all accrued interest thereon or damages. If the Acquisition
Agreement is terminated by Pioneer due to a breach by Costilla, Pioneer is
entitled to retain the $25 million deposit and all accrued interest thereon and
is also entitled to an additional payment from Costilla in the amount of $16
million, plus the cost and expenses of collection, as liquidated damages. In the
event the Acquisition Agreement is terminated by either party other than due to
a breach by the other party, the deposit and all accrued interest thereon will
be refunded to Costilla.

THE ACQUISITION PROPERTIES

General. The Acquisition Properties consist of (1) producing oil and gas
properties primarily located in the Permian Basin, the South/East Texas region
and the Mid-Continent region, (2) approximately 11 million gross undeveloped
mineral acres, (3) approximately 210,000 gross undeveloped leasehold acres, (4)
a license

20
<PAGE> 24

to use seismic data related to certain of the oil and gas properties to be
acquired, and (5) gas plants, pipelines and processing facilities.

The Company believes that the estimated proved reserves attributable to the
Acquisition Properties are 436 Bcfe as of October 1, 1998, with a PV-10 value of
approximately $275 million. The proved reserves attributable to the Acquisition
Properties are allocated approximately 35% to oil and 65% to gas. For the six
months ended June 30, 1998, the Acquisition Properties produced approximately
17,990 Mmcf of natural gas and 1,498 Mbbls of oil, resulting in net operating
income of approximately $37.2 million. The Acquisition also includes a license
to use approximately 400 square miles of 3-D seismic data located in the
South/East Texas region.

Oil and Gas Reserves. The following table sets forth by region certain
reserve information as of October 1, 1998 which relates to the Acquisition
Properties.

<TABLE>
<CAPTION>
PROVED RESERVES
-----------------------------------------------------
OIL GAS GAS EQUIVALENT PERCENT OF TOTAL
REGION (MBBLS) (MMCF) (MMCFE) GAS EQUIVALENT
------ ------- ------- -------------- ----------------
<S> <C> <C> <C> <C>
Permian Basin................................. 18,329 63,388 173,362 39.80
South/East Texas.............................. 4,333 125,506 151,504 34.78
Mid-Continent................................. 2,013 92,874 104,952 24.10
Rocky Mountain and Other...................... 797 971 5,753 1.32
------ ------- ------- ------
Total............................... 25,472 282,739 435,571 100.00
====== ======= ======= ======
</TABLE>

The estimated proved oil and gas reserves and estimated future net cash
flows therefrom attributable to the Acquisition Properties at October 1, 1998
are further described as follows:

<TABLE>
<CAPTION>
OIL GAS
(MBBLS) (MMCF)
-------- --------
<S> <C> <C>
Proved developed producing.................................. 19,647 193,207
Proved developed non-producing.............................. 1,627 45,544
Proved undeveloped.......................................... 4,198 43,988
-------- --------
Total proved...................................... 25,472 282,739
Future net cash flows before income taxes (in thousands).... $165,689 $307,708
Future net cash flows before income taxes, discounted at
10%(in thousands)......................................... $ 96,383 $179,001
</TABLE>

The reserve estimates reflected above were prepared by the Company. Average
oil and gas prices used to determine proved reserves and the present value of
estimated future net cash flow were $14.50 per Bbl and $1.69 per Mcf at October
1, 1998. Estimates of oil and gas reserves are subject to interpretation and
uncertainty. See "The Company -- Oil and Gas Reserves."

Productive Well Summary. The following table sets forth the gross and net
productive oil and gas wells included in the Acquisition Properties as of June
30, 1998. Productive wells are producing wells and wells capable of production.

<TABLE>
<CAPTION>
GROSS NET
----- ---
<S> <C> <C>
Oil wells................................................... 1,634 644
Gas wells................................................... 1,409 340
----- ---
Total............................................. 3,043 984
===== ===
</TABLE>

21
<PAGE> 25

Acreage. The following table sets forth certain information regarding the
developed and undeveloped leasehold acreage included in the Acquisition
Properties as of June 30, 1998. Acreage in which the interest is limited to
royalty, overriding royalty, mineral and similar interests is excluded.

<TABLE>
<CAPTION>
DEVELOPED UNDEVELOPED TOTAL
------------------- ----------------- -------------------
REGION GROSS NET GROSS NET GROSS NET
------ --------- ------- ------- ------- --------- -------
<S> <C> <C> <C> <C> <C> <C>
Permian Basin.................. 416,960 199,762 12,918 3,057 429,878 202,819
South/East Texas............... 287,040 114,588 16,503 13,061 303,543 127,649
Mid-Continent.................. 675,840 170,534 105,746 94,568 781,586 265,102
Other.......................... 88,960 16,824 74,273 67,636 163,233 84,460
--------- ------- ------- ------- --------- -------
Total................ 1,468,800 501,708 209,440 178,332 1,678,240 680,030
========= ======= ======= ======= ========= =======
</TABLE>

In addition, the Acquisition Properties include 542,720 gross (100,372 net)
developed mineral acres and 11,186,705 gross undeveloped mineral acres which are
not included in the foregoing table. The 11,729,425 gross total developed and
undeveloped mineral acres are located in the continental United States. These
interests include approximately 3.6 million acres of fee mineral interests,
which include ownership of all subsurface minerals and the rights to lease and
retain royalty interests in such properties. The remaining mineral interests,
constituting approximately 7.6 million acres, represent mineral interests
currently owned by Santa Fe Minerals, on which Pioneer has an option. Upon
consummation of the Acquisition, the Company will have the option to lease such
mineral interests for a five year primary term at a nominal cost per acre plus a
royalty interest reserved to Santa Fe Minerals. The options on such mineral
interests expire in 2009, subject to partial releases of the options in 1999 and
2004.

Other Assets. In addition to the above-described oil and gas properties,
the Acquisition Properties include gas plants, pipelines and processing
facilities which are primarily located in Oklahoma and Texas.

FUNDING THE ACQUISITION

Costilla intends to fund the Estimated Purchase Price with the net cash
proceeds from the Stock Issuance and borrowing under the New Credit Facility.
See "The Stock Issuance" and "Description of Certain Indebtedness -- New Credit
Facility." The net cash proceeds of the Stock Issuance are estimated to be
approximately $251 million, constituting 64% of the Estimated Purchase Price.
The Company expects to close the Stock Issuance the day prior to or the day of
the Acquisition closing, subject to stockholder approval and other closing
conditions. The Company plans to utilize advances under the New Credit Facility
to fund the remaining balance of approximately $139 million (36%) of the
Estimated Purchase Price. The Company expects to close the New Credit Facility
simultaneously with the closing of the Stock Issuance.

If either of these sources of financing become unavailable, the Company
will be required to seek alternative financing or risk termination of the
Acquisition Agreement and the consequences resulting therefrom. The Company does
not currently have any arrangements or commitments for alternative sources of
financing, and there can be no assurance that such sources will be available.
See "Potential Effects of Stockholder Vote -- Potential Effects of Not
Consummating the Transactions."

CERTAIN FEDERAL INCOME TAX CONSEQUENCES

The Acquisition will not result in any immediate federal income tax effects
to Costilla. Costilla will have a tax basis in the Acquisition Properties equal
to the purchase price allocated to the Acquisition Properties, and will be able
to claim depletion and depreciation on the Acquisition Properties.

ACCOUNTING TREATMENT

The Company will account for the Acquisition in accordance with the
purchase method of accounting. Accordingly, results of operations from the
Acquisition Properties will be included in the Company's consolidated financial
statements beginning upon consummation of the Acquisition.

22
<PAGE> 26

THE COMPANY

GENERAL

Costilla is an independent energy company engaged in the exploration,
acquisition and development of oil and gas properties. The Company's primary
operations are in the South/East Texas region, the Rocky Mountain region and the
Permian Basin. The Company's strategy focuses on utilizing current and
developing technological advancements to increase reserves through a targeted
exploration program, strategic property acquisitions, and development of
producing properties.

The following is primarily a description of the Company's historical and
current business before the Acquisition, with selected references to the
Acquisition and the Acquisition Properties. Certain of the tabular information
also contains pro forma information for the Company giving effect to the
Acquisition.

BUSINESS AND PROPERTIES

The Company began operating in 1988 and completed an initial public
offering of its Common Stock in October 1996. As of October 1, 1998, the Company
had total estimated net proved reserves of 11 Mmbbls of oil and 165 Bcf of gas,
aggregating 232 Bcfe (29% attributable to oil and 71% attributable to gas), with
a PV-10 Value of approximately $180 million. The Company also has a substantial
acreage position consisting of 1,007,479 gross (760,529 net) acres at June 30,
1998, 715,038 gross (653,296 net) of which are undeveloped.

The Company began active efforts to acquire and develop oil and gas
properties in 1993 and, from January 1, 1993 to June 30, 1998, closed nine
acquisitions for an aggregate purchase price of approximately $149 million. The
Acquisition is a continuation of this strategy of growth through selective
acquisitions. The three most significant acquisitions completed to date have
been:

- The acquisition of 36 Bcfe of proved reserves (at July 1, 1997),
extensive undeveloped acreage and seismic data located in the Rocky
Mountain region from Ballard Petroleum, L.L.C. ("Ballard") in August 1997
for approximately $41.2 million (the "Ballard Acquisition").

- The acquisition from a predecessor of Pioneer of 64 Bcfe of proved
reserves and undeveloped acreage located in the Permian Basin and the
South/East Texas region in June 1996 for approximately $38.7 million (the
"1996 Acquisition").

- The acquisition from a predecessor of Pioneer of 86 Bcfe of proved
reserves and undeveloped acreage in the Permian Basin, South/East Texas
and Rocky Mountain regions in June 1995 for approximately $46.6 million
(the "1995 Acquisition").

Following the Acquisition, the Company intends to continue its strategy to
increase its oil and gas reserves, production and cash flow from operations by
utilizing a three-pronged approach which combines an active exploration program
using 3-D seismic and other technological advances with strategic property
acquisitions and focused development drilling. The Company's management and
technical staff have significant oil and natural gas experience in the areas of
drilling and completions, production operations, acquisitions and divestitures
and reservoir engineering. Most members of the Company's technical staff, having
spent substantial portions of their careers specializing in the Company's core
operating regions, have in-depth knowledge of these regions. The Company has
sought to reduce its operating and commodity risks by holding a geographically
diverse portfolio of properties and the Acquisition further promotes this
strategy.

23
<PAGE> 27

OIL AND GAS RESERVES

The following table sets forth by region certain reserve information as of
October 1, 1998 which relates to the principal oil and gas properties currently
owned by Costilla and the Company pro forma for the Acquisition.

<TABLE>
<CAPTION>
PROVED RESERVES
-------------------------------------------------------------------------------
OIL GAS GAS EQUIVALENT PERCENT OF TOTAL
(Mbbls) (Mmcf) (Mmcfe) GAS EQUIVALENT
----------------- ------------------ ------------------ -----------------
PRO PRO PRO PRO
REGION COSTILLA FORMA COSTILLA FORMA COSTILLA FORMA COSTILLA FORMA
------ -------- ------ -------- ------- -------- ------- -------- ------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Permian Basin.............. 3,836 22,165 22,528 85,916 45,544 218,906 19.66% 32.81%
South/East Texas........... 1,920 6,253 117,104 242,610 128,624 280,128 55.54 41.99
Mid-Continent.............. 83 2,096 760 93,634 1,258 61,932 0.54 15.92
Rocky Mountain and Other... 5,329 6,126 24,205 25,176 56,179 106,210 24.26 9.28
------ ------ ------- ------- ------- ------- ------ ------
Total............ 11,168 36,640 164,597 447,336 231,605 667,176 100.00% 100.00%
====== ====== ======= ======= ======= ======= ====== ======
</TABLE>

Estimated total proved reserves of oil and gas as of October 1, 1998, for
Costilla and the Company pro forma for the Acquisition were as follows:

<TABLE>
<CAPTION>
COSTILLA PRO FORMA
----------------- -----------------
OIL GAS OIL GAS
(Mbbls) (Mmcf) (Mbbls) (Mmcf)
------- ------- ------- -------
<S> <C> <C> <C> <C>
Proved developed producing...................... 7,629 94,561 27,273 287,768
Proved developed non-producing.................. 249 9,162 1,876 54,706
Proved undeveloped.............................. 3,293 60,874 7,491 104,862
------ ------- ------ -------
Total proved.......................... 11,168 164,597 36,640 447,336
====== ======= ====== =======
</TABLE>

The following table sets forth the estimated future net cash flows as of
October 1, 1998 from the estimated proved reserves of Costilla and the Company
pro forma for the Acquisition:

<TABLE>
<CAPTION>
PRO
COSTILLA FORMA
-------- --------
(IN THOUSANDS)
<S> <C> <C>
Future net cash flows before income taxes................... $271,663 $745,060
Future net cash flows before income taxes, discounted at
10%....................................................... $179,631 $455,015
</TABLE>

The reserve estimates reflected above were prepared by the Company. Oil and
gas prices used to determine proved reserves and the present value of estimated
future net cash flow at October 1, 1998 were $13.26 per Bbl and $1.99 per Mcf
for Costilla and $14.12 per Bbl and $1.80 per Mcf pro forma.

The reserves data set forth herein present estimates only. Estimates of
economically recoverable oil and gas reserves and of future net cash flows
necessarily depend upon a number of variable factors and assumptions, such as
historical production from the area compared with production from other
producing areas, the assumed effects of regulations by governmental agencies and
assumptions concerning future oil and gas prices, future operation costs,
severance and excise taxes, development costs and workover and remedial costs,
all of which may vary considerably from actual results. For these reasons,
estimates of the economically recoverable quantities of oil and gas attributable
to any particular group of properties, classifications of such reserves based on
risk of recovery, and estimates of the future net cash flows expected therefrom
prepared by different engineers or by the same engineers but at different times
may vary substantially and such reserve estimates may be subject to downward or
upward adjustment based upon such factors. The Company therefore emphasizes that
the actual production, revenues, severance and excise taxes, development and
operating expenditures with respect to its reserves will likely vary from such
estimates, and such variances could be material.

In accordance with applicable requirements of the Commission, the estimated
discounted future net revenues from estimated proved reserves are based on
prices and costs as of the date of the estimate unless such prices or costs are
contractually determined at such date. Actual future prices and costs may be
24
<PAGE> 28

materially higher or lower. Actual future net revenues also will be affected by
factors such as actual production, supply and demand for oil and natural gas,
curtailments or increases in consumption by natural gas purchasers, changes in
governmental regulations or taxation and the impact of inflation on costs.

While the Company's current oil and gas reserves are attributable to in
excess of 2,000 proved and proved undeveloped wells and locations, approximately
31% of Costilla's total proved reserves at October 1, 1998 were attributable to
5 wells in the Southwest Speaks Field in Lavaca County, Texas. Each of these
wells has been completed in 1998. Estimates of proved undeveloped reserves, as
well as estimates made early in the productive life of wells, may be less
reliable than reserve estimates attributable to wells which have a longer
production history. Any downward revision of the reserve estimates attributable
to the Southwest Speaks Field, or any interference in production from such
field, could have a material adverse affect on the Company's future cash flows
and financial results. The Acquisition is expected to reduce the Company's
dependency on any such particular property by further spreading the risk among
properties that are more geographically and geologically diverse.

MARKETING ARRANGEMENTS

The Company sells its crude oil production under several pricing
arrangements, with a majority sold under arrangements based upon either New York
Mercantile Exchange ("NYMEX") prices or posted prices. Each of those two
arrangements are subject to market adjustments. The majority of the Company's
gas production is sold at spot market prices. The term "spot market" as used
herein refers to contracts with terms of six months or less or contracts which
call for a redetermination of sales prices every six months or earlier. The
Company does not believe that the loss of any of its principal oil or gas
purchasers would have a material adverse effect on it. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations" for a
discussion of the hedging activities conducted by the Company.

EXPLORATION AND DEVELOPMENT ACTIVITIES

The Company drilled, or participated in the drilling of, the following
number of wells during the periods indicated. At June 30, 1998, the Company was
in the process of drilling 8 gross (4.79 net) wells and was in the process of
completing 14 gross (8.60 net) wells as producers which are not reflected in the
following table.

<TABLE>
<CAPTION>
SIX MONTHS
ENDED
1997 1996 1995 JUNE 30, 1998
------------- ------------ ------------- -------------
GROSS NET GROSS NET GROSS NET GROSS NET
----- ----- ----- ---- ----- ----- ----- -----
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Exploratory:
Productive........................ 15 8.38 13 8.88 10 4.58 5 3.46
Dry............................... 10 5.81 2 2.00 6 2.57 7 5.01
--- ----- -- ---- -- ----- -- -----
Total..................... 25 14.19 15 10.88 16 7.15 12 8.47
=== ===== == ==== == ===== == =====
Development:
Productive........................ 86 58.72 16 9.93 1 0.44 16 7.69
Dry............................... 11 8.54 5 3.20 -- -- -- --
--- ----- -- ---- -- ----- -- -----
Total..................... 97 67.26 21 13.13 1 0.44 16 7.69
=== ===== == ==== == ===== == =====
Total:
Productive........................ 101 67.11 29 18.81 11 5.02 21 11.15
Dry............................... 21 14.35 7 5.20 6 2.57 7 5.01
--- ----- -- ---- -- ----- -- -----
Total..................... 122 81.46 36 24.01 17 7.59 28 16.16
=== ===== == ==== == ===== == =====
</TABLE>

The Company does not own any drilling rigs and all of its drilling
activities are conducted by independent contractors under standard drilling
contracts.

25
<PAGE> 29

PRODUCTIVE WELL SUMMARY

The following table sets forth the gross and net interest in productive oil
and gas wells as of June 30, 1998 for Costilla and the Company pro forma for the
Acquisition. Productive wells are producing wells and wells capable of
production.

<TABLE>
<CAPTION>
GROSS NET
-------------------- --------------------
COSTILLA PRO FORMA COSTILLA PRO FORMA
-------- --------- -------- ---------
<S> <C> <C> <C> <C>
Oil wells.............................................. 2,105 3,739 767 1,412
Gas wells.............................................. 1,352 2,761 268 608
----- ----- ----- -----
Total........................................ 3,457 6,500 1,035 2,020
===== ===== ===== =====
</TABLE>

ACREAGE

The following tables set forth certain information regarding the developed
and undeveloped leasehold acreage as of June 30, 1998 for Costilla and the
Company pro forma for the Acquisition. Acreage in which the interest is limited
to royalty, overriding royalty, mineral and similar interests is excluded.

Costilla:

<TABLE>
<CAPTION>
DEVELOPED UNDEVELOPED TOTAL
----------------- ----------------- -------------------
REGION GROSS NET GROSS NET GROSS NET
------ ------- ------- ------- ------- --------- -------
<S> <C> <C> <C> <C> <C> <C>
Permian Basin..................... 60,676 31,913 86,185 68,805 146,861 100,718
South/East Texas.................. 156,733 49,951 106,475 92,863 263,208 142,814
Mid-Continent..................... 37,431 10,450 149,402 148,879 186,833 159,329
Rocky Mountain and Other.......... 37,601 14,919 372,976 342,749 410,577 357,668
------- ------- ------- ------- --------- -------
Total................... 292,441 107,233 715,038 653,296 1,007,479 760,529
======= ======= ======= ======= ========= =======
</TABLE>

Pro Forma:

<TABLE>
<CAPTION>
DEVELOPED UNDEVELOPED TOTAL
------------------- ----------------- ---------------------
REGION GROSS NET GROSS NET GROSS NET
------ --------- ------- ------- ------- --------- ---------
<S> <C> <C> <C> <C> <C> <C>
Permian Basin.................. 477,636 231,675 99,056 71,862 576,692 303,537
South/East Texas............... 443,773 164,539 122,978 105,924 566,751 270,463
Mid-Continent.................. 713,271 180,984 255,148 243,447 968,419 424,431
Rocky Mountain and Other....... 126,561 31,743 447,249 410,385 573,810 442,128
--------- ------- ------- ------- --------- ---------
Total................ 1,761,241 608,941 924,431 831,618 2,685,672 1,440,559
========= ======= ======= ======= ========= =========
</TABLE>

Costilla does not currently own a significant amount of mineral interests.
The Acquisition Properties include a substantial acreage position in developed
and undeveloped mineral interests which are not included in the pro forma
information in the foregoing tables. See "The Acquisition -- The Acquisition
Properties -- Acreage." On a pro forma basis giving effect to the Acquisition,
the Company would have 542,720 gross (100,372 net) developed mineral acres and
11,186,705 gross undeveloped mineral acres, for a total of 11,729,425 gross
mineral acres located in the continental United States.

COMPETITION AND MARKETS

Competition in all areas of the Company's operations is intense. Major and
independent oil and gas companies and oil and gas syndicates actively bid for
desirable oil and gas properties, as well as for the equipment and labor
required to operate and develop such properties. A number of the Company's
competitors have financial resources and acquisition, exploration and
development budgets that are substantially greater than those of the Company,
which may adversely affect the Company's ability to compete with these
companies. Many of the Company's competitors have been engaged in the energy
business for a much longer time than the Company. Such companies may be able to
pay more for productive oil and gas properties

26
<PAGE> 30

and exploratory prospects and to define, evaluate, bid for and purchase a
greater number of properties and prospects than the Company's financial or human
resources permit. The Company's ability to acquire additional properties and to
discover reserves in the future will be dependent on its ability to evaluate and
select suitable properties and to consummate transactions in a highly
competitive environment.

The market for oil, gas and natural gas liquids produced by the Company
depends on factors beyond its control, including domestic and foreign political
conditions, the overall level of supply of and demand for oil, gas and natural
gas liquids, the price of imports of oil and gas, weather conditions, the price
and availability of alternative fuels, the proximity and capacity of gas
pipelines and other transportation facilities and overall economic conditions.
The oil and gas industry as a whole also competes with other industries in
supplying the energy and fuel requirements of industrial, commercial and
individual consumers.

REGULATION

The Company's oil and gas exploration, production and related operations
are subject to extensive rules and regulations promulgated by federal, state and
local agencies. Failure to comply with such rules and regulations can result in
substantial penalties. The regulatory burden on the oil and gas industry
increases the Company's cost of doing business and affects its profitability.
Because such rules and regulations are frequently amended or reinterpreted, the
Company is unable to predict the future cost or impact of complying with such
laws.

The State of Texas and many other states require permits for drilling
operations, drilling bonds and reports concerning operations and impose other
requirements relating to the exploration and production of oil and gas. Such
states also have statutes or regulations addressing conservation matters,
including provisions for the unitization or pooling of oil and gas properties,
the establishment of maximum rates of production from oil and gas wells and the
regulation of spacing, plugging and abandonment of such wells. The statutes and
regulations of certain states limit the rate at which oil and gas can be
produced from the Company's properties.

The Federal Energy Regulatory Commission ("FERC") regulates interstate
natural gas transportation rates and service conditions, which affect the
marketing of gas produced by the Company, as well as the revenues received by
the Company for sales of such production. Since the mid-1980s, the FERC has
issued a series of orders, including the Order 636 series ("Order 636"), that
have significantly altered the marketing and transportation of gas. Order 636
began a fundamental restructuring of interstate pipeline sales and
transportation services, including the unbundling by interstate pipelines of the
sales, transportation, storage and other components of services such pipelines
previously performed. One of the effects of these orders has been to increase
competition within all phases of the gas industry. It is difficult to predict
the ultimate impact of these and future FERC orders on the Company and its gas
marketing efforts.

Sales of oil and natural gas liquids by the Company are not regulated and
are made at market prices. The price the Company receives from the sale of these
products is affected by the cost of transporting the products to market.
Effective as of January 1, 1995, the FERC implemented regulations establishing
an indexing system for transportation rates for oil pipelines, which, generally,
index such rates to inflation, subject to certain conditions and limitations.
The Company is not able to predict with certainty what long-term effect, if any,
these regulations will have on it, but, other factors being equal, the
regulations may, over time, tend to increase transportation costs for oil and
natural gas liquids.

ENVIRONMENTAL MATTERS

Operations of the Company are subject to numerous and constantly changing
federal, state and local laws and regulations governing the discharge of
materials into the environment or otherwise relating to environmental
protection. These laws and regulations may require the acquisition of certain
permits, restrict or prohibit the types, quantities and concentration of
substances that can be released into the environment in connection with drilling
and production, restrict or prohibit drilling activities that could impact
wetlands, endangered or threatened species or other protected natural resources
and impose substantial liabilities for pollution resulting from the Company's
operations. Such laws and regulations may substantially increase the cost of
exploring for,
27
<PAGE> 31

developing or producing oil and gas and may prevent or delay the commencement or
continuation of a given project. In the opinion of the Company's management, the
Company is in substantial compliance with current applicable environmental laws
and regulations, and the cost of compliance with such laws and regulations has
not been material and is not expected to be material during the next fiscal
year. Nevertheless, changes in existing environmental laws and regulations or in
interpretations thereof could have a significant impact on the operating costs
of the Company, as well as the oil and gas industry in general. For instance,
legislation has been proposed in Congress from time to time that would
reclassify certain oil and gas production wastes as "hazardous wastes," which
reclassification would make exploration and production wastes subject to much
more stringent handling, disposal and clean-up requirements. State initiatives
to further regulate the disposal of oil and gas wastes and naturally occurring
radioactive materials could have a similar impact on the Company.

The Comprehensive Environmental Response, Compensation, and Liability Act
("CERCLA"), also known as the "Superfund" law, imposes liability, without regard
to fault or the legality of the original conduct, on certain classes of persons
that are considered to have contributed to the release of a "hazardous
substance" into the environment. These persons include the owner or operator of
the disposal site or the site where the release occurred and companies that
disposed or arranged for the disposal of the hazardous substances found at the
site. Persons who are or were responsible for releases of hazardous substances
found at the site and persons who are or were responsible for releases of
hazardous substances under CERCLA may be subject to joint and several liability
for the costs of cleaning up the hazardous substances that have been released
into the environment and for damages to natural resources, and it is not
uncommon for neighboring landowners and other third parties to file claims for
personal injury and property damage allegedly caused by the hazardous substances
released into the environment. The Company is able to control directly the
operation of only those wells with respect to which it acts as operator.
Notwithstanding the Company's lack of control over wells operated by others, the
failure of the operator to comply with applicable environmental regulations may,
in certain circumstances, be attributed to the Company. The Company has no
material commitments for capital expenditures to comply with existing
environmental requirements.

EMPLOYEES

At October 1, 1998, the Company had approximately 140 full-time employees.
None of the Company's employees is subject to a collective bargaining agreement.
The Company considers its relations with its employees to be good. In addition
to its employees, Costilla utilizes 10 consultants, and through its arrangements
with Ballard, has access to the approximately 30 Ballard employees for oil and
gas activities within the Rocky Mountain region. As a result of the Acquisition,
Costilla anticipates that it will employ additional field employees, the
majority of whom will likely be former employees of Pioneer whose duties are
directly related to the field operations of the Acquisition Properties. The
costs to the Company associated with such new field employees will be included
in the lease operating expenses for the Acquisition Properties. Under the
Acquisition Agreement, the Company is required to interview and evaluate certain
identified Pioneer field personnel. While Costilla is not obligated to offer
employment to any such persons, it will be required to fund certain severance
benefits for those it does not employ. See "Potential Effects of Stockholder
Vote -- Potential Effects of Consummating the Transactions -- Significant
Increase in Operations."

LEGAL PROCEEDINGS

The Company is a defendant or codefendant in minor lawsuits that have
arisen in the ordinary course of business. While the outcome of these lawsuits
cannot be predicted with certainty, management does not expect any of these to
have a material adverse effect on the Company's consolidated financial condition
or results of operations. Pursuant to the Acquisition Agreement, Costilla
assumes certain litigation related to the Acquisition Properties. While Costilla
does not believe that such matters will be material, litigation is inherently
uncertain and the actual results of such assumed litigation may be material and
adverse to the Company.

28
<PAGE> 32

TITLE TO PROPERTIES

The Company has obtained title opinions on substantially all of its
producing properties and believes that it has satisfactory title to such
properties in accordance with standards generally accepted in the oil and gas
industry. As is customary in the oil and gas industry, the Company performs a
minimal title investigation before acquiring undeveloped properties. A title
opinion is obtained prior to the commencement of drilling operations on such
properties. The Company's properties are subject to customary royalty interests,
liens incident to operating agreements, liens for current taxes and other
burdens which the Company believes do not materially interfere with the use of
or affect the value of such properties. Substantially all of the Company's oil
and gas properties are mortgaged to secure borrowings under the current credit
facility, and it is anticipated that substantially all of Costilla's current
properties and the Acquisition Properties will be mortgaged to secure the New
Credit Facility. See "Description of Certain Indebtedness -- New Credit
Facility."

OPERATIONAL HAZARDS AND INSURANCE

The Company's operations are subject to the hazards and risks inherent in
drilling, production and transportation of oil and gas, including fires, natural
disasters, explosions, encountering formations with abnormal pressures,
blowouts, cratering, pipeline ruptures, and spills, any of which can result in
loss of hydrocarbons, environmental pollution, personal injury or loss of life,
severe damage to and destruction of properties of the Company and others, and
suspension of operations. The Company maintains insurance of various types to
cover its operations. In addition, the Company maintains operator's extra
expense coverage which provides for care, custody and control of all material
wells drilled by the Company as operator. The Company believes that its
insurance is adequate and customary for companies of a similar size engaged in
operations similar to those of the Company, but losses could occur for
uninsurable or uninsured risks or in amounts in excess of existing insurance
coverage. The Company's general policy is to only engage drilling contractors
who provide substantial insurance coverage and name the Company as an additional
named insured. The occurrence of a significant adverse event, the risks of which
are not fully covered by insurance, could have a material adverse effect on the
Company's financial condition and results of operations. Moreover, no assurances
can be given that the Company will be able to maintain adequate insurance in the
future at rates it considers reasonable.

PRICE RANGE OF COMMON STOCK AND DIVIDEND POLICY

The Company completed its initial public offering of Common Stock on
October 2, 1996. On October 3, 1996 the Common Stock commenced trading on the
Nasdaq Stock Market's National Market under the trading symbol "COSE". The
following table sets forth the high and low sales price for the periods
presented, as reported by the Nasdaq National Market:

<TABLE>
<CAPTION>
HIGH LOW
------ ------
<S> <C> <C>
1996
Fourth Quarter (October 3 inception of trading)........... $13.63 $11.75
1997
First Quarter............................................. $15.50 $11.75
Second Quarter............................................ $14.50 $12.00
Third Quarter............................................. $14.25 $ 9.00
Fourth Quarter............................................ $16.00 $12.00
1998
First Quarter............................................. $12.75 $ 9.13
Second Quarter............................................ $11.50 $ 8.50
Third Quarter............................................. $10.50 $ 5.88
Fourth Quarter (through October 14, 1998)................. $ 7.00 $ 6.63
</TABLE>

On September 4, 1998, the last trading day before the public announcement
that Costilla and Pioneer had entered into the Acquisition Agreement, the high
and low per share sales price of the Common Stock, as

29
<PAGE> 33

reported by the Nasdaq National Market, was $8.25 and $7.50. As of September 30,
1998, there were approximately 1,600 record and beneficial holders of the Common
Stock and 9,665,115 shares were outstanding. On , 1998, the most
recent practicable date prior to the printing of this Proxy Statement, the high
and low per share sales price of the Common Stock on the Nasdaq National Market
was $ and $ .

The Company has never declared or paid any cash dividends on its Common
Stock. The Company's Board of Directors does not anticipate paying any cash
dividends in the foreseeable future, as it intends to retain cash to finance the
growth of the Company's business. The Indenture restricts the payment of
dividends and it is anticipated that the New Credit Facility will also restrict
the payment of dividends. In addition, the New Preferred Stock ranks senior to
the Common Stock with respect to any payment of dividends. The payment of any
cash dividends on the Common Stock in the future will depend on such factors as
the earnings, anticipated capital requirements, and operating and financial
condition of the Company and any other factors deemed relevant by the Board of
Directors.

30
<PAGE> 34

PRO FORMA CONDENSED FINANCIAL STATEMENTS

The unaudited Pro Forma Condensed Financial Statements of the Company have
been prepared to give effect to the Ballard Acquisition, the Acquisition and the
Stock Issuance and the application of the estimated net proceeds therefrom as if
such transactions (to the extent not already reflected) had taken place on June
30, 1998, for purposes of the Pro Forma Condensed Balance Sheet and as if the
transactions had taken place on January 1, 1997, for purposes of the Pro Forma
Condensed Statements of Operations. The Pro Forma Condensed Financial Statements
of the Company are not necessarily indicative of the results for the periods
presented had the Ballard Acquisition, the Acquisition and the Stock Issuance
taken place on January 1, 1997. In addition, future results may vary
significantly from the results reflected in the accompanying Pro Forma Condensed
Financial Statements because of normal production declines, changes in product
prices, and the success of future exploration and development activities, among
other factors. This information should be read in conjunction with the
Consolidated Financial Statements of Costilla Energy, Inc. and the Statements of
Revenues and Direct Operating Expenses with respect to the properties acquired
in the Ballard Acquisition and to be acquired in the Acquisition, all included
elsewhere herein.

31
<PAGE> 35

COSTILLA ENERGY, INC.

PRO FORMA CONDENSED BALANCE SHEET -- UNAUDITED
JUNE 30, 1998
(IN THOUSANDS)

ASSETS

<TABLE>
<CAPTION>
PRO FORMA
JUNE 30, PRO FORMA COSTILLA
1998 ADJUSTMENTS ENERGY, INC.
-------- ----------- ------------
<S> <C> <C> <C>
CURRENT ASSETS:
Cash and cash equivalents................................. $ 17,089 390,000(1) $ 17,089
(390,000)(2)
Accounts receivable:
Trade, net.............................................. 3,081 3,081
Oil and gas sales....................................... 7,954 7,954
Prepaid and other current assets.......................... 1,439 1,439
-------- --------
Total current assets............................... 29,563 29,563
-------- --------
PROPERTY, PLANT AND EQUIPMENT, AT COST:
Oil and gas properties, using the successful efforts
method of accounting:
Proved properties....................................... 233,420 272,049(2) 505,469
Unproved properties..................................... 47,076 104,634(2) 151,710
Accumulated depletion, depreciation and amortization...... (84,658) (84,658)
-------- --------
195,838 572,521
Other property and equipment, net......................... 3,628 13,317(2) 16,945
-------- --------
Total property, plant and equipment................ 199,466 589,466
-------- --------
OTHER ASSETS:
Deferred charges.......................................... 6,829 2,000(1) 8,829
Other..................................................... 2,400 2,400
-------- --------
Total other assets................................. 9,229 11,229
-------- --------
$238,258 $630,258
======== ========

LIABILITIES AND STOCKHOLDERS' EQUITY

CURRENT LIABILITIES:
Current maturities of long-term debt...................... $ 98 $ 98
Trade accounts payable.................................... 16,299 16,299
Undistributed revenue..................................... 3,312 3,312
Other current liabilities................................. 5,577 5,577
-------- --------
Total current liabilities.......................... 25,286 25,286
-------- --------
LONG-TERM DEBT, LESS CURRENT MATURITIES..................... 182,441 140,800(1) 323,241
-------- --------
OTHER NONCURRENT LIABILITIES................................ 313 313
-------- --------
STOCKHOLDERS' EQUITY:
Preferred stock, $.10 par value (3,000,000 shares
authorized; 50,000 shares, $1,000 liquidation value,
outstanding at June 30, 1998)........................... 5 10(1) 15
Common stock, $.10 par value (20,000,000 shares
authorized; 9,981,000 shares outstanding at June 30,
1998)................................................... 998 21(1) 1,019
Additional paid-in capital................................ 83,552 251,169(1) 334,721
Retained deficit.......................................... (54,337) (54,337)
-------- --------
Total stockholders' equity......................... 30,218 281,418
-------- --------
COMMITMENTS AND CONTINGENCIES............................... -- --
-------- --------
$238,258 $630,258
======== ========
</TABLE>

See accompanying notes to unaudited pro forma condensed financial statements.

32
<PAGE> 36

COSTILLA ENERGY, INC.

PRO FORMA CONDENSED STATEMENT OF OPERATIONS -- UNAUDITED
YEAR ENDED DECEMBER 31, 1997
(IN THOUSANDS, EXCEPT PER SHARE DATA)

<TABLE>
<CAPTION>
THE PRO FORMA
COSTILLA BALLARD ACQUISITION PRO FORMA COSTILLA
ENERGY, INC. ACQUISITION (PENDING) ADJUSTMENTS ENERGY, INC.
------------ ------------ ----------- ----------- ------------
<S> <C> <C> <C> <C> <C>
REVENUES............................ $ 76,501 $ 5,688 $151,830 $234,019
EXPENSES:
Oil and gas production............ 30,029 2,603 42,828 75,460
General and administrative........ 8,407 1,120(3) 10,527
1,000(4)
Exploration and abandonments...... 6,588 200(5) 6,788
Depreciation, depletion and
amortization................... 26,409 2,030(6) 74,909
46,470(7)
Impairment of oil and gas
properties..................... 28,189 28,189
Interest.......................... 12,979 2,010(8) 26,653
11,664(9)
-------- -------- -------- --------
112,601 2,603 42,828 222,526
-------- -------- -------- --------
INCOME (LOSS) BEFORE FEDERAL INCOME
TAXES AND EXTRAORDINARY ITEM...... (36,100) 3,085 109,002 11,493
PROVISION FOR FEDERAL INCOME TAXES
Current........................... 62 62
Deferred.......................... 90 3,870(10) 3,960
-------- -------- -------- --------
INCOME (LOSS) BEFORE EXTRAORDINARY
ITEM.............................. $(36,252) $ 3,085 $109,002 $ 7,471
======== ======== ======== ========
CUMULATIVE PREFERRED STOCK
DIVIDEND.......................... $ -- 10,850(11) $ 10,850
======== ========
INCOME (LOSS) BEFORE EXTRAORDINARY
ITEM APPLICABLE TO COMMON
EQUITY............................ $(36,252) $ (3,379)
======== ========
INCOME (LOSS) PER SHARE BEFORE
EXTRAORDINARY ITEM APPLICABLE TO
COMMON EQUITY..................... $ (3.49) $ (0.11)
======== ========
WEIGHTED AVERAGE SHARES
OUTSTANDING....................... 10,383 20,667(12) 31,050
======== ========
</TABLE>

See accompanying notes to unaudited pro forma condensed financial statements.

33
<PAGE> 37

COSTILLA ENERGY, INC.

PRO FORMA CONDENSED STATEMENT OF OPERATIONS -- UNAUDITED
SIX MONTHS ENDED JUNE 30, 1998
(IN THOUSANDS, EXCEPT PER SHARE DATA)

<TABLE>
<CAPTION>
THE PRE OFFERING
COSTILLA ACQUISITION PRO FORMA COSTILLA
ENERGY, INC. (PENDING) ADJUSTMENTS ENERGY, INC.
------------ ----------- ----------- ------------
<S> <C> <C> <C> <C>
REVENUES..................................... $ 32,712 $56,395 $ 89,107
EXPENSES:
Oil and gas production..................... 14,226 19,222 33,448
General and administrative................. 5,070 500(4) 5,570
Exploration and abandonments............... 5,228 5,228
Depreciation, depletion and amortization... 14,364 22,349(7) 36,713
Interest................................... 9,833 5,832(9) 15,665
-------- ------- --------
48,721 19,222 96,624
-------- ------- --------
INCOME (LOSS) BEFORE FEDERAL INCOME TAXES AND
EXTRAORDINARY ITEM......................... (16,009) 37,173 (7,517)
PROVISION FOR FEDERAL INCOME TAXES
Current.................................... -- --
Deferred................................... -- (2,631)(10) (2,631)
-------- ------- --------
INCOME (LOSS) BEFORE EXTRAORDINARY ITEM...... $(16,009) $37,173 $ (4,886)
======== ======= ========
CUMULATIVE PREFERRED STOCK DIVIDEND.......... $ 307 5,425(11) $ 5,732
======== ========
INCOME (LOSS) BEFORE EXTRAORDINARY ITEM
APPLICABLE TO COMMON EQUITY................ $(16,316) $(10,618)
======== ========
INCOME (LOSS) PER SHARE BEFORE EXTRAORDINARY
ITEM APPLICABLE TO COMMON EQUITY........... $ (1.63) $ (0.35)
======== ========
WEIGHTED AVERAGE SHARES OUTSTANDING.......... 10,027 20,667(12) 30,694
======== ========
</TABLE>

See accompanying notes to unaudited pro forma condensed financial statements.

34
<PAGE> 38

COSTILLA ENERGY, INC.

NOTES TO UNAUDITED PRO FORMA CONDENSED FINANCIAL STATEMENTS

(1) BASIS OF PRESENTATION

The Pro Forma Condensed Statements of Operations of the Company have been
prepared to give effect to the Ballard Acquisition, the Acquisition and the
Stock Issuance as if such transactions had taken place on January 1, 1997. The
Ballard Acquisition and the Acquisition are accounted for by the purchase
method.

Costilla Energy, Inc. -- Represents the historical consolidated
statements of operations for the year ended December 31, 1997 and the six
months ended June 30, 1998.

Ballard Acquisition -- Represents the revenues and direct operating
expenses of the properties acquired in the Ballard Acquisition for the
period from January 1, 1997 to August 28, 1997 (date of the Ballard
Acquisition).

The Acquisition -- Represents the revenues and direct operating
expenses of the Acquisition Properties for the year ended December 31, 1997
and the six months ended June 30, 1998.

(2) OIL AND GAS PROPERTIES ACCOUNTING POLICIES

The Company uses the successful efforts method of accounting for oil and
gas producing activities. Costs to acquire mineral interests in oil and gas
properties, to drill and equip exploratory wells that find proved reserves, and
to drill and equip development wells are capitalized. Costs to drill exploratory
wells that do not find proved reserves, geological and geophysical costs, and
costs of carrying and retaining unproved properties are expensed.

Unproved oil and gas properties that are individually significant are
periodically assessed for impairment of value, and a loss is recognized at the
time of impairment by providing an impairment allowance. Other unproved
properties are amortized based on the Company's experience of successful
drilling and average holding period. Capitalized costs of producing oil and gas
properties, after considering estimated dismantlement and abandonment costs and
estimated salvage values, are depreciated and depleted by the unit-of-
production method. Support equipment and other property and equipment are
depreciated over their estimated useful lives of the assets, which range from 5
to 7 years.

On sale or retirement of a complete unit of a proved property, the cost and
related accumulated depreciation, depletion, and amortization are eliminated
from the property accounts, and the resultant gain or loss is recognized. On
retirement or sale of a partial unit of proved property, the amount received is
treated as a reduction of the cost of the interest retained.

(3) PRO FORMA ENTRIES

(1) To record the issuance of 20,666,667 shares of Acquisition Common at a
price of $7.50 per share for estimated proceeds of $150,350,000 and issuance of
105,000 shares of New Preferred Stock for estimated proceeds of $100,850,000, in
each case net of estimated expenses of the Stock Issuance, and amounts advanced
under the New Credit Facility of $140,800,000, net of $2,000,000 of estimated
fees and expenses related to the loan.

(2) To record the purchase of the Acquisition Properties from Pioneer for
the Estimated Purchase Price of $390,000,000.

(3) To record the incremental general and administrative expenses incurred
at a contractual rate of approximately $140,000 per month as a result of the
Ballard Acquisition.

(4) To record the incremental general and administrative expenses necessary
as a result of the Acquisition at an estimated rate of $1,000,000 annually.

(5) To record the incremental geological and geophysical expenses incurred
at a contractual rate of approximately $25,000 per month as a result of the
Ballard Acquisition.
35
<PAGE> 39
COSTILLA ENERGY, INC.

NOTES TO UNAUDITED PRO FORMA CONDENSED FINANCIAL STATEMENTS
(CONTINUED)

(6) To record estimated incremental depletion expense for the properties
acquired in the Ballard Acquisition from January 1, 1997 through August 28, 1997
(date of the Ballard Acquisition).

(7) To record estimated incremental depletion, depreciation and
amortization expense for the properties acquired in the Acquisition.

(8) To adjust interest expense to reflect additional borrowings for the
properties acquired in the Ballard Acquisition from January 1, 1997 to August
28, 1997 (date of the Ballard Acquisition). Also included is the amortization of
loan fees of $478,000 over a five-year period. Interest includes $1,509,000
calculated on an 8.00% $30,000,000 acquisition term loan plus $437,000 on
additional bank financing of $8,200,000 at 8.00%.

Incremental interest expense includes the following components:

<TABLE>
<CAPTION>
YEAR ENDED SIX MONTHS ENDED
DECEMBER 31, 1997 JUNE 30, 1998
----------------- ----------------
(IN THOUSANDS)
<S> <C> <C>
Additional interest on borrowings associated with
the Ballard Acquisition........................... $1,946 $ -
Amortization of loan fees........................... 64 -
------ ------
$2,010 $ -
====== ======
</TABLE>

(9) To adjust interest expense to reflect additional borrowings for the
purchase of the Acquisition Properties. Also included is the amortization of
$2,000,000 of fees and expenses associated with the New Credit Facility over a
five-year period. Interest was calculated on incremental bank financing of
$140,800,000 at an annual rate of 8.00%.

Incremental interest expense includes the following components:

<TABLE>
<CAPTION>
YEAR ENDED SIX MONTHS ENDED
DECEMBER 31, 1997 JUNE 30, 1998
----------------- ----------------
(IN THOUSANDS)
<S> <C> <C>
Additional interest on borrowings associated with
the Acquisition................................... $11,264 $5,632
Amortization of loan fees........................... 400 200
------- ------
$11,664 $5,832
======= ======
</TABLE>

(10) To record the estimated deferred tax effect of projected taxable
income at an assumed tax rate of 35%.

(11) To record payment of cumulative dividends on the New Preferred Stock
at a coupon rate of 7.00%.

(12) To reflect issuance of 20,666,667 shares of Acquisition Common in the
calculation of basic earnings per share. No conversion of the New Preferred
Stock assumed for the earnings per share calculation since an assumed conversion
would be anti-dilutive.

(4) SUPPLEMENTAL PRO FORMA OIL AND GAS RESERVE INFORMATION

Estimated Quantities of Proved Oil and Gas Reserves

The estimates of proved oil and gas reserves, which are located in the
United States, were prepared by the Company as of January 1, 1997 and December
31, 1997. Reserves were estimated in accordance with guidelines established by
the Commission and FASB which require that reserve estimates be prepared under
existing economic and operating conditions with no provision for price and cost
escalations, except by contractual arrangements. The Company has presented the
pro forma reserve estimates utilizing an oil price of

36
<PAGE> 40
COSTILLA ENERGY, INC.

NOTES TO UNAUDITED PRO FORMA CONDENSED FINANCIAL STATEMENTS
(CONTINUED)

$15.96 per Bbl and a gas price of $1.91 per Mcf as of December 31, 1997. The
natural gas liquids reserves attributable to the Acquisition Properties are
presented with the pro forma natural gas reserve estimates. The pro forma
information assumes that the Ballard Acquisition and the Acquisition took place
on January 1, 1997.

Oil and gas reserve quantity estimates are subject to numerous
uncertainties inherent in the estimation of quantities of proved reserves and in
the projection of future rates of production and the timing of development
expenditures. The accuracy of such estimates is a function of the quality of
available data and of engineering and geological interpretation and judgment.
Results of subsequent drilling, testing and production may cause either upward
or downward revision of previous estimates. Further, the volumes considered to
be commercially recoverable fluctuate with changes in prices and operating
costs. The Company emphasizes that reserve estimates are inherently imprecise
and that estimates of new discoveries are more imprecise than those of currently
producing oil and gas properties. Accordingly, these estimates are expected to
change as additional information becomes available in the future.

Standardized Measure of Discounted Future Net Cash Flows Relating to Proved
Oil and Gas Reserves

The standardized measure of discounted future net cash flows is computed by
applying period-end prices of oil and gas (with consideration of price changes
only to the extent provided by contractual arrangements) to the estimated future
production of proved oil and gas reserves less estimated future expenditures
(based on period-end costs) to be incurred in developing and producing the
proved reserves, less estimated future income tax expenses (based on period-end
statutory tax rates, with consideration of future tax rates already legislated)
to be incurred on pretax net cash flows less tax basis of properties and
available credits, and assuming continuation of existing economic conditions.
The estimated future net cash flows are then discounted using a rate of 10% per
year to reflect the estimated timing of the future cash flows.

Discounted future cash flow estimates like those shown below are not
intended to represent estimates of the fair value of oil and gas properties.
Estimates of fair value should also consider probable reserves, anticipated
future oil and gas prices, interest rates, changes in development and production
costs and risks associated with future production. Because of these and other
considerations, estimates of fair value are necessarily subjective and
imprecise.

37
<PAGE> 41
COSTILLA ENERGY, INC.

NOTES TO UNAUDITED PRO FORMA CONDENSED FINANCIAL STATEMENTS
(CONTINUED)

<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31, 1997
------------------------------------
UNITED STATES MOLDOVA TOTALS
------------- ------- ----------
(IN THOUSANDS)
<S> <C> <C> <C>
Future cash flows.......................................... $1,642,582 $ 9,063 $1,651,645
Future costs:
Production............................................... (603,310) (1,943) (605,253)
Development.............................................. (109,553) (2,572) (112,125)
---------- ------- ----------
Future net cash flows before income taxes.................. 929,719 4,548 934,267
Future income taxes........................................ 166,128 951 167,079
---------- ------- ----------
Future net cash flows...................................... 763,591 3,597 767,188
10% annual discount for estimated timing of cash flows..... (307,324) (1,560) (308,884)
---------- ------- ----------
Standardized measure of discounted net cash flows.......... $ 456,267 $ 2,037 $ 458,304
========== ======= ==========
</TABLE>

Changes in Standardized Measure of Discounted Future Net Cash Flows From
Proved Reserves

<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31, 1997
-----------------------------------
UNITED STATES MOLDOVA TOTALS
------------- ------- ---------
(IN THOUSANDS)
<S> <C> <C> <C>
Increase (decrease):
Extensions and discoveries and improved recovery, net of
future production and development costs............... $ 69,140 $2,576 $ 71,716
Accretion of discount.................................... 106,052 -- 106,052
Net change in sales prices net of production costs....... (474,935) -- (474,935)
Changes in estimated future development costs............ 217 -- 217
Revisions of quantity estimates.......................... (41,735) -- (41,735)
Net change in income taxes............................... 199,618 (539) 199,079
Sales, net of production costs........................... (155,432) -- (155,432)
Sales of minerals in place............................... (29,975) -- (29,975)
Changes of production rates (timing) and other........... 21,676 -- 21,676
--------- ------ ---------
Net increase (decrease)............................... (305,374) 2,037 (303,337)
Standardized measure of discounted future net cash flows:
Beginning of period.............................. 761,641 -- 761,641
--------- ------ ---------
End of period.................................... $ 456,267 $2,037 $ 458,304
========= ====== =========
</TABLE>

38
<PAGE> 42

SELECTED FINANCIAL INFORMATION

The following table sets forth selected financial data of the Company. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations." The historical information should be read in conjunction with the
Consolidated Financial Statements and the notes thereto included elsewhere in
this Proxy Statement. The Company acquired significant producing oil and gas
properties in certain of the periods presented which affect the comparability of
the historical financial and operating data for the periods presented. The
historical results are not necessarily indicative of the Company's future
operations or financial results.

<TABLE>
<CAPTION>
SIX MONTHS ENDED
YEAR ENDED DECEMBER 31, JUNE 30,
--------------------------------------------------- -------------------
1997(1) 1996(1) 1995(1) 1994 1993 1998 1997
-------- -------- -------- -------- ------- -------- --------
(IN THOUSANDS, EXCEPT FOR RATIOS)
<S> <C> <C> <C> <C> <C> <C> <C>
STATEMENT OF OPERATIONS DATA:
Oil and gas revenues........................... $ 72,300 $ 53,919 $ 21,693 $ 7,637 $ 4,231 $ 32,015 $ 34,892
Total revenues................................... 76,501 55,026 21,816 7,836 4,397 32,712 35,812
Expenses:
Oil and gas production......................... 30,029 21,774 10,355 2,351 1,688 14,226 14,163
General and administrative..................... 8,407 5,238 3,571 1,184 952 5,070 3,370
Compensation related to option settlement...... -- -- 656 -- -- -- --
Exploration and abandonments................... 6,588 2,550 1,652 793 218 5,228 3,115
Depreciation, depletion and amortization....... 26,409 12,430 5,958 1,847 884 14,364 9,720
Impairment of oil and gas properties........... 28,189 -- -- -- -- -- --
Interest....................................... 12,979 11,281 4,591 1,458 605 9,833 5,516
Income (loss) from continuing operations....... (36,252) 535 (4,970) 163 73 (16,009) (134)
Net income (loss).............................. (36,471) (4,440) (4,970) 163 73 (16,308) (134)
Cumulative preferred stock dividend, preferred
return and accretion of redeemable members'
capital...................................... -- (3,930) (2,842) -- -- (307) --
Net income (loss) applicable to common
equity....................................... (36,471) (8,370) (7,812) 163 73 (16,615) (134)
Net income (loss) per common share............. (3.51) (1.29) (1.50) 0.03 0.01 (1.66) (0.01)
Weighted average shares outstanding............ 10,383 6,473 5,200 5,200 5,200 10,027 10,468
STATEMENT OF CASH FLOWS DATA:
Net cash provided by (used in):
Operating activities........................... $ 25,032 $ 12,350 $ 6,366 $ 1,527 $ 322 $ (2,976) $ 14,572
Investing activities........................... (92,597) (64,129) (62,467) (12,146) (6,731) (45,813) (34,453)
Financing activities........................... 58,562 61,531 58,830 10,618 6,315 62,262 13,268
OTHER FINANCIAL DATA:
Capital expenditures........................... $113,924 $ 70,017 $ 62,220 $ 11,868 $ 6,862 $ 48,971 $ 37,162
Dividends and distributions to members(2)...... -- 4,218 55 961 456 307 --
Adjusted EBITDA(3)............................. 38,065 27,108 7,234 4,301 1,757 13,416 18,278
Interest charges(4)............................ 12,461 10,253 4,591 1,458 605 9,541 5,262
Adjusted EBITDA(3)/interest charges(4)......... 3.lx 2.6x l.6x 2.9x 2.9x 1.4x 3.5x
BALANCE SHEET DATA (AS OF PERIOD END):
Working capital................................ $(11,511) $ 10,320 $ 2,654 $ 1,081 $ 1,612 $ 4,277 $ (2,167)
Total assets................................... 194,088 162,790 87,367 24,904 13,290 238,258 178,171
Total debt, less current maturities............ 163,087 100,262 71,494 23,613 12,034 182,441 114,826
Redeemable predecessor capital................. -- -- 11,576 -- -- -- --
Predecessor capital............................ -- -- (7,445) (747) 51 -- --
Stockholders' equity........................... 410 40,569 -- -- -- 30,218 39,202
</TABLE>

- ---------------

(1) The historical selected financial information of the Company includes the
results of operations of the Ballard Acquisition, the 1996 Acquisition and
the 1995 Acquisition as of August 28, 1997, June 14, 1996, and June 12,
1995, respectively (the closing date of each acquisition). See "Management's
Discussion and Analysis of Financial Condition and Results of Operations."

(2) The Company has not paid any dividends on its Common Stock since its initial
public offering.

(3) Adjusted EBITDA is presented because of its wide acceptance as a financial
indicator of a Company's ability to service or incur debt. Adjusted EBITDA
(as used herein) is calculated by adding interest, income taxes,
depreciation, depletion and amortization, impairment of oil and gas
properties, exploration and abandonment costs and extraordinary loss
resulting from extinguishment of debt to net income (loss). Adjusted EBITDA
should not be considered as an alternative to earnings (loss), or operating
earnings (loss), as defined by generally accepted accounting principles, as
an indicator of the Company's financial performance or to cash flow as a
measure of liquidity.

(4) Represents cumulative preferred stock dividends paid in cash and interest
expense, net of deferred charges amortization.

39
<PAGE> 43

MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS

GENERAL

Costilla is an independent energy company engaged in the exploration,
acquisition and development of oil and gas properties. From January 1, 1993 to
June 30, 1998, the Company closed nine acquisitions for an aggregate purchase
price of approximately $149 million. Two of those transactions involved
acquisitions from Pioneer's predecessor in 1995 and 1996 for a total purchase
price of approximately $85 million.

The Company's strategy is to utilize its technical staff and technological
advances to increase its oil and gas reserves, production and cash flow from
operations through an active exploration program and the acquisition and
development of proved reserves. In addition, Costilla continues to evaluate the
acquisition of undeveloped acreage for its exploration efforts. Costilla has
in-house exploration expertise using 3-D seismic technology to identify new
drilling opportunities as well as for the development of acquired properties.

The Company has grown primarily through acquisitions, which have impacted
its reported financial results in a number of ways. Properties sold by others
frequently have not received focused attention prior to sale. After acquisition,
certain of these properties are in need of maintenance, workovers, recompletions
and other remedial activity not constituting capital expenditures, which
substantially increase lease operating expenses. The increased production and
revenue resulting from these expenditures is predominately realized in periods
subsequent to the period of expense.

The Company has shown a significant increase in its oil and gas reserves
and production from 1995 through 1997, especially due to its acquisitions. The
following table sets forth certain operating data of Costilla for the periods
presented:

<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
--------------------------- SIX MONTHS ENDED
1997 1996 1995 JUNE 30, 1998
------- ------- ------- ----------------
<S> <C> <C> <C> <C>
OIL AND GAS PRODUCTION
Oil (Mbbls)........................... 2,175 1,726 950 1,049
Gas (Mmcf)............................ 14,698 9,205 4,806 7,562
Total (Mmcfe)......................... 27,750 19,560 10,506 13,856
AVERAGE SALES PRICES(1):
Oil (per Bbl)......................... $ 17.77 $ 19.87 $ 15.53 $ 15.39
Gas (per Mcf)......................... 2.29 2.13 1.45 2.10
PRODUCTION COST(2):
Per Mcfe.............................. $ 1.08 $ 1.11 $ 0.99 $ 1.03
Per dollar of sales................... 0.42 0.40 0.48 0.44
DEPRECIATION, DEPLETION AND
AMORTIZATION:
Per Mcfe.............................. $ 0.95 $ 0.64 $ 0.57 $ 1.04
Per dollar of sales................... 0.36 0.23 0.27 0.45
</TABLE>

- ---------------

(1) Before deduction of production taxes and including hedging results.

(2) Production cost includes lease operating expenses and production and ad
valorem taxes, if applicable, and excludes depreciation, depletion and
amortization.

Costilla uses the successful efforts method of accounting for its oil and
gas activities. Costs to acquire mineral interests in oil and gas properties, to
drill and equip exploratory wells that result in proved reserves, and to drill
and equip development wells are capitalized. Costs to drill exploratory wells
that do not result in proved reserves, geological, geophysical and seismic
costs, and costs of carrying and retaining unproved properties are expensed.
Capitalized costs of producing oil and gas properties, after considering
estimated dismantlement and abandonment costs and estimated salvage values, are
depreciated and depleted using the unit-of-production method. Unproved oil and
gas properties that are individually significant are periodically

40
<PAGE> 44

reviewed for impairment of value, and a loss is recognized at the time of
impairment by providing an impairment allowance. Other unproved properties are
amortized based on the Company's experience of successful drilling and average
holding period.

The Company has primarily utilized put option contracts and costless
collars to hedge the effect of price changes on a portion of its future oil and
gas production. Premiums paid and amounts receivable under the put option
contracts are amortized and accrued to oil and gas sales, respectively. If
market prices of oil and gas exceed the strike price of put options, the options
will expire unexercised, therefore, reducing the effective price received for
oil and gas sales by the cost of the related option. Conversely, if market
prices of oil and gas decline below the strike price of put options, the options
will be exercised, therefore, increasing the effective price received for oil
and gas sales by the proceeds received from the related option.

A costless collar establishes both a floor price and a ceiling for the
commodity through the simultaneous purchase of a put option contract and the
sale of a call option contract. Since the value of the put option and the call
option offset at the time of their purchase, the collar is costless, therefore
there are no premiums to amortize. If market prices of oil and gas decline below
the strike price of put options, the options will be exercised, therefore,
increasing the effective price received for oil and gas sales by the proceeds
received from the related option. Conversely, if market prices of oil and gas
exceed the strike price of call options, the Company is obligated to pay the
contracting counterparty an amount equal to the contracted volumes times the
difference between the market price and the strike price, therefore, reducing
the effective price received for oil and gas sales by the amount paid to the
counterparty.

The net effect of the Company's commodity hedging activities reduced oil
and gas revenues by $1,226,000, $1,705,000, and $80,000 for the years ended
December 31, 1997, 1996 and 1995, respectively. The net effect of the Company's
commodity hedging activities increased oil and gas revenues by $4,137,000 for
the six month period ended June 30, 1998 and reduced oil and gas revenues by
$746,000 for the comparable period in 1997. The Company established a costless
collar for oil by purchasing put options on 6,500 Bbls of oil per day which
establish a floor price of $18.50 per Bbl and selling call options on 6,500 Bbls
of oil per day at $22.55 per Bbl. These oil option contracts expired in August
1998. The referenced oil prices were based upon the price at which West Texas
Intermediate crude oil ("WTI") trades on the NYMEX. For the six months ended
June 30, 1998, the Company received a gross wellhead sales price for oil of
approximately 77% of the NYMEX price. The Company has established a costless
collar for gas by purchasing put options on 40,000 Mmbtu of gas per day which
establish a floor price of $2.40 per Mmbtu and selling call options on 40,000
Mmbtu of gas per day at $2.55 per Mmbtu. These gas option contracts continue
through October 1998. The referenced gas prices are based upon the index price
for Houston Ship Channel gas sales, which is approximately 100% of NYMEX. For
the six months ended June 30, 1998, the Company received a gross wellhead sales
price for gas of approximately 93% of NYMEX. As of June 30, 1998 the Company had
sold a put option on 40,000 Mmbtu of gas per day at $2.00 per Mmbtu based upon
the index price for Houston Ship Channel gas sales during the months of
September and October 1998.

In August 1998, the Company entered into new hedging arrangements with
respect to a significant portion of its crude oil production for the remainder
of 1998 and for the calendar year 1999. These arrangements consist of commodity
price swap contracts covering 5,000 Bbls of oil per day, which represented
approximately 95% of Costilla's average daily oil production at August 1998. The
contracts provide for a price of $16.25 per Bbl from September 1, 1998 through
December 31, 1998 and $16.40 per Bbl from January 1, 1999 through December 31,
1999. The referenced prices are based upon the price at which WTI trades on the
NYMEX. These contracts do not apply and do not provide a hedge for each trading
day during the periods covered on which the NYMEX price for WTI closes at less
than $13.25 per Bbl for the contract period during 1998 and $13.50 per Bbl
during 1999.

The Company utilizes interest rate swap agreements to reduce the potential
impact of increases in interest rates on floating-rate, long term debt. If
market rates of interest experienced during the applicable swap term are below
the rate of interest effectively fixed by the swap agreement, the rate of
interest incurred by the Company will exceed the rate that would have been
experienced under its then outstanding floating-rate indebtedness. The Company
had an interest rate swap agreement in place as of June 30, 1998 with a

41
<PAGE> 45

notional amount of $24 million and a fixed rate of 7.5%, which will expire in
January, 1999. Since the Company had no material amount of floating rate debt
outstanding at June 30, 1998, the interest swap agreement did not qualify as a
hedge and was marked to market with the carrying value being a liability of
approximately $313,000.

The Company's predecessor was classified as a partnership for federal
income tax purposes. Therefore, no income taxes were paid or provided by the
Company prior to the Company's initial public offering. Future tax amounts, if
any, will be dependent upon several factors, including but not limited to the
Company's results of operations.

RESULTS OF OPERATIONS

Six Months Ended June 30, 1998 Compared to Six Months Ended June 30, 1997

The Company's oil and gas revenues for the six months ended June 30, 1998
were $32,015,000, representing a decrease of $2,877,000 (8%) from revenues of
$34,892,000 in 1997. Lower commodity prices accounted for a decrease in revenues
of $4,818,000 which was partially offset by a combination of successful drilling
activities and revenues related to properties purchased or sold. The average net
oil price per barrel received in 1998 was $15.39 compared to $18.71 in 1997, an
18% decrease, and the average net gas price received in 1998 was $2.10 compared
to $2.30 in 1997, a 9% decrease. Revenues received from oil and gas hedges
accounted for $3.57 per Bbl and $0.05 per Mcf for the six months ended June 30,
1998. Oil and gas hedges cost $0.58 per Bbl and $0.03 per Mcf for the comparable
period in 1997.

Oil and gas production was 13,856 Mmcfe in 1998 compared to 12,943 Mmcfe in
1997, a 7% increase. Additional production from a combination of successful
drilling activities and acquired properties were largely offset by production
related to properties sold.

Interest and other revenues were $360,000 for the six months ended June 30,
1998, representing a $560,000 decrease (61%) compared to $920,000 in 1997.
Interest income decreased $117,000 to $136,000 for 1998 as compared with
$253,000 in 1997 due to decreased funds earning interest. Losses on investment
transactions of $35,000 and gains on investment transactions of $604,000 were
recorded for the six months ended June 30, 1998 and 1997, respectively. These
gains related to an interest rate swap contract which was marked-to-market.
During the six months ended June 30, 1998, the Company realized a gain of
$100,000 from the release of stock warrants it held in connection with a note
receivable. No similar transaction occurred in 1997.

Gain on sale of assets was $337,000 for the six months ended June 30, 1998
compared to a loss of $30,000 for 1997, representing an increase of $367,000.
Gains from the sale of certain oil and gas properties increased by approximately
$367,000.

Oil and gas production costs for the six month period ended June 30, 1998
were $14,266,000 ($1.03 per Mcfe), compared to $14,163,000 in 1997 ($1.09 per
Mcfe), representing an increase of $103,000. The 6% decrease in the oil and gas
production cost per Mcfe was due principally to a combination of lower
production costs on both newly completed wells and acquired properties and the
sale of certain oil and gas properties.

General and administrative expenses for the six months ended June 30, 1998
were $5,070,000, representing an increase of $1,700,000 (50%) from the 1997
amount of $3,370,000. The increase was primarily due to an increase in personnel
and related costs necessary to accommodate the increase in the Company's oil and
gas activities, including the Acquisition and Exploration Agreement with
Ballard.

Exploration and abandonment expense increased to $5,228,000 for the six
months ended June 30, 1998 compared to $3,115,000 in 1997. Dry hole and
abandonment costs increased to $3,994,000 in 1998 from $1,913,000 in 1997. The
Company incurred $624,000 of seismic costs for the six months ended June 30,
1998, compared to $892,000 in the comparable period in 1997. The Company
incurred $610,000 of other geological and geophysical costs during the six month
period ended June 30, 1998 compared to $309,000 for the same period in 1997. The
increase in exploration and abandonment expense was primarily related to the
Company's increased exploratory drilling activities in 1998 compared to 1997.

42
<PAGE> 46

Depreciation, depletion and amortization ("DD&A") expense from the six
month period ended June 30, 1998 was $14,364,000 compared to $9,720,000 for
1997, representing an increase of $4,644,000 (48%). During the 1998 period, DD&A
on oil and gas production was provided at an average rate of $1.04 per Mcfe
compared to $0.75 per Mcfe for 1997. Of the $4,644,000 increase, $3,753,000 was
due to the $0.05 per Mcfe increase in DD&A rate necessitated by lower oil and
gas prices at June 30, 1998 than those experienced at June 30, 1997.

Interest expense was $9,833,000 for the six months ended June 30, 1998,
compared to $5,516,000 for the comparable period in 1997. The $4,317,000 (78%)
increase was attributable to a combination of higher levels of average
outstanding indebtedness and the issuance in January 1998 of an additional $80
million of 10.25% senior notes due in 2006. The average amounts of applicable
interest-bearing debt in 1998 and 1997 were $189,583,000 and $102,263,000,
respectively. The effective annualized interest rate in 1998 was 10.4% as
compared to 10.8% in 1997.

Results of operations for the six months ended June 30, 1998 include an
extraordinary charge of $299,000. There were no extraordinary charges for the
comparable period in 1997. These extraordinary charges related to the early
extinguishment of the Acquisition Credit Facility (as defined below) and
consisted of previously capitalized debt issuance costs. A portion of the
proceeds from the 1998 offering of the Notes was used to repay the Acquisition
Credit Facility.

Year Ended December 31, 1997 Compared to Year Ended December 31, 1996

The Company's total oil and gas revenues for the year ended December 31,
1997 were $72,300,000, representing an increase of $18,381,000 (34%) over
revenues of $53,919,000 in 1996. This increase was primarily due to successful
drilling activities and the 1996 Acquisition, which accounted for approximately
$11,099,000 and $9,214,000 of increased revenue, respectively. The Ballard
Acquisition accounted for approximately $3,372,000 of the increase. Gas
imbalances accounted for approximately $2,340,000 of the increase, with an
average price of $1.56 per Mcf. Approximately 50% of the gas imbalance relates
to production in prior periods against which a valuation allowance had been
recorded due to uncertainty of ultimate collection. During the year ended
December 31, 1997, uncertainties related to these imbalances were substantially
reduced and the related valuation allowance reversed. Management does not expect
similar effects from gas imbalances in future periods. These increases were
partially offset by the $2,152,000 net effect of lower commodity prices. The
average oil price per barrel received in 1997 was $17.77 compared to $19.87 in
1996, an 11% decrease, and the average gas price received in 1997 was $2.29
compared to $2.13 in 1996, a 7% increase. The sale of certain properties in
April 1997 and December 1996 also partially offset the increased revenues in the
amount of $3,607,000.

Oil and gas production was 27,750 Mmcfe in 1997 compared to 19,560 Mmcfe in
1996, a 42% increase. Of the 8,190 Mmcfe increase, approximately 3,942 Mmcfe was
due to successful drilling activities and 3,234 Mmcfe was due to the properties
acquired in the 1996 Acquisition. Gas imbalances accounted for approximately
1,494 Mmcfe of the increase. The Ballard Acquisition properties accounted for
approximately 1,314 Mmcfe of the increase. The sale of certain properties in
April 1997 and December 1996 partially offset the increased production volumes.

Interest and other revenues were $940,000 for the year ended December 31,
1997 compared to $40,000 in 1996, representing an increase of $900,000. Of this
increase, $223,000 was related to increased interest income due to increased
funds earning interest. Gains on investment transactions of $510,000 were
recorded for the year ended December 31, 1997 related to an interest rate swap
contract which was marked-to-market. In the year ended December 31, 1996 losses
of $195,000 were recognized on certain investment transactions. During 1997,
losses of $146,000 related to an oil collar which was marked-to-market. No
comparable transactions existed in 1996.

Other income was $3,261,000 for the year ended December 31, 1997 compared
to $1,067,000 for 1996, representing an increase of $2,194,000 (206%). Gains
from the sale of certain oil and gas properties increased by approximately
$2,118,000. The remainder of the increase was due primarily to a gain of
approximately

43
<PAGE> 47

$70,000 recognized on the sale of the Company's interest in a partnership which
owned the Independence Plaza Building in Midland, Texas.

Oil and gas production costs for the year ended December 31, 1997 were
$30,029,000 ($1.08 per Mcfe), compared to $21,774,000 in 1996 ($1.11 per Mcfe),
representing an increase of $8,255,000 (38%), with approximately $4,026,000 of
the increase relating to the 1996 Acquisition and $1,583,000 to successful
drilling activities. The remainder of the increase was due primarily to
increased treating and transportation costs due to increased gas production and,
to a lesser extent, the Ballard Acquisition, offset in part by the sale of
certain high operating cost properties in April 1997. On a per Mcfe basis,
production costs decreased $0.03 (3%) due to a combination of the sale of
certain high operating cost properties in April 1997, the gas imbalance volumes
and lower production costs on newly completed wells.

General and administrative expenses for the year ended December 31, 1997
were $8,407,000, representing an increase of $3,169,000 (66%) from $5,238,000 in
1996. The increase is primarily due to additional personnel and related costs
necessary to accommodate the acceleration of the Company's oil and gas
activities, the Ballard Acquisition, increased insurance costs and other costs
for a full twelve month period related to becoming a public company in October
1996.

Exploration and abandonment expense increased to $6,588,000 for the year
ended December 31, 1997 compared to $2,550,000 in 1996. The Company incurred
$2,117,000 of seismic costs for the year ended December 31, 1997, compared to
$913,000 in 1996. Dry hole and abandonment costs increased to $3,584,000 in 1997
from $1,524,000 in 1996. The Company incurred $887,000 of other geological and
geophysical costs during the year ended December 31, 1997, compared to $113,000
in 1996. The increase in exploration and abandonments expense was primarily
related to the Company's increased drilling activities in 1997 compared to a
very low level of activity in 1996.

DD&A expense for the year ended December 31, 1997 was $26,409,000 compared
to $12,430,000 for 1996, representing an increase of $13,979,000 (112%). During
the 1997 period, DD&A on oil and gas production was provided at an average rate
of $0.95 per Mcfe compared to $0.63 per Mcfe for 1996. Approximately $3,751,000
of this increase was due to successful drilling activities, $3,078,000 related
to the 1996 Acquisition and an additional $1,018,000 of the increase was due to
the recording of gas imbalances. The remainder of the increase was due primarily
to the effect of lower oil and gas prices at December 31, 1997 than those
experienced at December 31, 1996.

Impairment of oil and gas properties for the year ended December 31, 1997
was $28,189,000. No comparable expense was recorded in 1996. This impairment
expense was determined under the guidelines of FAS 121 (Impairment of Long-Lived
Assets) using estimates of net undiscounted cash flow and estimated present
values for the Company's oil and gas reserves based upon the non-escalated
prices used in the Company's January 1, 1998 reserve report.

Interest expense was $12,979,000 for the year ended December 31, 1997,
compared to $11,281,000 for the comparable period in 1996. The $1,698,000 (15%)
increase was attributable primarily to increased levels of debt offset in part
by a decrease in the effective interest rate. The average amounts of applicable
interest-bearing debt in 1997 and 1996 were $128,207,000 and $95,671,000,
respectively. The effective annualized interest rate in 1997 was 10.1%, as
compared to 11.8% in 1996.

Results of operations for the year ended December 31, 1997 include an
extraordinary charge of $219,000 compared to $4,975,000 for the comparable
period in 1996. These extraordinary charges related to the early extinguishment
of the Company's prior bank credit facilities and consisted of the unamortized
balance of previously capitalized debt issuance costs.

44
<PAGE> 48

Year Ended December 31, 1996 Compared to Year Ended December 31, 1995

The Company's total oil and gas revenues for the year ended December 31,
1996 were $53,919,000, representing an increase of $32,226,000 (149%) over
revenues of $21,693,000 in 1995. This increase was primarily due to the 1996
Acquisition and 1995 Acquisition, which accounted for approximately $12,754,000
and $14,059,000 of the revenue increase, respectively. The remainder of the
increase was due to a combination of increased product prices, successful
drilling activities and the enhancement of existing production. The average oil
price per barrel received in 1996 was $19.87 compared to $15.53 in 1995, a 28%
increase, and the average gas price per Mcf received in 1996 was $2.13 compared
to $1.45 in 1995, a 47% increase.

Oil and gas production was 19,560 Mmcfe in 1996 compared to 10,506 Mmcfe in
1995, an increase of 86%. Of the 9,054 Mmcfe increase, approximately 4,338 Mmcfe
was due to the properties acquired in the 1996 Acquisition and 3,372 Mmcfe was
due to the properties acquired in the 1995 Acquisition, in each case including
enhancements of production after such acquisition. The remainder of the increase
was due to a combination of successful drilling activities and the enhancement
of existing production.

Interest and other revenues were $40,000 for the year ended December 31,
1996 compared to $123,000 in 1995, representing a decrease of $83,000, which was
primarily comprised of $195,000 in losses on investments held for trading
purposes and an increase in interest income of $67,000 in 1996 due to increased
funds earning interest. Also in 1996, the Company realized gains of $1,067,000
on various transactions for which no comparable sales were recorded in 1995.

Oil and gas production costs in 1996 were $21,774,000 ($1.11 per Mcfe),
compared to $10,355,000 in 1995 ($0.99 per Mcfe), representing an increase of
$11,419,000 (110%), due principally to the 1996 Acquisition and to a lesser
extent the 1995 Acquisition. On a per Mcfe basis, production costs increased
$0.12, due primarily to higher production costs per Mcfe for the properties
acquired in the 1996 Acquisition.

General and administrative expenses for the year ended December 31, 1996
were $5,238,000, representing an increase of $1,667,000 (47%) from 1995 of
$3,571,000. The increase is primarily due to an increase in personnel and
related costs necessary to accommodate the increased activities of the Company
due to the 1995 and 1996 Acquisitions. However, as noted above, production
volumes increased 86% and, therefore, general and administrative expenses per
Mcfe decreased to $0.27 per Mcfe for the year ended December 31, 1996 from the
$0.34 per Mcfe in 1995.

Results of operations for the year ended December 31, 1995 include non-cash
compensation expense of $656,000 deemed to have been received by a minority
interest owner of the Company who was deemed to have benefitted from the
cancellation of an option to purchase an additional interest in the Company held
by the other minority interest owner.

Exploration and abandonment expense increased to $2,550,000 in 1996
compared to $1,650,000 in 1995. The Company incurred $913,000 of seismic costs
for the year ended December 31, 1996, compared to $790,000 which were incurred
in 1995. Dry hole and abandonment costs increased to $1,524,000 in 1996 from
$860,000 in 1995.

DD&A expense for 1996 was $12,430,000 compared to $5,958,000 for 1995,
representing an increase of $6,472,000 (109%). During 1996, DD&A on oil and gas
production was provided at an average rate of $0.64 per Mcfe compared to $0.57
per Mcfe for 1995. The increases were due primarily to the 1996 and 1995
Acquisitions.

Interest expense was $11,281,000 in 1996, compared to $4,591,000 in 1995.
The $6,690,000 (146%) increase was attributable primarily to increased levels of
debt which the Company used to finance the 1996 Acquisition and amortization of
financing costs. The average amounts of applicable interest-bearing debt in 1996
and 1995 were $95,671,000 and $49,972,000, respectively. The effective
annualized interest rate in 1996 was 11.8%, as compared to 9.2% in 1995.

Results of operations for the year ended December 31, 1996 include an
extraordinary charge of $4,975,000, net of the related deferred tax benefit of
$1,042,000, related to the early extinguishment of the Company's prior bank
credit facilities (the "1995 Credit Facility" and the "Bridge Facility"). The
1995
45
<PAGE> 49

Credit Facility was replaced by the Bridge Facility in June 1996 and the Bridge
Facility was paid off with proceeds from the Company's initial public offering
and the sale of Notes in October 1996.

LIQUIDITY AND CAPITAL RESOURCES

Net Cash Provided By Operating Activities

For the six months ended June 30, 1998, net cash provided by operating
activities decreased to a negative $3.0 million from $14.6 million for 1997.
Cash provided by operations, before changes in operating assets and liabilities,
decreased to a negative $1.2 million from $9.5 million for the comparable period
in 1997 due primarily to lower oil and gas prices and exploratory dry holes.
With respect to the effect of lower commodity prices, oil and gas revenues
decreased by $4.8 million for the six months ended June 30, 1998 as compared to
the same period in 1997 because of lower oil and gas prices. Oil and gas
revenues attributable to commodity hedges amounted to $4.1 million for six
months ended June 30, 1998, $3.7 million of which related to the oil hedge.

Net Cash Used in Investing Activities

Net cash used in investing activities for the six months ended June 30,
1998 was $45.8 million. Approximately $11.8 million was used for the acquisition
of oil and gas properties, with $10.2 million going to Manti Resources ("Manti
Acquisition"), $34.5 million was used for exploration and development
activities, $2.2 was used to acquire the remaining membership interest in the
limited liability company through which the Company's Moldovan oil and gas
venture is conducted and $0.5 million for other property and equipment. Proceeds
from the sale of various oil and gas assets resulted in net cash provided from
investing activities of approximately $3.2 million. For the six months ended
June 30, 1997, net cash used in investing activities was $34.5 million.
Approximately $35.9 million was used for exploration and development activities,
$1.3 million was used for other property and $2.7 million was provided by sales
of oil and gas properties.

Financing Activities

For the six months ended June 30, 1998, the Company incurred $111 million
of debt, of which approximately $91.5 million was used to repay certain prior
bank debt, $10.2 million was used for the Manti Acquisition and the remainder
was used in connection with its exploration and development activities. In
addition, the Company used approximately $1.8 million for the purchase of
169,500 shares of Common Stock. Finally, in June 1998, the Company received net
proceeds of approximately $48 million when it sold $50 million of the
Outstanding Preferred Stock. During the six months ended June 30, 1997, the
Company incurred $14.6 million of new debt which was primarily used in
connection with its exploration and development activities and was also used for
the purchase of 98,000 shares of Common Stock for approximately $1.3 million.

The Company entered into its current bank credit facility in August 1997
(the "Revolving Credit Facility"). Approximately $19.9 million of the funds
initially borrowed were used for the extension and refinancing of a prior senior
credit facility and $11.2 million was used as a portion of the purchase price in
the Ballard Acquisition. The Revolving Credit Facility provides for a maximum
availability of $75 million, with a current borrowing base of $40 million, $0.5
million of which was borrowed at June 30, 1998. Borrowings under the Revolving
Credit Facility bear interest, at the Company's option, at a floating rate which
is at or above the lender's prime rate or above the applicable Eurodollar rate,
depending on the percentage of committed funds which have been borrowed.
Interest is payable quarterly as to base rate loans, and at the end of the
applicable interest period as to Eurodollar rate loans. The borrowing base of
the Revolving Credit Facility is automatically reduced by 5% each quarter
beginning in August 1999, and payments of principal are required in each such
quarter in which the outstanding principal balance is greater than the reduced
borrowing base. The remaining balance is payable on August 31, 2002, the
maturity date of the Revolving Credit Facility.

Contemporaneous with entering into the Revolving Credit Facility, the
Company also entered into a credit facility to provide the remaining financing
for the Ballard Acquisition. That credit facility was a term

46
<PAGE> 50

loan in the amount of $30 million which was repaid in full in connection with
the sale of Notes by the Company described in the following paragraph.

In January 1998 the Company issued $80 million of the Notes (the
"Supplemental Notes Offering"). The net proceeds of the Supplemental Notes
Offering were approximately $78.8 million. The Company used $30 million to repay
the Ballard Acquisition credit facility and $32.5 million to repay all but $0.5
million of the Revolving Credit Facility. In mid-January 1998 approximately $10
million of the remaining proceeds were used to fund the Manti Acquisition.

On June 3, 1998 the Company closed a private placement of 50,000 shares of
the Outstanding Preferred Stock to Enron Capital & Trade Resources Corp. and
Joint Energy Development Investments II Limited Partnership (jointly, "Enron")
for a purchase price of $50 million (the "Outstanding Preferred Stock
Offering"). Dividends accrue and are payable quarterly, commencing September 15,
1998, in cash, or in certain instances in shares of the Common Stock. The
dividend rate is 7% for dividends paid in cash and 8% for dividends paid in
shares of Common Stock. The holders of the Outstanding Preferred Stock may, at
any time, convert shares of Outstanding Preferred Stock into shares of the
Common Stock at a conversion price of $12.39 which, subject to certain
adjustments, would result in the issuance of 4,035,513 shares of Common Stock
upon conversion of the Outstanding Preferred Stock. The Company may, at its
option, redeem the shares of Outstanding Preferred Stock after June 15, 2001,
subject to certain limitations, for a premium reducing to par on June 15, 2004
and thereafter. Net proceeds from the Outstanding Preferred Stock Offering were
$48 million, of which $29 million was used to repay all but $0.5 million of the
Revolving Credit Facility and the remainder for general corporate purposes. The
Company anticipates that Enron will exchange all shares of the Outstanding
Preferred Stock for shares of the New Preferred Stock in the Stock Issuance and
that no shares of the Outstanding Preferred Stock will remain outstanding upon
consummation of the Stock Issuance.

Capital Resources

Funding for the Company's business activities has historically been
provided by bank financings, cash flow from operations, equity sales, property
divestitures and joint ventures with industry participants. The 1995
Acquisition, 1996 Acquisition and Ballard Acquisition were substantially funded
by bank financings. The Company is currently planning to execute its business
strategy, not including the Acquisition and the effects therefrom, with cash
flow from operations, net proceeds from the Supplemental Notes Offering, net
proceeds from the Outstanding Preferred Stock Offering and borrowings available
under the Revolving Credit Facility.

While the Company regularly engages in discussions relating to potential
acquisitions, the Company has no present agreement, commitment or understanding
with respect to any such acquisition, other than the Acquisition and
acquisitions of undeveloped acreage and various mineral interests in its normal
course of business. Any future acquisition may require additional financing and
will be dependent upon financing arrangements available at the time.

The Company believes that the increased availability under the Revolving
Credit Facility resulting from the application of net proceeds of the
Supplemental Notes Offering and the Outstanding Preferred Stock Offering and
cash flow from operations will be sufficient for its remaining 1998 capital
expenditures other than the Acquisition. However, funds available under the
Company's present bank credit facility were significantly reduced to fund the
$25 million performance deposit made upon execution of the Acquisition
Agreement. In the event the Acquisition is not consummated due to a breach by
Costilla, the Company would forfeit the $25 million deposit and be liable for an
additional $16 million in liquidated damages. The Company does not currently
have available, and has not made arrangements to obtain financing, to pay the
additional $16 million payment, which may make it necessary to sell assets to
fund the payment. The Company's ability to generate or obtain capital resources
necessary to fund its operating plans could be significantly and adversely
affected as a result of a failure to consummate the Acquisition. If the
Acquisition is consummated, the Company anticipates that cash flow from
operations will be sufficient for its 1999 capital expenditures, excluding
acquisitions. However, because the Company's ultimate 1999 capital expenditures,
future cash flows and the availability of financing are subject to a number of
variables, there can be no assurance that the Company's

47
<PAGE> 51

capital resources will be sufficient to maintain its capital expenditures. In
addition, if the Company is unable to generate sufficient cash flow from
operations to service its debt, it may be required to refinance all or a portion
of its debt or to obtain additional financing. There can be no assurance that
any such refinancing would be possible or that any additional financing could be
obtained.

Costilla intends to fund the Estimated Purchase Price with the net cash
proceeds from the Stock Issuance and borrowing under the New Credit Facility.
The net proceeds of the Stock Issuance are expected to be approximately $251
million, constituting 64% of the Estimated Purchase Price. The Company expects
to close the Stock Issuance the day prior to or the date of the Acquisition
closing, subject to stockholder approval and other closing conditions. The
Company plans to utilize advances under the New Credit Facility to fund the
remaining balance of approximately $139 million (36%) of the Estimated Purchase
Price. The Company expects that it will have a commitment from Bankers Trust
Company with respect to the New Credit Facility, and expects to close the New
Credit Facility simultaneously with the closing of the Stock Issuance.

If either of these sources of financing become unavailable, the Company may
be required to seek alternative financing or risk termination of the Acquisition
Agreement and the consequences resulting therefrom. The Company does not
currently have any arrangements or commitments for alternative sources of
financing, and there can be no assurance that such sources will be available.

Although certain of the Company's costs and expenses may be affected by
inflation, inflationary costs have not had a significant effect on the Company's
results of operations.

Capital Expenditures

During the six months ended June 30, 1998 the Company had oil and gas
expenditures of approximately $39.7 million, exclusive of the $14 million spent
on the acquisition of existing oil and gas properties. The $39.7 million of oil
and gas expenditures consisted of $16.3 million of exploration costs, $15.9
million of development costs, $4.4 million of undeveloped acreage and $5.3
million on wells in progress at June 30, 1998. The Company anticipates that its
capital expenditures for the third quarter of 1998 will be comparable to an
average of the levels for the first two quarters of 1998. The Company is
evaluating its fourth quarter capital expenditures based upon various factors,
including oil and gas prices and the results of its drilling activities, which
during 1998 have been almost entirely devoted to the drilling of gas wells. If
the Acquisition is consummated, the Company expects that cash flow from
operations will be adequate to fund 1999 oil and gas capital expenditures,
exclusive of any acquisitions.

Recent Accounting Pronouncements

Segment Reporting -- In June 1997, the FASB issued Statement of Accounting
Standards No. 131 "Disclosures about Segments of an Enterprise and Related
Information" ("FAS 131") which establishes standards for public business
enterprises for reporting information about operating segments in annual
financial statements and requires that such enterprises report selected
information about operating segments in interim financial reports issued to
shareholders. This statement also established standards for related disclosures
about products and services, geographic areas, and major customers. FAS 131 is
effective for financial statements for years beginning after December 15, 1997.

The Company operates in the one product line of oil and gas production in
limited geographic areas. This information and information about major customers
historically has been disclosed in the Company's annual financial statements.

Derivative Instruments and Hedging Activities -- In June 1998, the FASB
issued Statement of Financial Accounting Standards No. 133 "Accounting for
Derivative Instruments and Hedging Activities" which establishes accounting and
reporting standards for derivative instruments, including certain derivative
instruments embedded in other contracts, (collectively referred to as
derivatives) and for hedging activities. It requires that an entity recognize
all derivatives as either assets or liabilities in the statement of financial
position and measure those instruments at fair value. If certain conditions are
met, a derivative may be specifically designated as (a) a hedge of the exposure
to changes in the fair value of a recognized asset or

48
<PAGE> 52

liability or an unrecognized firm commitment, (b) a hedge of the exposure to
variable cash flows of a forecasted transaction, or (c) a hedge of the foreign
currency exposure of a net investment in a foreign operation, an unrecognized
firm commitment, an available-for-sale security, or a
foreign-currency-denominated forecasted transaction.

Under this Statement, an entity that elects to apply hedge accounting is
required to establish at the inception of the hedge the method it will use for
assessing the effectiveness of the hedging derivative and the measurement
approach for determining the ineffective aspect of the hedge. Those methods must
be consistent with the entity's approach to managing risk.

This Statement applies to all entities and is effective for all fiscal
quarters of fiscal years beginning after June 15, 1999. Initial application of
this Statement should be as of the beginning of an entity's fiscal quarter; on
that date, hedging relationships must be designated anew and documented pursuant
to the provisions of this Statement. Earlier application of all of the
provisions of this Statement is encouraged, but it is permitted only as of the
beginning of any fiscal quarter that begins after issuance of this Statement.
This Statement should not be applied retroactively to financial statements of
prior periods.

The Company anticipates that, upon application of this Statement, its
derivative financial instruments currently held will be classified as hedges of
the exposure to variable cash flows of forecasted transactions (i.e. future oil
and gas sales) and, as such, are not expected to have a material effect on its
results of operations.

YEAR 2000

The Company will be required to modify its information systems in order to
accurately process data referencing the Year 2000. Because of the importance of
occurrence dates in the oil and gas industry, the consequences of not pursuing
these modifications could be very significant to the Company's ability to manage
and report operating activities. The Company's third-party software vendor for
its integrated oil and gas information system is currently modifying the system
to accurately handle the Year 2000 issue. All necessary programming
modifications are scheduled to be completed by December 31, 1998. These
modifications are part of the routine updates the Company receives from its
third-party software vendor as part of its systems support contract, and the
Company believes it will not incur any material costs in addition to the
ordinary software maintenance costs in preparing its information systems for the
Year 2000 issue.

In addition to its information systems, the Company is conducting an
assessment of the Year 2000 issues with respect to the production and other
field equipment associated with its current properties and the Acquisition
Properties. A significant failure of such equipment may cause delays in
production and product transportation which could have a material adverse effect
on the Company. Following this assessment, the Company will establish a plan to
make such equipment Year 2000 compliant or develop a contingency plan for a
possible failure of such equipment.

The Year 2000 issues also affect service companies, purchasers of
production, utility providers and other persons with whom the Company contracts.
The Company has submitted Year 2000 compliance questionnaires to many of such
persons, but is currently not aware of the preparations undertaken by such
persons. A material and widespread failure of the utility service,
transportation of oil or gas, or similar service the Company utilizes could have
a material effect on the Company's production, cash flow and overall financial
condition. Therefore, failure of such third parties to adequately prepare for
Year 2000 issues may have a material adverse effect on the Company,
notwithstanding the Company's actions to prepare its own information systems.
The Company does not currently have a contingency plan in the event such third
parties are unable to provide services or products to the Company.

49
<PAGE> 53

SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

OWNERSHIP TABLE

Under regulations of the Securities and Exchange Commission, persons who
have power to vote or dispose of shares of the Company, either alone or jointly
with others, are deemed to be beneficial owners of such shares. The following
table sets forth certain information known by the Company regarding the
beneficial ownership of Common Stock as of September 30, 1998, by (i) each
person who is the beneficial owner of 5 percent or more of the outstanding
Common Stock (based upon copies of all Schedule 13Gs and 13Ds provided to the
Company through September 30, 1998 and written representations from holders),
(ii) each Director of the Company; (iii) each executive officer named in the
Summary Compensation Table, and (iv) all Officers and Directors of the Company
as a group. Unless otherwise noted, the persons and entities named below have
sole voting and investment power with respect to the shares listed opposite each
of their names.

<TABLE>
<CAPTION>
NON-CONVERSION
CURRENT PRO FORMA(1) CONVERSION PRO FORMA(2)
------------------------- ------------------------- -------------------------
AMOUNT AND AMOUNT AND AMOUNT AND
NATURE OF PERCENT NATURE OF PERCENT NATURE OF PERCENT
NAME (AND ADDRESS OF 5% OR BENEFICIAL OF BENEFICIAL OF BENEFICIAL OF
GREATER OWNERS) OWNERSHIP CLASS OWNERSHIP CLASS OWNERSHIP CLASS
-------------------------- ---------- ---------- ---------- ---------- ---------- ----------
<S> <C> <C> <C> <C> <C> <C>
New Investors....................... 20,666,667 68.1% 37,200,000 79.7%(3)
Enron Corp.......................... 4,165,128(4) 30.4%(3) -- -- -- --
1400 Smith Street
Houston, Texas 77002
Cadell S. Liedtke................... 2,330,060(5) 24.1% 2,330,060(5) 7.7% 2,330,060(5) 5.0%
400 W. Illinois
Midland, Texas 79701
Michael J. Grella................... 1,760,610(6) 18.2% 1,760,610(6) 5.8% 1,760,610(6) 3.8%
400 W. Illinois
Midland, Texas 79701
NationsBanc Capital Corp. .......... 936,000 9.7% 936,000 3.1% 936,000 2.0%
100 North Tryon Street
Charlotte, NC 28255
The Equitable Companies............. 899,800 9.3% 899,800 3.0% 899,800 1.9%
Incorporated(7)
787 Seventh Avenue
New York, New York 10019
Kestrel Investment Management....... 724,400 7.5% 724,400 2.4% 724,400 1.5%
411 Borel Avenue, Suite 403
San Francisco, California 94402
Cumberland Associates............... 690,000 7.1% 690,000 2.3% 690,000 1.5%
1114 Ave. of the Americas
New York, New York 10036
Henry G. Musselman.................. 642,500(8) 6.6% 642,500(8) 2.1% 642,500(8) 1.4%
400 W. Illinois
Midland, Texas 79701
W. D. Kennedy....................... 12,500(9) *(10) 12,500(9) *(10) 12,500(9) *(10)
Jerry J. Langdon.................... 10,000(9) *(10) 10,000(9) *(10) 10,000(9) *(10)
Samuel J. Atkins, III............... 10,000(9) *(10) 10,000(9) *(10) 10,000(9) *(10)
Bobby W. Page....................... 76,000(11) *(10) 76,000(11) *(10) 76,000(11) *(10)
Roger A. Freidline.................. 89,300(12) *(10) 89,300(12) *(10) 89,300(12) *(10)
All Officers and Directors as group
(15 persons)...................... 5,327,170(13) 52.0%(10) 5,327,170(13) 17.6%(10) 5,327,170(13) 11.4%(10)
</TABLE>

- ---------------

* Less than 1%

(1) Assumes the issuance of 20,666,667 shares of Acquisition Common (but not
any shares of Dividend Common or Conversion Common).

50
<PAGE> 54

(2) Assumes the issuance of 20,666,667 shares of Acquisition Common and
conversion of all of the shares of New Preferred Stock into 16,533,333
shares of Conversion Common, assuming a conversion rate of $9.375 per share
(but no issuance of any shares of Dividend Common). The holders of the New
Preferred Stock have the right to convert such stock into shares of
Conversion Common at any time after consummation of the Stock Issuance.

(3) For purposes of calculating these percentages, the shares which the named
person has the right to acquire within 60 days by conversion of Outstanding
Preferred Stock or New Preferred Stock described in these footnotes are
deemed outstanding shares with respect to that person's percentage
ownership.

(4) Represents (a) 129,615 shares owned directly by the following subsidiaries
of Enron Corp.: Joint Energy Development Investments II Limited Partnership
("JEDI") (97,211 shares) and Enron Capital & Trade Resources Corp. ("Enron
Capital") (32,404 shares); and (b) beneficial ownership of shares of Common
Stock initially issuable upon conversion of the Outstanding Preferred
Stock, which are presently convertible and owned of record by the following
subsidiaries of Enron Corp.: JEDI (beneficial owner of 3,026,634 shares of
Common Stock) and Enron Capital (beneficial owner of 4,035,513 shares,
3,026,634 indirectly as general partner of JEDI and 1,008,879 directly).
Due to the Exchange, no shares of Outstanding Preferred Stock will be
outstanding after consummation of the Stock Issuance. Enron Corp.'s
beneficial ownership of New Preferred Stock acquired in the Exchange is
included in the Pro Forma information for the New Investors.

(5) Includes (a) 2,270,060 shares owned directly by Mr. Liedtke and (b) 60,000
shares owned by the Marion and Cadell S. Liedtke Family Charitable
Foundation over which Mr. Liedtke holds voting and dispositive power.

(6) Includes (a) 1,682,510 shares owned directly by Mr. Grella and (b) 78,100
shares owned by the Grella Family Charitable Foundation over which Mr.
Grella holds voting and dispositive power.

(7) Represents shares owned by Alliance Capital Management L.P., a subsidiary
of the Equitable Companies Incorporated, held on behalf of clients, as
reported in the Schedule 13G filed by the Equitable Companies Incorporated,
as amended through December 31, 1997.

(8) Includes (a) 620,000 shares owned directly by Mr. Musselman, (b) 1,500
shares owned by Mr. Musselman's spouse as custodian for their children
under the Texas Uniform Transfers to Minors Act, and (c) 21,000 shares
owned by the Musselman Family Charitable Foundation over which Mr.
Musselman holds voting and dispositive power.

(9) Includes the right to acquire beneficial ownership of 10,000 shares of
Common Stock through presently exercisable options granted under the
Company's Outside Directors Plan.

(10) For purposes of calculating these percentages, the shares which the named
person or persons has or have the right to acquire within 60 days by
exercise of the stock options described in these footnotes are deemed
outstanding shares with respect to that person's percentage ownership and
with respect to the percentage ownership of all officers and directors as a
group.

(11) Includes the right to acquire beneficial ownership of 75,000 shares of
Common Stock through a presently exercisable option granted under the
Option Plan.

(12) Includes the right to acquire beneficial ownership of 85,000 shares of
Common Stock through a presently exercisable option granted under the
Option Plan.

(13) Includes all rights of executive officers and directors to acquire
beneficial ownership of 580,000 shares of Common Stock through presently
exercisable options granted under the Option Plan and the Outside Directors
Plan.

POTENTIAL CHANGE OF CONTROL

Current Management owned, as of September 30, 1998, in the aggregate
approximately 49% of the Outstanding Common Stock. Upon consummation of the
Stock Issuance, the New Investors will own in the aggregate approximately 68%
(80% assuming conversion of all of the New Preferred Stock) of the outstanding
Common Stock. See "Potential Effects of Stockholder Vote -- Potential Effects of
Consummating the Transactions -- Change in Principal Stockholders and Interests
of Management; Influence of New Investors."
51
<PAGE> 55

EXECUTIVE COMPENSATION

SUMMARY COMPENSATION TABLE

The following table sets forth information regarding the total compensation
for 1995, 1996 and 1997 received by the Company's Chief Executive Officer and
the other executive officers of the Company whose annual compensation exceeded
$100,000 in 1997. Information for 1996 is on an annualized basis based upon
amounts paid to the named individuals after the Corporate Reorganization (as
hereinafter defined).

<TABLE>
<CAPTION>
LONG-TERM
COMPENSATION
AWARDS
------------
ANNUAL COMPENSATION SECURITIES
--------------------------------- UNDERLYING ALL OTHER
OTHER ANNUAL OPTIONS/ COMPENSATION
NAME AND PRINCIPAL POSITION YEAR SALARY BONUS COMPENSATION SARS(1) (2)
- --------------------------- ---- -------- ------- ------------ ------------ ---------------
<S> <C> <C> <C> <C> <C> <C>
Cadell S. Liedtke(3).................... 1997 $300,000 $50,000 -- -- $ 9,417
Chairman of the Board 1996 300,000 -- -- -- 6,738
1995 185,700 -- -- -- --
Michael J. Grella(4).................... 1997 $300,000 $50,000 -- -- $ 9,417
President and Chief 1996 300,000 -- -- -- 6,352
Executive Officer 1995 261,750 -- -- -- 656,000
Henry G. Musselman(5)................... 1997 $239,792 $36,000 -- -- $ 3,750
Executive Vice President and 1996 215,000 10,000 -- -- 3,295
Chief Operating Officer 1995 139,800 -- -- -- --
Bobby W. Page(6)........................ 1997 $175,000 $14,583 $18,583(7) -- $ 2,625
Senior Vice President, 1996 150,000 5,208 -- 75,000 --
Treasurer, Secretary and Chief 1995 -- -- -- -- --
Financial Officer
Roger A. Freidline...................... 1997 $ 93,430 $ 7,786 $ 9,292(7) -- $ 78,938
Senior Vice President, 1996 88,981 7,415 -- 85,000 17,785
Exploration 1995 83,160 5,000 -- -- 7,190
</TABLE>

- ---------------

(1) The amount shown represents the number of shares subject to non-qualifying
stock options granted pursuant to the Option Plan as described under
"-- Aggregated Option Exercises and Fiscal Year-End Option Values."

(2) The amounts shown include contributions made by the Company pursuant to the
Company's 401(k) plan for the benefit of the named individuals. The amount
shown for Mr. Grella for 1995 represents non-cash compensation deemed to
have been accrued to him in connection with the cancellation of an option
held by a minority interest owner to purchase an additional interest in the
Company. The amounts shown for Mr. Freidline include payments made to him of
$5,111, $15,115 and $76,252 in 1995, 1996 and 1997, respectively, pursuant
to an overriding royalty interest compensation program entered into between
the Company's predecessors and Mr. Freidline. Such compensation arrangements
were discontinued prior to the Company's initial public offering in October
1996.

(3) Mr. Liedtke beneficially owns 2,302,560 shares of restricted Common Stock
issued to him in connection with the consolidation of the Company's
predecessors in October 1996 (the "Corporate Reorganization"), with a value
at December 31, 1997 of $25,040,340.

(4) Mr. Grella beneficially owns 1,350,440 shares of restricted Common Stock
issued to him in connection with the Corporate Reorganization, with a value
at December 31, 1997 of $14,686,035.

(5) Mr. Musselman beneficially owns 611,000 shares of restricted Common Stock
issued to him in connection with the Corporate Reorganization, with a value
at December 31, 1997 of $6,644,625.

(6) Mr. Page joined the Company in June 1996.

(7) Represents the dollar value of an award of shares of Common Stock and the
amount of a cash award equal to the income tax liability for the stock
award, all granted to the named officers under the Company's Bonus Incentive
Plan.

52
<PAGE> 56

EMPLOYMENT AGREEMENTS

Messrs. Liedtke, Grella and Musselman entered into employment agreements
(as the same have been amended, the "Founders Employment Agreements") with the
Company which became effective upon the closing of the Company's initial public
offering in October 1996. The Founders Employment Agreements are each for three
years, commencing in October 1996 and each will automatically renew for
successive one-year periods thereafter unless the employee is notified to the
contrary. The Founders Employment Agreements provide annual base salary levels
for Messrs. Liedtke and Musselman of $300,000 and $250,000, respectively.
Pursuant to an amendment to his employment agreement approved in April 1997, Mr.
Grella's annual base salary is determined by the Compensation Committee of the
Company's Board of Directors.

Each of Messrs. Liedtke, Grella and Musselman would receive his salary for
the remaining term of the applicable Founders Employment Agreement if the
Company were to terminate such person's employment other than for cause.
However, if such person were to voluntarily leave his employment with the
Company prior to the second anniversary of the Agreement, no further payments
would be required. If a voluntary termination were to occur subsequent to the
second anniversary of the Agreement, such person would be entitled to one year's
salary from the date of termination. Each Founders Employment Agreement provides
that the covered employee will not compete with the Company for a one year
period following his voluntary cessation of employment or termination of
employment for cause, if such event occurs within the initial three-year term of
the Agreement. Competitive activities are defined as engaging in the oil and gas
business in any area in which the Company is then active.

Bobby W. Page entered into an employment agreement (the "Page Employment
Agreement") with the Company effective June 30, 1996. The Page Employment
Agreement is for a period of three years from June 30, 1996 and will
automatically renew for successive one-year periods thereafter unless Mr. Page
is notified to the contrary by the Company. The Page Employment Agreement
provided a $25,000 bonus (which included Mr. Page's cost of relocation), plus a
base salary of $150,000 until January 1, 1997; $175,000 until January 1, 1998;
and $185,000 thereafter. In addition, Mr. Page received an option to purchase
75,000 shares of Common Stock, and receives certain insurance benefits and other
benefits generally available to the Company's employees. Mr. Page would receive
his salary for the remaining term of the Page Employment Agreement if the
Company were to terminate the Page Employment Agreement other than for cause.
However, if Mr. Page were to voluntarily leave his employment with the Company,
no further payments would be required.

OPTION GRANTS IN LAST FISCAL YEAR

There were no grants of stock options to the executive officers named in
the Summary Compensation Table in the 1997 fiscal year.

53
<PAGE> 57

AGGREGATED OPTION EXERCISES AND FISCAL YEAR-END OPTION VALUES

The following table provides information, with respect to the named
executive officers, regarding the exercise of options during fiscal year 1997
and the value of unexercised options held as of the end of fiscal year 1997:

<TABLE>
<CAPTION>
NUMBER OF VALUE OF
SECURITIES UNEXERCISED
UNDERLYING IN-THE-MONEY
UNEXERCISED OPTIONS OPTIONS AT
AT FY-END(#) FY-END($)
------------------- ----------------
SHARES ACQUIRED EXERCISABLE/ EXERCISABLE/
NAME ON EXERCISE(#) VALUE REALIZED UNEXERCISABLE UNEXERCISABLE(1)
---- --------------- -------------- ------------------- ----------------
<S> <C> <C> <C> <C>
Bobby W. Page............ 0 0 75,000/0 N/A
Roger A. Freidline....... 0 0 85,000/0 N/A
</TABLE>

- ---------------

(1) The option price of the options set forth above is $12.50 per share. The
closing sales price of the Common Stock on the Nasdaq National Market on
December 31, 1997 was $10.88 per share. Therefore, the options were not
in-the-money at fiscal year end 1997.

The options shown above were granted pursuant to the Option Plan which
provides for the grant of both incentive stock options and non-qualifying stock
options, as well as limited stock appreciation rights and supplemental bonuses,
to the employees of the Company and its subsidiaries, including officers and
directors who are salaried employees. A total of 1,250,000 shares of Common
Stock (subject to amendment as discussed under "The Plan Amendment") has been
authorized and reserved for issuance under the plan, with adjustments to reflect
changes in the Company's capitalization resulting from stock splits, stock
dividends and similar events. The plan is administered by the Compensation
Committee of the Board of Directors, which has the sole authority to interpret
the plan, to determine the persons to whom options will be granted, to determine
the basis upon which the options will be granted, and to determine the exercise
price, duration and other terms of the options to be granted under the plan;
provided that (a) the exercise price of each option granted under the plan may
not be less than the fair market value of the Common Stock on the date the
option is granted (and for incentive stock options, 110% of fair market value if
the employee is the beneficial owner of 10% or more of the Company's voting
securities), (b) the exercise price must be paid in cash, by surrendering
previously owned shares of Common Stock upon the exercise of the option or by a
promissory note or broker-assisted cashless exercise approved by the
Compensation Committee, (c) the term of the option may not exceed ten years, and
(d) no option is transferrable other than by will, the laws of descent and
distribution or pursuant to a qualified domestic relations order. Upon
termination of an optionee's employment (other than by death or disability), an
incentive stock option may be exercised prior to the expiration date of the
option or within three months after the date of such termination, whichever is
earlier, but only to the extent the optionee had the right to exercise the
option upon the date of such termination. The rights of the holder of a non-
qualifying stock option will be set forth in each option agreement. In the event
of the disability of an optionee, the option may be exercised by such person or
his personal representative at any time within one year of the termination of
such person's employment, but only to the extent the optionee had the right to
exercise the option as of the date of his disability. In the event of the death
of the optionee, the option may be exercised by his personal representative or
successor in interest at any time until the later of the expiration of the
option or one year after the optionee's death, to the extent the option was
exercisable at the time of the optionee's death. Incentive stock options may not
be granted under the plan to any individual if the effect of such grant would
permit that person to have the first opportunity to exercise such options, in
any calendar year, for the purchase of shares having a fair market value (at the
time of grant of the option) in excess of $100,000. Incentive stock options
granted under the plan are intended to have the federal income tax consequences
of a qualified stock option. As a result, the exercise of an incentive stock
option will not be a taxable event; the taxable event occurs at the time the
shares of Common Stock acquired upon exercise of the option are sold. If the
optionee holds such shares for the later of two years from the date the option
was granted or one year from the date of exercise of the option, the difference
between the price paid for the shares at exercise and the price for which those
shares are sold will be treated as capital gains income. If the optionee does
not hold the shares for the

54
<PAGE> 58

required holding period, the income would be treated as ordinary income rather
than capital gains income. The non-qualifying stock options granted under the
plan should be taxable when the option is exercised, at which time the optionee
would recognize ordinary income on the difference between the exercise price and
the fair market value of the shares on the date of exercise. The Company does
not receive compensation for the grant of stock options under the Option Plan
and treats such grants as compensation by the Company for federal income tax
purposes. The Board of Directors may amend the plan, without stockholder
approval, in any respect other than any amendment that requires stockholder
approval by law or the rules of an exchange on which the Common Stock is listed,
and may modify an outstanding option, including the repricing of non-qualifying
options, with the consent of the option holder. There are currently
approximately 140 persons who are eligible to participate under the plan.

COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION

The Compensation Committee consists of the following members of the Board
of Directors: Mr. Samuel J. Atkins, III, Mr. W. D. Kennedy, and Mr. Jerry J.
Langdon. None of the members of the Committee is, or has ever been, an officer
or employee of the Company.

DESCRIPTION OF CERTAIN INDEBTEDNESS

NEW CREDIT FACILITY

The Company expects that it will have a commitment from Bankers Trust
Company to provide a new bank credit facility (the "New Credit Facility"). The
New Credit Facility, which will be entered into contemporaneously with the Stock
Issuance, is expected to provide a revolving credit facility with a maximum
availability of $275 million, approximately $141 million of which is expected to
be borrowed upon closing against an anticipated available borrowing base of $225
million at that date. Borrowings under the New Credit Facility are expected to
bear interest, at the Company's option, at a floating rate which is at or above
the lender's prime rate or above the applicable Eurodollar rate, depending on
the percentage of committed funds which have been borrowed. Interest will be
payable quarterly as to base rate loans and at the end of the applicable
interest period as to Eurodollar loans. It is anticipated that the borrowing
base under the New Credit Facility will automatically reduce by 5% each quarter
beginning in December 2000, and payments of principal will be required in each
quarter in which the outstanding principal balance is greater than the reduced
borrowing base. The remaining balance is expected to be payable in December
2003, the anticipated maturity date of the New Credit Facility. Under the New
Credit Facility, the Company will be obligated to pay certain fees to the
lender, including a commitment fee based on the unused portion of the
commitment. The New Credit Facility will contain customary restrictive covenants
(including restrictions on the payment of dividends and the incurrence of
additional indebtedness) and will require the Company to comply with certain
financial ratios. The New Credit Facility will be secured by substantially all
of the Company's current oil and gas properties and the Acquisition Properties.

SENIOR NOTES

The Company currently has $180 million in aggregate principal amount of the
Notes outstanding under the Indenture. The Notes are general unsecured
obligations of the Company, pari passu in right of payment to all existing and
future senior indebtedness of the Company and senior in right of payment to all
other subordinated indebtedness of the Company. The Notes bear interest payable
semiannually at a rate of 10 1/4% and will mature in 2006.

The Notes are not redeemable until October 1, 2001. Thereafter, the Notes
are redeemable at any time at the option of the Company in whole or in part at
the redemption princes set forth in the Indenture. There is no mandatory sinking
fund for the Notes. Upon the occurrence of a change of control, the Company is
required to make an offer to purchase all of the Notes at 101% of the principal
amount thereof, plus accrued and unpaid interest to the date of purchase. See
"Potential Effects of Stockholder Vote -- Potential Effects of Consummating the
Transactions -- Indenture Issues."

55
<PAGE> 59

The Indenture contains certain covenants that, among other things, limit
the ability of the Company and certain of its subsidiaries to pay dividends or
make certain other restricted payments, issue preferred stock, incur additional
indebtedness, enter into transactions with affiliates, incur liens, engage in
certain sale and leaseback arrangements, make certain asset dispositions and
merge or consolidate with, or transfer substantially all of its assets to, any
other person. The Indenture also contains certain covenants that limit the
ability of the Company's subsidiaries to restrict their ability to make payments
to the Company. The Indenture contains customary events of default.

AUDITORS

The consolidated financial statements of the Company as of December 31,
1997 and 1996 and for each of the years in the three-year period ended December
31, 1997 have been audited by KPMG Peat Marwick LLP, independent certified
public accountants, whose report appears elsewhere herein.

The statements of revenues and direct operating expenses of the Acquisition
for the years ended December 31, 1997, 1996 and 1995, the statement of revenues
and direct operating expenses of the Ballard Acquisition for the year ended
December 31, 1996 and the statement of revenues and direct operating expenses of
the 1995 Acquisition for the period ended June 12, 1995, have been audited by
KPMG Peat Marwick LLP, independent certified public accountants, whose reports
appear elsewhere herein.

PETROLEUM ENGINEERS

Certain information appearing in this Proxy Statement regarding estimated
quantities of oil and gas reserves and the discounted present value of future
pre-tax cash flows therefrom attributable to certain of the Company's properties
at January 1, 1998 are based on reports reviewed by Williamson Petroleum
Consultants, Inc. ("Williamson"), an independent petroleum engineering firm.
Williamson has provided such services to the Company since 1996. There is no
relationship between Williamson and the Company other than such services.

56
<PAGE> 60

GLOSSARY

The terms defined in this section are used throughout this Proxy Statement.

Adjusted EBITDA. Calculated by adding interest, income taxes, depreciation,
depletion and amortization, exploration and abandonment costs and extraordinary
loss resulting from extinguishment of debt to net income (loss).

All-in finding costs. The amount of total capital expenditures, including
acquisition costs, and exploration and abandonment costs for oil and gas
activities divided by the amount of proved reserves (expressed in BOE) added
during the specified period (including the effect on proved reserves of reserve
revisions).

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

Bcf. One billion cubic feet.

Bcfe. One billion cubic feet of gas equivalent.

BOE. Barrels of oil equivalent. Determined using the ratio of six Mcf of
gas to one Bbl of crude oil, condensate or gas liquids.

Btu. One British thermal unit. The quantity of heat required to raise the
temperature of one pound of water one degree Fahrenheit.

Cfe. Cubic feet of gas equivalent. Determined using the ratio of six Mcf of
gas to one Bbl of crude oil, condensate or gas liquids.

Developed Acreage. The number of acres which are allocated or assignable to
producing wells or wells capable of production.

Development Well. A well drilled within the proved area of an oil or gas
reservoir to the depth of a stratigraphic horizon known to be productive.

Dry Well. A well found to be incapable of producing either oil or gas in
sufficient quantities to justify completion of an oil or gas well.

Exploratory Well. A well drilled to find and produce oil or gas in an
unproved area, to find a new reservoir in a field previously found to be
productive of oil or gas in another reservoir, or to extend a known reservoir.

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

Leasehold Acre. The full leasehold interest in one acre of land. A
leasehold interest is the interest of a person as a grantee or lessee under an
oil and gas lease, including the right to drill and produce minerals, subject to
the lessor's Royalty Interest.

Mbbl. One thousand barrels of crude oil or other liquid hydrocarbons.

MBOE. One thousand barrels of oil equivalent.

Mineral Acre. The full mineral interest in one acre of land. A mineral
interest is the property interest resulting from the severance of the rights to
minerals on and under land from the ownership of the land itself, and includes
the right to enter upon the land to explore, drill, produce and otherwise carry
on mining activities.

MMBOE. One million barrels of oil equivalent.

Mmbbls. One million barrels of crude oil or other liquid hydrocarbons.

Mmbtu. One million Btu's.

Mcf. One thousand cubic feet.

57
<PAGE> 61

Mcfe. One thousand cubic feet of gas equivalent.

Mmcf. One million cubic feet.

Mmcfe. One million cubic feet of gas equivalent.

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

PV-10 Value or Present Value of Estimated Future Net Revenues. The present
value of estimated future net revenues is an estimate of future net revenues
from a property at its acquisition date, at a specified date, after deducting
production and ad valorem taxes, future capital costs and operating expenses,
but before deducting federal income taxes. The future net revenues have been
discounted at an annual rate of 10% to determine their "present value." The
present value is shown to indicate the effect of time on the value of the
revenue stream and should not construed as being the fair market value of the
properties. Estimates have been made using constant oil and natural gas prices
and operating costs at the specified date.

Productive Well. A well that is producing oil or gas or that is capable of
production.

Proved Developed Reserves. Reserves that can be expected to be recovered
through existing wells with existing equipment and operating methods.

Proved Reserves. The estimated quantities of crude oil, natural gas and
natural gas liquids which geological and engineering data demonstrate with
reasonable certainty to be recoverable in future years from known reservoirs
under existing economic and operating conditions.

Proved Undeveloped Reserves. Reserves that are expected to be recovered
from new wells on undrilled acreage, or from existing wells where a relatively
major expenditure is required for recompletion.

Royalty Interest. An interest in an oil and gas property entitling the
owner to a share of oil and gas production free of costs of production.

3-D Seismic. Advanced technology method of detecting accumulations of
hydrocarbons identified by the collection and measurement of the intensity and
timing of sound waves transmitted into the earth as they reflect back to the
surface.

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

Working Interest. The operating interest which gives the owner the right to
drill, produce and conduct operating activities on the property and a share of
production.

58
<PAGE> 62

INDEX TO FINANCIAL STATEMENTS

<TABLE>
<S> <C>
Consolidated Financial Statements of Costilla Energy, Inc.:
Independent Auditors' Report.............................. F-2
Consolidated Balance Sheets as of December 31, 1997 and
1996................................................... F-3
Consolidated Statements of Operations for the years ended
December 31, 1997, 1996 and 1995....................... F-4
Consolidated Statements of Stockholders' Equity for the
years ended December 31, 1997, 1996 and 1995........... F-5
Consolidated Statements of Cash Flows for the years ended
December 31, 1997, 1996 and 1995....................... F-6
Notes to Consolidated Financial Statements................ F-7
Interim Consolidated Financial Statements of Costilla
Energy, Inc. (Unaudited):
Consolidated Balance Sheets as of December 31, 1997 and
June 30, 1998.......................................... F-27
Consolidated Statements of Operations for the six months
ended June 30, 1998 and 1997........................... F-28
Consolidated Statements of Cash Flows for the six months
ended June 30, 1998 and 1997........................... F-29
Notes to Interim Consolidated Financial Statements........ F-30
Financial Statements of the Pioneer Acquisition:
Independent Auditors' Report.............................. F-34
Statements of Revenues and Direct Operating Expenses for
the years ended December 31, 1997, 1996 and 1995 and
the Six Months ended June 30, 1998 and 1997
(Unaudited)............................................ F-35
Notes to the Statements of Revenues and Direct Operating
Expenses............................................... F-36
Financial Statements of the Ballard Acquisition:
Independent Auditors' Report.............................. F-39
Statements of Revenues and Direct Operating Expenses for
the year ended December 31, 1996 and the Six Months
ended June 30, 1997 and 1996 (Unaudited)............... F-40
Notes to the Statements of Revenues and Direct Operating
Expenses............................................... F-41
Financial Statements of the 1995 Acquisition:
Independent Auditors' Report.............................. F-44
Statement of Revenues and Direct Operating Expenses for
the period ended June 12, 1995......................... F-45
Notes to the Statement of Revenues and Direct Operating
Expenses............................................... F-46
</TABLE>

F-1
<PAGE> 63

INDEPENDENT AUDITORS' REPORT

The Board of Directors and Stockholders
Costilla Energy, Inc.:

We have audited the consolidated financial statements of Costilla Energy,
Inc. and subsidiaries as listed in the accompanying index. These consolidated
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these consolidated financial
statements based on our audits.

We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of Costilla
Energy, Inc. and subsidiaries as of December 31, 1997 and 1996, and the results
of their operations and their cash flows for each of the years in the three-year
period ended December 31, 1997, in conformity with generally accepted accounting
principles.

KPMG PEAT MARWICK LLP

Midland, Texas
March 6, 1998

F-2
<PAGE> 64

COSTILLA ENERGY, INC.

CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS)

ASSETS

<TABLE>
<CAPTION>
DECEMBER 31, DECEMBER 31,
1997 1996
------------ ------------
<S> <C> <C>
CURRENT ASSETS:
Cash and cash equivalents................................. $ 3,615 $ 12,618
Accounts receivable:
Trade, net............................................. 5,241 6,675
Affiliates............................................. -- 332
Oil and gas sales...................................... 9,312 9,031
Prepaid and other current assets.......................... 912 1,753
-------- --------
Total current assets.............................. 19,080 30,409
-------- --------
PROPERTY, PLANT AND EQUIPMENT, AT COST:
Oil and gas properties, using the successful efforts
method of accounting:
Proved properties...................................... 199,355 140,477
Unproved properties.................................... 35,971 4,482
Accumulated depletion, depreciation and amortization...... (71,152) (20,435)
-------- --------
164,174 124,524
Other property and equipment, net......................... 3,766 2,420
-------- --------
Total property, plant and equipment............... 167,940 126,944
-------- --------
OTHER ASSETS:
Deferred charges.......................................... 4,212 4,503
Note receivable -- other.................................. -- 250
Other..................................................... 2,856 684
-------- --------
Total other assets................................ 7,068 5,437
-------- --------
$194,088 $162,790
======== ========

LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Current maturities of long-term debt...................... $ 98 $ 98
Trade accounts payable.................................... 22,490 12,718
Undistributed revenue..................................... 4,566 3,517
Other current liabilities................................. 3,437 3,756
-------- --------
Total current liabilities......................... 30,591 20,089
-------- --------
LONG-TERM DEBT, LESS CURRENT MATURITIES..................... 163,087 100,262
-------- --------
OTHER NONCURRENT LIABILITIES................................ -- 1,870
-------- --------
STOCKHOLDERS' EQUITY:
Preferred stock, $.10 par value (3,000,000 shares
authorized; no shares outstanding)..................... -- --
Common stock, $.10 par value (20,000,000 shares
authorized; 10,150,500 shares outstanding at December
31, 1997 and 10,475,000 shares outstanding at December
31, 1996).............................................. 1,015 1,047
Additional paid-in capital................................ 37,425 41,081
Retained deficit.......................................... (38,030) (1,559)
-------- --------
Total stockholders' equity........................ 410 40,569
-------- --------
COMMITMENTS AND CONTINGENCIES............................... -- --
-------- --------
$194,088 $162,790
======== ========
</TABLE>

See accompanying notes to consolidated financial statements.

F-3
<PAGE> 65

COSTILLA ENERGY, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE DATA)

<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
------------------------------
1997 1996 1995
-------- ------- -------
<S> <C> <C> <C>
REVENUES:
Oil and gas sales......................................... $ 72,300 $53,919 $21,693
Interest and other........................................ 940 40 123
Gain on sale of assets.................................... 3,261 1,067 --
-------- ------- -------
76,501 55,026 21,816
-------- ------- -------
EXPENSES:
Oil and gas production.................................... 30,029 21,325 10,024
Oil and gas production -- affiliates...................... -- 449 331
General and administrative................................ 8,407 4,682 2,910
General and administrative -- affiliates.................. -- 556 661
Compensation related to option settlement................. -- -- 656
Exploration and abandonments.............................. 6,588 2,550 1,652
Depreciation, depletion and amortization.................. 26,409 12,430 5,958
Impairment of oil and gas properties...................... 28,189 -- --
Interest.................................................. 12,979 11,281 4,591
-------- ------- -------
112,601 53,273 26,783
-------- ------- -------
Income (loss) before federal income taxes and
extraordinary item................................... (36,100) 1,753 (4,967)
PROVISION FOR FEDERAL INCOME TAXES
Current................................................... 62 176 3
Deferred.................................................. 90 1,042 --
-------- ------- -------
INCOME (LOSS) BEFORE EXTRAORDINARY ITEM..................... (36,252) 535 (4,970)
Extraordinary loss resulting from early extinguishment
of debt, net of deferred tax benefit of $129 and
$1,042............................................... (219) (4,975) --
-------- ------- -------
NET LOSS.................................................... $(36,471) $(4,440) $(4,970)
======== ======= =======
PREFERRED RETURN AND ACCRETION OF REDEEMABLE MEMBERS'
CAPITAL................................................... $ -- $(3,930) $(2,842)
======== ======= =======
LOSS BEFORE EXTRAORDINARY ITEM APPLICABLE TO COMMON
EQUITY.................................................... $(36,252) $(3,395) $(7,812)
======== ======= =======
NET LOSS APPLICABLE TO COMMON EQUITY........................ $(36,471) $(8,370) $(7,812)
======== ======= =======
LOSS PER SHARE:
Loss before extraordinary item............................ $ (3.49) $ (0.52) $ (1.50)
Extraordinary loss resulting from early extinguishment of
debt, net of deferred tax benefit...................... (0.02) (0.77) --
-------- ------- -------
NET LOSS.................................................... $ (3.51) $ (1.29) $ (1.50)
======== ======= =======
WEIGHTED AVERAGE SHARES OUTSTANDING......................... 10,383 6,473 5,200
======== ======= =======
</TABLE>

See accompanying notes to consolidated financial statements.

F-4
<PAGE> 66

COSTILLA ENERGY, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)
(IN THOUSANDS)

<TABLE>
<CAPTION>
TOTAL
STOCKHOLDERS'
ADDITIONAL RETAINED EQUITY AND
PREDECESSOR COMMON PAID-IN EARNINGS PREDECESSOR
CAPITAL STOCK CAPITAL (DEFICIT) CAPITAL
----------- ------ ---------- --------- -------------
<S> <C> <C> <C> <C> <C>
BALANCE AT DECEMBER 31, 1994
(Predecessor)........................ $ (747) $ -- $ -- $ -- $ (747)
Issuance of predecessor interest..... 1,266 -- -- -- 1,266
Issuance costs....................... (753) -- -- -- (753)
Net loss............................. (4,970) -- -- -- (4,970)
Withdrawals.......................... (55) -- -- -- (55)
Imputed capital contribution on
settlement of option.............. 656 -- -- -- 656
Preferred return and accretion of
redeemable predecessor capital.... (2,842) -- -- -- (2,842)
------- ------ -------- -------- --------
BALANCE AT DECEMBER 31, 1995
(Predecessor)........................ (7,445) -- -- -- (7,445)
Net loss............................. (2,881) -- -- (1,559) (4,440)
Preferred return and accretion of
redeemable predecessor capital.... (2,456) -- -- -- (2,456)
Common stock issued, net............. -- 527 60,052 -- 60,579
Distributions to members............. (4,218) -- 4,218 -- --
Transfer of predecessor capital and
issuance of common stock pursuant
to the Offerings.................. 17,000 520 (23,189) -- (5,669)
------- ------ -------- -------- --------
BALANCE AT DECEMBER 31, 1996........... -- 1,047 41,081 (1,559) 40,569
Net loss............................. -- -- -- (36,471) (36,471)
Common stock issued, net............. -- 1 74 -- 75
Common stock repurchased and
retired........................... -- (33) (3,730) -- (3,763)
------- ------ -------- -------- --------
BALANCE AT DECEMBER 31, 1997........... $ -- $1,015 $ 37,425 $(38,030) $ 410
======= ====== ======== ======== ========
</TABLE>

See accompanying notes to consolidated financial statements.

F-5
<PAGE> 67

COSTILLA ENERGY, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)

<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
--------------------------------
1997 1996 1995
--------- --------- --------
<S> <C> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss......................................... $ (36,471) $ (4,440) $ (4,970)
Adjustments to reconcile net loss to net cash
provided by operating activities:
Depreciation, depletion and amortization...... 26,409 12,430 5,958
Impairment of oil and gas properties.......... 28,189 -- --
Exploration and abandonments.................. 1,517 491 --
Amortization of deferred charges.............. 262 1,131 137
Deferred income tax expense................... (39) -- --
Allowance for doubtful accounts............... 208 -- --
Other noncash................................. -- 103 (75)
Compensation related to option settlement..... -- -- 656
Gain on sale of oil and gas properties........ (3,261) (1,067) --
Extraordinary loss resulting from early
extinguishment of debt...................... 348 6,017 --
Gain on investment transactions............... (534) -- --
--------- --------- --------
16,628 14,665 1,706
Changes in operating assets and liabilities:
Decrease (increase) in accounts
receivable............................... 1,485 (8,462) (4,818)
Decrease (increase) in other assets......... (3,585) (1,076) (216)
Increase (decrease) in accounts payable..... 10,822 6,067 3,745
Increase (decrease) in other liabilities.... (318) 4,475 2,655
Increase (decrease) in deferred revenue..... -- (3,319) 3,294
--------- --------- --------
Net cash provided by operating
activities............................. 25,032 12,350 6,366
--------- --------- --------
CASH FLOWS FROM INVESTING ACTIVITIES:
Additions to oil and gas properties.............. (111,580) (67,010) (61,500)
Proceeds from sale of oil and gas properties..... 21,327 6,388 --
Additions to other property and equipment........ (2,344) (3,007) (720)
Advances on notes receivable -- other........... -- (500) --
Advances on affiliate notes receivable........... -- -- (247)
--------- --------- --------
Net cash used in investing activities.... (92,597) (64,129) (62,467)
--------- --------- --------
CASH FLOWS FROM FINANCING ACTIVITIES:
Borrowings under long-term debt.................. 96,304 228,707 62,704
Payments of long-term debt....................... (33,480) (199,840) (11,232)
Proceeds from issuance of common stock, net...... 75 60,579 --
Purchase of common stock......................... (3,763) -- --
Proceeds from redeemable predecessor capital..... -- -- 10,000
Deferred loan and financing costs................ (574) (8,191) (2,587)
Redemption of member's interest.................. -- (15,506) --
Distributions to members and withdrawals......... -- (4,218) (55)
--------- --------- --------
Net cash provided by financing
activities............................. 58,562 61,531 58,830
--------- --------- --------
NET INCREASE (DECREASE) IN CASH AND CASH
EQUIVALENTS...................................... (9,003) 9,752 2,729
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD..... 12,618 2,866 137
--------- --------- --------
CASH AND CASH EQUIVALENTS, END OF PERIOD........... $ 3,615 $ 12,618 $ 2,866
========= ========= ========
</TABLE>

See accompanying notes to consolidated financial statements.

F-6
<PAGE> 68

COSTILLA ENERGY, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(1) ORGANIZATION AND NATURE OF OPERATIONS

Costilla Energy, Inc. ("Costilla" or the "Company") was incorporated in
Delaware in June 1996 to consolidate and continue the activities previously
conducted by Costilla Energy, L.L.C., a Texas limited liability company, and its
wholly owned subsidiaries, to acquire the assets of CSL Management Corporation
("CSL") (which owned certain office equipment used by the Company), and to
acquire the stock of Valley Gathering Company ("Valley"). Costilla was formed
for the purpose of conducting a $60 million initial public offering of common
stock and a $100 million senior notes offering (the "Offerings"), which
Offerings were completed in early October 1996.

The Company is an oil and gas exploration and production concern with
properties located principally in South and East Texas, the Rocky Mountains and
the Permian Basin regions of the United States.

(2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Principles of Consolidation

As of December 31, 1997 and 1996, the consolidated financial statements
include the accounts of the Company and its wholly-owned subsidiaries. The
Company proportionately consolidates less than 100%-owned oil and gas
partnerships and joint ventures in accordance with industry practice. All
significant accounts and transactions between the Company and its subsidiaries
have been eliminated.

At December 31, 1996 Costilla had three wholly owned subsidiaries: (i)
Costilla Petroleum Corporation, a Texas corporation ("CPC"), which operated
properties owned by Costilla and owned minor interests in the same properties,
(ii) Statewide Minerals, Inc., a Texas corporation ("Statewide"), which had
engaged in the purchase of small royalty and mineral interests; and (iii)
Valley, which owned several small gas gathering systems, a small gas processing
plant, certain salt water disposal systems and gas compressors. Costilla and CPC
were the sole members of two Texas limited liability companies through which the
Company's Moldovan operations are conducted.

On January 1, 1997 CPC was merged into its parent and Costilla assumed the
business, assets and liabilities of CPC. On March 1, 1997 Valley was merged into
its parent and Costilla assumed the business, assets and liabilities of Valley.
On March 5, 1997 Statewide was dissolved. This dissolution was effected for
administrative purposes subsequent to the sale on December 31, 1996 of
substantially all of the assets of Statewide for net proceeds of approximately
$3.0 million. The remaining unsold producing oil and gas properties were
transferred to Costilla on December 31, 1996.

Use of Estimates

Preparation of the accompanying consolidated financial statements in
conformity with generally accepted accounting principles requires management to
make estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those estimates.

Cash and Cash Equivalents

For purposes of the statements of cash flows, cash and cash equivalents
include cash on hand and depository accounts held by banks.

Concentrations of Credit Risk

Financial instruments that potentially expose the Company to concentrations
of credit risk consist primarily of unsecured accounts receivable from
unaffiliated working interest owners and crude oil and natural

F-7
<PAGE> 69
COSTILLA ENERGY, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

gas purchasers. During the year ended December 31, 1997, the Company had sales
to two customers each which exceeded 10% of total revenues, one for 14.5% and
another for 12.2%. During the year ended December 31, 1996, the Company had
sales to one customer which accounted for 11.2% of total revenues.

Trade Receivables

Trade receivables generally consist of amounts due from outside working
interest owners for their proportionate share of drilling and operating costs
incurred by the Company, as operator of the related properties.

Hedging and Derivative Financial Instruments

The financial instruments that the Company accounts for as hedging
contracts must meet the following criteria: the underlying asset or liability
must expose the Company to price or interest rate risk that is not offset in
another asset or liability, the hedging contract must reduce that price or
interest rate risk, and the instrument must be designated as a hedge at the
inception of the contract and throughout the contract period. In order to
qualify as a hedge, there must be clear correlation between changes in the fair
value of the financial instrument and the fair value of the underlying asset or
liability such that changes in the market value of the financial instrument will
be offset by the effect of price or interest rate changes on the exposed items.

Premiums paid for commodity option contracts and interest rate swap
agreements which qualify as hedges are amortized to oil and gas sales and
interest expense, respectively, over the terms of the agreements. Unamortized
premiums are included in other assets in the consolidated balance sheet. Amounts
receivable under the commodity option contracts and interest rate swap
agreements are accrued as an increase in oil and gas sales and a reduction of
interest expense, respectively, for the applicable periods. When these
derivative financial instruments cease to qualify as hedges, these instruments
are classified as investments held for trading purposes. Investments held for
trading purposes are marked to market at the end of each reporting period and
the net balance change is recorded as other income (loss) in the consolidated
statement of operations for the applicable period.

Oil and Gas Properties

On sale of an entire interest in an unproved property for cash or cash
equivalent, gain or loss on the sale is recognized, taking into consideration
the amount of any recorded impairment if the property had been
F-8
<PAGE> 70
COSTILLA ENERGY, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

assessed individually. If a partial interest in an unproved property is sold,
the amount received is treated as a reduction of the cost of the interest
retained.

Impairment of Long-Lived Assets

As of January 1, 1995, the Company adopted the provisions of Statement of
Financial Accounting Standards No. 121 -- Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to be Disposed Of ("FAS 121").
Consequently, the Company reviews its long-lived assets to be held and used,
including oil and gas properties accounted for under the successful efforts
method of accounting, whenever events or circumstances indicate that the
carrying value of those assets may not be recoverable. An impairment loss is
indicated if the sum of the expected future cash flows, on a depletable unit
basis, is less than the carrying amount of such assets. In this circumstance,
the Company recognizes an impairment loss for the amount by which the carrying
amount of the asset exceeds the fair value of the asset as determined based upon
discounted future net cash flows.

Deferred Charges

The Company capitalized certain costs incurred in connection with the
issuance of $100 million of senior notes and with obtaining the Revolving Credit
Facility (see Note 7 for definitions and descriptions of each). These costs are
being amortized over the lives of the related instruments.

Revenue Recognition

The Company uses the sales method of accounting for crude oil revenues.
Under this method, revenues are recognized based on actual volumes of oil sold
to purchasers.

The Company uses the entitlements method of accounting for natural gas
revenues. Under this method, revenues are recognized based on actual production
of natural gas. As of December 31, 1997, the Company had recorded a net gas
imbalance receivable for gas previously produced of approximately $2,341,000,
comprised of approximately 1,496,000 mcf at a net price of $1.56 per mcf.

Stock-based Compensation

The Company accounts for employee stock-based compensation using the
intrinsic value method prescribed by Accounting Principles Board Opinion No. 25,
"Accounting for Stock Issued to Employees" ("APB 25"). Accordingly, the Company
has only adopted the disclosure provisions of Statement of Financial Accounting
Standards No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123"). See
Note 12 for the pro forma disclosures of compensation expense determined under
the fair-value provisions of SFAS 123.

Income Taxes

The Company accounts for income taxes in accordance with the provisions of
Statement of Financial Accounting Standards No. 109, "Accounting for Income
Taxes" ("SFAS 109"). Under the asset and liability method of SFAS 109, deferred
tax assets and liabilities are recognized for the future tax consequences
attributable to differences between the financial statement carrying amounts of
existing assets and liabilities and their respective tax bases. Deferred tax
assets and liabilities are measured using enacted tax rates expected to apply to
taxable income in the years in which those temporary differences are expected to
be recovered or settled. Under SFAS 109, the effect on deferred tax assets and
liabilities of a change in tax rate is recognized in income in the period that
includes the enactment date.

F-9
<PAGE> 71
COSTILLA ENERGY, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Earnings Per Share

In February, 1997 the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards No. 128, "Earnings per Share" ("FAS 128")
which simplifies the existing standards for computing earnings per share ("EPS")
and makes them comparable to international standards. In accordance with the
provisions of FAS 128, the Company adopted FAS 128 in its year ended December
31, 1997 financial statements, although no restatement of prior period EPS
information has been necessary. Under FAS 128, primary EPS is replaced by
"basic" EPS, which excludes dilution and is computed by dividing income
available to common stockholders by the weighted average number of common shares
outstanding for the period. "Diluted" EPS, which is computed similarly to
fully-diluted EPS, reflects the potential dilution that could occur if
securities or other contracts to issue common stock were exercised or converted
into common stock or resulted in the issuance of common stock that then shared
in the earnings of the entity. For the years ended December 31, 1997, 1996 and
1995, the computation of diluted net loss per share was antidilutive; therefore,
the amounts reported for basic and diluted net loss per share were the same.
Basic and diluted net income (loss) per share is reduced by the preferred
return, accretion and redemption premium on redeemable members' capital for the
years ended December 31, 1996 and 1995. For the periods prior to the Offerings,
the weighted average shares outstanding attributable to predecessor capital are
the 5,200,000 shares issued to the predecessor members upon conversion of the
LLC.

Environmental

The Company is subject to extensive Federal, state and local environmental
laws and regulations. These laws, which are constantly changing, regulate the
discharge of materials into the environment and may require the Company to
remove or mitigate the environmental effects of the disposal or release of
petroleum or chemical substances at various sites. Environmental expenditures
are expensed or capitalized depending on their future economic benefit.
Expenditures that relate to an existing condition caused by past operations and
that have no future economic benefits are expensed. Liabilities for expenditures
of a noncapital nature are recorded when environmental assessment and/or
remediation is probable, and the costs can be reasonably estimated. Such
liabilities are generally recorded at their undiscounted amounts unless the
amount and timing of payments is fixed or reliably determinable.

Reclassifications

Certain reclassifications have been made to the 1995 financial statements
to conform to the 1996 and 1997 presentation.

(3) ACQUISITION OF OIL AND GAS PROPERTIES

On August 28, 1997, the Company consummated the purchase from Ballard
Petroleum LLC ("Ballard") of certain oil and gas properties for an adjusted
purchase price of approximately $41.2 million (the "Ballard Acquisition"). The
properties are located primarily in the Rocky Mountain region of the United
States. The transaction was accounted for using the purchase method. The results
of operations of the acquired properties are included in the Consolidated
Statements of Operations as of the acquisition closing date, August 28, 1997. In
addition, the Company and Ballard have entered into an Acquisition and
Exploration Agreement that establishes an area of mutual interest in the Rocky
Mountain region in which the parties will jointly own, acquire, explore and
develop oil and gas properties.

On June 14, 1996, the Company consummated the purchase from Parker and
Parsley Petroleum Company of certain oil and gas properties for an adjusted
purchase price of approximately $38.7 million (the "1996 Acquisition"). The
properties are located primarily in south and west Texas. The transaction was
accounted for using the purchase method. The results of operations of the
acquired properties are included in the Consolidated Statements of Operations as
of the acquisition closing date, June 14, 1996. The Company
F-10
<PAGE> 72
COSTILLA ENERGY, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

subsequently sold for approximately $3.3 million its wholly-owned subsidiary,
Costilla Pipeline Corporation, which owned the Three Rivers Pipeline purchased
in the 1996 Acquisition. Certain other acquired properties, which were located
outside the Company's areas of strategic focus, were sold in 1996. No gain or
loss was recorded on these sales.

In June 1995 the Company acquired a group of oil and gas properties from
Parker and Parsley Petroleum Company for an adjusted purchase price of
approximately $46.6 million (the "1995 Acquisition"). The properties are located
in the Permian Basin, Gulf Coast and Rocky Mountain regions. The transaction was
accounted for using the purchase method. The results of operations of the
acquired properties are included in the Consolidated Statements of Operations as
of the acquisition date of June 12, 1995. Certain other acquired properties,
which were located outside the Company's areas of strategic focus, were sold in
1995. No gain or loss was recorded on these sales.

Pro Forma Results of Operations (unaudited)

The following table reflects the pro forma results of operations as though
the 1996 Acquisition , net of the related properties sold, and the Ballard
Acquisition had occurred on January 1, 1996. The pro forma amounts are not
necessarily indicative of the results that may be reported in the future.

<TABLE>
<CAPTION>
YEARS ENDED
DECEMBER 31,
-------------------
1997 1996
-------- -------
(IN THOUSANDS)
<S> <C> <C>
Revenues.................................................... $ 82,189 $75,563
Net income (loss) before extraordinary item................. (39,029) 1,007
Net income (loss) per share before extraordinary item....... (3.76) 0.10
</TABLE>

(4) IMPAIRMENT OF LONG-LIVED ASSETS

The Company adopted FAS 121 effective as of January 1, 1995. FAS 121
requires that long-lived assets held and used by an entity, including oil and
gas properties accounted for under the successful efforts method of accounting,
be reviewed for impairment whenever events or changes in circumstances indicate
that the carrying amount of an asset may not be recoverable. Long-lived assets
to be disposed of are to be accounted for at the lower of carrying amount or
fair value less cost to sell when management has committed to a plan to dispose
of the assets. All companies, including successful efforts oil and gas
companies, were required to adopt FAS 121 for fiscal years beginning after
December 15, 1995.

In order to determine whether an impairment had occurred at December 31,
1997, the Company estimated the expected future cash flows of its oil and gas
properties on a depletable unit basis and compared such future cash flows to the
carrying amount of the related oil and gas properties to determine if the
carrying amount was recoverable. If the costs of a depletable unit did not
appear to be recoverable, impairment on the depletable unit was recorded equal
to the difference between the estimated present value and the costs. These
estimates of net undiscounted cash flow and estimated present values for the
Company's total oil and gas reserves were based upon the non-escalated prices
used in the Company's December 31, 1997 reserve report. Based on this process, a
noncash pre-tax writedown of $28,189,000 in the carrying amount of the Company's
proved properties was recorded at December 31, 1997. No writedown in the
carrying amount of the Company's proved properties was recorded at December 31,
1996.

(5) DERIVATIVE FINANCIAL INSTRUMENTS

The Company utilizes derivative financial instruments to manage
well-defined interest rate and commodity price risks. The Company is exposed to
credit losses in the event of nonperformance by the counterparties to its
interest rate swap agreements and its commodity hedges. The Company only deals
with reputable

F-11
<PAGE> 73
COSTILLA ENERGY, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

financial institutions as counterparties and anticipates that such
counterparties will be able to fully satisfy their obligations under the
contracts. The Company does not obtain collateral or other security to support
financial instruments subject to credit risk but monitors the credit standing of
the counterparties.

Commodity Hedges. The Company utilizes option contracts to hedge the effect
of price changes on future oil and gas production. If market prices of oil and
gas exceed the strike price of put options, the options will expire unexercised,
therefore, reducing the effective price received for oil and gas sales by the
cost of the related option. If market prices of oil and gas exceed the strike
price of call options, the Company is obligated to pay the contracting
counterparty an amount equal to the contracted volumes times the difference
between the market price and the strike price, therefore, reducing the effective
price received for oil and gas sales by the amount paid to the counterparty.

The net effect of the Company's commodity hedging activities reduced oil
and gas revenues by $1,226,000, $1,705,000, and $80,000 for the years ended
December 31, 1997, 1996 and 1995, respectively.

The following table sets forth the future volumes hedged by year and the
weighted-average strike price of the option contracts at December 31, 1997:

<TABLE>
<CAPTION>
OIL GAS
DAILY VOLUME DAILY VOLUME STRIKE PRICE
(BBLS) (MMBTU) TERM PER BBL/MMBTU
------------ ------------ ---- -------------
<S> <C> <C> <C> <C>
Oil:
1998................ 6,500 -- Jan. 98 - Aug. 98 $18.50 - $22.55(a)
Gas:
1998................ -- 5,000 Jan. 98 - Oct. 98 $2.00(b)
</TABLE>

- ---------------

(a) Represents the strike prices of a collar established with the purchase of a
put option contract and the sale of a call option contract.

(b) Represents the strike price on a purchased put option contract.

In March 1998 the Company purchased put options on 40,000 Mmbtu of gas per
day, establishing a floor price of $2.15 per Mmbtu, and sold call options on
40,000 Mmbtu of gas per day, establishing a ceiling price at $2.55 per Mmbtu,
for the period April 1998 through October 1998.

Interest Rate Swap Agreements. Prior to the Offerings, the Company utilized
two interest rate swap agreements to reduce the potential impact of increases in
interest rates on floating-rate long-term debt. Concurrent with the issuance of
the $100 million of 10.25% fixed-rate senior notes in early October 1996, the
two interest rate swap agreements ceased to be hedges. These interest rate swap
agreements were marked-to-market and the related liability recorded. The
liability for the two interest rate swap agreements was $1,712,000 at December
31, 1996. A $60 million interest rate swap agreement expired in May 1997. As a
result of the Company's borrowings against its line of credit, which bears
interest on a floating rate basis, the remaining $24 million interest rate swap
agreement again fully qualified as a hedge in August 1997. At each borrowing
date from October 1996 to August 1997, a portion of the interest rate swap
agreement was marked-to-market with the resulting gains or losses recorded as
investment income or loss while the hedge portion was being amortized over the
remaining life of the agreement. As a result of expiration and marking the
agreements to market, the Company recorded a net investment gain of
approximately $510,000 during the year ended December 31, 1997. Concurrent with
the payment of all of the Company's floating rate debt from proceeds of the 1998
Notes (as defined and discussed in Note 7), the interest rate swap agreement
ceased to qualify as a hedge. As a result of marking-to-market the interest rate
swap agreement at that time, the Company recorded an additional liability of
approximately $23,000. The interest rate swap agreement in place as of December
31, 1997 has a notional amount of $24 million with a fixed rate of 7.5% and will
expire in January, 1999.

F-12
<PAGE> 74
COSTILLA ENERGY, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

(6) FAIR VALUE OF FINANCIAL INSTRUMENTS

The following table presents the carrying amounts and estimated fair values
of the Company's financial instruments at December 31, 1997 and 1996. FASB
Statement No. 107, Disclosures about Fair Value of Financial Instruments,
defines the fair value of a financial instrument as the amount at which the
instrument could be exchanged in a current transaction between willing parties.

<TABLE>
<CAPTION>
1997 1996
------------------- -------------------
CARRYING FAIR CARRYING FAIR
AMOUNT VALUE AMOUNT VALUE
-------- -------- -------- --------
(IN THOUSANDS)
<S> <C> <C> <C> <C>
Financial Assets:
Cash, cash equivalents and restricted
cash.................................. $ 3,615 $ 3,615 $ 12,618 $ 12,618
Receivables (trade)...................... 5,241 5,241 6,675 6,675
Receivables (oil and gas sales).......... 9,312 9,312 9,031 9,031
Commodity option contracts............... 190 1,488 592 (2,172)
Gas imbalances receivable................ 2,341 3,087 -- --
Notes receivable -- affiliate............ 476 476 684 542
Notes receivable -- other................ 250 250 500 500
Financial liabilities:
Payables (trade)......................... 22,490 22,490 12,718 12,718
Long-term debt........................... 163,087 167,587 100,262 105,512
Interest rate swap and option
agreements............................ 521 493 1,712 1,712
</TABLE>

The carrying amounts shown in the table are included in the statement of
financial position under the indicated captions.

The following methods and assumptions were used to estimate the fair value
of each class of financial instruments:

Cash, trade receivables, notes receivable-other and trade payables:
The carrying amounts approximate fair value because of the short maturity
of those instruments.

Commodity option contracts: The carrying amount comprises the
unamortized premiums paid for the option contracts. The fair value is
estimated using option pricing models and essentially values the potential
for the option contracts to become in-the-money through changes in
commodity prices during the remaining terms.

Gas imbalances receivable: The carrying amount reflects the net
quantity of gas imbalances receivable based upon current prices at December
31, 1997.

Notes receivable -- affiliate: The amounts reported relate to notes
receivable from an affiliated company. The carrying amount reflects an
estimate of net present value using an assumed annual interest rate of 9%
based upon the anticipated note payment schedule.

Long-term debt: The fair value of the Company's long-term debt is
based upon the quoted market price for the senior notes at December 31,
1997 and 1996 and the carrying amounts outstanding under the two credit
facilities at December 31, 1997 (see Note 7 for a complete discussion of
long-term debt).

Interest rate swap agreements: At December 31, 1997, the Company had
an interest rate swap agreement outstanding with a notional amount of $24
million. This agreement is more fully described in Note 5. The carrying
amount is equal to the sum of the unamortized premiums paid for the
agreement and the fair value. The fair values of each of the open interest
rate swap agreements was obtained from

F-13
<PAGE> 75
COSTILLA ENERGY, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

bank quotes and represent the estimated amount the Company would pay upon
termination of the agreements at December 31, 1997 and 1996, taking into
consideration interest rates at that date.

(7) LONG-TERM DEBT

Long-term debt consists of the following (thousands):

<TABLE>
<CAPTION>
DECEMBER 31,
--------------------
1997 1996
-------- --------
<S> <C> <C>
10.25% Senior Notes due 2006................................ $100,000 $100,000
Revolving Credit Facility................................... 33,000 100
Acquisition Credit Facility................................. 30,000 --
Other notes payable......................................... 185 260
-------- --------
163,185 100,360
Less current maturities................................... 98 98
-------- --------
$163,087 $100,262
======== ========
</TABLE>

In August 1997, the Company entered into a credit agreement (the "Revolving
Credit Facility") with Bankers Trust Company, as agent, to refinance its
existing bank indebtedness and to finance a portion of the Ballard Acquisition
purchase price. The Revolving Credit Facility provides for a maximum
availability of $75.0 million, $33.0 million of which was borrowed at December
31, 1997 against an available borrowing base of $36.5 million at such date.
Borrowings under the Revolving Credit Facility bear interest, at the Company's
option, at a floating rate which is at or above the Lender's prime rate or above
the applicable Eurodollar rate, depending on the percentage of committed funds
which have been borrowed. Interest is payable quarterly as to base rate loans,
and at the end of the applicable interest period as to Eurodollar loans. The
borrowing base of the Revolving Credit Facility is automatically reduced by 5%
each quarter beginning in August 1999, and payments of principal are required in
each quarter in which the outstanding principal balance is greater than the
reduced borrowing base. The remaining balance is payable on August 28, 2002, the
maturity date of the Revolving Credit Facility. Under the Revolving Credit
Facility, the Company is obligated to pay certain fees to the lender, including
a commitment fee based on the unused portion of the commitment. The Revolving
Credit Facility contains customary restrictive covenants (including restrictions
on the payment of dividends and the incurrence of additional indebtedness) and
requires the Company to maintain (i) a current ratio of not less than 1.0 to
1.0, including amounts available under the Revolving Credit Facility and
excluding current maturities under the Revolving Credit Facility and the
Acquisition Credit Facility, (ii) a ratio of EBITDA to interest expense of not
less than 2.50 to 1 and (iii) a minimum tangible net worth. Borrowings under the
Revolving Credit Facility are secured by substantially all of the assets of the
Company.

In August 1997, the Company also entered into a second credit agreement
(the "Acquisition Credit Facility") with Bankers Trust Company, as agent, to
provide funds for a substantial portion of the Ballard Acquisition purchase
price. The Acquisition Credit Facility is a term loan in the amount of $30.0
million and is subject to a borrowing base to be determined at least
semi-annually. Borrowings under the Acquisition Credit Facility bear interest,
at the Company's option, at a floating rate which is above the Lender's prime
rate or the applicable Eurodollar rate. Interest is payable quarterly as to base
rate loans, and at the end of the applicable interest period as to Eurodollar
loans. Principal payments commence in February 1998, and are $1.7 million
quarterly for the first year and $1.4 million each quarter thereafter for two
years, with all remaining amounts due at maturity, February 28, 2001. Borrowings
under the Acquisition Credit Facility are secured by the assets acquired in the
Ballard Acquisition.

F-14
<PAGE> 76
COSTILLA ENERGY, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

commencing April 1, 1997. The Notes may not be redeemed prior to October 1,
2001, and thereafter at a premium reducing to par, plus interest, by maturity.
There is no mandatory redemption of the Notes required prior to maturity. The
Notes are general unsecured senior obligations of the Company and rank equally
in right of payment with all other senior indebtedness of the Company and senior
in right of payment of all existing future subordinated indebtedness of the
Company. The Notes are subject to an Indenture between the Company and a
trustee. The Indenture restricts, among other things, the Company's ability to
incur additional indebtedness, pay dividends or make certain other restricted
payments, incur liens, engage in any sale and leaseback transaction, sell stock
of subsidiaries, apply net proceeds from certain assets sales, merge or
consolidate with any other person, sell, assign, transfer, lease, convey or
otherwise dispose of substantially all of the assets of the company, or enter
into certain transactions with affiliates. Net proceeds from the sale of the
Notes of approximately $96.1 million were used to repay existing indebtedness.

In October 1996, the Company entered into a credit agreement (the "1996
Credit Facility") with NationsBank of Texas, N.A The 1996 Credit Facility
provided for a revolving line of credit with the availability of funds and
letters of credit being subject to a borrowing base determination at least
semiannually. The borrowing base provided a maximum availability of $50.0
million (which amount was also the initial borrowing base), $100,000 of which
was outstanding at December 31, 1996. Availability under the borrowing base was
initially limited to $20.0 million for working capital and $30.0 million for
acquisitions of oil and gas properties meeting certain criteria established by
the lender. Borrowings under the 1996 Credit Facility bore interest, at the
Company's option, at a floating rate which was at or above the NationsBank, N.A.
prime rate or the LIBOR rate, depending on the percentage of committed funds
which were borrowed. Interest was payable quarterly and principal was to be
amortized in twelve equal installments commencing two years from the date of the
credit agreement. Under the 1996 Credit Facility, the Company was obligated to
pay certain fees to the lender, including a commitment fee which ranged from
0.30% to 0.40% based on the unused portion of the commitment. The 1996 Credit
Facility contained customary restrictive covenants (including restrictions on
the payment of dividends and the incurrence of additional indebtedness) and
required the Company to maintain a current ratio of not less than 1.0 to 1.0, a
ratio of Adjusted EBITDA to interest expense of not less than 2.0 to 1.0 and a
minimum tangible net worth. Borrowings under the 1996 Credit Facility were
secured by substantially all of the assets of the Company and any subsidiary of
the Company that guaranteed the Company's obligations under the 1996 Credit
Facility. None of the Company's subsidiaries guaranteed the Company's
obligations under the 1996 Credit Facility.

In June 1996, the Company entered into a loan agreement with NationsBridge,
L.L.C. to provide financing of up to $125 million ("Bridge Loan"). The proceeds
of this Bridge Loan were used to finance the 1996 Acquisition, to refinance the
1995 Credit Facility and for other general corporate purposes. The Company
capitalized certain costs incurred in obtaining the Bridge Loan and amortized
these costs over the estimated life of the Bridge Loan. Concurrent with the
Offerings, the $2,665,000 remaining unamortized balance of these deferred
charges were expensed as an extraordinary item.

In June 1995, the Company entered into a Credit Agreement ("1995 Credit
Facility") with a syndicate of banks to provide financing for an aggregate $185
million senior secured revolving line of credit ("Revolver Notes") and an
aggregate $15 million in senior secured term notes ("Term Notes"). In June 1996,
these notes in a total amount of $71,494,000 were paid off with a portion of the
proceeds of the Bridge Loan. The Company capitalized certain costs incurred in
obtaining the 1995 Credit Facility and amortized these costs over the lives of
the notes. Concurrent with the Bridge Loan, the $1,640,000 remaining unamortized
balance of these deferred charges were expensed as an extraordinary item.

F-15
<PAGE> 77
COSTILLA ENERGY, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Notes are subject to the same terms and conditions as the Notes. Net proceeds
from the sale of the 1998 Notes of approximately $78.8 million were used to
repay the Acquisition Credit Facility in full, all but $500,000 of the Revolving
Credit Facility and the remainder was used for general corporate working capital
needs.

In light of the issuance of the 1998 Notes and the concurrent repayment of
the Acquisition Credit Facility , there are no current maturities of long-term
debt. Therefore, all amounts owed under the Revolving Credit Facility and
Acquisition Facility as of December 31, 1997 have been classified as long-term
obligations.

The Company paid interest on long-term debt of $12,198,937, $8,838,971 and
$4,453,684 in 1997, 1996 and 1995, respectively.

(8) INCOME TAXES

Concurrent with the Offerings, the Company became a tax paying entity for
U.S. Federal income tax purposes. At that date, the tax basis of the Company's
assets and liabilities exceeded the book basis by approximately $3,500,000,
resulting in a deferred tax asset of approximately $1,200,000. A valuation
allowance was provided for 100% of this deferred tax asset.

Income tax provision (benefit) and amounts separately allocated were as
follows (thousands):

<TABLE>
<CAPTION>
YEAR ENDED
DECEMBER 31,
----------------
1997 1996
----- -------
<S> <C> <C>
Income (loss) before extraordinary item..................... $ 152 $ 1,218
Extraordinary loss resulting from early extinguishment of
debt...................................................... (129) (1,042)
----- -------
$ 23 $ 176
===== =======
</TABLE>

In 1997, the Company's effective tax rate differs from the U.S. Federal
statutory rate primarily because of a valuation allowance established for net
operating loss carryforwards, as discussed below. The Company's effective tax
rate does not differ materially from the U.S. Federal statutory rate in 1996.

The tax effects of temporary differences that give rise to significant
portions of deferred tax assets and deferred tax liabilities were as follows:

<TABLE>
<CAPTION>
DECEMBER 31,
-------------------
1997 1996
-------- -------
<S> <C> <C>
Deferred tax assets (liabilities):
Net operating loss carryforwards.......................... $ 15,331 $ 2,805
Interest rate swap agreements............................. 116 599
Oil and gas properties, principally due to differences in
depletion, impairment and the deduction of intangible
drilling costs for tax purposes........................ 1,253 (1,692)
Other..................................................... 1,365 --
-------- -------
Net deferred tax asset...................................... 18,065 1,712
Valuation allowance of net deferred tax asset............... (18,065) (1,712)
-------- -------
Net deferred tax asset, net of valuation allowance.......... $ -- $ --
======== =======
</TABLE>

A valuation allowance is provided for when it is more likely than not that
some portion of the deferred tax assets will not be realized. Due to
uncertainties arising from a lack of earnings history and based on management's
intentions to continue an aggressive drilling program (generating intangible
drilling costs which

F-16
<PAGE> 78
COSTILLA ENERGY, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

are projected to create future losses for tax purposes), it does not appear more
likely than not that the Company will be able to utilize all the available
carryforwards prior to their ultimate expiration.

At December 31, 1997, the Company had net operating loss carryforwards of
approximately $43.8 million, which are available to offset future regular
taxable income, if any. The carryforwards expire December 31, 2011 and 2012.

(9) COMMITMENTS AND CONTINGENCIES

Leases

The Company leases equipment and office facilities under operating leases
on which rental expense for the years ended December 31, 1997, 1996 and 1995 was
$376,978, $416,442 and $311,221, respectively. Future minimum lease commitments
under noncancellable operating leases at December 31, 1997 are as follows
(thousands):

<TABLE>
<S> <C>
1998........................................................ $ 394,372
1999........................................................ 376,699
2000........................................................ 327,517
2001........................................................ 352,302
2002........................................................ 343,924
Thereafter.................................................. 1,023,048
</TABLE>

Employment Agreements

In 1996, the Company entered into employment agreements with four of its
executive officers. The employment agreements are each for three years and each
will automatically renew for successive one-year periods thereafter unless the
employee is notified to the contrary. These employment agreements provide for
base annual salary levels totaling $1,035,000 for 1998.

Each employee would receive his salary for the remaining term of the
applicable employment agreement if the Company were to terminate such person's
employment other than for cause. If such person were to voluntarily leave his
employment with the Company prior to the second anniversary of the employment
agreement no further payments would be required. With the exception of one of
the Company's executive officers, if a voluntary termination were to occur after
the second anniversary of the employee agreement, such person would be entitled
to one year's salary from the date of termination. With the exception of one of
the Company's executive officers, the employee agreements provide that the
covered employee will not compete with the Company for a one year period
following his voluntary cessation of employment or termination of employment for
cause, in either case if such event occurs within the initial three-year term of
the employee agreement.

Exploration and Development

In July 1995, the Republic of Moldova (located in Eastern Europe between
Romania and the Ukraine) granted a Concession Agreement to Resource Development
Company Limited, L.L.C. ("Redeco"), an entity not affiliated with the Company.
The Company paid Redeco $90,000 and agreed to bear the first $2.0 million of
Concession expenses in return for a 50.0% interest in Redeco. Upon reaching the
$2.0 million in 1996, Redeco elected, according to the agreement, to pay the
Company for half of all amounts expended in excess of $750,000 plus interest.
The Concession Agreement covers the entire country with respect to oil and gas
and other minerals and continues for various time periods depending on the
nature of the activity conducted. The Company has no material fixed financial
commitments with respect to the Concession. As of December 31, 1997, the
Company's share of costs expended was $3,681,137.

F-17
<PAGE> 79
COSTILLA ENERGY, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Letters of Credit

As a result of certain bonding and hedging counterparty requirements, the
Company has caused irrevocable letters of credit to be issued by a bank totaling
$996,000. As of December 31, 1997, no amounts had been drawn on these letters of
credit.

(10) 401(k) PLAN

The Company has established a qualified cash or deferred arrangement under
IRS code section 401(k) covering substantially all employees. Under the plan,
the employees have an option to make elective contributions of a portion of
their eligible compensation, not to exceed specified annual limitations, to the
plan and the Company has an option to match a percentage of the employee's
contribution. The Company has made matching contributions to the plan totaling
$122,336, $58,713, and $22,531 in 1997, 1996 and 1995, respectively.

(11) REDEEMABLE PREDECESSOR CAPITAL AND PREDECESSOR CAPITAL

During 1995, NationsBanc Capital Corporation ("NBCC") contributed $10
million in exchange for a 30% ownership interest in the Company including the
preferential return described below. Of this amount $1,266,000 was attributed to
the non-redeemable portion of predecessor capital and $8,734,000 was attributed
to redeemable predecessor capital. Preferred return and accretion of predecessor
capital included in the consolidated statements of operations and the
consolidated statements of stockholders' equity includes accretion of the amount
attributable to redeemable predecessor capital to $10,000,000 over a two year
period beginning February 17, 1995. As described below, the redemption amount
was ultimately to be equal to $10,000,000 plus a preferred return and an
additional redemption amount related to NBCC's redeemable interest not subject
to preferential return.

Concurrent with the Offerings, NBCC's membership interest was redeemed for
a total of $15,506,614 and 936,000 common shares were issued to NBCC. After
accounting for the Underwriter's exercise of its over-allotment option in
November 1996, NBCC owns 8.94% of the 10,475,000 common shares outstanding at
December 31, 1996. The following table details the redemption price paid to
NBCC:

<TABLE>
<S> <C>
NBCC Preferred Capital Contribution......................... $10,000,000
Preferred Return............................................ 2,732,376
-----------
Adjusted NBCC Preferred Capital Contribution................ 12,732,376
PLUS: 10% Redemption Premium................................ 1,273,238
PLUS: Aggregate Redemption Price of NBCC's Redeemable
Unrestricted Common Units................................. 1,500,000
-----------
Total Redemption Price Paid NBCC............................ $15,505,614
===========
</TABLE>

Redeemable predecessor capital was subject to a preferential return of 15%
per annum and was redeemable at any time at the Company's option, subject to a
redemption premium as described below, or at NBCC's option on February 17, 2003
or at an earlier date upon occurrence of certain events including a change in
control, certain changes in management, a change in the Company's status as a
limited liability company for tax purposes, or violation of any of various other
restrictive provisions contained in the Regulations of Costilla Energy, Inc.
(the "Regulations"). The 15% preferred return was treated as a reduction of
predecessor capital.

In addition, a portion of NBCC's interest not subject to preferential
return was classified as redeemable predecessor capital as the Company could
have been be required to repurchase such interest upon the occurrence of certain
events similar to those events requiring redemption of the redeemable
predecessor

F-18
<PAGE> 80
COSTILLA ENERGY, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

capital described above and, in any event, on or after February 17, 2000. Such
interest could have, at the Company's option, been repurchased to the extent the
Company has exercised its right to redeem all or a portion of the redeemable
members' interest subject to the preferential return. The redemption price the
Company would have paid in either instance would be determined by the year in
which the predecessor capital was repurchased, up to an aggregate of $5,500,000.
Prior to the Offerings in October 1996, the ultimate redemption price of
$5,500,000 was being accrued ratably over the period from February 17, 1995
through February 17, 2000 and was treated as a reduction of predecessor capital.

(12) STOCK-BASED COMPENSATION

Outside Directors Stock Option Plan

The Outside Directors Stock Option Plan provides for the issuance of stock
options to the outside directors of the Company. A total of 50,000 shares has
been authorized and reserved for issuance under the plan, subject to adjustments
to reflect changes in the Company's capitalization resulting from stock splits,
stock dividends and similar events. Only outside directors are eligible to
participate in the plan. Outside directors are those directors of the Company
who are not executive officers or regular salaried employees of the Company as
of the date the Option is granted. Under the plan, an option for 1,000 shares of
Common Stock will be granted to each person who qualifies as an outside director
each year that such person is elected as a director of the Company. The exercise
price of each option granted under the plan will be the fair market value (as
reported on the Nasdaq National Market) of the Common Stock at the time the
option is granted and may be paid either in cash, shares of Common Stock or a
broker-assisted cashless transaction. Each option will be exercisable
immediately, and will expire ten years from the date of grant.

The plan was amended during 1997 to provide that a total of 100,000 shares
be authorized and reserved for issuance under this plan and that each person
qualifying as an outside director shall receive an option for 5,000 shares each
year that such person is elected as a director of the Company. During the year
ended December 31, 1997, options on 15,000 shares were granted under this plan,
leaving 85,000 options available for future grant under the plan as of December
31, 1997. The options granted during 1997 have a term of ten (10) years and an
exercise price of $12.50 per share, a price equal to the market price on the
date of grant. The weighted average fair value, as calculated under the
provisions of FAS 123, of the options granted in 1997 was $8.56 per share.

Bonus Incentive Plan

The Bonus Incentive Plan provides that the Board of Directors each year may
award bonuses in cash, Common Stock, or some combination thereof, to those
officers, directors, employees and advisors of the Company or a subsidiary of
the Company, who the Board of Directors determines have contributed to the
success of the Company. A total of 150,000 shares of Common Stock has been
authorized and reserved for issuance under the plan, subject to adjustments to
reflect changes in the Company's capitalization resulting from stock splits,
stock dividends and similar events. All officers, directors, employees and
advisors of the Company or a subsidiary of the Company who have completed a
minimum of 180 days of service and are employed or retained by the Company or
such subsidiary on the last day of the plan year, other than such persons who
own ten percent or more of the outstanding shares of the Common Stock during
that year, are eligible to participate in the plan. Bonus awards will be
determined based upon a number of factors, including performance and salary
level of the participant and the financial performance of the Company and its
subsidiaries. Bonuses will be awarded after review and upon approval of the
Board of Directors, subject to the terms and conditions of the plan.

The plan was amended during 1997 to provide that the plan be administered
by the Compensation Committee of the Board of Directors, that awards of
incentive compensation under this plan be made within 120 days after the
expiration of each fiscal year and the removal of the exclusion of ten percent
or more

F-19
<PAGE> 81
COSTILLA ENERGY, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

shareholders as eligible participants in the plan. During the year ended
December 31, 1997, 4,500 shares were issued under this plan at the current
market price of $13.38 per share.

1996 Stock Option Plan

The 1996 Stock Option Plan provides for the grant of both incentive stock
options and non-qualifying stock options, as well as limited stock appreciation
rights and supplemental bonuses, to the employees of the Company and its
subsidiaries, including officers and directors who are salaried employees. A
total of 850,000 shares of Common Stock has been authorized and reserved for
issuance under the plan, subject to adjustments to reflect changes in the
Company's capitalization resulting from stock splits, stock dividends and
similar events. The plan is administered by the Board of Directors. The Board of
Directors has the sole authority to interpret the plan, to determine the persons
to whom the options will be granted, to determine the basis upon which the
options will be granted, and to determine the exercise price, duration and other
terms of the options to be granted under the plan; provided that (a) the
exercise price of each option granted under the plan may not be less than the
fair market value of the Common Stock on the date the option is granted (and for
incentive stock options, 110% of fair market value if the employee is the
beneficial owner of 10% or more the Company's voting securities), (b) the
exercise price must be paid in cash, by surrendering previously owned shares of
Common Stock upon the exercise of the option or by a promissory note or
broker-assisted cashless exercise approved by the Board of Directors, (c) the
term of the option may not exceed ten years, and (d) no option is transferable
other than by will, the laws of descent and distribution or pursuant to a
qualified domestic relations order. Limited stock appreciation rights may be
granted under the plan with respect to specified options, allowing the option
holder to receive, in cash, the difference between the exercise price and the
market value in the event of a change in control of the Company. The Board of
Directors may also grant supplemental bonuses under the plan which are cash
bonuses not to exceed the amount of income tax liability incurred by a plan
participant upon the exercise of a non-qualifying stock option or a limited
stock appreciation right with respect to which the bonus was granted. The Board
of Directors may amend without stockholder approval, in any respect other than
any amendment that requires stockholder approval by law, and may modify any
outstanding option, including the repricing of non-qualifying options, with the
consent of the option holder. There are currently approximately 135 employees
who are eligible to participate in the plan.

The plan was amended during 1997 to provide that the plan be administered
by the Compensation Committee of the Board of Directors and that a total of
1,250,000 shares be authorized and reserved for issuance under this plan.

No options were issued under this plan during 1997. During 1996, the
Company granted 711,750 stock options pursuant to the 1996 Stock Option Plan,of
which 1,500 shares were exercised in 1997. There were 547,750 options available
for future grant under the plan as of December 31, 1997. The options granted
during 1996 have a term of ten (10) years and an exercise price of $12.50 per
share, a price equal to the market price on the date of the grant. The weighted
average fair value, as calculated under the provision of SFAS 123, of the
options granted in 1996 was $6.73 per share.

The Company applies APB 25 and related Interpretations in accounting for
its stock option awards. Accordingly, no compensation expense has been
recognized for its stock option awards. If compensation expense for the stock
option awards had been determined consistent with SFAS 123, the Company's net
loss and net loss per share, for the year ended December 31, 1997 and 1996 would
have been adjusted to the following pro forma amounts:

<TABLE>
<CAPTION>
1997 1996
------------ -----------
<S> <C> <C>
Net loss................................................ $(37,740,000) $(6,285,276)
Net loss per share...................................... (3.63) (1.58)
</TABLE>

F-20
<PAGE> 82
COSTILLA ENERGY, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Under SFAS 123, the fair value of each stock option grant is estimated on
the date of grant using the Black-Scholes option pricing model with the
following weighted average assumptions used for grants in 1997 and 1996:

<TABLE>
<CAPTION>
1997 1996
------- -------
<S> <C> <C>
Risk-free interest rate..................................... 6.25% 6.25%
Expected life............................................... 5 years 5 years
Expected volatility......................................... 80% 54%
Expected dividend yield..................................... 0% 0%
</TABLE>

(13) RELATED PARTY TRANSACTIONS

Certain members and officers of the Company have owned interests in and
held positions with A&P Meter Service and Supply, Inc. ("A&P"), CSL, 511 Tex
L.C. ("511 Tex"), and Valley.

Advances from the Company to A&P have been consolidated into two promissory
notes. The first note, which was originally executed December 31, 1994, totals
$390,000, including accrued interest. The note bears interest at a floating rate
equal to the "prime rate" plus 1.0%. No principal or interest payments are due
until the maturity of the note at December 31, 2004. The note is secured by a
second lien on A&P's accounts receivable, inventory and equipment. The second
note is in the amount of $294,000, including accrued interest and is dated May
22, 1996. The note is unsecured and is payable upon demand. During 1997, the
Company created an allowance of $208,000 related to these notes to reflect the
estimated present value of anticipated future payments on these notes. During
1997, 1996 and 1995, the Company paid $561,343, $520,519 and $612,139,
respectively, to A&P for goods and services provided.

During 1996 and 1995, the Company paid $517,352 and $592,920, respectively,
to CSL for management fees and lease payments on equipment.

During 1996 and 1995, the Company paid $50,742 and $67,896, respectively,
to 511 Tex for office rent.

During 1996 and 1995 the Company paid $484,000 and $440,884, respectively,
to Valley for gas compression and salt water disposal charges. During 1996 and
1995, Valley paid the Company $383,139 and $109,399, respectively, for operating
costs of its salt water disposal wells and gas compressors.

During 1996 and 1995 the LLC paid $75,000 each year to NationsBank Capital
Corp. for management fees. No management fees are due to NationsBank Capital
Corp. for any period subsequent to the Offerings.

(14) OIL AND GAS EXPENDITURES

The following table reflects costs incurred in oil and gas property
acquisition, exploration and development activities:

<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
------------------------------
1997 1996 1995
-------- ------- -------
(THOUSANDS)
<S> <C> <C> <C>
Property acquisition costs:
Proved.............................................. $ 25,731 $39,505 $52,470
Unproved............................................ 32,415 721 1,742
Exploration........................................... 16,194 6,760 5,627
Development........................................... 43,942 17,723 158
-------- ------- -------
$118,282 $64,709 $59,997
======== ======= =======
</TABLE>

F-21
<PAGE> 83
COSTILLA ENERGY, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

(15) SUPPLEMENTAL OIL AND GAS RESERVE INFORMATION (UNAUDITED)

The estimates of proved oil and gas reserves, which are located principally
in the United States, were prepared by the Company as of December 31, 1997 and
1995 and by Williamson Petroleum Consultants as of December 31, 1996. Williamson
Petroleum Consultants performed a review of approximately 72% of the Company's
estimated United States reserves as of December 31, 1997 (on a PV-10 basis). The
Moldova reserve estimates were prepared by W. Scott Epley, P.E. as of December
31, 1997. Reserves were estimated in accordance with guidelines established by
the SEC and FASB which require that reserve estimates be prepared under existing
economic and operating conditions with no provision for price and cost
escalations except by contractual arrangements. The Company has presented the
United States reserve estimates utilizing an oil price of $15.29 per Bbl and a
gas price of $2.20 per Mcf as of December 31, 1997 and an oil price of $24.17
per Bbl and a gas price of $3.96 per Mcf as of December 31, 1996. The Company
has presented the Moldovan reserve estimates utilizing an oil price of $16.00
per Bbl and a gas price of $2.08 per Mcf as of December 31, 1997.

Oil and Gas Producing Activities

F-22
<PAGE> 84
COSTILLA ENERGY, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

<TABLE>
<CAPTION>
UNITED STATES MOLDOVA TOTAL
----------------- ----------------- -----------------
NATURAL NATURAL NATURAL
OIL GAS OIL GAS OIL GAS
(MBBLS) (MMCF) (MBBLS) (MMCF) (MBBLS) (MMCF)
------- ------- ------- ------- ------- -------
<S> <C> <C> <C> <C> <C> <C>
Total Proved Reserves:
Balance, January 1, 1995............ 4,009 27,512 -- -- 4,009 27,512
Revisions of previous estimates... (570) 425 -- -- (570) 425
Extensions and discoveries........ 605 8,922 -- -- 605 8,922
Production........................ (950) (4,806) -- -- (950) (4,806)
Purchases of minerals-in-place.... 7,694 46,099 -- -- 7,694 46,099
------ ------- ------ ------- ------ -------
Balance, December 31, 1995.......... 10,788 78,152 -- -- 10,788 78,152
Revisions of previous estimates... 1,782 5,440 -- -- 1,782 5,440
Extensions and discoveries........ 1,169 13,581 -- -- 1,169 13,581
Production........................ (1,726) (9,205) -- -- (1,726) (9,205)
Sales of minerals-in-place........ (119) (482) -- -- (119) (482)
Purchases of minerals-in-place.... 5,106 32,786 -- -- 5,106 32,786
------ ------- ------ ------- ------ -------
Balance, December 31, 1996.......... 17,000 120,272 -- -- 17,000 120,272
Revisions of previous estimates... (3,651) 3,064 -- -- (3,651) 3,064
Extensions and discoveries........ 2,465 58,888 395 1,318 2,860 60,206
Production........................ (2,175) (14,698) -- -- (2,175) (14,698)
Sales of minerals-in-place........ (2,065) (27,743) -- -- (2,065) (27,743)
Purchases of minerals-in-place.... 2,983 7,536 -- -- 2,983 7,536
------ ------- ------ ------- ------ -------
Balance, December 31, 1997.......... 14,557 147,319 395 1,318 14,952 148,637
====== ======= ====== ======= ====== =======
Proved Developed Reserves:
January 1, 1995................... 2,632 16,340 -- -- 2,632 16,340
December 31, 1995................. 8,566 57,393 -- -- 8,566 57,393
December 31, 1996................. 14,018 90,023 -- -- 14,018 90,023
December 31, 1997................. 10,646 84,558 -- 359 10,646 84,917
</TABLE>

Standardized Measure of Discounted Future Net Cash Flows Relating to Proved
Oil and Gas Reserves

The standardized measure of discounted future net cash flows is computed by
applying year-end prices of oil and gas (with consideration of price changes
only to the extent provided by contractual arrangements) to the estimated future
production of proved oil and gas reserves less estimated future expenditures
(based on year-end costs) to be incurred in developing and producing the proved
reserves, less estimated future income tax expenses (based on year-end statutory
tax rates, with consideration of future tax rates already legislated) to be
incurred on pretax net cash flows less tax basis of the properties and available
credits, and assuming continuation of existing economic conditions. The
estimated future net cash flows are then discounted using a rate of 10% per year
to reflect the estimated timing of the future cash flows.

F-23
<PAGE> 85
COSTILLA ENERGY, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

associated with future production. Because of these and other considerations,
any estimate of fair value is necessarily subjective and imprecise.

<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
---------------------------------
1997 1996 1995
--------- --------- ---------
(THOUSANDS)
<S> <C> <C> <C>
UNITED STATES
Future cash flows................................. $ 547,584 $ 887,100 $ 350,653
Future costs:
Production...................................... (205,454) (323,288) (145,510)
Development..................................... (41,291) (25,469) (16,806)
--------- --------- ---------
Future net cash flows before income taxes......... 300,839 538,343 188,337
Future income taxes............................... 31,249 144,836 --
--------- --------- ---------
Future net cash flows............................. 269,590 393,507 188,337
10% annual discount for estimated timing of cash
flows........................................... (95,704) (165,273) (75,041)
--------- --------- ---------
Standardized measure of discounted net cash
flows........................................... $ 173,886 $ 228,234 $ 113,296
========= ========= =========
MOLDOVA
Future cash flows................................. $ 9,063 $ -- $ --
Future costs:
Production...................................... (1,943) -- --
Development..................................... (2,572) -- --
--------- --------- ---------
Future net cash flows before income taxes......... 4,548 -- --
Future income taxes............................... 951 -- --
--------- --------- ---------
Future net cash flows............................. 3,597 -- --
10% annual discount for estimated timing of cash
flows........................................... (1,560) -- --
--------- --------- ---------
Standardized measure of discounted net cash
flows........................................... $ 2,037 $ -- $ --
========= ========= =========
TOTALS
Future cash flows................................. $ 556,647 $ 887,100 $ 350,653
Future costs:
Production...................................... (207,397) (323,288) (145,510)
Development..................................... (43,863) (25,469) (16,806)
--------- --------- ---------
Future net cash flows before income taxes......... 305,387 538,343 188,337
Future income taxes............................... 32,200 144,836 --
--------- --------- ---------
Future net cash flows............................. 273,187 393,507 188,337
10% annual discount for estimated timing of cash
flows........................................... (97,264) (165,273) (75,041)
--------- --------- ---------
Standardized measure of discounted net cash
flows........................................... $ 175,923 $ 228,234 $ 113,296
========= ========= =========
</TABLE>

F-24
<PAGE> 86
COSTILLA ENERGY, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Changes in Standardized Measure of Discounted Future Net Cash Flows From
Proved Reserves
(In Thousands)

<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
-------------------------------
1997 1996 1995
--------- -------- --------
(THOUSANDS)
<S> <C> <C> <C>
UNITED STATES
Increase (decrease):
Purchase of minerals -- in place.................. $ 22,753 $ 49,966 $ 77,343
Extensions and discoveries and improved recovery,
net of future production and development
costs.......................................... 69,140 25,910 9,799
Accretion of discount............................. 31,180 11,330 3,678
Net change in sales prices net of production
costs.......................................... (170,943) 108,160 (3,422)
Changes in estimated future development costs..... 2,515 4,187 (2,419)
Revisions of quantity estimates................... (17,890) 29,485 (2,855)
Net change in income taxes........................ 63,408 (83,570) --
Sales, net of production costs.................... (42,271) (32,146) (11,338)
Sales of minerals in place........................ (29,975) (1,330) --
Changes of production rates (timing) and other.... 17,735 2,946 5,731
--------- -------- --------
Net increase (decrease)...................... (54,348) 114,938 76,517
Standardized measure of discounted future net cash
flows:
Beginning of period.......................... 228,234 113,296 36,779
--------- -------- --------
End of period................................ $ 173,886 $228,234 $113,296
========= ======== ========
MOLDOVA
Increase (decrease):
Purchase of minerals-in place..................... $ -- $ -- $ --
Extensions and discoveries and improved recovery,
net of future production and development
costs.......................................... 2,576 -- --
Accretion of discount............................. -- -- --
Net change in sales prices net of production
costs.......................................... -- -- --
Changes in estimated future development costs..... -- -- --
Revisions of quantity estimates................... -- -- --
Net change in income taxes........................ (539) -- --
Sales, net of production costs.................... -- -- --
Sales of minerals in place........................ -- -- --
Changes of production rates (timing) and other.... -- -- --
--------- -------- --------
Net increase (decrease)...................... 2,037 -- --
Standardized measure of discounted future net cash
flows:
Beginning of period.......................... -- -- --
--------- -------- --------
End of period................................ $ 2,037 $ -- $ --
========= ======== ========
</TABLE>

F-25
<PAGE> 87
COSTILLA ENERGY, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
-------------------------------
1997 1996 1995
--------- -------- --------
(THOUSANDS)
<S> <C> <C> <C>
TOTALS
Increase (decrease):
Purchase of minerals-in place..................... $ 22,753 $ 49,966 $ 77,343
Extensions and discoveries and improved recovery,
net of future production and development
costs.......................................... 71,716 25,910 9,799
Accretion of discount............................. 31,180 11,330 3,678
Net change in sales prices net of production
costs.......................................... (170,943) 108,160 (3,422)
Changes in estimated future development costs..... 2,515 4,187 (2,419)
Revisions of quantity estimates................... (17,890) 29,485 (2,855)
Net change in income taxes........................ 62,869 (83,570) --
Sales, net of production costs.................... (42,271) (32,146) (11,338)
Sales of minerals in place........................ (29,975) (1,330) --
Changes of production rates (timing) and other.... 17,735 2,946 5,731
--------- -------- --------
Net increase (decrease)...................... (52,311) 114,938 76,517
Standardized measure of discounted future net cash
flows:
Beginning of period.......................... 228,234 113,296 36,779
--------- -------- --------
End of period................................ $ 175,923 $228,234 $113,296
========= ======== ========
</TABLE>

The 1997 future cash flows shown above include amounts attributable to
proved undeveloped reserves requiring approximately $42.5 million of future
development costs. If these reserves are not developed, the standardized measure
of discounted future net cash flows for 1997 shown above would be reduced by
approximately $42.3 million.

F-26
<PAGE> 88

PART I -- FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

COSTILLA ENERGY, INC.

CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS)

ASSETS

<TABLE>
<CAPTION>
JUNE 30, DECEMBER 31,
1998 1997
----------- ------------
(UNAUDITED)
<S> <C> <C>
CURRENT ASSETS:
Cash and cash equivalents................................. $ 17,089 $ 3,615
Accounts receivable:
Trade, net............................................. 3,081 5,241
Oil and gas sales...................................... 7,954 9,312
Prepaid and other current assets.......................... 1,439 912
-------- --------
Total current assets.............................. 29,563 19,080
-------- --------
PROPERTY, PLANT AND EQUIPMENT, AT COST:
Oil and gas properties, using the successful efforts
method of accounting:
Proved properties...................................... 233,420 199,355
Unproved properties.................................... 47,076 35,971
Accumulated depletion, depreciation and amortization...... (84,658) (71,152)
-------- --------
195,838 164,174
Other property and equipment, net......................... 3,628 3,766
-------- --------
Total property, plant and equipment............... 199,466 167,940
-------- --------
OTHER ASSETS:
Deferred charges.......................................... 6,829 4,212
Other..................................................... 2,400 2,856
-------- --------
Total other assets................................ 9,229 7,068
-------- --------
$238,258 $194,088
======== ========

LIABILITIES AND STOCKHOLDERS' EQUITY

CURRENT LIABILITIES:
Current maturities of long-term debt...................... $ 98 $ 98
Trade accounts payable.................................... 16,299 22,490
Undistributed revenue..................................... 3,312 4,566
Other current liabilities................................. 5,577 3,437
-------- --------
Total current liabilities......................... 25,286 30,591
-------- --------
LONG-TERM DEBT, LESS CURRENT MATURITIES..................... 182,441 163,087
-------- --------
OTHER NONCURRENT LIABILITIES................................ 313 --
-------- --------
STOCKHOLDERS' EQUITY:
Preferred stock, $.10 par value (3,000,000 shares
authorized; 50,000 shares, $1,000 liquidation value,
outstanding at June 30, 1998 and no shares outstanding
at December 31, 1997).................................. 5 --
Common stock, $.10 par value (20,000,000 shares
authorized; 9,981,000 shares outstanding at June 30,
1998 and 10,150,500 shares outstanding at December 31,
1997).................................................. 998 1,015
Additional paid-in capital................................ 83,552 37,425
Retained deficit.......................................... (54,337) (38,030)
-------- --------
Total stockholders' equity........................ 30,218 410
-------- --------
COMMITMENTS AND CONTINGENCIES............................... -- --
-------- --------
$238,258 $194,088
======== ========
</TABLE>

See accompanying notes to consolidated financial statements.

F-27
<PAGE> 89

COSTILLA ENERGY, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)

<TABLE>
<CAPTION>
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
------------------- ------------------
1998 1997 1998 1997
-------- -------- -------- -------
<S> <C> <C> <C> <C>
REVENUES:
Oil and gas sales................................... $16,670 $15,279 $ 32,015 $34,892
Interest and other.................................. 155 154 360 920
Gain on sale of assets.............................. -- -- 337 --
------- ------- -------- -------
16,825 15,433 32,712 35,812
------- ------- -------- -------
EXPENSES:
Oil and gas production.............................. 7,441 6,794 14,226 14,163
General and administrative.......................... 2,577 1,856 5,070 3,370
Exploration and abandonments........................ 2,078 1,774 5,228 3,115
Depreciation, depletion and amortization............ 8,305 4,806 14,364 9,720
Interest............................................ 5,094 2,809 9,833 5,516
------- ------- -------- -------
25,495 18,039 48,721 35,884
------- ------- -------- -------
Loss before federal income taxes and
extraordinary item............................. (8,670) (2,606) (16,009) (72)
PROVISION FOR FEDERAL INCOME TAXES
Current............................................. -- -- -- 62
Deferred............................................ -- (191) -- --
------- ------- -------- -------
LOSS BEFORE EXTRAORDINARY ITEM........................ (8,670) (2,415) (16,009) (134)
Extraordinary loss resulting from early
extinguishment of debt........................... -- -- (299) --
------- ------- -------- -------
NET LOSS.............................................. $(8,670) $(2,415) $(16,308) $ (134)
======= ======= ======== =======
CUMULATIVE PREFERRED STOCK DIVIDEND................... $ 307 $ -- $ 307 $ --
======= ======= ======== =======
LOSS BEFORE EXTRAORDINARY ITEM APPLICABLE TO COMMON
EQUITY.............................................. $(8,977) $(2,415) $(16,316) $ (134)
======= ======= ======== =======
NET LOSS APPLICABLE TO COMMON EQUITY.................. $(8,977) $(2,415) $(16,615) $ (134)
======= ======= ======== =======
LOSS PER SHARE:
Loss before extraordinary item...................... $ (0.90) $ (0.23) $ (1.63) $ (0.01)
Extraordinary loss resulting from early
extinguishment of debt........................... -- -- (0.03) --
------- ------- -------- -------
NET LOSS.............................................. $ (0.90) $ (0.23) $ (1.66) $ (0.01)
======= ======= ======== =======
WEIGHTED AVERAGE SHARES OUTSTANDING................... 9,981 10,459 10,027 10,468
======= ======= ======== =======
</TABLE>

See accompanying notes to consolidated financial statements.

F-28
<PAGE> 90

COSTILLA ENERGY, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
(UNAUDITED)

<TABLE>
<CAPTION>
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
------------------- -------------------
1998 1997 1998 1997
-------- -------- -------- --------
<S> <C> <C> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
NET LOSS.......................................... $ (8,670) $ (2,415) $(16,308) $ (134)
ADJUSTMENTS TO RECONCILE NET LOSS TO NET CASH
PROVIDED BY OPERATING ACTIVITIES:
Depreciation, depletion and amortization....... 8,305 4,806 14,364 9,720
Exploration and abandonments................... 165 11 262 58
Amortization of deferred charges............... 287 459 481 610
Deferred income tax expense.................... -- (191) -- --
Allowance for doubtful accounts................ -- 208 -- 208
Gain on sale of oil and gas properties......... -- -- (337) 30
Extraordinary loss resulting from early
extinguishment of debt....................... -- -- 299 --
Gain on investment transactions................ (1) (224) (5) (981)
-------- -------- -------- --------
86 2,654 (1,244) 9,511
Changes in operating assets and liabilities:
Decrease (increase) in accounts receivable... 3,606 2,485 3,518 1,864
Decrease (increase) in other assets.......... 276 (21) 54 (429)
Increase (decrease) in accounts payable...... (5,662) (1,580) (7,445) 3,435
Increase (decrease) in other liabilities..... (2,158) (2,425) 2,141 191
-------- -------- -------- --------
Net cash provided by (used in)
operating activities.................... (3,852) 1,113 (2,976) 14,572
-------- -------- -------- --------
CASH FLOWS FROM INVESTING ACTIVITIES:
Additions to oil and gas properties............... (17,706) (20,672) (48,474) (35,878)
Proceeds from sale of oil and gas properties...... 658 1,842 3,158 2,709
Additions to other property and equipment......... (298) (613) (497) (1,284)
-------- -------- -------- --------
Net cash used in investing activities..... (17,346) (19,443) (45,813) (34,453)
-------- -------- -------- --------
CASH FLOWS FROM FINANCING ACTIVITIES:
Borrowings under long-term debt................... 16,000 14,600 111,000 14,600
Payments of long-term debt........................ (29,021) (19) (91,541) (37)
Proceeds from issuance of preferred stock, net.... 47,957 -- 47,957 --
Proceeds from issuance of common stock, net....... -- -- -- 14
Purchase of common stock.......................... -- (1,248) (1,841) (1,248)
Deferred loan and financing costs................. (123) -- (3,313) (61)
-------- -------- -------- --------
Net cash provided by (used in)
financing activities.................... 34,813 13,333 62,262 13,268
-------- -------- -------- --------
NET INCREASE (DECREASE) IN CASH AND CASH
EQUIVALENTS....................................... 13,615 (4,997) 13,473 (6,613)
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD...... 3,473 11,002 3,615 12,618
-------- -------- -------- --------
CASH AND CASH EQUIVALENTS, END OF PERIOD............ $ 17,088 $ 6,005 $ 17,088 $ 6,005
======== ======== ======== ========
</TABLE>

See accompanying notes to consolidated financial statements.

F-29
<PAGE> 91

COSTILLA ENERGY, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 1998
(UNAUDITED)

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

The interim financial information as of June 30, 1998, and for the six
months ended June 30, 1998 and 1997, is unaudited. Certain information and
footnote disclosures normally included in financial statements prepared in
accordance with generally accepted accounting principles have been condensed or
omitted in this form 10-Q pursuant to the rules and regulations of the
Securities and Exchange Commission. However, in the opinion of management, these
interim financial statements include all the necessary adjustments to fairly
present the results of the interim periods and all such adjustments are of a
normal recurring nature. The interim consolidated financial statements should be
read in conjunction with the audited financial statements for the year ended
December 31, 1997.

Costilla Energy, Inc. ("Costilla" or the "Company") was incorporated in
Delaware in June 1996 to consolidate and continue the activities previously
conducted by Costilla Energy, L.L.C., a Texas limited liability company (the
"LLC"), and its wholly owned subsidiaries, to acquire the assets of CSL
Management Corporation (which owned certain office equipment used by the
Company), and to acquire the stock of Valley Gathering Company. Costilla was
formed for the purpose of conducting a $60 million initial public offering of
common stock and a $100 million senior notes offering (the "Offerings"), which
Offerings were completed in early October 1996.

The Company is an oil and gas exploration and production concern with
properties located principally in South and East Texas, the Rocky Mountains and
the Permian Basin regions of the United States.

2. DERIVATIVE FINANCIAL INSTRUMENTS

The Company utilizes derivative financial instruments to manage
well-defined commodity price and interest rate risks. The Company is exposed to
credit losses in the event of nonperformance by the counterparties to its
commodity hedges and its interest rate swap agreements. The Company only deals
with reputable financial institutions as counterparties and anticipates that
such counterparties will be able to fully satisfy their obligations under the
contracts. The Company does not obtain collateral or other security to support
financial instruments subject to credit risk but monitors the credit standing of
the counterparties.

Commodity Hedges. The Company utilizes put option contracts and costless
collars to hedge the effect of price changes on a portion of its future oil and
gas production. Premiums paid and amounts receivable under the put option
contracts are amortized and accrued to oil and gas sales, respectively. If
market prices of oil and gas exceed the strike price of put options, the options
will expire unexercised, therefore, reducing the effective price received for
oil and gas sales by the cost of the related option. Conversely, if market
prices of oil and gas decline below the strike price of put options, the options
will be exercised, therefore, increasing the effective price received for oil
and gas sales by the proceeds received from the related option.

The Company has established a costless collar for oil by purchasing put
options in August 1997 on 6,500 Bbls of oil per day which establish a floor
price of $18.50 per Bbl and selling call options on 6,500 Bbls of
F-30
<PAGE> 92
COSTILLA ENERGY, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS --(CONTINUED)

oil per day at $22.55 per Bbl. These oil option contracts continue through
August 1998. The referenced oil prices are based upon the price at which West
Texas Intermediate crude oil ("WTI") trades on the New York Mercantile Exchange
("NYMEX"). The Company has established a costless collar for gas by purchasing
put options on 40,000 Mmbtu of gas per day which establish a floor price of
$2.40 per Mmbtu and selling call options on 40,000 Mmbtu of gas per day at $2.55
per Mmbtu. These gas option contracts continue through October 1998. The
referenced gas prices are based upon the index price for Houston Ship Channel
gas sales. As of June 30, 1998 the Company had sold a put option on 40,000 Mmbtu
of gas per day at $2.00 per Mmbtu based upon the index price for Houston Ship
Channel gas sales during the months of September and October 1998.

Interest Rate Swap Agreements. The Company had an interest rate swap
agreement in place as of June 30, 1998 with a notional amount of $24 million, a
fixed rate of 7.5% and which will expire in January, 1999. Since the Company had
no material amount of floating rate debt outstanding at June 30, 1998, the
interest swap agreement did not qualify as a hedge and was marked to market with
the carrying value being a liability of approximately $313,000.

3. ACQUISITIONS

On August 28, 1997, the Company consummated the purchase from Ballard
Petroleum LLC ("Ballard") of certain oil and gas properties for an estimated
adjusted purchase price of approximately $41.2 million (the "Ballard
Acquisition"). The properties are located primarily in the Rocky Mountain region
of the United States. The transaction was accounted for using the purchase
method. The results of operations of the acquired properties are included in the
Consolidated Statements of Operations as of the acquisition closing date, August
28, 1997. In addition, the Company and Ballard have entered into an Acquisition
and Exploration Agreement that establishes an area of mutual interest in the
Rocky Mountain Region in which the parties will jointly own, acquire, explore
and develop properties.

PRO FORMA RESULTS OF OPERATIONS

The following table reflects the pro forma results of operations for the
six months ended June 30, 1997, as though the Ballard Acquisition occurred as of
January 1, 1997. The pro forma amounts are not necessarily indicative of results
that may be reported in the future.

<TABLE>
<CAPTION>
SIX MONTHS ENDED
JUNE 30, 1997
----------------
(IN THOUSANDS)
<S> <C>
Revenues.................................................... $41,936
Net income before extraordinary items....................... (163)
Net income per share before extraordinary items............. (0.02)
</TABLE>

4. LONG TERM DEBT

F-31
<PAGE> 93
COSTILLA ENERGY, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS --(CONTINUED)

the reduced borrowing base. The remaining balance is payable on August 28, 2002,
the maturity date of the Revolving Credit Facility. Under the Revolving Credit
Facility, the Company is obligated to pay certain fees to the lender, including
a commitment fee based on the unused portion of the commitment. The Revolving
Credit Facility contains customary restrictive covenants (including restrictions
on the payment of dividends and the incurrence of additional indebtedness) and
requires the Company to maintain (i) a current ratio of not less than 1.0 to
1.0, including amounts available under the Revolving Credit Facility and
excluding current maturities under the Revolving Credit Facility and the
Acquisition Credit Facility, (ii) a ratio of EBITDA to interest expense, for the
last twelve months as of the end of each quarter, of not less than 1.75 to 1
through December 31, 1998, 2.3 to 1 through December 31, 1999 and 2.5 to 1
thereafter and (iii) a minimum tangible net worth. Borrowings under the
Revolving Credit Facility are secured by substantially all of the assets of the
Company.

Contemporaneous with entering into the Revolving Credit Facility, the
Company also entered into a second credit agreement (the "Acquisition Credit
Facility") to provide the remaining financing for the Ballard Acquisition. The
Acquisition Credit Facility was a term loan in the amount of $30.0 million which
was repaid in full in connection with the sale of the 1998 Notes.

In October 1996, the Company issued $100 million aggregate principal amount
of 10.25% Senior Notes due October 1, 2006 (the "Notes"). The Notes were sold at
par and interest is payable April 1 and October 1, commencing April 1, 1997. The
Notes may not be redeemed prior to October 1, 2001, and thereafter at a premium
reducing to par, plus interest, by maturity. There is no mandatory redemption of
the Notes required prior to maturity. The Notes are general unsecured senior
obligations of the Company and rank equally in right of payment with all other
senior indebtedness of the Company and senior in right of payment of all
existing future subordinated indebtedness of the Company. The Notes are subject
to an Indenture between the Company and a trustee. The Indenture restricts,
among other things, the Company's ability to incur additional indebtedness, pay
dividends or make certain other restricted payments, incur liens, engage in any
sale and leaseback transaction, sell stock of subsidiaries, apply net proceeds
from certain assets sales, merge or consolidate with any other person, sell,
assign, transfer, lease, convey or otherwise dispose of substantially all of the
assets of the company, or enter into certain transactions with affiliates. Net
proceeds from the sale of the Notes of approximately $96.1 million were used to
repay existing indebtedness.

In January 1998, the Company issued an additional $80 million aggregate
principal amount of 10.25% Senior Notes due October 1, 2006 (the "1998 Notes").
The notes were sold at a premium (102.5%) and interest is payable April 1 and
October 1, commencing April 1, 1998. The 1998 Notes may not be redeemed prior to
October 1, 2001, and thereafter at a premium reducing to par, plus interest, by
maturity. The 1998 Notes are subject to the same terms and conditions as the
Notes. Net proceeds from the sale of the 1998 Notes of approximately $78.8
million were used to repay the Acquisition Credit Facility in full, all but
$500,000 of the Revolving Credit Facility and the remainder was used for general
corporate working capital needs.

5. CONVERTIBLE PREFERRED STOCK

On June 3, 1998 the Company closed a private placement of 50,000 shares of
its 7% (8% Paid in Kind) Series A Cumulative Convertible Preferred Stock (the
"Preferred Stock") to Enron Capital & Trade Resources Corp. and Joint Energy
Development Investments II Limited Partnership for a purchase price of $50.0
million (the "Convertible Preferred Stock Offering"). Dividends accrue and are
payable quarterly, commencing September 15, 1998, in cash, or in certain
instances in shares of the Company's Common Stock. The dividend rate is 7% for
dividends paid in cash and 8% for dividends paid in shares of Common Stock. The
holders of the Preferred Stock may, at any time, convert shares of Preferred
Stock into shares of the Company's Common Stock at a conversion price of $12.39
which, subject to certain adjustments, would result in the issuance of 4,035,513
shares of Common Stock upon conversion of the Preferred Stock. The Registrant

F-32
<PAGE> 94
COSTILLA ENERGY, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS --(CONTINUED)

may, at its option, redeem the shares of Preferred Stock after June 15, 2001,
subject to certain limitations, for a premium reducing to par on June 15, 2004
and thereafter. Net proceeds from the Convertible Preferred Stock Offering were
$48.0 million, of which $29.0 million was used to repay all but $0.5 million of
the Revolving Credit Facility and the remainder for general corporate purposes.

6. REPORTING COMPREHENSIVE INCOME

In June 1997, the FASB issued Statement of Accounting Standards No. 130
"Reporting Comprehensive Income" ("FAS 130") which establishes standards for
reporting and display of comprehensive income and its components in a full set
of general-purpose financial statements. Specifically, FAS 130 requires that an
enterprise (i) classify items of other comprehensive income by their nature in a
financial statement and (ii) display the accumulated balance of other
comprehensive income separately from retained earnings and additional paid-in
capital in the equity section of a statement of financial position. This
statement is effective for fiscal years beginning after December 15, 1997. The
Company has adopted the provisions of FAS 130 in its consolidated financial
statements for periods ending after December 31, 1997. The Company had no
financial instruments giving rise to comprehensive income during the three and
six month periods ended June 30, 1998.

Comprehensive income consists of the change in equity of a business
enterprise during a period from transactions and other events and circumstances
from nonowner sources. Specifically, this includes net income and other
comprehensive income, which is made up of certain changes in assets and
liabilities that are not reported in a statement of operations but are included
in the balances within a separate component of equity in a statement of
financial position. Such changes include, but are not limited to, unrealized
gains for marketable securities and future contracts, foreign currency
translation adjustments and minimum pension liability adjustments.

F-33
<PAGE> 95

INDEPENDENT AUDITORS' REPORT

The Board of Directors and Stockholders
Costilla Energy, Inc.:

We have audited the accompanying statements of revenues and direct
operating expenses of the Pioneer Acquisition (see Note 1) for the years ended
December 31, 1997, 1996 and 1995. The statements are the responsibility of the
Company's management. Our responsibility is to express an opinion on the
statements based on our audits.

We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the statements of revenues and direct
operating expenses are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements. An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as
evaluating the overall statement presentation. We believe that our audits
provide a reasonable basis for our opinion.

The accompanying statements of revenues and direct operating expenses were
prepared for the purpose of complying with the rules and regulations of the
Securities and Exchange Commission (for inclusion in the Proxy Statement of
Costilla Energy, Inc. as described in Note 1) and is not intended to be a
complete presentation of the Pioneer Acquisition interests' revenues and
expenses.

In our opinion, the statements of revenues and direct operating expenses
referred to above present fairly, in all material respects, the revenues and
direct operating expenses of the Pioneer Acquisition for the years ended
December 31, 1997, 1996 and 1995, in conformity with generally accepted
accounting principles.

KPMG PEAT MARWICK LLP

Midland, Texas
October 9, 1998

F-34
<PAGE> 96

COSTILLA ENERGY, INC.
PIONEER ACQUISITION

STATEMENTS OF REVENUES AND DIRECT OPERATING EXPENSES
(IN THOUSANDS)

<TABLE>
<CAPTION>
(UNAUDITED)
SIX MONTHS ENDED
YEAR ENDED YEAR ENDED YEAR ENDED JUNE 30,
DECEMBER 31, DECEMBER 31, DECEMBER 31, -----------------
1997 1996 1995 1998 1997
------------ ------------ ------------ ------- -------
<S> <C> <C> <C> <C> <C>
REVENUES:
Oil.................................... $ 53,818 $ 55,672 $40,695 $19,748 $27,372
Natural gas............................ 90,517 90,912 45,695 32,123 46,611
Natural gas liquids.................... 4,368 2,315 1,880 3,332 791
-------- -------- ------- ------- -------
148,703 148,899 88,270 55,203 74,774
-------- -------- ------- ------- -------
DIRECT OPERATING EXPENSES:
Lease operating........................ 31,041 25,915 24,385 15,331 15,357
Workovers.............................. 3,821 2,516 2,339 748 1,815
Production taxes....................... 7,966 7,431 5,095 3,143 3,912
-------- -------- ------- ------- -------
42,828 35,862 31,819 19,222 21,084
-------- -------- ------- ------- -------
OPERATING INCOME......................... 105,875 113,037 56,451 35,981 53,690
NET REVENUES FROM GAS PLANTS............. 3,127 2,283 1,537 1,192 1,534
-------- -------- ------- ------- -------
REVENUES IN EXCESS OF DIRECT OPERATING
EXPENSES............................... $109,002 $115,320 $57,988 $37,173 $55,224
======== ======== ======= ======= =======
</TABLE>

See the accompanying notes to these statements.

F-35
<PAGE> 97

COSTILLA ENERGY, INC.
PIONEER ACQUISITION

NOTES TO THE STATEMENTS OF REVENUES AND DIRECT OPERATING EXPENSES

(1) BASIS OF PRESENTATION

On September 4, 1998 Costilla Energy, Inc., (the "Company") executed a
Purchase and Sale Agreement (the "Acquisition Agreement") to acquire from
Pioneer Natural Resources USA, Inc. ("Pioneer") certain oil and gas properties
(the "Pioneer Acquisition") for approximately $410 million. The Pioneer
Acquisition is scheduled to close on or about December 15, 1998. The
accompanying statements of revenues and direct operating expenses for the
Pioneer Acquisition do not include general and administrative expenses, interest
income or expense, a provision for depreciation, depletion and amortization, or
any provision for income taxes since historical expenses of this nature incurred
by Pioneer are not necessarily indicative of the costs to be incurred by the
Company.

Historical financial information reflecting financial position, results of
operations, and cash flows of the Pioneer Acquisition were not available and are
not presented because the purchase price was assigned to the oil and gas
property interests acquired. Other assets acquired and liabilities assumed were
not material. Accordingly, the historical statements of revenues and direct
operating expenses of the Pioneer Acquisition are presented in lieu of the
financial statements required under Rule 3-05 of Securities and Exchange
Commission Regulation S-X.

Revenues in the accompanying statements of revenues and direct operating
expenses are recognized on the sales method. Under this method, revenues are
recognized based on actual volumes of oil and natural gas sold to purchasers.
Direct operating expenses are recognized on the accrual method.

Preparation of the accompanying statements of revenues and direct operating
expense requires management to make estimates and assumptions that affect the
reported amounts of revenues and direct operating expenses during the reporting
period. Actual results could differ from those estimates.

Interim Statements of Revenues and Direct Operating Expenses

The interim financial information for the periods ended June 30, 1998 and
1997, is unaudited. However, in the opinion of management, the interim
statements of revenues and direct operating expenses include all the necessary
adjustments to fairly present the results of the interim periods and all such
adjustments are of a normal recurring nature. The interim statements of revenues
and direct operating expenses should be read in conjunction with the audited
statements of revenues and direct operating expenses for the years ended
December 31, 1997, 1996 and 1995.

(2) COMMITMENTS AND CONTINGENCIES

Under the Acquisition Agreement, the Company assumes responsibility for all
duties, claims and liabilities related to the properties acquired regardless of
when such duties, claims or liabilities arose or arise. The Company has agreed
to indemnify Pioneer with respect to all such duties, claims and liabilities.
Upon closing of the Pioneer Acquisition, the Company also becomes responsible
and liable for certain litigation associated with the properties acquired,
although the Company believes that such litigation is not material. The Company
is conducting a due diligence review of the properties acquired in part to
identify the assumed liabilities. However, due to the number of properties
acquired and the scope of the assumed liabilities, there may be significant
obligations which are unknown prior to closing the Pioneer Acquisition. Such
unknown liabilities may have a material adverse effect on the future operating
results of the Pioneer Acquisition.

F-36
<PAGE> 98
COSTILLA ENERGY, INC.
PIONEER ACQUISITION

NOTES TO THE STATEMENTS OF REVENUES AND DIRECT
OPERATING EXPENSES -- (CONTINUED)

(3) SUPPLEMENTARY FINANCIAL INFORMATION FOR OIL AND GAS PRODUCING ACTIVITIES
(UNAUDITED)

Estimated Quantities of Proved Oil and Gas Reserves

Reserve information presented below for the Pioneer Acquisition, as of
January 1, 1995, December 31, 1995, December 31, 1996 and December 31,1997, is
based on reserve estimates prepared by the Company's engineers, using prices and
costs in effect at that date. Changes in reserve estimates were derived by
adjusting such quantities and values for actual production using historical
prices and costs.

Proved reserves are estimated quantities of crude oil and natural gas which
geological and engineering data demonstrate with reasonable certainty to be
recoverable in future years from known reservoirs under existing economic and
operating conditions. Proved developed reserves are those which are expected to
be recovered through existing wells with existing equipment and operating
methods. Oil and gas reserve quantity estimates are subject to numerous
uncertainties inherent in the estimation of quantities of proved reserves and in
the projection of future rates of production and the timing of development
expenditures. The accuracy of such estimates is a function of the quality of
available data and of engineering and geological interpretation and judgment.
Results of subsequent drilling, testing and production may cause either upward
or downward revision of previous estimates. Further, the volumes considered to
be commercially recoverable fluctuate with changes in prices and operating
costs. The Company emphasizes that reserve estimates are inherently imprecise
and that estimates of new discoveries are more imprecise than those of currently
producing oil and gas properties. Accordingly, these reserve estimates are
expected to change as additional information becomes available in the future.

Below are the net estimated quantities of proved reserves and proved
developed reserves for the Pioneer Acquisition.

<TABLE>
<CAPTION>
OIL NGL'S GAS
(MBBLS) (MBBLS) (MMCF)
------- ------- -------
<S> <C> <C> <C>
Proved reserves at January 1, 1995.......................... 34,103 9,636 351,571
Revisions of previous estimates............................. 1,196 548 25,152
Production.................................................. (2,397) (173) (30,338)
------ ------ -------
Proved reserves at December 31, 1995........................ 32,902 10,011 346,385
Revisions of previous estimates............................. 2,167 781 13,495
Production.................................................. (2,666) (129) (39,102)
------ ------ -------
Proved reserves at December 31, 1996........................ 32,403 10,663 320,778
Revisions of previous estimates............................. (265) (876) (14,373)
Production.................................................. (2,827) (345) (38,021)
------ ------ -------
Proved reserves at December 31, 1997........................ 29,311 9,442 268,384
====== ====== =======
Proved developed reserves at December 31, 1997.............. 24,435 5,337 231,843
====== ====== =======
</TABLE>

Standardized Measure of Discounted Future Net Cash Flows of Proved Oil and Gas
Reserves

The Company has estimated the standardized measure of discounted future net
cash flows and changes therein relating to proved oil and gas reserves in
accordance with the standards established by the Financial Accounting Standards
Board through its Statement No. 69. The estimates of future cash flows and
future production and development costs are based on year-end sales prices for
oil and gas, estimated future production of proved reserves, and estimated
future production and development costs of proved reserves, based on current
costs and economic conditions. The estimated future net cash flows are then
discounted at a rate of 10%.

F-37
<PAGE> 99
COSTILLA ENERGY, INC.
PIONEER ACQUISITION

NOTES TO THE STATEMENTS OF REVENUES AND DIRECT
OPERATING EXPENSES -- (CONTINUED)

Discounted future net cash flow estimates like those shown below are not
intended to represent estimates of the fair market value of oil and gas
properties. Estimates of fair market value should also consider probable
reserves, anticipated future oil and gas prices, interest rates, changes in
development and production costs, risks associated with future production and a
provision for future income taxes. Because of these and other considerations,
any estimate of fair market value is necessarily subjective and imprecise.

The following are the Company's estimated standardized measure of
discounted future net cash flows from proved reserves attributable to the
Pioneer Acquisition as of December 31, 1997, 1996 and 1995 (in thousands):

<TABLE>
<CAPTION>
DECEMBER 31
------------------------------------
1997 1996 1995
---------- ---------- ----------
<S> <C> <C> <C>
Future:
Cash inflows................................... $1,094,998 $1,889,918 $1,443,566
Production costs............................... (397,856) (568,699) (478,246)
Development costs.............................. (68,262) (65,105) (63,625)
---------- ---------- ----------
Net cash flows before income taxes..... 628,880 1,256,114 901,695
10% annual discount for estimated timing of
cash flows.................................. (267,449) (568,710) (375,419)
---------- ---------- ----------
Standardized measure of discounted future net
cash flows before income taxes.............. $ 361,431 $ 687,404 $ 526,276
========== ========== ==========
</TABLE>

The following are the sources of changes in the standardized measure of
discounted net cash flows for the years ended December 31, 1997, 1996 and 1995
(in thousands):

<TABLE>
<CAPTION>
DECEMBER 31
--------------------------------
1997 1996 1995
--------- --------- --------
<S> <C> <C> <C>
Increases (decreases)
Accretion of discount............................ $ 68,740 $ 52,628 $ 43,625
Net change in sales prices net of production
costs......................................... (280,271) 218,089 97,302
Changes in estimated future development costs.... (1,814) (810) (1,975)
Changes in production rates (timing) and other... 10,221 (34,665) (25,715)
Revision of quantity estimates................... (16,974) 38,923 33,236
Sales net of production costs.................... (105,875) (113,037) (56,451)
--------- --------- --------
Net increase (decrease).................. (325,973) 161,128 90,022
Standardized measure of discounted future net
cash flows:
Beginning of year........................ 687,404 526,276 436,254
--------- --------- --------
End of year.............................. $ 361,431 $ 687,404 $526,276
========= ========= ========
</TABLE>

F-38
<PAGE> 100

INDEPENDENT AUDITORS' REPORT

The Board of Directors and Stockholders
Costilla Energy, Inc.:

We have audited the accompanying statement of revenues and direct operating
expenses of the Ballard Acquisition (see Note 1) for the year ended December 31,
1996. The statement is the responsibility of the Company's management. Our
responsibility is to express an opinion on the statement based on our audit.

We conducted our audit in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the statement of revenues and direct
operating expenses is free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements. An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as
evaluating the overall statement presentation. We believe that our audit
provides a reasonable basis for our opinion.

The accompanying statement of revenues and direct operating expenses was
prepared for the purpose of complying with the rules and regulations of the
Securities and Exchange Commission (for inclusion in Form S-4 of Costilla
Energy, Inc. as described in Note 1) and is not intended to be a complete
presentation of the Ballard Acquisition interests' revenues and expenses.

In our opinion, the statement of revenues and direct operating expenses
referred to above presents fairly, in all material respects, the revenues and
direct operating expenses of the Ballard Acquisition for the year ended December
31, 1996, in conformity with generally accepted accounting principles.

KPMG PEAT MARWICK LLP

Midland, Texas
November 7, 1997

F-39
<PAGE> 101

COSTILLA ENERGY, INC.

BALLARD ACQUISITION

STATEMENTS OF REVENUES AND DIRECT OPERATING EXPENSES
(IN THOUSANDS)

<TABLE>
<CAPTION>
(UNAUDITED)
SIX MONTHS ENDED
YEAR ENDED JUNE 30,
DECEMBER 31, ----------------
1996 1997 1996
------------ ------ ------
<S> <C> <C> <C>
REVENUES:
Oil....................................................... $ 9,833 $4,553 $4,540
Natural gas............................................... 1,481 1,571 853
------- ------ ------
11,314 6,124 5,393
------- ------ ------
DIRECT OPERATING EXPENSES:
Lease operating........................................... 2,453 1,465 1,099
Workovers................................................. 417 290 406
Production taxes.......................................... 732 402 325
------- ------ ------
3,602 2,157 1,830
------- ------ ------
REVENUES IN EXCESS OF DIRECT OPERATING EXPENSES............. $ 7,712 $3,967 $3,563
======= ====== ======
</TABLE>

See the accompanying notes to these statements.

F-40
<PAGE> 102

COSTILLA ENERGY, INC.

BALLARD ACQUISITION

NOTES TO THE STATEMENTS OF REVENUES AND
DIRECT OPERATING EXPENSES

(1) BASIS OF PRESENTATION

On August 28, 1997 Costilla Energy, Inc., (the "Company") acquired from
Ballard Petroleum, LLC certain oil and gas properties (the "Ballard
Acquisition") for approximately $41.2 million. The accompanying statements of
revenues and direct operating expenses for the Ballard Acquisition do not
include general and administrative expenses, interest income or expense, a
provision for depreciation, depletion and amortization, or any provision for
income taxes since historical expenses of this nature incurred by Ballard are
not necessarily indicative of the costs to be incurred by the Company.

Historical financial information reflecting financial position, results of
operations, and cash flows of the Ballard Acquisition were not available and are
not presented because the purchase price was assigned to the oil and gas
property interests acquired. Other assets acquired and liabilities assumed were
not material. Accordingly, the historical statements of revenues and direct
operating expenses of the Ballard Acquisition are presented in lieu of the
financial statements required under Rule 3-05 of Securities and Exchange
Commission Regulation S-X.

Interim Statements of Revenues and Direct Operating Expenses

The interim financial information for the periods ended June 30, 1997 and
1996, is unaudited. However, in the opinion of management, the interim
statements of revenues and direct operating expenses include all the necessary
adjustments to fairly present the results of the interim periods and all such
adjustments are of a normal recurring nature. The interim statements of revenues
and direct operating expenses should be read in conjunction with the audited
statement of revenues and direct operating expenses for the year ended December
31, 1996.

(2) SUPPLEMENTARY FINANCIAL INFORMATION FOR OIL AND GAS PRODUCING ACTIVITIES
(UNAUDITED)

Estimated Quantities of Proved Oil and Gas Reserves

Reserve information presented below for the Ballard Acquisition, as of
January 1, 1996 and December 31, 1996, is based on reserve estimates prepared by
the Company's engineers, using prices and costs in effect at that date. Changes
in reserve estimates were derived by adjusting such quantities and values for
actual production using historical prices and costs.

F-41
<PAGE> 103
COSTILLA ENERGY, INC.

BALLARD ACQUISITION

NOTES TO THE STATEMENTS OF REVENUES AND
DIRECT OPERATING EXPENSES -- (CONTINUED)

changes in prices and operating costs. The Company emphasizes that reserve
estimates are inherently imprecise and that estimates of new discoveries are
more imprecise than those of currently producing oil and gas properties.
Accordingly, these reserve estimates are expected to change as additional
information becomes available in the future.

Below are the net estimated quantities of proved reserves and proved
developed reserves for the Ballard Acquisition.

<TABLE>
<CAPTION>
OIL GAS
(MBBLS) (MMCF)
------- ------
<S> <C> <C>
Proved reserves at January 1, 1996.......................... 4,746 10,529
Extensions and discoveries.................................. 18 2,457
Production.................................................. (510) (651)
----- ------
Proved reserves at December 31, 1996........................ 4,254 12,335
===== ======
Proved developed reserves at December 31, 1996.............. 4,138 9,878
===== ======
</TABLE>

Standardized Measure of Discounted Future Net Cash Flows of Proved Oil and Gas
Reserves

Discounted future net cash flow estimates like those shown below are not
intended to represent estimates of the fair market value of oil and gas
properties. Estimates of fair market value should also consider probable
reserves, anticipated future oil and gas prices, interest rates, changes in
development and production costs and risks associated with future production.
Because of these and other considerations, any estimate of fair market value is
necessarily subjective and imprecise.

The following are the Company's estimated standardized measure of
discounted future net cash flows from proved reserves attributable to the
Ballard Acquisition as of December 31, 1996 (in thousands):

<TABLE>
<S> <C>
Future:
Cash inflows.............................................. $143,236
Production costs.......................................... (46,312)
Development costs......................................... (871)
--------
Net cash flows before income taxes................ 96,053
10% annual discount for estimated timing of cash flows...... (34,735)
--------
Standardized measure of discounted future net cash flows
before income taxes....................................... $ 61,318
========
</TABLE>

F-42
<PAGE> 104
COSTILLA ENERGY, INC.

BALLARD ACQUISITION

NOTES TO THE STATEMENTS OF REVENUES AND
DIRECT OPERATING EXPENSES -- (CONTINUED)

The following are the sources of changes in the standardized measure of
discounted net cash flows for the year ended December 31, 1996 (in thousands):

<TABLE>
<S> <C>
Standardized measure, January 1, 1996....................... $32,538
Extensions and discoveries, net of development costs........ 5,452
Sales, net of production costs.............................. (7,712)
Net change in prices........................................ 29,762
Accretion of discount....................................... 3,254
Other....................................................... (1,976)
-------
Standardized measure, December 31, 1996..................... $61,318
=======
</TABLE>

F-43
<PAGE> 105

INDEPENDENT AUDITORS' REPORT

The Board of Directors and Stockholders
Costilla Energy, Inc.:

We have audited the accompanying statement of revenues and direct operating
expenses of the 1995 Acquisition (see Note 1) for the period ended June 12,
1995. The statement is the responsibility of the Company's management. Our
responsibility is to express an opinion on the statement based on our audit.

In our opinion, the statement of revenues and direct operating expenses
referred to above presents fairly, in all material respects, the revenues and
direct operating expenses of the 1995 Acquisition for the period ended June 12,
1995, in conformity with generally accepted accounting principles.

KPMG PEAT MARWICK LLP

Midland, Texas
July 4, 1996

F-44
<PAGE> 106

COSTILLA ENERGY, INC.

1995 ACQUISITION

STATEMENT OF REVENUES AND DIRECT OPERATING EXPENSES
(IN THOUSANDS)

<TABLE>
<CAPTION>
PERIOD ENDED
JUNE 12,
1995
------------
<S> <C>
REVENUES:
Oil....................................................... $ 7,572
Natural gas............................................... 3,358
-------
10,930
-------
DIRECT OPERATING EXPENSES:
Lease operating........................................... 4,550
Workovers and dry hole costs.............................. 109
Production taxes.......................................... 923
-------
5,582
-------
REVENUES IN EXCESS OF DIRECT OPERATING EXPENSES............. $ 5,348
=======
</TABLE>

See the accompanying notes to this statement.

F-45
<PAGE> 107

COSTILLA ENERGY, INC.

1995 ACQUISITION

NOTES TO THE STATEMENT OF REVENUES AND
DIRECT OPERATING EXPENSES

(1) BASIS OF PRESENTATION

On June 12, 1995 Costilla Energy, Inc., formerly Costilla Energy, L.L.C.
and Costilla Petroleum Company (collectively, the "Company") acquired from
Parker & Parsley Development L.P. and Parker & Parsley Producing L.P.
(collectively, "Parker & Parsley") certain oil and gas properties (the "1995
Acquisition") for $46,621,371. The accompanying statement of revenues and direct
operating expenses for the 1995 Acquisition do not include general and
administrative expenses, interest income or expense, a provision for
depreciation, depletion and amortization, or any provision for income taxes
since historical expenses of this nature incurred by Parker & Parsley are not
necessarily indicative of the costs to be incurred by the Company.

Historical financial information reflecting financial position, results of
operations, and cash flows of the 1995 Acquisition are not presented because the
purchase price was assigned to the oil and gas property interests acquired.
Other assets acquired and liabilities assumed were not material. Accordingly,
the historical statement of revenues and direct operating expenses of the 1995
Acquisition is presented in lieu of the financial statements required under Rule
3-05 of Securities and Exchange Commission Regulation S-X.

Revenues in the accompanying statement of revenues and direct operating
expenses are recognized on the sales method. Under this method, revenues are
recognized based on actual volumes of oil and natural gas sold to purchasers.
Direct operating expenses are recognized on the accrual method.

(2) SUPPLEMENTARY FINANCIAL INFORMATION FOR OIL AND GAS PRODUCING ACTIVITIES
(UNAUDITED)

Estimated Quantities of Proved Oil and Gas Reserves

Reserve information presented below for the 1995 Acquisition is based on
reserve estimates prepared by the Company's engineers, using prices and costs in
effect at June 12, 1995. Changes in reserve estimates were derived by adjusting
such quantities and values for actual production using historical prices and
costs.

F-46
<PAGE> 108
COSTILLA ENERGY, INC.

1995 ACQUISITION

NOTES TO THE STATEMENT OF REVENUES AND
DIRECT OPERATING EXPENSES -- (CONTINUED)

Below are the net estimated quantities of proved reserves and proved
developed reserves for the 1995 Acquisition.

<TABLE>
<CAPTION>
OIL GAS
(MBBLS) (MMCF)
------- ------
<S> <C> <C>
Proved reserves at January 1, 1995.......................... 7,534 46,507
Production.................................................. (479) (2,405)
----- ------
Proved reserves at June 12, 1995............................ 7,055 44,102
===== ======
Proved developed reserves at June 12, 1995.................. 6,707 38,151
===== ======
</TABLE>

Standardized Measure of Discounted Future Net Cash Flows of Proved Oil and Gas
Reserves

Discounted future net cash flow estimates like those shown below are not
intended to represent estimates of the fair market value of oil and gas
properties. Estimates of fair market value should also consider probable
reserves, anticipated future oil and gas prices, interest rates, changes in
development and production costs and risks associated with future production.
Because of these and other considerations, any estimate of fair market value is
necessarily subjective and imprecise.

The following are the Company's estimated standardized measure of
discounted future net cash flows from proved reserves attributable to the 1995
Acquisition as of June 12, 1995 (in thousands):

<TABLE>
<S> <C>
Future:
Cash inflows.............................................. $191,758
Production costs.......................................... (93,268)
Development costs......................................... (4,797)
--------
Net cash flows before income taxes................ 93,693
10% annual discount for estimated timing of cash flows...... (33,074)
--------
Standardized measure of discounted future net cash flows
before income taxes....................................... $ 60,619
========
</TABLE>

The following are the sources of changes in the standardized measure of
discounted net cash flows for the period ended June 12, 1995 (in thousands):

<TABLE>
<S> <C>
Standardized measure, January 1, 1995....................... $55,670
Sales, net of production costs.............................. (5,348)
Net change in prices........................................ 8,032
Accretion of discount....................................... 2,517
Other....................................................... (252)
-------
Standardized measure, June 12, 1995......................... $60,619
=======
</TABLE>

F-47
<PAGE> 109
PRELIMINARY COPY

PROXY

COSTILLA ENERGY, INC.

THIS PROXY IS SOLICITED BY THE BOARD OF DIRECTORS AND MAY BE

REVOKED PRIOR TO ITS EXERCISE

The undersigned hereby appoints Cadell S. Liedtke, Michael J. Grella
and Henry G. Musselman and each of them, with full power of substitution, to act
as attorneys and proxies for the undersigned and to vote all shares of Common
Stock of Costilla Energy, Inc. (the "Company") which the undersigned is entitled
to vote at the Special Meeting of Stockholders to be held on ______________,
1998 at 10:00 a.m., local time, and at any adjournments or postponements
thereof, on the matters set forth in the Notice of Special Meeting of
Stockholders and Proxy Statement dated _____________, 1998 (the "Proxy
Statement"), as follows:

<TABLE>
<CAPTION>
Proposal No. 1: The Charter Amendment to amend the Company's Certificate of
Incorporation to increase the number of shares of authorized
Common Stock from 20 million shares to 100 million shares
(as further described in the Proxy Statement).
<S> <C>
FOR [ ]

AGAINST [ ]

ABSTAIN [ ]
</TABLE>

<TABLE>
<CAPTION>
Proposal No. 2: The Stock Issuance to approve the issuance of up to 250,000
of Convertible Preferred Stock and up to 35 million shares
of Common Stock and the potential issuance of an
indeterminable number of shares of Common Stock in payment
of dividends on and upon conversion of the Convertible
Preferred Stock (as further described in the Proxy
Statement).
<S> <C>
FOR [ ]

AGAINST [ ]

ABSTAIN [ ]
</TABLE>

<PAGE> 110

<TABLE>
<CAPTION>
Proposal No. 3: The Plan Amendment to amend the Company's 1996 Stock Option
Plan to increase the number of shares of Common Stock
authorized and reserved for issuance under the plan (as
further described in the Proxy Statement).
<S> <C>
FOR [ ]

AGAINST [ ]

ABSTAIN [ ]
</TABLE>

THIS PROXY WILL BE VOTED AS DIRECTED, BUT IF NO INSTRUCTIONS ARE
SPECIFIED, IT WILL BE VOTED IN FAVOR OF THE PROPOSALS SHOWN ABOVE. IF ANY OTHER
BUSINESS IS PRESENTED AT SUCH MEETING, THIS PROXY WILL BE VOTED BY THE PROXY
HOLDERS IN THEIR BEST JUDGMENT. AT THE PRESENT TIME, THE BOARD OF DIRECTORS
KNOWS OF NO OTHER BUSINESS TO BE PRESENTED AT THE MEETING.

This Proxy should be dated, signed by the Stockholder exactly as his
name appears on this Proxy, and returned promptly in the enclosed envelope.
PERSONS SIGNING IN A FIDUCIARY CAPACITY SHOULD SO INDICATE, AND JOINT OWNERS
SHOULD EACH SIGN. By signing below, the undersigned acknowledges receipt from
the Company of the Proxy Statement.

Dated: , 1998.
---------------------------
Signed:

-------------------------------------------

PROXIES MUST BE SIGNED AND DATED TO BE VALID
<PAGE> 111

PIONEER 1998 DIVESTITURE PACKAGE

PURCHASE AND SALE AGREEMENT

by and between

PIONEER NATURAL RESOURCES USA, INC.

as Seller

and

COSTILLA ENERGY, INC.

as Purchaser
<PAGE> 112
TABLE OF CONTENTS

<TABLE>
ARTICLE 1. SALE AND PURCHASE
<S> <C>
Effective Time. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Sale and Purchase. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Excluded Assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Defined Terms. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

ARTICLE 2. CONSIDERATION

Consideration. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
Manner of Payment. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
Like Kind Exchange Option. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Performance Deposit. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Allocations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

ARTICLE 3. DEFECTS

Definition of Acceptable Title. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Definition of Permitted Encumbrances. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Environmental and Physical Assessment. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
Identified Claims. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
Notice of Defects. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
Remedy for Defects. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
Special Defects. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
Preferential Purchase Rights and Consents to Assign. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

ARTICLE 4. SELLER'S REPRESENTATIONS AND DISCLAIMERS

Existence. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
Power. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
Authorization. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
Brokers. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
Foreign Person. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
Permits. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
Compliance with Law. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
Taxes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
Litigation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
LIMITATION AND DISCLAIMER OF REPRESENTATIONS AND WARRANTIES . . . . . . . . . . . . . . . . . . . . . . . . . . 24
</TABLE>

<PAGE> 113
<TABLE>
ARTICLE 5. REPRESENTATIONS, WARRANTIES AND COVENANTS OF PURCHASER
<S> <C>
Existence. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
Power. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
Authorization. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
Brokers. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
Investment Intent. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
Due Diligence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
Sophisticated Buyer. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
Economic Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
Financing. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
Accredited Investor. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26

ARTICLE 5A. ADDITIONAL COVENANTS

Maintenance of Assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
No Encumbrances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
Operations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
Access to Records. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
Permissions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29

ARTICLE 6. SELLER'S CONDITIONS OF CLOSING

Representations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
Performance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
Officer's Certificate. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
Pending Matters. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
HSR Act. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

ARTICLE 7. PURCHASER'S CONDITIONS OF CLOSING

HSR Act. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
Officer's Certificate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
Seller's Performance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

ARTICLE 8. CLOSING.

Time and Place of Closing. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
Closing Obligations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
Shareholder and Board Approval of Transaction; Closing Date Extension . . . . . . . . . . . . . . . . . . . . . 31
</TABLE>

<PAGE> 114
<TABLE>
ARTICLE 9. POST-CLOSING OBLIGATIONS
<S> <C>
Receipts and Credits; Suspense Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
Costs and Liabilities; Indemnity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
Further Assurances. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
Delivery of Records. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
Access to Data and Records. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
Purchaser's Release of Seller. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
Retroactive Effect. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
Inducement to Seller. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
Purchaser's Indemnity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
Related Agreements. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
Litigation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
Evidence of Compliance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
Seller's Indemnity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
Release of Liens. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40

ARTICLE 10. TERMINATION

Right of Termination. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
Effect of Termination. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41

ARTICLE 11. TAXES

Apportionment of Ad Valorem and Property Taxes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
Sales Taxes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
Other Taxes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
Cooperation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42

ARTICLE 12. PHYSICAL CONDITION OF THE ASSETS

Prior Use of Assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
Assumption of Assets in Present Condition. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
Casualty Loss. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
</TABLE>

<PAGE> 115
<TABLE>
ARTICLE 13. MISCELLANEOUS
<S> <C>
Governing Law. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
Entire Agreement. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
Waiver. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
Captions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
Assignability. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
Notices. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
DTPA Waiver. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
Expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
Severability. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
Damages. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
No Third Party Beneficiary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
Survival. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
Counterparts. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
Not to be Construed Against Drafter. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
Waiver of Jury Trial. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
Publicity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
Accounting. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
Operatorship. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48
HSR Act. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
Seller's Employees. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
Time of Performance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
No Partnership Created. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
Express Negligence Rule; Conspicuousness. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
Arbitration. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
Filing and Recording. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
</TABLE>

Exhibit "A" Subject Properties
Exhibit "A-I" Alongside Interests
Exhibit "B" Form of Assignment and Bill of Sale
Exhibit "C" Lands
Schedule 1 to Exhibit "A" Compressor Inventory List (GC Only)
Schedule 2 to Exhibit "A" Non-leasehold Equipment (GC Only)
Schedule 3 to Exhibit "A" Victoria Office & Yard (GC Only)
Schedule 4 to Exhibit "A" Undeveloped Leasehold (All)
Schedule 5 to Exhibit "A" Vehicle Report (All)
Schedule 6 to Exhibit "A" Gas Plants (PB & MC)
Schedule 3.1 Warwink Wells
Schedule 3.6A ARIES Proved Developed Producing
Schedule 3.6B NonARIES Producing Mineral Wells
Schedule 4.9 Litigation Schedule
Schedule 9.11 Purchaser Assumed Litigation
Schedule 13.24 Arbitration

<PAGE> 116

PURCHASE AND SALE AGREEMENT

This PURCHASE AND SALE AGREEMENT (this "Agreement") is made this 4th
day of September 1998, by and between PIONEER NATURAL RESOURCES USA, INC., a
Delaware corporation ("Seller"), and COSTILLA ENERGY, INC., a Delaware
Corporation ("Purchaser").

RECITALS:

WHEREAS, on the terms and conditions provided in this Agreement,
Seller has agreed to sell and Purchaser has agreed to purchase certain of
Seller's interests in certain oil and gas leases, agreements, contracts, real
property, personal property, equipment and related rights hereinafter defined.

NOW, THEREFORE, for good and valuable consideration and for the mutual
covenants contained herein, Seller and Purchaser hereby agree as follows:

ARTICLE 1. SALE AND PURCHASE

1.1. Effective Time. The effective time and date of the purchase
and sale contemplated hereby shall be 7:00 a.m. October 1, 1998 at the site of
the respective Subject Properties as defined below (the "Effective Time").

1.2. Sale and Purchase. Subject to the terms and conditions herein
contained, at Closing, as defined below, and effective as of the Effective Time,
Seller shall sell, assign, transfer and convey to Purchaser, and Purchaser shall
purchase, accept and receive, the right, title, and interest, if any, of Seller
as of the Effective Time [and, as to 1.2(a) below (the "Sale Interest")] in and
to the following described assets, less and except the Excluded Assets (the
"Assets"):

(a) the oil, gas and mineral leases and leasehold interests
appurtenant to the wells and/or Units described in Exhibit
"A" attached hereto and incorporated herein to the extent and
only to the extent they cover the lands described on Exhibit
C attached hereto together with Seller's interest in any
pooled, communitized or unitized acreage to the extent and
only to the extent any such interest directly pertains to such
wells and lands and all of the rights appurtenant thereto (the
"Subject Properties") (said interests to include all of the
lands covered by said leases appurtenant to the wells on
Exhibit "A" except in the instance(s) where Seller has
retained a well on or other rights or interests in said leases
and

<PAGE> 117

leaseholds in which event Purchaser shall receive the
pro-ration acreage attributable to the affected well(s) listed
on Exhibit "A" (or other minimum spacing unit or acreage
applicable) or such other lands as Purchaser and Seller may
agree, said lands to be described on Exhibit "A" to the
Assignment and Bill of Sale.);

(b) to the extent, and only to the extent, attributable or
allocable to the Subject Properties: (1) all wells (including,
but not limited to, the wells described in Exhibit "A" and all
other oil, gas, injection and water wells whether plugged or
unplugged and whether abandoned or not) ("Wells"), equipment,
gathering pipelines, gas facilities, gathering systems,
gathering, storage, distribution, treating, processing and
disposal facilities and tanks, tools, buildings, and all other
real or tangible personal property and fixtures which, as to
each of the foregoing items, are located on or directly and
solely related to the Subject Properties, including, without
limitation, items of personal property described in Schedules
1, and 2, to Exhibit "A", and specifically including portable
tools, snow vehicles, equipment, inventory, and the vehicles
listed on Schedule 5 to Exhibit "A" (collectively, the
"Rolling Stock") used exclusively on or exclusively
appurtenant to the Subject Properties or the Wells but except
as provided above, excluding personal property not solely
appurtenant to the Wells and personal property temporarily
located on the Subject Properties; (2) all oil, gas, mineral
and other hydrocarbon substances produced, saved and sold on
or after the Effective Time; (3) to the extent the same are
assignable or transferable by Seller, all orders, contracts,
title opinions and documents, abstracts of title, leases,
deeds, unitization agreements, pooling agreements, operating
agreements, division of interest statements, participation
agreements, gas purchase, sale transportation and processing
agreements and all other agreements and instruments; (4) all
surface leasehold and surface fee estates (but only to the
extent overlying and within the boundaries of the lands
comprising the Subject Properties or exclusively appurtenant
to or exclusively held and exclusively used in connection with
the operations of the Subject Properties), easements,
rights-of- way, licenses, authorizations, permits and similar
rights and interests, limited by and subject to the rights,
conditions and restrictions of third parties; (5) to the
extent assignable and limited by and subject to the rights of
third parties, lease files, land files, operating files, well
files, oil and gas sales contract files, gas processing files,
logs, test data, production histories, division order files,
abstracts, title files and materials, and all other books,
files and records (the "Records"), and all rights thereto,
limited by and subject to the rights of third parties; (6) all
other rights, privileges, benefits and powers conferred upon
the owner and holder of interests in the Subject Properties;
(7) all other interests in oil, gas and other minerals of
whatever nature directly appurtenant to the Subject
Properties, including, without limitation, all fee mineral and
royalty interests, reversionary interests, farmout rights and
overriding royalty interests; (8) a license, on Seller's
customary terms,

<PAGE> 118

to all existing seismic and geophysical raw data possessed by
Seller on the Effective Time, wholly owned by Seller, to the
extent and only to the extent covering the area directly
within the boundaries of the Subject Properties or within one
mile of the Subject Properties (but only to the extent it does
not cross over onto the boundary of a retained interest of
Seller or an Excluded Asset) and only to the extent permitted
by the applicable agreements and subject to all rights of
third parties and all conditions or restrictions imposed by
said third parties.

(c) to the extent and only to the extent necessary for the
ownership, use or development of the Subject Properties and
limited by and subject to the rights of and conditions or
restrictions imposed by third parties and applicable
agreements, the concurrent, nonexclusive right of ingress and
egress with respect to the fee, fee mineral, leasehold and
royalty retained or owned by Seller in the area of the
Subject Properties.

(d) the wells, real or personal property (or mixed property),
interests, assets, facilities or equipment identified on
Exhibit "A", Schedules 1, 2, 3, 4, 5 or 6, which may or may
not be expressly included in the engineering data previously
furnished to Purchaser but which constitute a part of the
Subject Properties and those interests, assets, facilities and
equipment appurtenant to the Subject Properties but which are
identified subsequent to the Execution Date by and placed on
Exhibit "A" or any of the Schedules listed immediately above
prior to Closing by Seller.

(e) the interests described on Exhibit "A-I " attached hereto
when offered by the owners thereof prior to Closing shall be
purchased by Purchaser at Closing for a value proportionate to
the allocated value of Seller's related interest in said
Asset, whether or not such interests are acquired by the
Seller on or prior to Closing, unless such interests are
subject to Defects specifically included in any Notice of
Defects delivered hereunder, in which case, at Seller's sole
option, (i) such affected interest shall be excluded from the
Assets or (ii) the value with respect to such interest shall
be reduced by the lesser of the cost to cure said defect or
the said defect value not to exceed the proportionate
allocated value for said interest and such interest shall be
conveyed to Purchaser at Closing as part of the Assets. All
such interests acquired by Purchaser shall be deemed to be a
part of the Sale Interest and subject to the terms of this
Agreement for all purposes and the Purchase Price shall be
increased at Closing by the amount allocated to such acquired
interests.

(f) the undeveloped leasehold identified in Exhibit A and more
fully described on Schedule 4 to Exhibit "A" together with all
contract rights, personal property or other rights directly
related thereto to the extent assignable, and subject to and
limited by the rights of third parties and Related Agreements.

<PAGE> 119
(g) the domestic U.S. mineral interests, royalty and overriding
royalty interests to the extent covering lands outside the
areas, land, counties, or parishes in the states described on
Exhibit E, with Seller expressly retaining, among other
things, all right, title and interest in the domestic U.S.
mineral interests, royalty and overriding royalty interests
inside the areas, land, counties, or parishes in the states
described on Exhibit E, (with such retained interests of
Seller referred to as the "Excluded Minerals", with Excluded
Minerals being considered Excluded Assets for purposes of this
Agreement) provided, however, as to such Excluded Minerals
should any land ultimately and specifically described on an
Exhibit "A" to any Assignment and Bill of Sale delivered to
Purchaser by Seller, pursuant to this Agreement (and an
interest in said land is intended to be conveyed thereby) fall
within the description for and conflict with the description
of Excluded Minerals, then as to and only as to the specific
lands described in the said Assignment and Bill of Sale
between Seller and Purchaser, all mineral, royalty and
overriding royalty interests of Seller, if any, to the extent
and only to the extent directly pertaining to and within the
boundaries of said specifically described lands shall not be
considered to be Excluded Minerals and shall be considered to
have been conveyed to Purchaser pursuant to the terms of this
Agreement, and only to the extent assignable, and subject and
limited by the rights of third parties and Related Agreements.

(h) the plants (the "Gas Plants") described on Schedule 6 to
Exhibit A and gathering systems appurtenant thereto to the
extent assignable and subject to and limited by the rights of
third parties and Related Agreements.

1.3. Excluded Assets. Notwithstanding anything in this Agreement to
the contrary, the Assets do not include and Purchaser agrees and acknowledges
that Seller has reserved and retained from the Assets and hereby reserves and
retains unto itself any and all rights, titles and interests in and to (a)
Excluded Minerals, leasehold and other interests pertaining to lands and
leasehold not within the boundaries of the lands comprising the Subject
Properties (b) the right of ingress and egress with respect to the Assets for
the purpose of mining, drilling, exploring, operating, holding, producing and
developing any interest including, without limitation, the oil, gas and mineral
leasehold, fee, fee mineral and royalty interests retained or owned by Seller
for oil, gas, minerals and other hydrocarbon substances, or other lawful
substances, (c) seismic, geologic and geophysical records, information, and
interpretations relating to the Assets, subject to Section 1.2 (b) (8) above and
Section 9.5 (iii), (d) any and all records which consist of previous or
contemporaneous offers, discussions, or analyses associated with the purchase,
sale or exchange of the Assets or any part thereof, proprietary or interpretive
information, reserve data, internal communications, personnel information
unrelated to the personnel interviewed and evaluated by Purchaser pursuant to
Section 13.20 below, tax information, information covered by a non-disclosure
obligation and information or documents covered by a legal privilege;(the
"Excluded Records") (e) originals or copies of Excluded Records and copies of
records retained by Seller; (f) all claims rights and causes of action against
third parties, asserted and unasserted, known and unknown relating to the period
prior to the Effective Time relating to the Assets; (g) to the extent Seller has
reserved interests, including

<PAGE> 120

deep rights, or to the extent Seller currently uses or may need to use the
following rights for its operations in the area of the Subject Properties
Seller reserves concurrent interests in any and all applicable easements,
rights of way, licenses, permits, contracts or other rights relating to the
reserved interests or interests in the area; (h) communication equipment,
leased or rented equipment or facilities, office equipment, computer equipment
and software; (i) all pipelines, gas plants, equipment and rights of way owned
or operated by Seller or any affiliate of Seller and which are not solely
appurtenant to the Wells or used exclusively therewith (except the Gas
Plants); (j) all oil in storage at the Effective Time; (k) wells, leases or
leasehold interests or other interests described on Exhibit A or any Schedule
thereto, which pursuant to and in accordance with this Agreement are not
included in an Assignment and Bill of Sale or another conveyancing instrument
delivered to Purchaser on or after Closing; (l) partnership interests, the Mesa
Offshore Royalty Trust, other royalty trust interests or other interests of
whatever nature listed on Exhibit A which Seller determines in its sole
discretion it will be unable to convey at Closing, or unable to convey in a
timely manner or without undue conditions or restrictions (as determined in
Seller's sole discretion) in which event Seller will advise Purchaser, the
affected interest will be removed from this Agreement, and an adjustment in the
Purchase Price will be made at Closing by the allocation for said affected
interest; (m) an overriding royalty equal to an undivided 1/32nd of eight
eighths proportionately reduced to the interest conveyed by Seller pursuant to
this Agreement in and to the WARWINK West wells and lands appurtenant thereto
as identified in Exhibit A or Exhibit C to this Agreement; and (n) items
excluded elsewhere in this Agreement, (a) through (n), collectively, the
"Excluded Assets").

1.4. Defined Terms.

"Acceptable Title" has the meaning as set forth in Section
3.1.

"Act" means the Securities Act of 1933.

"Adjusted Purchase Price" has the meaning set forth in Section
2.1.

"Affiliate" means, as to any Person each other Person that
directly or indirectly (through one or more intermediaries or
otherwise) controls, is controlled by, or is under common
control with, such Person.

"Agents" has the meaning as set forth in Section 3.3.

"Assets" has the meaning as set forth in Section 1.2.

"Business Day" or "Business Days" means a day or days
excluding Saturdays, Sundays and U.S. Legal Holidays.

"Casualty Loss" has the meaning as set forth in Section 12.3.

"Claims" has the meaning as set forth in Section 9.2.a.

<PAGE> 121

"Closing" means the consummation of the purchase and sale of
the Assets by Purchaser and Seller as contemplated in this
Agreement.

"Closing Date" has the meaning as set forth in Section 8.1.

"Code" means the United States Internal Revenue Code of 1986
as Amended.

"Confidentiality Agreement" has the meaning as set forth in
Section 13.2.

"Days" or "days" means calendar days unless stated otherwise.

"Defect" and "Defects" has the meaning as set forth in Section
3.5.

"Deposit" has the meaning as set forth in Section 2.4.

"Effective Time" has the meaning as set forth in Section 1.2.

"Environmental Defect" means a condition or circumstance
which constitutes a violation of applicable Environmental Laws

"Environmental Laws" means any and all Laws that relate to:
(a) the prevention of pollution or environmental damages, (b)
the abatement, remediation or elimination of pollution or
environmental damage, (c) the protection of the environment
generally, and/or (d) the protection of Persons or property
from actual or potential exposure (or the effects of exposure)
to pollution or environmental damage; including without
limitation, the Clean Air Act, as amended, the Clean Water
Act, as amended, the Comprehensive Environmental Response,
Compensation and Liability Act of 1980, as amended, the
Federal Water Pollution Control Act, as amended, the Resource
Conservation and Recovery Act of 1976, as amended, the Safe
Drinking Water Act, as amended, the Toxic Substance and
Control Act, as amended, the Superfund Amendments and
Reauthorization Act of 1986, as amended the Hazardous and the
Solid Waste Amendments Acts of 1984, as amended, and the Oil
Pollution Act of 1990, as amended.

"Examination Period" has the meaning as set forth in Section
3.3.

"Excluded Assets" has the meaning as set forth in Section 1.3.

"Execution Date" means the date on which the last of the
Parties executes this Agreement.

"Final Accounting" has the meaning as set forth in Section
13.17.B.

<PAGE> 122

"Final Accounting Date" has the meaning as set forth in
Section 13.17.B.

"HSR Act" has the meaning as set forth in Section 13.19.

"Identified Claims" has the meaning as set forth in Section
3.4.

"Imbalances" has the meaning as set forth in Section 9.1.

"Knowledge of Seller [or Purchaser, as the case may be]", or
"to the best of Seller's [or Purchaser's as the case may be]
knowledge and belief" or words of similar import shall mean
only the then existing actual non-privileged knowledge of any
president or vice president (without obligation of further
inquiries) of Seller [or Purchaser, as the case may be], and
is not intended to imply that such party in fact has actual
knowledge of the subject matter to which such terms apply.

"Laws" means laws, statutes, ordinances, permits, decrees,
orders, judgments, rules or regulations (including without
limitation Environmental Laws) which are promulgated, issued
or enacted by a governmental entity (whether federal, state or
local) or tribal authority having appropriate jurisdiction.

"Letter Agreement" has the meaning as set forth in Section
13.2.

"NORM" has the meaning as set forth in Section 9.2.c.

"Notice of Defects" has the meaning as set forth in Section
3.5.

"Notice Period" has the meaning as set forth in Section 9.2.d.

"Party" means either Purchaser or Seller.

"Parties" means collectively the Purchaser and Seller.

"Permitted Encumbrances" has the meaning as set forth in
Section 3.2.

"Person" means and individual, corporation, partnership,
association, join stock company, trust or trustee thereof,
estate or executor thereof, unincorporated organization or
joint venture, court or other governmental unit or other
agency or subdivision thereof, or any other legally
recognizable entity.

"Gas Plants" has the meaning set forth in Section 1.2(h);

<PAGE> 123

"Preferential Rights" has the meaning as set forth in Section
3.2.c.

"Property" is the real property or properties, surface and
subsurface, in which and on which the Assets, or any portion
thereof, are located or pertain and includes the land, if any,
described or referred to in Exhibit "A".

"Property Taxes" has the meaning as set forth in Section
11.1.

"Purchase Price" has the meaning as set forth in Section 2.1.

"Records" has the meaning as set forth in Section 1.2.b.

"Related Agreements" has the meaning as set forth in Section
9.10.

"Representative" and "Representatives" have the same meanings
as set forth in Section 9.2.f.

"Sale Interest" has the meaning as set forth in Section 1.2.

"Subject Properties" has the meaning as set forth in Section
1.2.a.

"Suspense Funds" has the meaning as set forth in Section 9.1.

"Title Defect" has the meaning as set forth in Section
3.5.(a).

"Wells" has the meaning as set forth in Section 1.2.b.

ARTICLE 2. CONSIDERATION

2.1. Consideration. As consideration for this Agreement and the
benefits contained herein, at Closing, Purchaser (i) shall pay to Seller Four
Hundred and Ten Million Dollars $410,000,000 (US$) (the " Purchase Price"), as
may be adjusted pursuant hereto (the "Adjusted Purchase Price) The Purchase
Price has been allocated by Purchaser as provided on Exhibit "A". From December
15, 1998 until Closing the Purchase Price shall earn and accrue interest to the
benefit of Seller at a rate equal to that earned on the Deposit. Said interest
on the Purchase Price shall be paid or credited to Seller at Closing. If
Seller has delayed Closing by exercise of its rights pursuant to Section 8.1.
then interest on the Purchase Price will not accrue during of the period of
delay but upon the end of the delay period interest will again accrue on the
Purchase Price until Closing and paid or credited to Seller at Closing at the
rate and in the manner provided above without adjustment to the Purchase Price.

2.2. Manner of Payment. At Closing, except as provided in the
following Section 2.3, Purchaser shall pay Seller or Seller's designee the
Adjusted Purchase Price by wire transfer of immediately available funds as
follows:

<PAGE> 124

Account: Pioneer Natural Resources USA, Inc.
Account No: 1290288845
NationsBank, N.A.
ABA Routing No: 111000012
Attention: Frank Stowers
NationsBank N.A.-Midland
(915) 685-2179

2.3. Like Kind Exchange Option. Seller and Purchaser hereby agree
that Seller, in lieu of the sale of the Assets to Purchaser for the cash
consideration provided herein, shall have the right at any time prior to
Closing to assign all or a portion of its rights under this Agreement to a
qualified intermediary in order to accomplish the transactions contemplated
hereby in a manner that will comply, either in whole or in part, with the
requirements of a like kind exchange pursuant to Section 1031 of the Internal
Revenue Code of 1986, as amended ("Code"). In the event Seller assigns its
rights under this Agreement pursuant to this Section 2.3, Seller agrees to
notify Purchaser in writing of such assignment before Closing. If Seller
assigns its rights under this Agreement, Purchaser agrees to (i) consent to
Seller's assignment of its rights in this Agreement, (ii) deposit the Adjusted
Purchase Price with the qualified escrow or qualified trust account designated
by Seller at Closing, and (iii) take such further actions, at Seller's cost, as
are reasonably required to effectuate the transactions contemplated hereby
pursuant to Code Section 1031, but, in so acting, Purchaser shall have no
liability to any Party in connection with such actions. All risks associated
with any like kind exchange and compliance thereof with applicable laws, rules
and regulations shall be the sole responsibility of Seller, and Seller agrees
to indemnify and hold Purchaser harmless from and against all costs, expenses,
liabilities and obligations which arise as a result of Purchaser's agreement
contained in this Section 2.3.

2.4. Performance Deposit. Prior to the execution hereof or upon
the execution hereof Purchaser, as evidence of good faith, has paid or shall
pay to Seller twenty five million U.S. dollars ($25,000,000) (the "Deposit") in
immediately available funds by wire transfer pursuant to Section 2.2 above or
by Cashiers Check. Except as provided in this Agreement the Deposit will not
bear interest for Purchaser and is not refundable. If Closing occurs, such
Deposit and any interest accruing thereon during the period from the Execution
Date to the Effective Time shall be credited to Purchaser at the Closing. From
October 1, 1998 to Closing any interest on the Deposit shall be credited to
Seller, without any adjustment to the Purchase Price for such accrued interest
credited to Seller. If Closing does not occur or the Agreement is terminated,
the Deposit (including any accrued interest) shall be applied as provided in
Section 10.2. Until disposed of in accordance with the terms of this Agreement
or until termination of this Agreement, the Deposit shall be held and invested
by Seller in marketable obligations issued or unconditionally guaranteed by the
United States of America or an instrumentality or agency thereof and entitled
to the full faith and credit of the United States of America, or in money
market and/or mutual funds that invest solely in such obligations.

<PAGE> 125

2.5. Allocations. Within five (5) calendar days after receipt of
an allocation request from Seller, Purchaser will deliver to Seller a good
faith allocation of the Purchase Price to each of the Subject Properties or
Assets not previously allocated under 2.1 above.

ARTICLE 3. DEFECTS

3.1. Definition of Acceptable Title. As used herein, the term
"Acceptable Title" shall mean, as to the Gas Plants such right, title and
interest of that ownership interest expressed on Schedule 6 to Exhibit A that
is free and clear of all liens and encumbrances except for "Permitted
Encumbrances" provided, however that the presence of a preferential right to
purchase provision shall not be considered to be a Defect as defined in Section
3.5 below and, as to the Subject Properties except the wells listed on Schedule
3.1, the, "WARWINK" wells and the lands appurtenant thereto which are expressly
excluded from the Defect provisions of this Agreement and upon which Purchaser
shall not be permitted any claim for Defects including without limitation
Identified Claims, such right, title and interest that as to the existing
production from the currently producing intervals in the wells, (a) entitles
Seller to receive not less than the net revenue interest set forth in Exhibit
"A" of all oil, gas and associated liquid and gaseous hydrocarbons produced,
saved and marketed from the currently producing horizons of the respective
Subject Properties, (b) obligates Seller to bear costs and expenses relating to
the maintenance, development, and operation of all wells drilled to horizons
with current production relative to the respective Subject Properties in an
amount not greater than the working interest set forth in Exhibit "A", unless
there is a corresponding increase in the applicable net revenue interest, and
(c) except for Permitted Encumbrances, is free and clear of all liens, claims
and encumbrances; provided, however that the presence of a preferential right
to purchase provision shall not be considered to be a Defect as defined in
Section 3.5 below. Purchaser acknowledges and agrees that any net revenue
interests and working interests reflected on Exhibit "A" are for the
convenience of Seller and Purchaser and included solely for the purpose of
determining Acceptable Title prior to Closing; Seller does not and shall not
represent or warrant that the Sale Interest is equal to any such interests in
any respect, but agrees that (i) for purposes of determining Defects prior to
Closing, with respect to those Subject Properties listed on Exhibit "A" with
"0.0000" "APO" interests, the "APO" interests shall be deemed to be the same as
the corresponding "BPO" interests, and (ii) Purchaser may assert as a Title
Defect (as defined in and pursuant to Section 3.5 below) any matter reasonably
expected, as to existing production, to reduce the net revenue interest
assigned to such Subject Property or well or any matter reasonably expected, as
to existing production, to increase the working interest assigned to such
Subject Property and well unless there is a corresponding increase in the
applicable net revenue interest.

3.2. Definition of Permitted Encumbrances. As used herein, the
term "Permitted Encumbrances" shall mean the following items, provided none of
the following items shall operate, as of Closing, to increase the working
interest of Seller as set forth in Exhibit "A" for any of the Subject
Properties, without a corresponding increase in the applicable net revenue

<PAGE> 126

interest, or decrease the net revenue interest of Seller set forth in Exhibit
"A" for any of the Subject Properties:

(a) lessors' royalties, overriding royalties, production payments,
reversionary interests and similar burdens;

(b) division orders and sales contracts;

(c) preferential rights to purchase not identified in writing to
Seller pursuant to Section 3.7 below, or, if so identified,
with respect to which, prior to Closing (1) waivers are
obtained from the appropriate Parties, (2) the appropriate
time period for asserting such rights has expired without an
exercise of such rights, or (3) appropriate Parties have
exercised such rights and the Purchase Price has been adjusted
where appropriate with reference to the value allocated in
Exhibit "A" to the affected Asset ("Preferential Rights");

(d) rights to consent to assignments required by this Agreement
held by Persons other than governmental entities and not
identified in writing to Seller pursuant to Section 3.7 below,
or, if so identified, with respect to which, prior to Closing
(1) waivers or consents are obtained from the appropriate
Parties, or (2) the prescribed time period for denying such
consent has expired;

(e) materialman's, mechanic's, repairman's, employee's,
contractor's, operator's, tax, and other similar liens,
assessments or charges arising in the ordinary course of
business for obligations that are not yet due or delinquent,
or if delinquent, that are being contested by Seller or the
affected operator in good faith in the normal course of
business;

(f) rights to consent by, required notices to, filings with, or
other actions by governmental entities in connection with the
sale or conveyance of oil and gas leasehold and fee estates or
interests therein, which consents, notices, filings and/or
other actions are customarily obtained after closing;

(g) easements, rights-of-way, servitudes, permits, surface leases
and other rights in respect of surface operations affecting
the Assets which in the aggregate are not such as to interfere
materially with the operation or use of any of the Subject
Properties or materially reduce the value thereof;

(h) rights reserved to or vested in any governmental, statutory or
public authority to control or regulate any of the Assets in
any manner, and all applicable laws, rules and orders of any
governmental authority affecting the Assets;

<PAGE> 127

(i) operating agreements, unit agreements, unit operating
agreements, pooling agreements and pooling designations
affecting the Subject Properties which are of public record or
contained in the Records or otherwise available to Purchaser
and all actions taken or operations occurring in the normal
course of business pursuant to such instruments;

(j) Title Defects that Purchaser may have expressly waived in
writing or which are deemed to have been waived pursuant to
Section 3.6;

(k) all conveyances, reservations and exceptions of public record
or contained in the Records affecting the Assets which in the
aggregate are not such as to interfere materially with the
operation or use of any of the Subject Properties or
materially reduce the value thereof; and

(l) all other liens, charges, encumbrances, contracts, agreements,
instruments, obligations, defects and irregularities affecting
the Assets which are not such as to interfere materially with
the operation or use of the affected Subject Properties or
materially reduce the value thereof.

3.3. Environmental and Physical Assessment. Subject to the terms
hereof and the Confidentiality Agreement, Purchaser shall have the right at its
sole risk and expense to make an environmental and other physical assessment of
the Assets during the period ("Examination Period") beginning on the Execution
Date and ending at 5:00 p.m. on the forty fifth (45th) day after the Execution
Date. If Purchaser desires to undertake an environmental assessment, both the
consultant(s) and the scope of the proposed assessment, including testing
protocols, must be acceptable to Seller before work may begin, however, Seller
will not unreasonably withhold its acceptance and will respond to Purchaser's
request in this regard by 5:00 p.m. the next business day after such request
and Purchaser shall indemnify, defend and hold harmless Seller as provided in
this Section 3.3. regarding the subject environmental assessment not
withstanding Seller's "acceptance" of same. During Seller's normal business
hours and subject to the terms of this Agreement Purchaser and its employees,
contractors, lenders and consultants ("Agents") shall have the right to enter
upon the Assets operated by Seller and all buildings and improvements thereon
(and Seller shall use reasonable efforts to obtain permission for Purchaser to
gain access to Assets operated by others but such access and the terms of such
access cannot be guaranteed) inspect the same, conduct soil and water tests and
borings, and generally conduct such tests, examinations, investigations and
studies as may be reasonably necessary or appropriate for the preparation of
appropriate environmental and other reports relating to the Assets, their
condition, and the presence of wastes or contaminants. Purchaser shall provide
Seller with 48 hours prior notice of such activities related to the Assets,
regardless of who operates the same, and Seller shall have the right to (i)
witness all such tests and investigations, (ii) receive an equal distribution
of all samples taken by Purchaser or its Agents, and (iii) prohibit such tests
and investigations which it believes could materially damage its properties or
business interests provided, however that if Purchaser disagrees with Seller's
prohibition hereunder then parties shall discuss the reasons for such
disagreement and if no consensus is reached on such

<PAGE> 128

issue, and if Seller does not remove the prohibition, either Purchaser or
Seller may remove such Asset by written notice to Seller, or Buyer as the case
may be, in which case the Purchase Price shall be reduced by said Asset's
allocated value and provided that Seller shall have the right to terminate this
Agreement if the Assets removed by Purchaser or Seller hereunder exceed 2% (two
percent), individually or in the aggregate, of the Purchase Price. Entry onto
the Assets by Purchaser or its Agents will be subject to third-party
restrictions, if any, and to Seller's safety, industrial hygiene, and drug and
alcohol policies and guidelines and Purchaser will be responsible for assuring
compliance with same by itself and its Agents. Until the Closing, Purchaser
and its Agents shall keep any data or information acquired by all such
examinations and the results of all analyses of such data and information
strictly confidential and not disclose any of the same to any Person unless
otherwise required by law or regulation and then only after written notice to
Seller of the need for disclosure and the identity of all intended recipients.
Seller hereby grants Purchaser access to the Assets to conduct its
environmental and other physical assessment upon the condition that, in
accordance with Section 9.2, PURCHASER HEREBY INDEMNIFIES, DEFENDS AND HOLDS
SELLER AND ITS AFFILIATES AND THEIR RESPECTIVE REPRESENTATIVES HARMLESS FROM
AND AGAINST ANY AND ALL CLAIMS OF WHATEVER NATURE FOR OR RELATED TO PERSONAL
INJURY, DEATH OR PROPERTY DAMAGE ARISING OUT OF OR AS A RESULT OF THE
ACTIVITIES BY OR ON BEHALF OF PURCHASER OR ITS AGENTS ON OR RELATED TO THE
ASSETS IN CONDUCTING SUCH ENVIRONMENTAL AND PHYSICAL ASSESSMENTS OR THE
EXERCISE OF ITS RIGHTS UNDER THIS SECTION 3.3.. If during the Examination
Period, Purchaser determines in good faith that there is an "Environmental
Defect", Purchaser may include notice of such Defect in any Notice of Defects
delivered hereunder; provided, that any such matter not included in a Notice of
Defects shall be and hereby is forever waived by Purchaser.

3.4. Identified Claims. During the Examination Period and up to
the fifty fifth (55th) day after the Execution Date, Seller shall make
available to Purchaser for examination and copying (at Purchaser's cost) any of
the Records and Seller's accounting records relating to the Assets as Purchaser
may reasonably request. Seller shall also permit Purchaser's Representatives
to consult with Seller's employees and Seller's independent contractors who
have knowledge concerning the Assets during normal business hours regarding
such records; provided, that such consultation shall not unreasonably disrupt
the performance by such employee or independent contractor of its duties with
Seller. If during the Examination Period, Purchaser determines in good faith
that (i) royalties, rentals or other payments due in respect of the Assets
prior to the Effective Time have not been paid (except for those amounts in
suspense), or (ii) there are unsatisfied claims, demands, liabilities or
obligations in respect of the Assets based upon omissions, events or
occurrences prior to the Effective Time (collectively, "Identified Claims"),
Purchaser may include notice of such Identified Claims in any Notice of Defects
delivered hereunder; provided, that any such matter not included in a Notice of
Defects shall be and hereby is forever waived by Purchaser.

<PAGE> 129

3.5. Notice of Defects. If any matter is discovered by Purchaser
that, in Purchaser's reasonable, good faith opinion, would (a) cause any of the
Sale Interest or the Gas Plants not to be Acceptable Title (a "Title Defect");
(b) constitute an Environmental Defect; or (c) constitute an Identified Claim
((a) through (c) to the extent that each such matter exceeds a value of
$15,000.00 net to Seller's interest (other than for (b) which individual
defects net to Seller's interest must exceed a minimum of $100,000.00)
individually, a "Defect", and collectively, the "Defects"), then if the total
value of all Defects exceeds five percent (5%) (the "Threshold")of the Purchase
Price, Purchaser may provide written notice (a "Notice of Defects") thereof
actually delivered to Seller not later than noon, on the fifty fifth (55th) day
after the Execution Date but if such 55th day falls on a Saturday or Sunday
then such notice may be delivered no later than noon on the next business day.
A Notice of Defects shall specifically identify the Defect and include (i) the
Purchaser's purported value of each specific Defect which value in the case of
Title Defects and Identified Claims only cannot exceed the value of the
affected Assets as set out on Exhibit "A", (ii) an identification of each
affected Asset, (iii) Purchaser's basis for determining the existence and value
of such Defect, together with all associated reports, opinions, data,
valuations, assessments, conclusions and supporting calculations, and (iv)
Purchaser's statement of steps necessary to cure each such Defect to its
satisfaction, all of which shall be kept strictly confidential by Purchaser and
its Agents prior to Closing on the affected Assets, except to the extent
required by law, regulation or order of any court or other governmental
authority or as may be necessary to address Defects identified in a Notice of
Defects. On any occasion when Seller disputes the value of a purported
Environmental Defect submitted by Purchaser, Seller may at its sole cost retain
a third party environmental consultant (the "Consultant") for the purpose of
reviewing Purchaser's said Environmental Defect and the decision of said
Consultant as to the value of the said Environmental Defect shall be binding on
the Parties hereto for purposes of establishing the value of said Environmental
Defect.

3.6. Remedy for Defects. In Seller's sole discretion, but without
obligation, it may, at its sole cost, take such steps as are reasonably
necessary to cure or minimize Defects identified in a Notice of Defects. In
addition to performing curative, Seller at its sole option and upon written
notice to Purchaser may remove the affected Subject Property from this
Agreement and adjust the Purchase Price by the Allocation for the removed
Subject Properties unless Purchaser waives the subject Defect(s) by written
notice within two (2) days after the date of Seller's notice to Purchaser
hereunder. In the event Seller is unable or elects not to cure or minimize any
or all Defects above the applicable 5% of Purchase Price Threshold shown in
Section 3.5 above and if any examination by Purchaser results in a finding that
the interest of Seller is greater than stated in Exhibit "A" and such increase
(which such increase must be identified in any notice to Seller), serves to
increase the value of the Subject Property or component of the Assets, Seller
and Purchaser may, at Seller's option, meet and use their best efforts to agree
in good faith on the validity of each Defect claim and the need for and amount
of any mutually acceptable Purchase Price adjustment.

(a) Title Defect adjustments shall be made with reference (as a
maximum) to the allocated value for each affected Asset as set
forth in Exhibit "A" and with the following criteria:

<PAGE> 130

(1) If the Defect is based on Seller's owning a different
net revenue interest than that shown on Exhibit "A",
then the adjustment will be the absolute value of the
number determined by the following formula:

(i) for instances where the correct interest
is less than the interest expressed in
Exhibit "A",

Adjustment = A x (1-[B/C])

A = Allocation for the affected Asset
B = correct net revenue agreed by the Parties for
the affected Asset
C = net revenue for the affected Asset as shown
on Exhibit "A"

(ii) for instances where the correct interest
is greater than the interest expressed in the
Exhibit "A", the formula would be the same
except that ; B= Net revenue for the affected
assets as shown on Exhibit "A" and C= The
correct net revenue for the affected asset;
provided , however, in either 1(i) or 1(ii)
if either the numerator or denominator is
zero (0), then the adjustment will unless
agreed otherwise by the parties be the
allocated value for the affected Subject
Asset.

(2) If the claim is based on an obligation or burden that
is liquidated in amount, then the adjustment will be
the sum agreed by the Parties necessary to remove the
obligation or burden from the affected Asset.

(3) If the claim is based on an obligation or burden that
is not liquidated, but can be estimated with
reasonable certainty, the adjustment will be the sum
agreed by the Parties necessary to compensate
Purchaser on the Closing Date for the adverse
economic effect on the affected Asset.

(i) Subject to (ii) below, if the amount of the adjustment for
each Defect cannot be determined based on the above criteria,
and if the parties cannot otherwise agree on the amount of an
adjustment, Seller may, at its sole option and upon written
notice to Purchaser, either:

(1) terminate this Agreement and refund the
deposit and all accrued interest thereon
subject to Section 10.2;

(2) remove the affected Asset from this Agreement
and adjust the Purchase Price by the
allocation for the Asset, or

<PAGE> 131

(3) elect to resolve the dispute under the
arbitration provisions of this Agreement.

(ii) The Purchase Price will be adjusted only if the sum (i.e.
offsetting of increases and decreases) of all adjustments
under this section (not otherwise resolved hereto) as to Title
Defects, or Identified Claims or Environmental Defects exceed
and then only to the extent exceeding the Threshold. If the
sum of all adjustments for Defects would result in the
Purchase Price being reduced by more than ten (10) percent,
Seller may, at its sole option, upon written notice to
Purchaser, either:

(1) terminate this Agreement and refund the
deposit and all accrued interest thereon
subject to Section 10.2; or

(2) remove all or a portion of the affected
Assets from the Agreement and adjust the
Purchase Price by the allocation for the
Assets.

(b) Seller will have thirty days after receipt of Purchaser's
Notice of Defects, or until five days before the Closing Date
if it determines that an Environmental Defect (whether
material or not) may exist with respect to an Asset, to elect
any of the following:

(1) adjust the allocation for an Asset by a mutually
acceptable amount reflecting Seller's proportionate
share, based on its working interest, of the cost
reasonably estimated to remediate the Environmental
Defect (in the manner described below or by the
Consultant) affecting the Assets:

(2) remove the affected Asset from this Agreement and
adjust the Purchase Price by the allocation for the
affected Asset.

(3) remedy, or agree to remedy, the Environmental Defect
as provided below;

(4) or terminate this Agreement and refund the deposit
and all accrued interest thereon subject to Section
10.2.

Seller may delay Closing until the end of this thirty-day
period, which delay will be in addition to and under the same
terms as Seller's right to delay Closing under Section 8.1.

If the Purchase Price is adjusted because of an Environmental
Defect, the amount of the adjustment will be based on the cost
to remediate the Environmental

<PAGE> 132

Defect, but only to the level required by the Environmental
Laws in effect on the Execution Date but not to exceed the
allocation for the affected Asset(s). Seller may require
Purchaser to remit the full allocation at Closing, without
adjustment for the Environmental Defect, but if it does so, it
will pay the amount of the adjustment to Purchaser when the
remediation performed by Purchaser is complete under
applicable law. If the cost to remediate exceeds the amount
of the adjustment, Purchaser will pay the additional costs to
remediate the Environmental Defect as required by applicable
law.

(c) If Seller elects or agrees with Purchaser to remediate an
Environmental Defect or is required by governmental or
regulatory agency to remediate a Environmental Defect, the
following will govern the remediation:

(1) Seller will be responsible for all negotiations and
contacts with federal, state, and local agencies and
authorities with regard to the Environmental Defect
or remediation. Purchaser may not make any
independent contacts with agency, authority, or other
third party with respect to the Environmental Defect
or remediation and will keep all information
regarding the Environmental Defect confidential,
except in each instance to the extent required by
applicable law.

(2) Seller will remediate the Environmental Defect to the
level agreed upon by Seller and Purchaser, but in no
event will Seller be required to remediate the
Environmental Defect beyond the level required by the
Environmental Laws in effect on the Execution Date.

(3) Purchaser will grant and warrant access to the Assets
and entry on the Property after Closing to Seller,
its Representatives, and third parties conducting
assessments or remediation, to the extent and as long
as necessary to conduct and complete the assessment
or remediation work, to remove equipment and
facilities, and to perform any other activities
reasonably necessary in connection with assessment or
remediation.

(4) Purchaser will use its best efforts not to interfere
with Seller's ingress or egress or assessment or
remediation activities. Seller will make reasonable
efforts to perform the work so as to minimize
disruption to Purchaser's business activities and to
the Assets and the Property.

(5) Seller will continue remediation of the Environment
Defect until the first of the following occurs:

<PAGE> 133

(a) The appropriate governmental authorities
provide written notice to Seller or Purchaser
that no further remediation of the
Environmental Defect is required; or

(b) Seller determines that the Environmental
Defect has been remediated to the level
required by the Environmental Laws or as
agreed by the Parties.

Upon the occurrence of either (a) or (b) above,
Seller will notify Purchaser that remediation of the
Environmental Defect is complete and provide a copy
of the notification described in a (a) above, if
applicable. Upon delivery of Seller's notice, Seller
will be released, without further action or
documentation, from all liability and have no further
obligations under any provisions of this Agreement in
connection with said Environmental Defect.

(6) Until Seller completes remediation of an
Environmental Defect, Seller and Purchaser will each
notify the other of any pending or threatened Claim,
action, or proceeding by any authority or private
party that relates to or would affect the
environmental condition, the assessment, or the
remediation of the affected Assets or Property.

(7) After delivery of possession or Closing (whichever
occurs first) and before Seller has completed
remediation of an Environmental Defect, if a leak,
spill, or discharge of any material or substance
("Occurrence") occurs on the Property or Assets, or
any part of them, Purchaser will promptly notify
Seller and act promptly to minimize the effects of
the Occurrence. If a spill, leak or discharge occurs
and Seller determines that it may affect that area
where Seller is conducting remediation or assessment,
Purchaser will hire a consultant (who must be
acceptable to Seller) to assess the effect of the
Occurrence on the environmental condition of the
Property, Interest, and Seller's remediation work and
the cost of the additional work required as the
result of the Occurrence. Unless the Occurrence was
caused solely by Seller, Purchaser will be
responsible for the incremental cost of remediating
the impact of the Occurrence. If Seller's
remediation is expanded to incorporate remediation of
the Occurrence, Purchaser will promptly pay its share
of costs and expenses to Seller as the work is
performed, within thirty days of receipt of invoices
for the work (with supporting documentation).
Payments not made timely will bear interest at a rate
of twelve percent per annum or the maximum lawful
rate, whichever is less, compounded daily from the
date of Purchaser's receipt of the invoice until
paid.

<PAGE> 134

If the cost of the additional work equals or exceeds
the cost which would have been incurred but for the
Occurrence, Seller will pay Purchaser the cost that
would have been incurred by Seller to complete the
remediation but for the Occurrence. As consideration
for this payment, Purchaser will accept the
environmental condition of the Property and Assets as
they exist on the date of the payment, assume full
responsibility for remediating the Property and
Assets and related off-site contamination in
accordance with this Agreement, and agree to release,
indemnify, hold harmless, and defend Seller and its
Representatives as to Claims arising from the
Occurrence to the same extent as described in Article
9.

(8) If Seller undertakes remediation as to any Assets in
which Seller's ownership was less than 100% Purchaser
will bill the other working interest owners for their
share of the remediation expenses. Regardless of
whether Seller recoups any amount from the other
working interest owners, Purchaser will refund to
Seller, within sixty days of each Seller invoice,
with documentation, any amounts expended by Seller
over the amount formerly attributable to Seller's
working interest share.

(9) If Seller will assess or remediate the Assets or
Property after Closing, the Assignment and Bill of
Sale or other recordable instrument will restate the
rights and obligations of this section.

(d) If the Aggregate Net Amount of Purchase Price adjustments
mutually agreed and/or as a result of Seller's removal of
Assets hereunder, plus the amount of any uninsured Casualty
Losses and Casualty Losses not fully covered by insurance (to
the extent of such deficiency only), plus the value of any of
the Subject Properties (with reference to the allocated value
thereof on Exhibit "A" as a maximum) to the extent taken in
condemnation or under the right of eminent domain prior to the
end of the Examination Period, or with respect to which
proceedings for such purposes shall be pending or threatened
in writing at such time, equals or exceeds twenty percent
(20%) of the Purchase Price, or (ii) if the aggregate value of
Subject Properties subject to Preferential Rights to be
exercised at Closing equals or exceeds eighty percent (80%) of
the Purchase Price, then Seller or Purchaser may, upon written
notice to the other, terminate this Agreement, without
liability or further obligation to the other party, subject to
Section 10.2. Seller shall have an absolute right to
terminate this Agreement upon written notice to Purchaser,
without liability or further obligation to Purchaser if the
Defects presented by Purchaser exceed ten percent (10%) of the
Purchase Price. Seller shall have no obligation hereunder to
Purchaser or any Person to sell, convey deliver or otherwise
transfer all or any part of the Assets if Purchaser or Seller
terminates this Agreement pursuant to this Section 3.6.
Purchaser agrees and acknowledges that Seller has no
obligation to adjust the Purchase Price with respect to
Defects.

<PAGE> 135

If Closing occurs, Purchaser shall be deemed to have forever
waived and/or assumed any and all Claims, known and unknown,
arising from or related to any and all Defects or title to or
defect or other condition of the Assets in whole or in part,
including, without limitation, whether or not identified in a
Notice of Defects, and notwithstanding the fact that Seller
may not have cured any such Defect(s) to Purchaser's
satisfaction, and Seller shall have no obligation with respect
thereto. As used in this Agreement, the "Aggregate Net
Amount" of Purchase Price adjustments shall be determined by
subtracting from the value of all Defects asserted by
Purchaser (y) the value of all interests by which Seller's
actual interests in the Subject Properties exceeds the net
revenue interests set forth on Exhibit "A" hereto, and (z) the
value of Defects asserted by Purchaser which are cured or
otherwise resolved to Purchaser's reasonable satisfaction.

(e) Notwithstanding any provision in this Section 3.6 to the
contrary, in the event Seller delivers a notice terminating
this Agreement pursuant to this Section 3.6, Purchaser shall
have until 5:00 p.m. on the first Business Day after receipt
of said notice to forever waive, by written notice delivered
to Seller on or before said date and time, Defects which
constitute the grounds stated for termination in said
termination notice and if Purchaser so waives said Defects and
matters the notice of termination delivered by Seller shall be
considered withdrawn.

3.6A & 3.6 B Special Defects.

3.6A Not withstanding anything contained in this Agreement to the
contrary, if during the Examination Period Purchaser discovers, acting in good
faith, that Seller owns no interest in any of the Subject Properties or the Gas
Plants because the applicable oil and gas lease or leases have expired, have
been disposed of, or otherwise, and Seller cannot cause any interest to be
conveyed to Purchaser in the affected Subject Properties or Gas Plants then
Purchaser may include any such matter ( a "Special Defect") in the Notice of
Defects delivered pursuant to Section 3.5 and, if Seller, acting in good faith,
agrees with the findings of Purchaser, without consideration of the Threshold
Purchaser shall be entitled to a reduction in the Purchase Price equal to the
agreed value of such Special Defects based on, and not to exceed, the allocated
value of each affected Subject Properties or Gas Plants as set forth on Exhibit
"A" and said Subject Properties or Gas Plants shall be removed from this
Agreement, provided that any such matter not included in the Notice of Defects
shall be and hereby is forever waived by Purchaser. Further, if during the
Examination Period Purchaser discovers, acting in good faith, that the Working
Interest and/or Net Revenue interests for the Reserves, and only for the
Reserves, classified on Schedule 3.6A attached hereto as "Proved Developed
Producing" (abbreviated as "PDP") shown in Seller's ARIES database delivered to
Purchaser on August 29, 1998 (the "ARIES") which was used by Purchaser to
evaluate the Subject Properties is greater than the respective interest for such
Subject Properties shown in Exhibit "A", Purchaser shall without consideration
of the Threshold (after providing notice of same to Seller in the Notice of
Defects) be entitled to a reduction in the Purchase Price based on, and not to
exceed, the allocated value of

<PAGE> 136
the affected Subject Properties using the formula shown in Article 3.6 (a)
(1)(i); provided, however, A= Allocated Value of the affected Subject Property,
B= Respective Exhibit "A" Interest, C= Respective ARIES Interest, provided,
however, that any matter not included in the Notice of Defects shall be and
hereby is forever waived by Purchaser. Similarly, where the interest shown on
the ARIES is less than that shown on Exhibit "A" whether asserted by Seller or
Purchaser (and Purchaser shall in good faith include all such instances in any
Notice of Defect), Seller shall be entitled to an increase in the Purchase
Price using the same formula with however, A= Allocated Value of the affected
Subject Property, B= Respective ARIES Interest, C= Respective Exhibit "A"
Interest ; provided however, if in either event that the numerator or the
denominator is zero (0) then the adjustment would unless mutually agreed
otherwise by the parties be the Allocated Value of the affected Subject
Property.

3.6B With respect to any reduction to the purchase price resulting
from the application of 3.6A above, Seller agrees that such reduction shall be
offset by the value as agreed between the Seller and Purchaser of those wells
listed on Exhibit A and which are identified on Schedule 3.6B which represent
producing mineral interest that were not on ARIES.

3.7. Preferential Purchase Rights and Consents to Assign. Upon
written notification to Seller by Purchaser identifying Persons (and their
addresses) holding preferential rights to purchase affecting the Assets or the
right to consent with respect to any assignments required hereby, other than
such consents of governmental authorities which are usually obtained in the
normal course of business after Closing, actually received by Seller not later
than the earlier of (i) fifteen (15) days prior to the Closing Date, or (ii)
five (5) business days prior to the latest date prior to Closing permitted by
the subject agreement for such notice to be provided, or upon Seller's own
initiative but without any obligation to so initiate, Seller shall send notice
of this Agreement to all such Persons (y) offering to sell to each such Person
the Assets for which a preferential right is held on and subject to the terms
hereof and for the same allocated value for such Assets reflected on Exhibit
"A", or (z) requesting, where appropriate, consent to any assignment required
in connection herewith. Notwithstanding the foregoing, Purchaser shall be
ultimately responsible for obtaining all approvals and consents from each and
every applicable Person, including, but not limited to, lessors, joint interest
owners, farmors, sublessors, assignors, grantors, co-parties to Agreements,
governmental bodies having jurisdiction, or other third parties and will
provide Seller on or before the Closing Date with proof of each consent,
approval or waiver. Purchaser shall be entitled to review and approve the form
of all such notices; provided, that such approval shall not be unreasonably
withheld or delayed. If, prior to Closing, any of such Persons asserting a
preferential purchase right notifies Seller that it intends to consummate the
purchase of the Assets to which it holds a preferential purchase right
pursuant to the terms and conditions hereof, or if the period allowed for
acceptance of the notice provided by Seller has not expired or will not expire
as of Closing (subject to Seller's right to extend the date of Closing) then
such Assets shall be excluded at Closing from the Assets to be conveyed to
Purchaser under this Agreement and the Purchase Price shall be reduced by the
allocated value of such Assets reflected in Exhibit "A"; provided, however,
that if the holder of such preferential right fails to consummate the purchase
of such Assets before, on or within a

<PAGE> 137

reasonable time after the Closing Date (taking into account the notice or
acceptance period for the right of preferential purchase and a reasonable
amount of time, as determined by Seller, to assemble documentation for such
separate sale), then Seller shall promptly so notify Purchaser, and Seller
shall sell immediately to Purchaser, and Purchaser shall purchase from Seller,
for a price equal to the allocated value of such Assets and upon the other
terms of this Agreement, the Assets to which the preferential purchase right
was asserted. All Assets for which all preferential purchase rights have been
waived or have not been accepted prior to expiration after timely notice of
the acceptance period by the holder of such right, shall be sold to Purchaser
at Closing pursuant and subject to the provisions of this Agreement. If one
(1) or more of the holders of any preferential purchase rights notifies Seller
subsequent to Closing that it intends to assert its preferential purchase
right, Seller shall give notice thereof to Purchaser, whereupon Purchaser shall
satisfy all such preferential purchase right obligations of Seller to such
holders including, but not limited to, transferring the affected Assets to the
holder of such rights and shall indemnify and hold Seller harmless from and
against any and all Claims, liabilities, losses, costs and expenses (including,
without limitation, court costs and reasonable attorneys' fees) in connection
therewith, and Purchaser shall be entitled to receive upon satisfaction in full
by Purchaser of all the foregoing obligations all proceeds received from such
holders in connection with such preferential purchase rights. Purchaser shall
indemnify and hold harmless Seller from and against any and all Claims,
liabilities, losses, costs and expenses (including, without limitation, court
costs and reasonable attorneys' fees) asserted or incurred at any time (whether
before, on or after Closing) with respect to or arising directly or indirectly
from the claims of any Person to a preferential purchase right affecting any of
the Assets transferred to Purchaser hereunder.

ARTICLE 4. SELLER'S REPRESENTATIONS AND DISCLAIMERS

Seller represents to Purchaser that:

4.1. Existence. Pioneer Natural Resources USA, Inc. is a Delaware
corporation, duly formed, validly existing and in good standing under the laws
of the State of Delaware.

4.2. Power. Seller has the requisite power and authority to enter
into and perform this Agreement and the transactions contemplated hereby. The
execution, delivery and performance of this Agreement by Seller, and the
transactions contemplated hereby, will not (a) violate any provision of
Seller's Articles of Incorporation or other governing documents, (b) conflict
with, result in a breach of, constitute a default (or an event that with the
lapse of time or notice, or both would constitute a default) under any
agreement or instrument to which Seller is a Party or by which Seller is bound,
(c) to the best knowledge and belief of Seller, violate any judgment, order,
ruling, or decree applicable to Seller and entered or delivered in a proceeding
in which Seller was or is a named Party, or (d) to the best knowledge and
belief of Seller, violate any applicable law, rule or regulation.

<PAGE> 138

4.3. Authorization. The execution, delivery and performance of
this Agreement and the transactions contemplated hereby have been duly and
validly authorized by all requisite action on the part of Seller. This
Agreement has been duly executed and delivered on behalf of Seller, and at the
Closing all documents and instruments required hereunder to be executed and
delivered by Seller shall be duly executed and delivered. This Agreement and
such documents and instruments shall constitute legal, valid and binding
obligations of Seller enforceable in accordance with their terms subject,
however, to the effect of bankruptcy, insolvency, reorganization, moratorium
and similar laws from time to time in effect relating to the rights and
remedies of creditors, as well as to general principles of equity (regardless
of whether such enforceability is considered in a proceeding in equity or at
law).

4.4. Brokers. Seller has incurred no obligation or liability,
contingent or otherwise, for brokers' or finders' fees in respect of the
matters provided for in this Agreement which will be the responsibility of
Purchaser, and any such obligation or liability that might exist shall be the
sole obligation of Seller.

4.5. Foreign Person. Seller is not a "foreign person" within the
meaning of the Code.

4.6. Permits. To the best of Seller's knowledge Seller possesses
all material licenses, permits, certificates, orders, approvals and
authorizations necessary to own the Assets and to carry on its business as now
being conducted.

4.7. Compliance with Law. To the best of Seller's knowledge,
Seller is in material compliance with all laws, ordinances, rules, regulations
and orders applicable to the Assets, including, without limitation, all
environmental laws, ordinances, rules, regulations and orders, except to the
extent of any non-compliance that is not reasonably expected to result in a
material adverse affect on the Assets.

4.8. Taxes. All ad valorem, property, production, severance,
excise, and similar taxes and assessments based on or measured by the ownership
of property or the production of hydrocarbons or the receipt of proceeds
therefrom attributable to the Assets that have become due and payable have been
properly and timely paid, except to the extent of any failure that is not
reasonably expected to result in a material adverse effect on the Assets, and
except to the extent that such taxes are due and payable but contested,
protested or appealed by Seller.

4.9. Litigation. To Seller's best knowledge and belief, no
litigation, investigation or other proceeding in which Seller (or its direct
predecessor in title) is a named Party affects any of the Assets whether
pending or threatened in writing which is based upon omissions, events or
occurrences prior to the date of this Agreement, other than as disclosed on
Schedule 4.9 attached hereto.

<PAGE> 139

4.10. LIMITATION AND DISCLAIMER OF REPRESENTATIONS AND WARRANTIES
THE EXPRESS REPRESENTATIONS AND/OR WARRANTIES OF SELLER CONTAINED IN THIS
AGREEMENT ARE EXCLUSIVE AND ARE IN LIEU OF ALL OTHER REPRESENTATIONS AND
WARRANTIES, EXPRESS, IMPLIED, STATUTORY, OR OTHERWISE, AND THE REPRESENTATIONS
AND/OR WARRANTIES CONTAINED HEREIN SHALL TERMINATE IN ALL RESPECTS UPON
CLOSING. ANY ASSIGNMENT AND BILL OF SALE OR OTHER CONVEYANCE EXECUTED AND
DELIVERED PURSUANT HERETO SHALL BE: (a) WITHOUT ANY WARRANTY OR REPRESENTATION
OF TITLE, EITHER EXPRESS, IMPLIED, STATUTORY OR OTHERWISE; (b) WITHOUT ANY
EXPRESS, IMPLIED, STATUTORY OR OTHER WARRANTY OR REPRESENTATION AS TO THE
CONDITION, QUANTITY, QUALITY, FITNESS FOR A PARTICULAR PURPOSE, CONFORMITY TO
MODELS OR SAMPLES OF MATERIALS OR MERCHANTABILITY OF ANY OF THE ASSETS OR THEIR
FITNESS FOR ANY PURPOSE; AND (c) WITHOUT ANY OTHER EXPRESS, IMPLIED, STATUTORY
OR OTHER WARRANTY OR REPRESENTATION WHATSOEVER. AT CLOSING, PURCHASER SHALL
HAVE INSPECTED OR WAIVED ITS RIGHT TO INSPECT THE RECORDS AND THE ASSETS FOR
ALL PURPOSES AND SATISFIED ITSELF AS TO THE PHYSICAL AND ENVIRONMENTAL
CONDITION OF THE ASSETS AND PROPERTY BOTH SURFACE AND SUBSURFACE, INCLUDING BUT
NOT LIMITED TO CONDITIONS SPECIFICALLY RELATED TO THE PRESENCE, RELEASE OR
DISPOSAL OF HAZARDOUS SUBSTANCES. PURCHASER IS RELYING SOLELY UPON ITS OWN
INSPECTION OF THE ASSETS AND PROPERTY, AND, PURCHASER SHALL ACCEPT ALL OF THE
SAME IN THEIR "AS IS, WHERE IS" CONDITION. IN ADDITION, EXCEPT AS EXPRESSLY
PROVIDED OTHERWISE IN THIS AGREEMENT, SELLER MAKES NO WARRANTY OR
REPRESENTATION, EXPRESS, IMPLIED, STATUTORY OR OTHERWISE, AS TO THE ACCURACY OR
COMPLETENESS OF ANY DATA, REPORTS, RECORDS, PROJECTIONS, INFORMATION OR
MATERIALS NOW, HERETOFORE OR HEREAFTER FURNISHED OR MADE AVAILABLE TO PURCHASER
IN CONNECTION WITH THIS AGREEMENT, INCLUDING, WITHOUT LIMITATION, ANY
DESCRIPTION OF THE ASSETS, PRICING ASSUMPTIONS, OR QUALITY OR QUANTITY OF
HYDROCARBON RESERVES (IF ANY) ATTRIBUTABLE TO THE ASSETS OR THE ABILITY OR
POTENTIAL OF THE ASSETS TO PRODUCE HYDROCARBONS OR THE ENVIRONMENTAL CONDITION
OF THE ASSETS OR PROPERTY OR ANY OTHER MATTERS CONTAINED IN CONFIDENTIAL
INFORMATION OR ANY OTHER MATERIALS FURNISHED OR MADE AVAILABLE TO PURCHASER BY
SELLER OR BY SELLER'S AGENTS OR REPRESENTATIVES. ANY AND ALL SUCH DATA,
RECORDS, REPORTS, PROJECTIONS, INFORMATION AND OTHER MATERIALS FURNISHED BY
SELLER OR BY SELLER'S AGENTS OR REPRESENTATIVES OR OTHERWISE MADE AVAILABLE TO
PURCHASER OR PURCHASER'S REPRESENTATIVES ARE PROVIDED TO OR FOR THE BENEFIT OF
PURCHASER AS A CONVENIENCE, AND SHALL NOT CREATE OR GIVE RISE TO ANY LIABILITY
OF OR AGAINST SELLER OR SELLER'S AGENTS OR REPRESENTATIVES. ANY RELIANCE ON OR
USE OF THE SAME SHALL BE AT PURCHASER'S SOLE RISK.

<PAGE> 140

THE ASSIGNMENTS AND BILLS OF SALE OR OTHER CONVEYANCES TO BE DELIVERED BY
SELLER AT CLOSING SHALL EXPRESSLY SET FORTH THE LIMITATIONS AND DISCLAIMERS OF
REPRESENTATIONS AND WARRANTIES CONTAINED IN THIS PARAGRAPH.

ARTICLE 5. REPRESENTATIONS, WARRANTIES AND
COVENANTS OF PURCHASER

Purchaser represents and warrants to and covenants with Seller that:

5.1. Existence. Purchaser is a Delaware corporation duly
organized, validly existing and in good standing under the laws of the State of
Delaware.

5.2. Power. Purchaser has the requisite power and authority to
enter into and perform this Agreement and the transactions contemplated hereby.
The execution, delivery and performance of this Agreement by Purchaser, and the
transactions contemplated hereby, will not (a) violate any provision of any
Purchaser's certificate or articles of incorporation or organization, as the
case may be, bylaws, regulations or other governing documents; (b) to the best
knowledge and belief of Purchaser, conflict with, result in a breach of,
constitute a default (or an event that with the lapse of time or notice, or
both would constitute a default) under any agreement or instrument to which
Purchaser is a Party or by which Purchaser is bound, (c) to the best knowledge
and belief of Purchaser, violate any judgment, order, ruling, or decree
applicable to Purchaser and entered or delivered in a proceeding in which
Purchaser was or is a named Party; or (d) to the best knowledge and belief of
Purchaser, violate any applicable law, rule or regulation.

5.3. Authorization. The execution, delivery and performance of this
Agreement and the transactions contemplated hereby have been duly and validly
authorized by all requisite action on the part of Purchaser. This Agreement
has been duly executed and delivered on behalf of Purchaser, and at the Closing
all documents and instruments required hereunder to be executed and delivered
by Purchaser shall have been duly executed and delivered. This Agreement and
such documents and instruments shall constitute legal, valid and binding
obligations of Purchaser enforceable in accordance with their terms, subject,
however, to the effect of bankruptcy, insolvency, reorganization, moratorium
and similar laws from time to time in effect relating to the rights and
remedies of creditors, as well as to general principles of equity (regardless
of whether such enforceability is considered in a proceeding in equity or at
law).

5.4. Brokers. Purchaser has not incurred any obligation or
liability, contingent or otherwise, for brokers' or finders' fees in respect of
the matters provided for in this Agreement which will be the responsibility of
Seller, and any such obligation or liability that might exist shall be the sole
obligation of Purchaser.

<PAGE> 141
5.5. Investment Intent. Purchaser is acquiring the Assets for
Purchaser's own account for investment, and not with a view to any distribution
thereof within the meaning of the Securities Act of 1933 (the "Act"), and shall
not resell any or all of the Assets except in compliance with all applicable
securities laws.

5.6. Due Diligence. Purchaser represents, warrants and covenants
that it has or will perform prior to Closing sufficient review and due
diligence, including review of file data and inspections, to evaluate the
Assets and Property to Purchaser's complete satisfaction as a prudent and
knowledgeable Purchaser.

5.7. Sophisticated Buyer. The Purchaser is a sophisticated buyer,
knowledgeable in the evaluation and acquisition of oil and gas properties, and
understands that by purchasing oil and gas properties or interests, the
Purchaser may be exposed to risks and liabilities associated with the oil and
gas business. The Purchaser is engaged in the business of exploring for or
production oil and gas or other minerals as an ongoing business. By reason of
this knowledge and experience, the Purchaser will evaluate the merits and risks
of the properties or interests to be purchased from Seller and will form an
opinion based solely upon the Purchaser's knowledge and experience and not upon
any opinion or predictions by Seller, its employees, agents, or
representatives.

5.8. Economic Risk. The Purchaser is aware that ownership of any
of the oil and gas properties or interests is highly speculative and subject to
substantial risks, and the Purchaser is capable of bearing the high degree of
economic risk and burdens of any purchase of the Assets from Seller, including,
but not limited to, the possibility of the complete loss of the Purchase Price,
all contributed capital, the loss of all anticipated tax benefits (if any), the
lack of a public market and limited transferability of such interests or
properties;

5.9. Financing. Purchaser has or will have adequate funding or
financing to pay the Purchase Price at Closing.

5.10. Accredited Investor. Purchaser is an "accredited investor" as
that item is defined in Regulation D promulgated under the Act.

ARTICLE 5A. ADDITIONAL COVENANTS

Seller covenants and agrees that from and after the execution of this
Agreement and until the Closing Date:

5A.1. Maintenance of Assets. Seller will not sell, transfer, assign,
convey or otherwise dispose of any of the Assets subject to Seller's direct
control, other than (a) oil, gas and other hydrocarbons produced, saved and
sold in the ordinary course of business, (b) personal property and equipment
which is replaced with property and equipment of comparable or better value and
utility in the ordinary and routine maintenance and operation of the Subject
Properties, and (c) as required in connection with any exercise of preferential
rights or as otherwise required to satisfy obligations to third parties under
contracts presently existing.

<PAGE> 142

5A.2. No Encumbrances. Seller will not create any lien, security
interest or encumbrance on the Assets, the oil or gas attributable to the
Assets, or the proceeds thereof, other than Permitted Encumbrances. To the
extent there exists liens, security interests or mortgages on the Assets or any
part thereof created by Seller which are identified to Seller in writing by
Purchaser prior to the end of the Examination Period, Seller, shall deliver to
Purchaser releases of same, including associated financing statements on or
before Closing.

5A.3. Operations. With respect to any of the Subject Properties and
the Gas Plants operated by Seller, (and as to 5A.3. (b), (f), (h), and (j)
below with regard to Subject Properties not operated by Seller). Seller will
endeavor in good faith until Closing (subject to this Agreement and the rights
of affected Parties under applicable agreements) to:

(a) cause the Subject Properties and Gas Plants to be
developed, maintained and operated in compliance with
applicable laws, ordinances, rules, regulations and
orders and in a prudent, good and workmanlike manner,
maintain insurance now in force with respect to the
Subject Properties, and pay or cause to be paid all
costs and expenses in connection therewith;

(b) not approve the drilling of any new well on the
Subject Properties without the advance written
consent of Purchaser, which consent (which may not be
unreasonably withheld) or non-consent must be given
by Purchaser within three (3) days of the notice
from Seller;

(c) not take any action or fail to take any action which
is reasonably expected to result in any termination
of the leases forming a part of the Subject
Properties;

(d) perform and comply with all of its obligations under
agreements relating to or affecting the Subject
Properties and Gas Plants;

(e) carry on its business with respect to the Subject
Properties and Gas Plants in substantially the same
manner as it has heretofore;

(f) not enter into or assume any contract, agreement or
commitment which is not in the ordinary course of
business as heretofore conducted or which involves
payments, receipts or potential liabilities with
respect to any one of the Subject Properties or Gas
Plants of more than $50,000, (net to Seller)
excluding emergency expenditures; and

<PAGE> 143

(g) not resign or otherwise voluntarily relinquish its
rights as operator of any of the Subject Properties
or Gas Plants for which it serves as operator on the
date hereof.

(h) not grant any preferential right to purchase or
similar right or agree to require the consent of any
Party to the transfer and assignment of the Assets to
Purchaser, subject to existing contractual
obligations;

(i) not enter into any gas sales contract or crude oil
sales or supply contract with respect to the Subject
Properties or Gas Plants which is not terminable
without penalty upon notice of thirty (30) days or
less;

(j) not enter into any transaction the effect of which,
considered as a whole, would be to cause Seller's
ownership interest in any of the Subject Properties
or Gas Plants to be decreased from its ownership
interest as of the date hereof;

(k) if any approval or consent by any federal, state or
local governmental authority is required to vest
Acceptable Title to any of the Sale Interest or Gas
Plants in Purchaser at Closing, exercise its best
efforts, as reasonably requested in writing by
Purchaser, to obtain all such required approvals or
consents at Purchaser's expense;

(l) through Closing, endeavor to give prompt written
notice to Purchaser of any notice of default (or
written threat of default, whether disputed or
denied) received or given by Seller after the date
hereof under any instrument or agreement affecting
the Subject Properties to which Seller is a Party or
by which it or any of the Subject Properties is
bound;

(m) to the extent it can do so without violating any
third party agreement and subject to the rights of
third parties, exercise its best efforts to provide
(as soon as practicable) Purchaser with a copy of
each material authority for expenditure and material
contract affecting the Subject Properties or Gas
Plants entered into after the Execution Date,
provided, however, that the provision of such matters
to Purchaser is for informational purposes only and
that Purchaser shall have no right to comment upon or
object to any such matter that is otherwise not in
violation of this Agreement.

5A.4. Access to Records. Seller will endeavor to provide Purchaser
and its Agents through the Examination Period 1) access to the Records located
in Seller's data room during the hours 8 a.m. to 12 p.m. seven days a week at
Seller's Midland, Texas office, access to other Records during normal business
hours at Seller's office and 2) adequate work space (as determined solely by
Seller) at such offices to review the Records, 3) access to a copy machine,

<PAGE> 144

at Purchaser's cost, at such offices, and 4) reasonable access to Seller's
personnel during normal business hours. Seller, at Purchaser's cost, will
assist Purchaser in obtaining access to and the right to review and copy
Records pertaining to the Subject Properties, producing minerals and Gas Plants
not in Seller's possession or control. From and after the Execution Date
through the Closing Date, Seller shall endeavor to not add to or remove from
the Records any contracts, instruments, documents or other materials except for
such additions and removals as are done in the ordinary course of business with
respect to on-going operations.

5A.5. Permissions. Seller will use reasonable efforts, at
Purchaser's cost, to assist Purchaser in obtaining all permissions, approvals,
and consents of federal, state and local governmental authorities and other
third parties required of Seller as may be required to consummate the sale
contemplated hereunder.

ARTICLE 6. SELLER'S CONDITIONS OF CLOSING

Seller's obligation to consummate the transactions provided for herein
is subject only to the satisfaction or waiver by Seller on or before the
Closing Date of the following conditions:

6.1. Representations. The representations and warranties of
Purchaser contained in Article 5 shall be true and correct in all material
respects on the Closing Date as though made on and as of that date.

6.2. Performance. Purchaser shall have performed in all material
respects the obligations, covenants and agreements hereunder to be performed by
it at or prior to the Closing, including but not limited to payment of the
Purchase Price.

6.3. Officer's Certificate. Purchaser shall have delivered to
Seller a certificate of an executive officer dated the Closing Date, certifying
on behalf of Purchaser that the conditions set forth in Sections 6.1 and 6.2
have been fulfilled.

6.4. Pending Matters. No suit, action or other proceeding by a
third party or a governmental authority shall be pending or threatened which
seeks substantial damages from Seller in connection with, or seeks to restrain,
enjoin or otherwise prohibit, the consummation of the transactions contemplated
by this Agreement.

6.5. HSR Act. The waiting period required by the HSR Act (as
defined in Section 13.19 below) shall have expired or been terminated, if
applicable.

<PAGE> 145
ARTICLE 7. PURCHASER'S CONDITIONS OF CLOSING

Purchaser's obligation to consummate the transactions provided for
herein is subject only to the satisfaction or waiver by Purchaser on or before
the Closing Date of the following conditions:

7.1. HSR Act. The waiting period required by the HSR Act (as
defined in Section 13.19 below) shall have expired or been terminated, if
applicable.

7.2. Officer's Certificate. Seller shall have delivered to
Purchaser a certificate of an executive officer dated the Closing Date
certifying on behalf of Seller that the representations contained in the first
sentence, and the first sentence only, of each of Section 4.1 through Section
4.5 are true and correct in all material respects on the Closing Date.

7.3. Seller's Performance. Seller has performed in all material
respects the Seller's covenants in Sections 5A.1 and 5A.2 and Seller shall have
performed in all material respects the obligations in this Agreement to be
performed by Seller at Closing pursuant to Article 8.

ARTICLE 8. CLOSING.

8.1. Time and Place of Closing. If the conditions to Closing have
been satisfied or expressly waived by the Party entitled to the benefits
thereof, the consummation of the transactions contemplated hereby ("Closing")
shall take place at one of Seller's offices on or before December 15, 1998 at
9:00 a.m., or at such other place and time or in such other manner agreed upon
by Seller and Purchaser ("Closing Date"); provided, that Seller shall have the
right to extend Closing for thirty (30) days for any reason and up to an
additional fifteen (15) days to respond to any Notice of Defects provided by
Purchaser and that any extension by Seller shall not serve to provide Purchaser
rights not otherwise expressly provided herein, nor to extend any rights of
Purchaser contained herein, including, without limitation, those contained in
Section 3.5.

8.2 Closing Obligations. At the Closing, the following events
shall occur, each being a condition precedent to the others and each being
deemed to have occurred simultaneously with the others:

(a) Seller shall execute, acknowledge and deliver to Purchaser
multiple originals of an Assignment and Bill of Sale in
substantially the form attached hereto as Exhibit "B", and
Purchaser shall, execute, acknowledge and deliver same to
Seller. (Seller may require the Parties to execute separate
instruments for each state, county or parish in which the
Assets are located to facilitate recording.);

(b) Seller and Purchaser shall execute, acknowledge and deliver
transfer orders or letters in lieu directing all purchasers of
production to make payment to Purchaser of proceeds
attributable to the Sale Interest;

<PAGE> 146

(d) Purchaser and Seller shall execute and deliver a settlement
statement (the "Preliminary Settlement Statement") prepared by
Seller and setting forth the Purchase Price and all
adjustments thereto using information to the extent then
available and if not then available then Seller's reasonable
good faith estimate thereof, subject to Section 13.17;

(e) Purchaser and Seller shall execute and deliver appropriate
state or federal lease assignment forms, appropriate
resignation or change of operator forms and other instruments
and certificates; and

(f) Purchaser shall take all such other action as may be necessary
to carry out its obligations under this Agreement.

(g) Subject to Section 13.18, Seller shall execute and deliver to
Purchaser appropriate resignation of operator and change of
operator forms reasonably requested by Purchaser prior to
fifteen (15) business days before the Closing Date.

8.2. Shareholder and Board Approval of Transaction; Closing Date
Extension. (a) Purchaser represents and warrants to Seller that in order for
Purchaser to consummate the transactions contemplated by this Agreement,
Purchaser must seek and obtain the approval of its shareholders, which approval
will require the filing with the United States Securities and Exchange
Commission (the "SEC") of a proxy statement (the "Proxy Statement") pursuant to
Regulation 14A promulgated under the Securities Exchange Act of 1934.
Accordingly, Purchaser agrees to use its best efforts to prepare and file with,
and have cleared by, the SEC, the Proxy Statement as promptly as practicable
after the execution of this Agreement. Purchaser shall use its best efforts to
cause the Proxy Statement to be mailed to its shareholders as promptly as
practicable after it is cleared by the SEC, and shall duly call a meeting of
its shareholders to be held within 20 days after the Proxy Statement has been
cleared by the SEC for the purpose of approving the transactions contemplated
by this Agreement. In addition, Purchaser shall, through its Board of
Directors, recommend to its shareholders that they approve the transactions
contemplated by this Agreement, and, provided such actions are consistent with
their fiduciary duties, shall not rescind such recommendation. (b) Without
limiting the generality of the foregoing, Purchaser shall promptly (but in any
event within 10 days of the date of this Agreement) obtain and deliver to
Seller written agreements (in form and substance acceptable to Seller) from
each of Cadell S. Liedtke, Michael J. Grella, and Henry G. Musselman
irrevocably committing such shareholders to vote their shares in favor of the
transactions contemplated by this Agreement. (c) If Purchaser has not mailed
its definitive Proxy Statement to its shareholders on or before November 23,
1998, and the failure to mail results from the lack of clearance of the Proxy
Statement by the SEC (through no fault of Purchaser), than the Closing Date
shall be extended for such number of days as shall be necessary in order to
obtain clearance from the SEC; provided, however, (i) the Closing Date shall
not be extended beyond January 15, 1999, and (ii) on or after December 15,
1998, the Purchase Price shall be increased by adding interest thereto for each
day that the Closing has not occurred, with such interest to be computed at a
rate equal to that earned on the Deposit.

<PAGE> 147

ARTICLE 9. POST-CLOSING OBLIGATIONS.

9.1. Receipts and Credits; Suspense Funds. Upon Closing and
Subject to the terms hereof, all monies, refunds, proceeds, receipts, credits,
receivables, accounts and income attributable to the Assets (a) for all periods
of time from and after the Effective Time shall be the sole property and
entitlement of the Purchaser, and, to the extent received by Seller, Seller
shall fully disclose and account therefor to Purchaser promptly, and (b) for
all periods of time prior to the Effective Time shall be the sole property and
entitlement of Seller to the extent received by Purchaser or Seller prior to
the Final Accounting Date or allocated to Seller in the Final Accounting, and
if received by Purchaser, Purchaser shall fully disclose and account therefor
to Seller promptly. Purchaser shall pay Seller for Seller's share of
hydrocarbons attributable to the purchased Assets in storage above the pipeline
connection or in transit on the Effective Time at the relevant contract price,
net applicable taxes. Seller and Purchaser recognize that as of the Effective
Time there may be over or under imbalances with respect to gas production
attributable to the Subject Properties ("Imbalances") and hereby agree that (i)
Imbalances shall not be included in any Identified Claims asserted hereunder,
and (ii) the Subject Properties will be conveyed specifically subject to
Imbalances which exist as of the Effective Time, with Purchaser, as of Closing,
bearing and assuming all obligations with respect to any overproduction account
or liability and receiving the benefit of and being credited with any
underproduction account or credit; provided, however, that with respect to
Subject Properties that are subject to gas balancing agreements, Purchaser (x)
may include any net overproduced Imbalance as an Identified Claim hereunder, or
(y) at Closing shall pay Seller an amount determined by multiplying the net
underproduced Imbalance by $1.00/MCF with Purchaser, as of Closing, bearing and
assuming all obligations with respect to any overproduction account or
liability and receiving the benefit of and being credited with any
underproduction account or credit. At Closing, Seller shall deliver to
Purchaser all amounts in Seller's possession due third party owners of
interests in the Subject Properties, and Purchaser agrees that it shall be
solely responsible for the disposition of such funds, the payment thereof to
the rightful owners and the payment, if any, of royalty thereon (the "Suspense
Funds").

9.2. Costs and Liabilities; Indemnity

(a) As used in this Agreement, "Claims", "CLAIMS",
"claims" or "Claims" shall include costs, expenses,
obligations, claims, demands, causes of action,
lawsuits, liabilities, damages, fines, penalties,
debts, losses and judgments of any kind or character,
whether matured or absolute or contingent, accrued or
unaccrued, liquidated or unliquidated, known or
unknown, and all costs, expenses and fees (including,
without limitation,

<PAGE> 148

interest, attorneys' fees, costs of experts, court
costs and costs of investigation) incurred in
connection therewith, including, but not limited to
claims arising from or directly or indirectly related
to death, personal injury, property damage,
environmental damage or the remediation thereof,
royalty, operating, suspense and capital obligations
attributable to the Assets or the Property. As used
in this Section 9.2, "Assets" shall include the
Suspense Funds.

(b) Notwithstanding anything in this Agreement to the
contrary, it is the express intent and agreement of
Seller and Purchaser that, if Closing occurs,
Purchaser shall accept the Assets and Property in
their "as is, where is" condition, subject to any and
all faults, defects, deficiencies, irregularities and
claims related or attributable in any manner
thereto, including, without limitation, Title
Defects, Environmental Defects, Identified Claims or
any other matter affecting in any respect the title
or physical condition of, or the right to own, use,
operate, develop or enjoy, the Assets, whether known
or unknown, liquidated or unliquidated, fixed or
contingent, direct or indirect.

(c) At Closing and without further action or
documentation, Purchaser (1) shall assume, be
responsible for and comply with all duties and
obligations, express or implied, arising at any time
with respect to the Assets, including, without
limitation (i) those arising under or by virtue of
any lease, contract, agreement, document, permit,
law, statute, rule, regulation or order of any
governmental authority or court (specifically
including, without limitation, any governmental
request or other requirement to plug, re-plug or
abandon or re-abandon any well of whatsoever type,
status or classification, or take any clean-up,
remedial or other action with respect to the Assets
or Property), (ii) preferential rights to purchase
and (iii) third party consents; (2) shall assume, be
responsible for and pay all claims affecting or
arising, directly or indirectly, at any time in
connection with the Assets, including, without
limitation, claims for personal or property injury or
damage, environmental cleanup, remediation, or
compliance, or for any other relief, arising directly
or indirectly from or incident to, the use,
occupation, operation, maintenance or abandonment of
or production from the Assets, or condition of the
Assets or Property, whether latent or patent,
including, without limitation, contamination of
property or premises with Naturally Occurring
Radioactive Materials ("NORM"), and whether or not
arising solely from or contributed to by the
negligence in any form, whether active or passive, or
of any kind or nature, of Seller or its predecessors
in title or their respective Affiliates agents,
employees or contractors; and (3) SHALL DEFEND,
INDEMNIFY AND HOLD SELLER HARMLESS FROM

<PAGE> 149

ANY AND ALL CLAIMS ARISING, ASSERTED OR DUE AT ANY
TIME, WHETHER BEFORE, ON OR AFTER THE EFFECTIVE TIME,
IN CONNECTION WITH THE FOREGOING; AND, FURTHER,
WITHOUT LIMITING THE GENERALITY OF THE FOREGOING,
PURCHASER WILL INDEMNIFY, DEFEND AND HOLD HARMLESS
SELLER FROM ALL CLAIMS ARISING AT ANY TIME, WHETHER
BEFORE, ON OR AFTER THE EFFECTIVE TIME, MADE BY ANY
PERSON AND ARISING OUT OF OR RESULTING FROM:

- THE OWNERSHIP OR OPERATION OF THE ASSETS BY OR ON
BEHALF OF SELLER OR ITS PREDECESSORS IN TITLE OR ACTS
OR OMISSIONS BY OR ON BEHALF OF SELLER OR ITS
PREDECESSORS IN TITLE IN CONNECTION WITH OR
PERTAINING TO THE ASSETS;

- THE OWNERSHIP OR OPERATION OF THE ASSETS BY OR ON
BEHALF OF PURCHASER OR ITS SUCCESSORS IN TITLE OR THE
ACTS OR OMISSIONS BY OR ON BEHALF OF PURCHSER OR ITS
SUCCESSORS IN TITLE IN CONNECTION WITH OR PERTAINING
TO THE ASSETS;

- THE ACTS OR OMISSIONS OF THIRD PARTIES RELATING TO
THE ASSETS;

- THE REVIEW, INSPECTION AND ASSESSMENT OF THE ASSETS
BY PURCHASER;

- AN ERROR IN DESCRIBING THE ASSETS;

- RIGHTS AND OBLIGATIONS OF THE PARTIES OR THIRD
PARTIES UNDER RELATED AGREEMENTS;

- FAILURE BY THIRD PARTIES TO APPROVE OR CONSENT TO ANY
ASPECT OF THIS TRANSACTION;

- OBLIGATIONS TO PLUG, RE-PLUG, ABANDON OR RE-ABANDON
WELLS, REMOVE FACILITIES, EQUIPMENT, PIPELINES AND
FLOWLINES, CLOSE PITS AND REMOVE SUMPS, AND RESTORE,
CLEAN UP AND/OR REMEDIATE THE ASSETS OR PROPERTY;

- PAYMENTS, ROYALTIES OR DISBURSEMENTS PAID OR PAYABLE
BY SELLER OR PURCHASER TO THIRD PARTIES WITH REGARD
TO THE ASSETS;

<PAGE> 150
- THE PHYSICAL OR ENVIRONMENTAL CONDITION OF OR
RELATING TO THE ASSETS OR PROPERTY OR ANY DISPOSAL
SITE (WHETHER ON THE ASSETS OR PROPERTY OR OFFSITE)
CONTAINING MATERIALS OR WASTES FROM THE OPERATION'S
OR ACTIVITIES ON THE PROPERTY OR ASSETS INCLUDING
CLAIMS UNDER ANY LAW OR ENVIRONMENTAL LAW;

- REMEDIATION ACTIVITIES, INCLUDING DAMAGES INCURRED BY
BUYER DURING OR ARISING FROM REMEDIATION ACTIVITIES
RELATING TO THE ASSETS OR PROPERTY;

- INABILITY OR FAILURE TO OBTAIN THE TRANSFER OF A
PERMIT OR AUTHORIZATION OR THE INABILITY TO OBTAIN A
PERMIT OR AUTHORIZATION RELATING TO THE ASSETS.

(d) From and after Closing, any claim for indemnity
hereunder shall be made by written notice, together
with a written description of any claims asserted
stating the nature and basis of such claim and, if
ascertainable, the amount thereof. Purchaser shall
have a period of twenty (20) days after receipt of
such notice within which to respond thereto or, in
the case of a claim which requires a shorter time for
response, then within such shorter period as
specified by Seller in such notice (the "Notice
Period"). If Purchaser denies liability hereunder or
fails to provide the defense for any claim, Seller
may defend or compromise the claim as it deems
appropriate without prejudice to any of Seller's
rights hereunder, with no right of Purchaser to
approve or disapprove any actions taken in connection
therewith by Seller. If Purchaser accepts liability
and responsibility for the defense of any claim, it
shall so notify Seller as soon as is practicable
prior to the expiration of the Notice Period and
undertake the defense or compromise of such claim
with counsel selected by Purchaser and reasonably
acceptable to Seller. If Purchaser undertakes the
defense or compromise of such claim, Seller shall be
entitled, at its own expense, to participate in such
defense. No compromise or settlement of any claim
shall be made without reasonable notice to Seller,
and without the prior written approval of Seller,
unless such compromise or settlement includes a
general and complete release of Seller, its
Affiliates and their respective Representatives in
respect of the matter, with prejudice, and with no
express or written admission of liability on the part
of Seller, its Affiliates and their respective
Representatives, and no constraints on the future
conduct of its or their respective businesses.
Purchaser acknowledges that

<PAGE> 151

its obligations to indemnify, defend and hold Seller
and its Affiliates harmless under this Agreement
includes obligations to pay the attorneys' fees and
court costs incurred by Seller and its Affiliates in
defending said Claims, regardless of the merits of
said Claims.

(e) Seller shall have the right at all times to
participate, at its sole cost, in the preparation for
any hearing or trial related to the indemnities set
forth in this Agreement, as well as the right to
appear on its own behalf or to retain separate
counsel to represent it at any such hearing or trial.

(f) THE INDEMNITIES PROVIDED IN THIS AGREEMENT SHALL
EXTEND TO SELLER AND ITS AFFILIATES AND ANY PERSON
WHO AT ANY TIME HAS SERVED OR IS SERVING AS A
DIRECTOR, OFFICER, EMPLOYEE, CONSULTANT, INVITEE OR
AGENT THEREOF (EACH A "REPRESENTATIVE" AND
COLLECTIVELY "REPRESENTATIVES"), AND EACH OF THEIR
RESPECTIVE HEIRS, EXECUTORS, SUCCESSORS AND ASSIGNS,
AND SHALL APPLY TO ALL CLAIMS SUBJECT TO INDEMNITY
HEREUNDER, INCLUDING THOSE BASED ON NEGLIGENCE OF ANY
NATURE, INCLUDING SOLE NEGLIGENCE, SIMPLE NEGLIGENCE,
CONCURRENT NEGLIGENCE, ACTIVE NEGLIGENCE, PASSIVE
NEGLIGENCE, STRICT LIABILITY OR FAULT OF SELLER (OR
ANY OTHER INDEMNIFIED PARTY) OR ANY OTHER THEORY OF
LIABILITY OR FAULT, WHETHER OF LAW (WHETHER COMMON OR
STATUTORY) OR IN EQUITY.; PROVIDED, HOWEVER,
PURCHASER SHALL NOT BE LIABLE FOR OR INDEMNIFY SELLER
FOR ANY CLAIM ASSERTED BY PURCHASER ARISING DIRECTLY
FROM A BREACH OF A MATERIAL TERM OF THIS AGREEMENT BY
SELLER AND FOR WHICH AND ONLY TO THE EXTENT THAT,
PURCHASER HAS OBTAINED AGAINST SELLER A BINDING ,
FINAL, NON-APPEALABLE ARBITRATION DECISION PURSUANT
TO THIS AGREEMENT OR COURT JUDGEMENT THE
INDEMNIFICATION PROVISIONS OF THIS SECTION 9.2 SHALL
BE IN ADDITION TO ANY OTHER INDEMNITY PROVISIONS
CONTAINED IN THIS AGREEMENT, AND IT IS EXPRESSLY
UNDERSTOOD AND AGREED THAT THE TERMS OF THIS SECTION
9.2 SHALL CONTROL OVER ANY CONFLICTING OR
CONTRADICTING TERMS OR PROVISIONS CONTAINED IN THIS
AGREEMENT, AND SHALL SURVIVE CLOSING.

9.3. Further Assurances. After Closing, Seller and Purchaser agree
to take such further actions and to execute, acknowledge and deliver all such
further documents that are

<PAGE> 152

necessary or useful in carrying out the purposes of this Agreement or of any
document delivered pursuant hereto. The parties will cooperate at all times
after Closing to execute and record correction instruments to correct
scrivener's errors in the preparation of Closing documents. Prior to Closing
upon written notice form Purchaser, delivered at least thirty (30) days prior
to the Closing Date, that Seller is not qualified to do business in one or more
states such that any conveyance of Assets located in such states would not be
valid, Seller shall cooperate with Purchaser and take such steps to gain good
standing in such states to make such proposed conveyances of Assets valid.

9.4. Delivery of Records. As soon as reasonably possible but no
later than thirty (30) days after the Closing Date, Seller shall deliver
originals or copies consistent with this Agreement at Seller's and Purchaser's
equally shared cost, of the Records to Purchaser; provided, that Seller (i)
shall exercise its best efforts to provide Purchaser at Closing or as soon
thereafter as is practicable with all Records necessary to assume and conduct
operations of the Assets, and (ii) shall have the right to retain, as its own,
original Records that pertain to the Excluded Assets and copies (at Seller's
and Purchaser's equally shared cost) of all other Records. No later than
thirty (30) days after Closing, Seller further agrees to assist Purchaser (at
Purchaser's cost) in making an electronic transfer of all Records applicable to
the Subject Properties. Such electronic data to include but is not limited to:
Property Master files, Name and Address files, (owners, purchasers, operators,
etc.), Division of Interest decks for billing and revenue, Oil and Gas
Purchaser Division Order/Property cross-reference, Land Records (Lease, tracts,
Critical Dates, Text file, Ownership, Rentals, Billing), Chart of Accounts,
Billing Category Codes, County and State Code cross-reference, System Code
Tables or Legends (Suspense Codes, Interest Types, Product Codes, etc.) Gas
Contract Records (Master File, Text, Details, Fees, Calendar, etc.), Owner
Netting Information, Production Records (Tank Master, Closing Stock, Production
Master, State Information, etc.), AFE Information, Revenue Suspense and/or
Billing suspense, Owner Net (Share) Revenue and Billing History, Property Gross
(8/8) Revenue and Billing History, Operated Property Production Information
(and Non-Operated if available), Operated Property Production Tax History
Information, Land Records (Rental Payments), Payout Information and Schedules,
1099 Information, Accounts Payable and Revenue information. Seller's
obligation pursuant to this Section 9.4 shall be limited to Seller's present
capability to perform such electronic transfers without disruption or undue
inconvenience to Seller's ongoing business, and further, Seller shall not be
required to create, assemble or develop such electronic files or records.

9.5. Access to Data and Records. Subject to the rights of third
parties and Seller's proprietary rights, Seller shall (i) provide Purchaser and
its Agents with reasonable access to Seller's books and records relating to the
Assets (both paper and electronic) before and after Closing as necessary for
Purchaser, at Purchaser's cost, to prepare its financial statements, (ii)
electronically download Seller's Records at Purchaser's cost regarding the
Subject Properties into Purchaser's accounting and land system within ten (10)
days after the Execution Date and thereafter, prior to Closing, electronically
update Purchaser's accounting, land and lease records at least one (1)
additional time from Seller's Records, so long as such electronic downloading

<PAGE> 153

efforts are not disruptive of Seller's business or accounting or land
departments and (iii) assist Purchaser, at Purchaser's cost, in acquiring the
appropriate licenses, permits and authorizations to possess and use all or part
of the seismic and geophysical data regarding the Subject Properties, subject
to the rights of third parties and to confidentiality or limited use conditions
or other conditions or restrictions required by Seller or such third parties.

9.6 Purchaser's Release of Seller. At Closing and without
further documentation, Purchaser releases and discharges Seller and Sellers
Affiliates from all Claims relating to the Assets, the Property or this
transaction, regardless of when or how the Claim arose or arises or whether
the Claim was foreseeable or unforeseeable. Purchaser's release of Seller and
its Affiliates includes Claims resulting in any way from the negligence or
strict liability of Seller and its Affiliates, whether the negligence or strict
liability is active passive, joint, concurrent, or sole. There are no
exceptions to Purchasers release of Seller and its Affiliates, and this release
is binding on Purchaser and its successors and assigns. PURCHASER EXPRESSLY
WARRANTS AND REPRESENTS AND DOES HEREBY STATE AND REPRESENT THAT NO PROMISE OR
AGREEMENT WHICH IS NOT HEREIN EXPRESSED HAS BEEN MADE TO PURCHASER IN EXECUTING
THIS AGREEMENT OR AGREEING TO THIS RELEASE AND THAT PURCHASER IS NOT RELYING
UPON ANY STATEMENT OR REPRESENTATION OF SELLER OR ANY AGENT OR AFFILIATE OF
SELLER. PURCHASER HAS BEEN REPRESENTED BY LEGAL COUNSEL AND SAID COUNSEL HAS
READ AND EXPLAINED TO PURCHASER THE ENTIRE CONTENTS OF THIS AGREEMENT AND THIS
RELEASE AND EXPLAINED THE LEGAL CONSEQUENCES THEREOF.

9.7 Retroactive Effect. Purchaser acknowledges that Purchaser's
obligations to release, indemnify, defend, and hold Seller and its Affiliates
harmless apply to matters occurring or arising before, on and after the
Effective Time to the extent provided in this Agreement.

9.8. Inducement to Seller. Purchaser acknowledges that it
evaluated its obligations under this article before it determined and submitted
its bid for the Assets and that its assumption of these obligations is a
material inducement to Seller to enter into this Agreement with and Close the
sale to Purchaser.

9.9 Purchaser's Indemnity. Except for Seller's Indemnity
contained in Section 9.13 below, it is the intent of Purchaser and Seller that
Seller be indemnified, defended and held harmless by Purchaser in a manner so
that Seller will be protected as if it has never at any time owned or operated
the Assets or the Property or any interest therein or pertaining thereto, in
whole or in part.

9.10. Related Agreements. Without further action or documentation,
unless specifically provided otherwise in this Agreement, the sale of the
Assets is made subject to all oil, gas and mineral leases, assignments,
subleases, farmout agreements, joint operating

<PAGE> 154
agreements, pooling agreements, letter agreements, easements, rights of way,
and all other agreements with respect to or pertaining to the Assets to the
extent they are binding on Seller or Seller's Affiliates (the "Related
Agreements"). Upon Closing, Purchaser expressly assumes the obligations and
liabilities of Seller or Seller's Affiliates under such agreements insofar as
the obligations and liabilities concern or pertain to the Assets and will
execute any documents necessary to effectuate such assumption. The Parties
agree that this Section 9.10 is applicable to all instruments whether they are
recorded or not.

9.11. Litigation. Upon and after Closing, Purchaser shall assume
all obligations of Seller and Seller's Affiliates and be responsible and liable
for all litigation listed on Schedule 9.11 and all matters, costs, judgments,
and expenses related thereto or arising therefrom. Notwithstanding Section 9.2
(c) above, 9.6, 9.9, and 12.2, upon Closing, Seller shall be responsible and
liable for all litigation which has been filed and served on Seller before the
Execution Date to which Purchaser is not a party and Seller is a party and
which is not listed on Schedule 9.11. Seller reserves the right to remove
litigation from Schedule 9.11 on or before Closing.

9.12. Evidence of Compliance. For Seller-operated Assets, Purchaser
shall deliver to Seller on or prior to 120 days after the Closing (1) evidence
of compliance with the rules and regulations dealing with the plugging and
abandoning of wells included in the Assets, including evidence of the
appropriate bond, surety letter, or letter of credit which has been accepted by
the relevant regulatory agency; (2) proof that Purchaser has been approved by
the relevant regulatory agency as operator of the Assets, including all Wells
that are subject to this Agreement; and (3) evidence that Purchaser has obtained
all necessary permits or transfers of permits to operate the Assets. For matters
which Purchaser has been unable to provide the necessary evidence and proof,
Purchaser shall provide Seller with a status report and action plan for
obtaining such required evidence and proof and continue diligently in its
efforts until all such matters have been achieved. Purchaser shall indemnify,
defend and hold harmless Seller and Seller's Representatives from all Claims
arising from or relating to Purchaser's failure to obtain or failure to obtain
in a timely manner the evidence or proof described in this Section 9.12 (1), (2)
and (3) above.

9.13. Seller's Indemnity. Notwithstanding any other provision of
this Article 9, for the period beginning on the Closing Date and ending on the
first anniversary of the Closing Date (the "Seller Indemnity Period") Seller
shall defend, indemnify and hold harmless Purchaser from any and all bona fide
third party claims asserted during the Seller Indemnity Period to the extent,
and only to the extent, directly relating to the mispayment, nonpayment or
underpayment of royalties for the for the Sale Interest applicable to the
period of Seller's ownership of the Affected Assets.

9.14. Release of Liens. To the extent there exists liens, security
interests or mortgages on the Assets or any part thereof created by Seller
which are identified to Seller in writing by Purchaser prior to the end of the
Examination Period, Seller, shall deliver to Purchaser releases of same,
including associated financing statements on or before Closing.

<PAGE> 155

ARTICLE 10. TERMINATION

10.1. Right of Termination. This Agreement and the transactions
contemplated hereby may be terminated at any time at or prior to the Closing:

(a) By Seller if Closing does not occur on or before
December 15, 1998, unless the Closing Date is extended by Purchaser pursuant to
and subject to Section 8.3 above in which event by Seller if Closing does not
occur on or before January 15, 1999;

(b) By mutual consent of the parties;

(d) By Purchaser by notice delivered to Seller on or
before Closing if all conditions described in Article 7 shall not have
been met and such noncompliance shall not have been caused or waived
by the actions or inactions of Purchaser; or

(e) By Seller by notice delivered to Purchaser on or
before Closing if (1) all conditions described in Article 6 shall not
have been met and such noncompliance shall not have been caused or
waived by the actions or inactions of Seller, or (2) Purchaser has not
made the filings and requests required of it in Section 8.3 in the
time required thereunder or by the first sentence of Section 13.20
prior to thirty days after the Execution Date.

10.2. Effect of Termination. If this Agreement is terminated
pursuant to Section 10.1, this Agreement shall become void and of no further
force or effect (except for the provisions of Section 3.3, Article 5, Section
10.2, and Article 13 each of which shall survive such termination and continue
in full force and effect). If this Agreement is terminated by Purchaser
pursuant to Section 10.1 (d) above, in the absence of a default by Purchaser,
Purchaser may, at its sole option, seek arbitration pursuant to Section 13.24
hereto to enforce whatever legal or equitable rights and remedies may be
appropriate and applicable, including, without limitation, damages and/or
specific performance of this Agreement, or in lieu thereof and with a written
release for all claims for the default(s) which is/are the basis for such
termination subject to the reasonable satisfaction of Seller, elect to receive
a refund of the Deposit and all accrued interest thereon which shall be
returned by Seller to Purchaser. If this Agreement is terminated by Seller
pursuant to Section 10.1(a) or (e) above, Seller shall have no further
liability to Purchaser and shall be entitled to retain the Deposit and all
accrued interest and to receive from Purchaser as its sole and exclusive remedy
liquidated damages in the amount of $41,000,000 plus the costs and expenses of
obtaining said amount from Purchaser, including attorneys fees, court costs,
and other expenses, less and except the amount of the Deposit and all accrued
interest on the Deposit which may be retained by Seller. If this Agreement is
terminated pursuant to Section 10.1(b) or (c) above, the Deposit and all
accrued interest on the Deposit shall be returned by Seller to Purchaser with
neither party having further remedy or recourse, except in the event the
termination is made in bad faith. Notwithstanding anything to the contrary
contained in this Agreement, upon any termination of this Agreement pursuant to
Section 10.1 by Seller, Seller shall be free immediately to enjoy all rights of
ownership of the Assets and may sell, transfer,

<PAGE> 156

encumber or otherwise dispose of the Assets to any party without any
restriction under this Agreement and without any impairment of its rights
hereunder to recover damages from Purchaser arising from any default hereunder
by Purchaser.

ARTICLE 11. TAXES

11.1. Apportionment of Ad Valorem and Property Taxes. All ad
valorem taxes, real property taxes, personal property taxes, and similar
obligations concerning the Assets with respect to the tax period in which the
Effective Time occurs ("Property Taxes") shall be apportioned as of the
Effective Time between Seller and Purchaser. Seller shall file or cause to be
filed all required reports and returns incident to the Property Taxes and shall
pay or cause to be paid to the taxing authorities all Property Taxes relating
to the tax period in which the Effective Time occurs. Purchaser shall pay to
Seller Purchaser's pro rata portion of Property Taxes within thirty (30) days
after receipt of Seller's invoice therefor.

11.2. Sales Taxes. The Purchase Price excludes any sales taxes or
other taxes required to be paid in connection with the sale of property
pursuant to this Agreement. Purchaser shall be liable for all sales, gross
receipts, use and other taxes, conveyance, transfer and recording fees and real
estate transfer stamps or taxes that may be imposed on any transfer of property
pursuant to this Agreement. These taxes shall be collected and remitted under
applicable law. Purchaser shall indemnify and hold Seller harmless with
respect to the payment of any of these taxes including any interest or
penalties assessed thereon.

11.3. Other Taxes. All taxes (other than income taxes) which are
imposed on or with respect to the production of oil, natural gas or other
hydrocarbons or minerals or the receipt of proceeds therefrom (including but
not limited to severance, production, and excise taxes) shall be apportioned
between the Parties based upon the respective shares of production taken by
the Parties. From and after Closing, Purchaser shall be responsible for paying
or withholding or causing to be paid or withheld all such taxes and for filing
all statements, returns, and documents incident thereto.

11.4. Cooperation. Each Party to this Agreement shall provide the
other Party with reasonable access to all relevant documents, data and other
information which may be required by the other Party for the purpose of
preparing tax returns and responding to any audit by any taxing jurisdiction.
Each Party to this Agreement shall cooperate with all reasonable requests of
the other Party made in connection with contesting the imposition of taxes.
Notwithstanding anything to the contrary in this Agreement, neither Party to
this Agreement shall be required at any time to disclose to the other Party any
tax return or other confidential tax information for a period of at least 12
months.

<PAGE> 157

ARTICLE 12. PHYSICAL CONDITION OF THE ASSETS

12.1. Prior Use of Assets. THE ASSETS AND PROPERTY HAVE BEEN USED
FOR EXPLORATION, DEVELOPMENT, PRODUCTION, STORAGE, AND TRANSPORTATION OF OIL
AND GAS AND RELATED OIL FIELD OPERATIONS. PHYSICAL CHANGES IN THE PROPERTY MAY
HAVE OCCURRED AS A RESULT OF SUCH USES. THE ASSETS OR THE PROPERTY ALSO MAY
INCLUDE BURIED PIPELINES, WASTES AND OTHER EQUIPMENT, WHETHER OR NOT OF A
SIMILAR NATURE, THE LOCATIONS OF WHICH MAY BE HIDDEN OR NOT NOW BE KNOWN OR
NOT READILY APPARENT BY A PHYSICAL INSPECTION OF THE AFFECTED ASSETS.
HYDROCARBONS AND OTHER SUBSTANCES, INCLUDING HAZARDOUS SUBSTANCES, MAY HAVE
COME TO BE RELEASED OR LOCATED ON OR BENEATH THE SURFACE OF THE ASSETS OR THE
PROPERTY.

12.2 Assumption of Assets in Present Condition. PURCHASER
ACKNOWLEDGES THAT (i) THE CONSUMMATION OF THIS AGREEMENT AND THE TRANSACTIONS
CONTEMPLATED THEREBY BY PURCHASER SHALL BE SOLELY ON THE BASIS OF ITS OWN
INVESTIGATION OF THE PHYSICAL CONDITION OF THE ASSETS AND PROPERTY, INCLUDING,
WITHOUT LIMITATIONS, SUBSURFACE CONDITION; (ii) THE ASSETS AND PROPERTY HAVE
BEEN USED IN THE MANNER AND FOR THE PURPOSES SET FORTH ABOVE AND THAT PHYSICAL
CHANGES TO THE ASSETS AND THE PROPERTY MAY HAVE OCCURRED AS A RESULT OF SUCH
USE; AND (iii) NORM AND ASBESTOS OR MAN-MADE MATERIAL FIBERS (COLLECTIVELY
"MMMF") MAY BE PRESENT AT SOME LOCATIONS. PURCHASER ACKNOWLEDGES THAT NORM IS A
NATURAL PHENOMENON ASSOCIATED WITH MANY OIL FIELDS IN THE UNITED STATES AND
THROUGHOUT THE WORLD. PURCHASER SHALL MAKE ITS OWN DETERMINATION OF THIS
PHENOMENON AND OTHER CONDITIONS. SELLER DISCLAIMS ANY LIABILITY ARISING OUT OF
OR IN CONNECTION WITH ANY PRESENCE OF NORM OR MMMF ON OR AFFECTING THE ASSETS OR
THE PROPERTY. IN ACCORDANCE WITH SECTION 9.2 AND AT CLOSING, PURCHASER SHALL
ASSUME THE RISK THAT THE ASSETS OR THE PROPERTY MAY CONTAIN WASTES OR
CONTAMINANTS AND ADVERSE PHYSICAL CONDITIONS, INCLUDING THE PRESENCE OF
PIPELINES, EQUIPMENT AND OTHER ITEMS OF PERSONAL PROPERTY, TANK BOTTOMS, HEATER
TREATER SLUDGE, AND WASTES OR CONTAMINANTS WHICH MAY NOT HAVE BEEN REVEALED BY
PURCHASER'S INVESTIGATION. IN ACCORDANCE WITH SECTION 9.2 AND AT CLOSING, ALL
RESPONSIBILITY AND LIABILITY RELATED TO DISPOSALS, SPILLS, WASTES, OR
CONTAMINATION, OR OTHER ADVERSE PHYSICAL CONDITIONS ON, BELOW, OR RELATED TO OR
AFFECTING THE ASSETS AS WELL AS THE PROPERTY SHALL BE ASSUMED BY PURCHASER AND
PURCHASER SHALL NOT WITHSTANDING WHEN THE BASIS FOR ANY CLAIM, ACTION, SUIT,
JUDGMENT (INCLUDING, WITHOUT LIMITATION, THOSE FOR DEATH, PERSONAL INJURY OR
PROPERTY DAMAGE) SHALL HAVE OCCURRED, INDEMNIFY, DEFEND AND HOLD SELLER HARMLESS
THEREFROM PURSUANT TO SECTION 9.2.

<PAGE> 158

12.3. Casualty Loss. In the event of any material damage by fire or
other casualty to any of the Assets prior to the Closing ("Casualty Loss"),
this Agreement shall remain in full force and effect, and as to each affected
Asset, Seller shall at its election either collect (and when collected pay over
to Purchaser) or assign to Purchaser any and all insurance claims related to
such damage, and Purchaser shall take title to the affected Asset without
reduction in the Purchase Price.

ARTICLE 13. MISCELLANEOUS

13.1. Governing Law.This Agreement and all instruments executed in
accordance herewith shall be governed by and interpreted in accordance with the
laws of the State of Texas, without regard to conflict of law rules that would
direct application of the laws of another jurisdiction, except to the extent
that it is mandatory that the law of the jurisdiction wherein the Assets are
located shall apply. In the event of any litigation or other proceeding in
connection with this Agreement, the venue for any such proceeding shall be in a
court of competent jurisdiction located in Dallas County, Texas, and the
prevailing Party shall be entitled to recover its reasonable attorney's fees
and costs incurred therein from the other Party, in addition to any damages
awarded.

13.2. Entire Agreement. This Agreement, all agreements and
instruments executed in connection herewith and the Confidentiality Agreement
dated April 15, 1998, between Purchaser and Seller (the "Confidentiality
Agreement") and that Letter Agreement dated September 1, 1998 by and between
the Purchaser and Seller constitute the entire agreement between the Parties
and supersede all prior agreements, understandings, negotiations and
discussions, whether oral or written, of the Parties. The Letter Agreement and
the Confidentiality Agreement remain in full force and effect. No supplement,
amendment, alteration, modification, waiver or termination of this Agreement
shall be binding unless executed in writing by the Parties hereto.

13.3. Waiver. No waiver of any of the provisions of this Agreement
shall be deemed or shall constitute a waiver of any other provisions hereof
(whether or not similar), nor shall such waiver constitute a continuing waiver
unless otherwise expressly provided.

13.4. Captions. The captions in this Agreement are for convenience
only and shall not be considered a part of or affect the construction or
interpretation of any provision of this Agreement.

13.5. Assignability. Purchaser shall not assign (whether before, at
or after Closing) this Agreement or any of its rights or obligations hereunder
without the prior written consent of the Seller, which may be withheld or
conditioned for any or no reason. Any assignment made without such consent
shall be void. Seller shall not assign this Agreement or any of its rights or
obligations hereunder without the prior written consent of Purchaser, which
consent shall not be

<PAGE> 159

unreasonably withheld. Except as otherwise provided herein, this Agreement
shall be binding upon and inure to the benefit of the Parties hereto and their
respective permitted successors and assigns, however, in any event Purchaser
shall remain responsible and liable for the performance of the obligations of
Purchaser under this Agreement. All future conveyances of all or a portion of
the Assets shall expressly recognize and perpetuate the rights and obligations
set out in this Agreement.

13.6. Notices. Any notice provided or permitted to be given under
this Agreement shall be in writing, and may be served by personal delivery or
by registered or certified U.S. mail, addressed to the Party to be notified,
postage prepaid, return receipt requested. Notice deposited in the mail in the
manner hereinabove described shall be deemed to have been given and received on
the date of the delivery as shown on the return receipt. Notice served in any
other manner (including by facsimile delivery) shall be deemed to have been
given and received only if and when actually received by the addressee. For
purposes of notice, the addresses of the Parties shall be as follows:

SELLER:

Pioneer Natural Resources USA, Inc.

Attn: Ray Alameddine and W.T. Howard
1400 Williams Square West
5205 North O'Connor Blvd.
Irving, Texas 75039-3746
Telephone: 972/444-9001
Fax: 972/402/7066

PURCHASER:

Costilla Energy, Inc.

Attn: Clifford N. Hair, Jr.
400 West Illinois, Suite 1000
Midland, Texas 79701
Telephone: 915/686-6030
Fax: 915/686-6083

With copy to:

Michael J. Grella
400 West Illinois, Suite 1000
Midland, Texas 79701
Telephone: 915/686-6010
Fax: 915/688-4089

<PAGE> 160

Each Party shall have the right, upon giving three (3) days prior notice to the
other in the manner hereinabove provided, to change its address for purposes of
notice to any other appropriate street address.

13.7. DTPA Waiver. TO THE EXTENT APPLICABLE TO THE ASSETS OR ANY
PORTION THEREOF, PURCHASER HEREBY VOLUNTARILY WAIVES THE PROVISIONS OF THE
TEXAS DECEPTIVE TRADE PRACTICES ACT, CHAPTER 17, SUBCHAPTER E, SECTIONS 17.41
THROUGH 17.63, INCLUSIVE (OTHER THAN SECTION 17.555, WHICH IS NOT WAIVED), TEX.
BUS. & COM. CODE., A LAW THAT GIVES CONSUMERS SPECIAL RIGHTS AND PROTECTIONS.
IN ORDER TO EVIDENCE ITS ABILITY TO GRANT SUCH WAIVER, PURCHASER HEREBY
REPRESENTS AND WARRANTS TO SELLER THAT IT (i) IS IN THE BUSINESS OF SEEKING OR
ACQUIRING, BY PURCHASE OR LEASE, GOODS OR SERVICES FOR COMMERCIAL OR BUSINESS
USE; (ii) HAS CONSULTED WITH AN ATTORNEY OF PURCHASER'S OWN CHOOSING; (iii)
HAS KNOWLEDGE AND EXPERIENCE IN FINANCIAL, BUSINESS AND OIL AND GAS MATTERS
THAT ENABLE IT TO EVALUATE THE MERITS AND RISKS OF THE TRANSACTIONS
CONTEMPLATED HEREBY; (iv) IS NOT IN A SIGNIFICANTLY DISPARATE BARGAINING
POSITION; AND (v) THAT THIS WAIVER IS A MATERIAL AND INTEGRAL PART OF THIS
AGREEMENT AND THE CONSIDERATION THEREOF.

13.8. Expenses. Each Party shall be solely responsible for all
expenses incurred by it in connection with this transaction (including, without
limitation, fees and expenses of its own legal counsel and accountants).

13.9. Severability. The provisions of this Agreement are severable
at Seller's option. If a court of competent jurisdiction finds any part of
this Agreement to be void, invalid, or otherwise unenforceable, then Seller may
decide whether to enforce this Agreement without the void, invalid, or
unenforceable parts or to terminate this Agreement.

13.10. Damages. The Parties waive any rights to special, indirect,
punitive, exemplary, or consequential damages resulting from a breach of this
Agreement.

13.11. No Third Party Beneficiary This Agreement is not intended to
create, nor shall it be construed to create, any rights in any third party
under doctrines concerning third party beneficiaries.

13.12. Survival. The representations and warranties of the Parties
under this Agreement shall not survive, but shall terminate upon and be
extinguished by, Closing; provided, however, that (i) all representations,
warranties, disclaimers, releases, waivers, covenants, agreements and
indemnities contained within Sections 1.2, 2.3, 3.3, 3.6, 3.7, and 5.1 through
5.9, and Articles 9, 11, 12 and 13 of this Agreement shall survive the Closing,
further provided, that,

<PAGE> 161

notwithstanding anything herein to the contrary, Purchaser expressly agrees and
acknowledges that it shall have no remedy or recourse against Seller or its
Affiliates or any of their respective Representatives with respect to the
condition of the Assets or any representation or warranty made in connection
with this Agreement, except as expressly provided by Section 3.6. and 3.6.A.

13.13. Counterparts. This Agreement may be executed in one or more
counterparts, each of which shall be deemed an original, but all of which
together shall constitute one and the same instrument.

13.14. Not to be Construed Against Drafter. Purchaser and Seller
acknowledge that they have read this Agreement, have had the opportunity to
review it with an attorney of their respective choice, and have agreed to all
its terms. Under these circumstances, Purchaser and Seller agree that the rule
of construction that a contract be construed against the drafter shall not be
applied in interpreting this Agreement and that in the event of any ambiguity
in any of the terms or conditions of this Agreement, including any exhibits
hereto and whether or not placed of record, such ambiguity shall not be
construed for or against any Party hereto on the basis that such Party did or
did not author the same.

13.15. Waiver of Jury Trial. SELLER AND PURCHASER DO HEREBY
IRREVOCABLY WAIVE, TO THE FULLEST EXTENT PERMITTED BY LAW, ANY AND ALL RIGHT TO
A TRIAL BY JURY IN ANY ACTION, SUIT OR OTHER LEGAL PROCEEDING BASED UPON,
ARISING OUT OF OR RELATING TO THIS AGREEMENT THE RIGHTS AND OBLIGATIONS UNDER
THIS AGREEMENT OR THE TRANSACTIONS CONTEMPLATED HEREBY.

13.16. Publicity. Seller and Purchaser shall consult with each other
with regard to all publicity and other releases and disclosures to be made
prior to, at or after Closing concerning this Agreement and the transactions
contemplated hereby, which are not otherwise expressly permitted by the
Confidentiality Agreement, and, except as required by applicable law or the
applicable rules or regulations of any governmental body or stock exchange,
neither Party shall make any disclosure or issue any publicity or other release
without the prior written consent of the other Party, which consent shall not
be unreasonably withheld or delayed.

13.17 Accounting.

A. Seller shall deliver to Purchaser on or before the fourth
business day prior to Closing the Preliminary Settlement
Statement setting forth any adjustments to the Purchase Price
provided for in or required by this Agreement including,
without limitation, items such as the Purchase Price, Deposit,
expenses, prepaid items, revenue received, Property Taxes,
excise and energy taxes, copying and recording fees, to the
extent such information is available or estimated by Seller on
or before Closing. The Preliminary Settlement Statement shall
be prepared in accordance with this Agreement and with
standard industry and accounting practices. In connection
with the preparation of the Preliminary Settlement Statement,
the

<PAGE> 162

Purchase Price shall be (1) increased by (a) the costs and
expenses that are attributable to the Assets for the period
from the Effective Time to the Closing Date that are paid,
incurred or assessed by Seller (including, but not limited to,
Seller's internal cost for administrative overhead for each
well operated by Seller at the rate of $435.00 per well per
month for wells not otherwise subject to an applicable COPAS
overhead rate under an operating agreement and an amount equal
to the applicable COPAS overhead rate less any non-operator
billed overhead amounts that have actually been received by
Seller for wells subject to an applicable COPAS under an
operating agreement), and (b) other amounts due Seller and
contemplated hereby, and (2) reduced by (a) proceeds received
by Seller for hydrocarbons attributable to the Subject
Properties produced after the Effective Time, and (b) other
amounts due Purchaser and contemplated hereby.

B. Within 150 days after the Closing, Seller shall prepare, in
accordance with this Agreement and with standard industry and
accounting practices, and deliver to Purchaser, a final
accounting statement showing the proration and calculation of
credits and payment obligations of Purchaser and Seller
hereunder. As soon as reasonably practicable after receipt
thereof, Purchaser shall deliver to Seller a written report
containing any changes that Purchaser proposes to be made to
such statement. The Parties shall use their best efforts to
reach agreement (the "Final Accounting") on the final
accounting statement on or before the 150th day after the
Closing Date (such date the "Final Accounting Date", whether
or not Seller and Purchaser have agreed on the Final
Accounting). Once the Final Accounting has been agreed to by
Purchaser and Seller, there shall be no further adjustments to
the Purchase Price and Seller shall within thirty (30) days
send a check to Purchaser for the agreed amount owed by Seller
or invoice Purchaser for the amount owed by Purchaser and
Purchaser shall pay Seller the invoice amount within thirty
(30) days of the date of said invoice.

13.18. Operatorship. Seller does not represent to Purchaser that
Purchaser will automatically succeed to the operatorship of any given Subject
Property as to which Seller is currently the operator. Purchaser recognizes
and agrees that Purchaser will be required to comply with applicable operating
agreements, unit operating agreements or other similar contracts relating to
any elections or other selection procedures in order to succeed Seller as
operator.

13.19. HSR Act. The Parties shall exercise their best efforts to file
(or will cause their ultimate parent entities to file) with the United States
Federal Trade Commission and the United States Department of Justice all
notifications and reports required for the transaction contemplated hereby
under the Hart-Scott-Rodino Antitrust Improvements Act of 1976 ("HSR Act"), and
shall request expedited treatment and early termination of the prescribed
waiting period. The Parties will reasonably cooperate with each other in
regards to providing available

<PAGE> 163

data or access thereto to each other to facilitate the necessary filing. Both
Parties shall use their best efforts to promptly supply any supplemental or
additional information which may be requested in connection therewith pursuant
to the HSR Act and shall comply in all material respects with the requirements
of the HSR Act. Closing of the transaction contemplated hereby shall be
postponed unless and until all necessary filings and notifications under the
HSR Act have been made, including the provision of any required additional
information or documents, and the waiting period referred to in such Act shall
have expired or terminated, however, in no event shall the time for Closing be
extended or postponed pursuant to the foregoing provision beyond December 15,
1998. Subject to this Agreement, if the waiting period expires or terminates
prior to the Closing Date, the Parties will proceed to Closing on the Closing
Date and if the waiting period expires or terminates after the scheduled
Closing Date, the Parties shall close the subject transaction on or prior to
the fourth day after the expiration or termination of said waiting period.

13.20. Seller's Employees. Purchaser will interview and evaluate in
accordance with its normal employment procedures those Persons employed as
field personnel in the capacity of pumper, foreman, operator, technician,
mechanic, superintendent, repairman, utility man, or other similar field
classifications by Seller in connection with the Subject Properties and
identified by letter of even date herewith from Seller to Purchaser who desire
to be considered for employment by Purchaser, and will offer in writing
employment to those Persons for whom Purchaser in its sole discretion
determines a need. If Purchaser fails to offer such employment to all of such
Persons, Purchaser shall not, as a result of such failure, otherwise be in
default under this Agreement, but shall be required to reimburse Seller for
severance benefits paid by Seller to each such Person not offered employment by
Purchaser; provided, that such reimbursement shall not exceed that amount
determined by multiplying each such employee's normal weekly wage by twelve
(12). Persons offered employment with Purchaser will be offered employment at
their current work location with compensation and benefits comparable to those
provided to Purchaser's current employees performing similar tasks, or, if
none, with compensation and benefits comparable to those provided by Seller
Such offers shall be made prior to Closing, but shall be contingent upon the
occurrence of Closing and such employment shall not commence until Closing. If
any such Person employed by Purchaser is terminated by Purchaser within six (6)
months of Closing, Purchaser shall pay such Person a severance benefit equal to
the amount determined by multiplying each such employee's normal weekly wage by
ten (10). Purchaser shall have no obligation under this Section 13.20 with
respect to Persons offered employment by Purchaser pursuant to this Section
13.20 who decline such employment, except that the foregoing provisions shall
apply to the extent that such Person accepts employment with Purchaser or any
of its Affiliates within twelve (12) months of Closing.

13.21. Time of Performance. Time is of the essence in the performance
of all covenants and obligations under this Agreement.

13.22. No Partnership Created. It is not the purpose or intention of
this Agreement to create (and it shall not be construed as creating) a joint
venture, partnership or any type of

<PAGE> 164

association, and the Parties are not authorized to act as agent or principal
for each other with respect to any matter related hereto.

13.23. Express Negligence Rule; Conspicuousness. BUYER ACKNOWLEDGES
THAT THE PROVISIONS IN THIS AGREEMENT THAT ARE SET OUT IN ITALICS, IN BOLD,
UNDERLINE OR CAPITALS (OR ANY COMBINATION THEREOF) SATISFY THE REQUIREMENTS FOR
THE EXPRESS NEGLIGENCE RULE AND/OR ARE CONSPICUOUS.

13.24. Arbitration. Because of the high cost of litigation in
dollars, time and resources, Purchaser and Seller intend to and do hereby
establish an efficient, fair and binding out-of-court dispute resolution
procedure to be followed in the unlikely event any claim or controversy should
arise between the Parties after the date hereof out of or concerning in any
respect any of the following:

(1) the Property or Assets or either Seller's or
Purchaser's conduct with respect to the Property or
Assets, either before, on, or after the Effective
Time, or

(2) the conduct of Seller or Purchaser prior to the
execution of this Agreement or the conduct of Seller
or Purchaser prior to the Closing Date or Effective
Time (whichever is later), or

(3) the performance, applicability, validity,
enforceability, or interpretation of the Agreement or
any provision in this Agreement or any Closing or
post-Closing documents.

Accordingly, Purchaser, its successors, and assigns, and
Seller its successors and assigns agree that any Claim or controversy as
described above of whatever nature, including, any action in tort, contract, or
any statutory action (hereinafter referred to as "Disputed Claim" in this
section), or the arbitrability of any such Disputed Claim, shall be resolved in
accordance with the terms, conditions, and procedures set forth in Schedule
13.24 and will be binding on Purchaser, its successors, and assigns, and
Seller. Neither Purchaser, its successors, or assigns, nor Seller its
successors and assigns will prosecute or commence any suit or action against
the other Party relating to any matters that are subject to this Section 13.24.

Notwithstanding the above, any Disputed Claim by Purchaser for
which Purchaser has given notice to Seller on or prior to Closing that is not
settled prior to Closing and any Disputed Claim by either Party arising out of
facts that are the subject of existing or prospective litigation filed by a
third party at any time against Purchaser or Seller will, at Seller's sole
option, not be subject to this Section 13.24.

<PAGE> 165
13.25. Filing and Recording. Purchaser will file or record the
various originals of the Assignment and Bill of Sale and other conveyancing
documents promptly after Closing at Purchaser's sole cost. The recording Party
will provide either the original or photocopies of the recorded documents,
including the recording data, to the non-recording Party promptly. If
Purchaser fails to promptly record such documents then Seller may record such
documents. Purchaser will reimburse Seller for the costs of filing, recording,
and other reasonable fees actually incurred by Seller if Seller records or
files said documents, such costs or fees to be used in the Final Accounting
Settlement.

EXECUTED as of the date first set forth above.

SELLER:

PIONEER NATURAL RESOURCES USA, INC.

By:
------------------------------------------------

Name: Timothy L. Dove
------------------------------------------------

Its: Executive Vice President-Business Development
------------------------------------------------

PURCHASER:

COSTILLA ENERGY, INC.

By:
-----------------------------------------------

Name: Clifford N. Hair, Jr.
-----------------------------------------------

Its: Senior Vice President-Land
-----------------------------------------------