COSTILLA ENERGY INC, DEFS14A, 1998-11-04

COSTILLA ENERGY INC
DEFS14A, 1998-11-04
CRUDE PETROLEUM & NATURAL GAS

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<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:

[ ] Preliminary Proxy Statement

[ ] Confidential, for use of the Commission
Only (as permitted by Rule 14a-6(e)(2))

[X] 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:

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2) Form, Schedule or Registration Statement No.:

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3) Filing Party:

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4) Date Filed:

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<PAGE> 2

COSTILLA ENERGY, INC.

400 WEST ILLINOIS, SUITE 1000
MIDLAND, TEXAS 79701

November 9, 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 November 30,
1998.

At the Special Meeting, you will be asked to approve certain matters,
including those 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 certain of
these matters. Specifically, you will be asked to approve the following:

(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 50 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

COSTILLA ENERGY, INC.

400 WEST ILLINOIS, SUITE 1000
MIDLAND, TEXAS 79701

NOTICE OF SPECIAL MEETING OF STOCKHOLDERS

TO BE HELD ON NOVEMBER 30, 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 November 30, 1998 to consider and vote upon the
following matters, which include certain matters related to 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

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 November 30, 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, including those 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 50 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 November 9, 1998.

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

The Date of This Proxy Statement is November 9, 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).

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<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....................................... 18
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...................................... 23
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>

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<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 50 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 Gulf Coast 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 Gulf Coast 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
approximately 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 of up to 50 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 and the
other terms thereof 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 is expected to be an institutional accredited
investor and 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 54% 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 Statements 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.

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<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% 77.8% 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 30,277,282 shares of Common Stock
will be outstanding, compared with 9,610,615 shares of Common Stock outstanding
as of November 2, 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 46,810,615 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 54% 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 17% (11% 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 30,277,282 (46,810,615 in the event of conversion of all of the
New Preferred Stock) shares of Common Stock outstanding, compared to 9,610,615
shares outstanding at November 2, 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, it is anticipated that the New
Investors will be 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 contractually
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 will assume 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 will also become 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, which
effects may be material and adverse. 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 otherwise breaches certain
provisions 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 November 9, 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 November 30, 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 50 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 November 4, 1998 are
entitled to notice of and to vote at the Meeting. At the close of business on
such date, the Company had 9,610,615 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 54% of the outstanding shares of Common Stock, representing more
than the number of 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 50 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 are expected 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. There can be no assurance that any of
such terms will actually become part of the Stock Issuance, and a Stockholder's
vote on the Stock Issuance should not be based upon an expectation related to
such terms. 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."

The Stock Issuance may be subject to the filing requirements of the
Hart-Scott-Rodino Antitrust Improvements Act of 1976 (the "HSR Act") depending
upon the amount and class of securities acquired by each New Investor. The
Company and certain of the New Investors may be required to make filings under
the HSR Act and, if filings are required, the waiting period provided under the
HSR Act will have to expire or be terminated prior to closing of the Stock
Issuance. The Company believes that all requirements under the HSR Act will be
satisfied, and will not delay the closing.

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

15
<PAGE> 19

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 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 is expected to 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
16
<PAGE> 20

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,
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 prior to or the day of the
closing of the Acquisition; 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.

17
<PAGE> 21

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 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 shares 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 of Directors 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 shares 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 was filed with
the Commission on October 16, 1998 as an attachment to the Company's preliminary
proxy materials.

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 for up to 30 days under certain circumstances
in order to obtain Stockholder approvals related to the

19
<PAGE> 23

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 will assume
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 will also become
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 Gulf Coast 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 oil and gas properties to
be acquired, and (5) gas plants, pipelines and processing facilities.

20
<PAGE> 24

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 million. The Acquisition also includes a license to
use approximately 400 square miles of 3-D seismic data located in the Gulf Coast
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
Gulf Coast.................................... 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
Gulf Coast..................... 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 receive an adjusted grossed up basis in the
Acquisition Properties by allocating the purchase price over the Acquisition
Properties as required by Sections 1060 and 338(b)(5) of the Internal Revenue
Code of 1986, as amended, and is expected to be able to claim depletion and
depreciation on such properties as provided by current federal income tax law.

In addition, to the extent that Costilla must satisfy contingent
liabilities assumed in connection with the Acquisition Agreement, such costs are
expected to be considered as additional consideration for the Acquisition
Properties and will not qualify as deductible expenses. Such costs may be added
to Costilla's adjusted grossed up basis in the Acquisition Properties when they
are paid and will be allocated among the acquired assets in the same manner as
the original allocation.

22
<PAGE> 26

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.

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 Gulf Coast 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 the 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
Gulf Coast 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, Gulf Coast 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.

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<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%
Gulf Coast................. 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
three productive wells and two proved undeveloped locations in the Southwest
Speaks Field in Lavaca County, Texas. Each of the three productive 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 effect 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
Gulf Coast........................ 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
Gulf Coast..................... 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 will
assume 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 November 2, 1998)................. $ 7.75 $ 5.44
</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. On November 2,
1998, the most recent practicable date prior to the printing of this Proxy
Statement, there were 9,610,615 shares of Common Stock outstanding held by
approximately 1,600 record and beneficial holders, and the high and low per
share sales price of the Common Stock on the Nasdaq National Market was $7.63
and $7.38.

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 18,279
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 cash 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 receive 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

48
<PAGE> 52

specifically designated as (a) a hedge of the exposure to changes in the fair
value of a recognized asset or 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 intends to 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 October 23, 1998 (unless a different
date is specified), 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 November 2, 1998 and written
representations from certain 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 68.3% 37,200,000 79.5%(3)
Enron Corp.......................... 4,165,128(4) 30.4%(3) 129,615(4) * 129,615(4) *
1400 Smith Street
Houston, Texas 77002
Cadell S. Liedtke................... 2,776,060(5) 28.9% 2,776,060(5) 9.2% 2,776,060(5) 5.9%
400 W. Illinois
Midland, Texas 79701
Michael J. Grella................... 1,783,810(6) 18.5% 1,783,810(6) 5.8% 1,783,810(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
Wellington Management Company
LLP(7)............................ 860,000 9.0% 860,000 2.8% 860,000 1.8%
75 State Street
Boston, MA 02109
Kestrel Investment Management....... 724,400 7.5% 724,400 2.4% 724,400 1.5%
411 Borel Avenue, Suite 403
San Mateo, California 94402
Henry G. Musselman.................. 642,650(8) 6.7% 642,650(8) 2.1% 642,650(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)...................... 5,797,520(13) 60.3%(10) 5,797,520(13) 19.2%(10) 5,797,520(13) 12.4%(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).

(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). It is anticipated that
the holders of the New Preferred Stock will have the right to convert such
stock into shares of Conversion Common at any time after consummation of
the Stock Issuance.

50
<PAGE> 54

(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 expected to be acquired in the
Exchange is included in the pro forma information for the New Investors,
and the beneficial ownership indicated for Enron Corp. in the pro forma
information represents only the shares of Common Stock currently owned by
JEDI and Enron Capital and does not include shares which they have, or are
expected to have after the Exchange, the right to acquire upon conversion.

(5) Includes (a) 2,716,060 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 shared voting and dispositive
power.

(6) Includes (a) 1,683,710 shares owned directly by Mr. Grella and (b) 100,100
shares owned by the Grella Family Charitable Foundation over which Mr.
Grella holds shared voting and dispositive power.

(7) Represents beneficial ownership as of June 30, 1998, confirmed by
Wellington Management Company LLP in its capacity as investment advisor on
behalf of its clients and based upon shared voting power with respect to
522,000 shares and shared dispositive power with respect to 860,000 shares.

(8) Includes (a) 620,000 shares owned directly by Mr. Musselman, (b) 1,650
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 shared 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 October 23, 1998, in the aggregate
approximately 54% 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. It is anticipated that the New Investors will agree not to take
actions which would result in a change of control under the Indenture. See
"Potential Effects of Stockholder Vote -- Potential Effects of Consummating the
Transactions -- Change in Principal Stockholders and Interests of Management;
Influence of New Investors" and " -- Indenture Issues."

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 value of unexercised options held as of the
end of fiscal year 1997 (no options were exercised by the named executive
officers during 1997):

<TABLE>
<CAPTION>
NUMBER OF VALUE OF
SECURITIES UNEXERCISED
UNDERLYING IN-THE-MONEY
UNEXERCISED OPTIONS OPTIONS AT
AT FY-END(#) FY-END($)
------------------- ----------------
EXERCISABLE/ EXERCISABLE/
NAME UNEXERCISABLE UNEXERCISABLE(1)
---- ------------------- ----------------
<S> <C> <C>
Cadell S. Liedtke.................................... 0/0 N/A
Michael J. Grella.................................... 0/0 N/A
Henry G. Musselman................................... 0/0 N/A
Bobby W. Page........................................ 75,000/0 N/A
Roger A. Freidline................................... 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

54
<PAGE> 58

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 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: Messrs. Samuel J. Atkins, III, W. D. Kennedy, Jerry J. Langdon and
Timothy J. Detmering. 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 receive 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

55
<PAGE> 59

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."

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 7,946 231,843
====== ====== =======
</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 the Proxy Statement 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

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 November 30,
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 November 9, 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
shares of Convertible Preferred Stock and up to 50 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 from
1,250,000 shares to 4 million shares (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 the
Stockholder's 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:

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PROXIES MUST BE SIGNED AND DATED TO BE VALID