84
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-K
(Mark One)
X Annual report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the Fiscal year ended December 31, 1998
or
? Transition report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the transition period from __________ to _______________
Commission file number: 000-23701
SOUTHWEST ROYALTIES, INC. SOUTHWEST ROYALTIES
(Exact Name of Registrant as HOLDINGS, INC.
Specified in Its Charter) (Exact Name of Registrant
as
Specified in Its Charter)
Delaware Delaware
(State or Other Jurisdiction of (State or Other
Jurisdiction of
Incorporation or Organization) Incorporation or
Organization)
75-1917432 75-2724264
(I.R.S. Employer Identification (I.R.S. Employer
Identification
Number) Number)
407 North Big Spring, Suite 300
Midland, Texas 79701
(Address of Principal Executive (Zip Code)
Offices)
Registrants' Telephone Number, Including Area Code: (915) 686-9927
Securities to be registered pursuant to Section 12(b) of the Act: None
Securities to be registered pursuant to Section 12(g) of the Act:
10.5% Senior Notes due 2004
(Title of Class)
Indicate by check whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act
of 1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days. Yes X No
Indicate by check mark if disclosure of delinquent files pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be
contained, to the best of registrant's knowledge, in definitive proxy or
information statements incorporated by reference in Part III of this Form
10-K or any amendment to this Form 10-K. X
<PAGE>
As of March 31, 1999, Southwest Royalties, Inc. had outstanding 100
shares of common stock, $.10 par value, which is its only class of stock.
As of March 31, 1999, Southwest Royalties Holdings, Inc. had outstanding
1,075,868 shares of common stock, $.10 par value, which is its only class
of stock. The common stock of Southwest Royalties Holdings, Inc. is not
traded on any exchange and, therefore, its aggregate market value and the
value of shares held by nonaffiliates cannot be determined. All of the
outstanding shares of Southwest Royalties, Inc. are held by Southwest
Royalties Holdings, Inc.
Documents Incorporated by Reference: None
TABLE OF CONTENTS
Page Number
PART I
Item 1. Business 3
Item 2. Properties 21
Item 3. Legal Proceedings 28
Item 4. Submission of Matters to a Vote of Security Holders 28
PART II
Item 5. Market for Registrant's Common Equity and Related
Stockholder Matters 29
Item 6. Selected Financial and Operating Data 31
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations 33
Item 7A. Quantitative and Qualitative Disclosures About Market Risk44
Item 8. Financial Statements and Supplementary Data 46
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure 79
PART III
Item 10. Directors and Executive Officers of the Registrant 80
Item 11. Executive Compensation 82
Item 12. Security Ownership of Certain Beneficial Owners and Management
83
Item 13. Certain Relationships and Related Transactions 84
PART IV
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K
84
<PAGE>
Parts I and II of this Report contain ''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 Securities Exchange Act of
1934, as amended (the "Exchange Act'). All statements other than
statements of historical facts included in this Report, including, without
limitation, statements in "Item 1. Business" and under "Item 2. Properties"
and "Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations" regarding proved reserves, estimated future net
reserves, present values, planned capital expenditures (including the
amount and nature thereof), increases in oil and gas production, the number
of wells anticipated to be drilled and the Company's financial position,
business strategy and other plans and objective for future operations, are
forward-looking statements. Although the Company believes that the
expectations reflected in such forward-looking statements are reasonable,
there can be no assurance that the results or developments anticipated by
the Company will be realized or, even if substantially realized, that they
will have the expected consequences to or effects on its business or
operations. There are numerous risks and uncertainties that can affect the
outcome and timing of such events, including many factors beyond the
control of the Company.
All subsequent written and oral forward looking statements
attributable to the Company or persons acting on its behalf are expressly
qualified in their entirety by such factors. The Company assumes no
obligation to update any such forward-looking statements.
PART I
Certain oil and gas terms used in this report are defined under "Item
1. Business - Glossary of Oil and Gas Terms."
ITEM 1. BUSINESS.
The Company
Southwest Royalties Holdings, Inc. ("SRH") , a Delaware corporation,
was formed in 1997 to serve as a holding company for Southwest Royalties,
Inc. ("Southwest"), Sierra Well Service, Inc. ("Sierra") and Midland Red
Oak Realty, Inc. ("Red Oak"). SRH is an independent oil and gas company
engaged in the acquisition, development and production of oil and gas
properties, primarily in the Permian Basin of West Texas and southeastern
New Mexico, through its wholly-owned subsidiary, Southwest. Since 1983,
Southwest has grown primarily through selective acquisitions of producing
oil and gas properties, both directly and through the oil and gas
partnerships it manages. SRH also participates in the well servicing
industry through its affiliate, Sierra, and owns and manages real estate
properties through its subsidiary, Red Oak. References in this report to
the "Company" are to SRH and its consolidated subsidiaries, including
Southwest and Red Oak, and Sierra, an unconsolidated affiliate.
The principal operating subsidiary of SRH is Southwest, a Delaware
corporation that was formed in 1983 to acquire and develop oil and gas
properties. Southwest initially financed the acquisition of oil and gas
reserves and its exploration and development efforts through public and
private limited partnership offerings. Southwest is a general partner of
these limited partnerships, owns interests in these partnerships and
receives management fees and operating cost reimbursements from these
partnerships. As of December 31, 1998, Southwest had total estimated net
proved reserves of 20.9 MMBbls of oil and 58.3 Bcf of natural gas,
aggregating 30.7 MMBoe, with a PV-10 Value of $71.9 million. Southwest's
primary operations are in the Permian Basin of West Texas and southeastern
New Mexico.
Red Oak, a Delaware corporation, was formed in 1992 to own and manage
commercial real estate properties, including shopping centers and office
buildings, in secondary real estate markets in the southwestern United
States. As of December 31, 1998, Red Oak owned and managed 23 commercial
real estate properties. SRH owns approximately 81% of the common stock of
Red Oak on a diluted basis.
<PAGE>
Sierra, a Delaware corporation, was formed in 1992 to provide certain
well services for oil and gas companies. Sierra provides a broad range of
well services to oil and gas companies, including workover rig services,
liquids handling and other services. As of December 31, 1998, the Company
directly owns approximately 29% of the common stock of Sierra and
indirectly owns an additional 10% interest through Southwest, which is the
general partner and 15% interest holder in each of two partnerships that
own approximately 70% of the common stock of Sierra. The Company's
interest in Sierra can be diluted as a result of common stock warrants held
by Sierra's lender, if the related debt is outstanding at December 31,
1999. The conversion percentage increases over time as long as the related
debt remains outstanding. As of July 1, 1997, Sierra was deconsolidated
from SRH and is currently being accounted for as an equity investment.
Southwest has three subsidiaries, Midland Southwest Software, Inc.
("Southwest Software"), Threading Products International, LLC ("TPI"), and
Blue Heel Company ("Blue Heel"). Southwest Software creates and markets
computer software to the oil and gas industry and provides all information
system services as well as hardware maintenance and technical support for
Southwest and Sierra through contractual agreements. TPI produces inserts
used to cut threads by manufacturers of threaded products. Blue Heel holds
a nominal interest in certain oil and gas properties owned by Southwest.
Red Oak has six wholly-owned subsidiaries, MRO Properties, Inc.
("MROP"), MRO Management, Inc. ("MRO Management"), MRO Commercial, Inc.
("MRO Commercial"), MRO N Cross, Inc. ("Northcross"), MRO La Placita, Inc.
("La Placita"), and MRO Madera, Inc. ("Madera"). MROP, MRO Commercial,
Northcross, La Placita, and Madera each hold titles to certain real estate
properties and are the borrowers under the credit agreements related to
such properties. These credit agreements are non-recourse to Red Oak. MRO
Management performs real estate management services for Red Oak, MROP, MRO
Commercial, Northcross, La Placita, Madera and for third party clients.
Both Sierra and Red Oak are operated separately from Southwest;
however, Southwest provides both with significant administrative and
accounting support. Under the terms of separate service agreements,
Southwest provides Sierra and Red Oak with administrative services
including accounting, bookkeeping, tax preparation and banking and
disbursement services. Both agreements have an initial term of five years
and renew from year to year if not terminated. Under each agreement,
Southwest receives a fixed fee of $12,000 per month. These fees may be
adjusted at any time by agreement of the parties. The service agreements
may be terminated upon 30 days' notice by either party to the agreements.
Southwest and Red Oak are currently in discussion to renegotiate the
management agreement due to the reduced need for Southwest's administrative
and accounting services by Red Oak.
The Company's principal executive offices are located at 407 North Big
Spring, Suite 300, Midland, Texas 79701. The Company's telephone number is
(915) 686-9927.
Operating Strategy
Funding for the Company's business activities has historically been
provided by operating cash flows, bank borrowings and debt issuance,
reserve-based financing and sales of equity. Any future capital
expenditures or acquisitions will require additional equity or financing
and will be dependent upon financing arrangements available at the time.
The significant decrease in oil and gas prices over the last year has
severely limited cash flow from operations and rendered most other
financing sources unavailable, or if available, on very unattractive terms
to the Company. Based on current commodity prices, production, rent
revenues and its highly leveraged position, the Company probably will not
be able to meet operating and debt obligations beyond 1999.
<PAGE>
Management is constantly monitoring the Company's cash position and
its ability to meet its financial obligations as they become due, and in
this effort, is exploring various strategies for addressing its current and
future liquidity needs. During 1998, for instance, Southwest sold $5.7
million of oil and gas properties in an ongoing effort to decrease its
production costs and improve its cash position. As of December 31, 1998,
SRH's consolidated cash balance was $13.8 million, of which $12.4 million
was available to Southwest.
In response to the recent and severe decline in oil price, the Company
has initiated a short-term alternate business plan that delays certain
development and exploratory projects until the market strengthens. The
Company is tentatively budgeting $8 million in capital expenditures in its
oil and gas business for 1999. The $8 million capital expenditure budget
is for development projects. The final budget will depend on financial
strategies that are currently being developed including hedging strategies,
divestitures and company structure. The budget will also be affected by the
volatility of the oil and gas commodity prices. Further revisions may be
necessary during the year in response to market conditions and any
restructuring which can be negotiated by the Company.
The Company concentrates its oil and gas activities in the Permian
Basin of West Texas and southeastern New Mexico, with properties in this
region representing over 90% of the Company's PV-10 Value at December 31,
1998. The Company believes that its long-life oil and gas properties and
large inventory of development projects in the Permian Basin, coupled with
region-specific geological, engineering and production experience, provide
it with focused operations. Company-operated properties comprised
approximately 66% of its PV-10 Value at December 31, 1998, allowing
substantial control over the incurrence and timing of capital and operating
expenditures.
The Company hopes to continue the expansion of its real estate
business, primarily in the southwestern United States. However, the
expansion will depend, to a large extent on Red Oak's ability to
restructure its current debt, or sell equity to reduce its highly leveraged
capital structure. Red Oak is currently experiencing financial
difficulties and is having problems meeting its operating and debt service
obligations as they become due. Red Oak's financial difficulties stem
largely from lagging rents, non-cash producing leveraged assets, and its
highly leveraged capital structure in general. The Company expects that
Red Oak's active management practices will lead to consolidation benefits,
cost savings, more efficient utilization and improved cash flow, thereby,
lessening its financial difficulties.
Southwest
General. Since inception, the Company has focused on increasing its
reserves and average daily production of oil and gas through acquisitions
of producing properties and development drilling and production enhancement
activities. However, due to the severe depression experienced throughout
the oil and gas industry which started in the last quarter of 1997 and is
currently continuing, the Company is experiencing financial difficulties in
servicing it's highly leveraged capital structure, and therefore, is
limited in its ability to make acquisitions or participate in developmental
drilling and production enhancement activities.
Private Placement. On October 14, 1997, Southwest completed a $200
million private placement of 10.5% Senior Notes due 2004, Series A ("Series
A Notes") pursuant to Rule 144A of the Securities Act (the "Private
Placement"). Thereupon, the Series A Notes were offered and sold by the
underwriters only to qualified institutional buyers. The net proceeds from
the Private Placement were approximately $190 million. Proceeds from the
Offering were used to among other things, provide approximately $69 million
for an oil and gas acquisition and approximately $27 million for working
capital. The Series A Notes were issued pursuant to an indenture, dated
October 14, 1997 (the "Indenture"), by and among Southwest, as Issuer, SRH,
as the Parent Guarantor, and State Street Bank and Trust Company, N.A., as
Trustee (the "Trustee").
<PAGE>
Exchange Offer. On March 11, 1998, Southwest concluded a registered
offering to exchange the Series A Notes for 10.5% Series B Senior Notes due
2004, which had been registered under the Securities Act ("Notes"). The
form and terms of the Notes are identical in all material respects to the
form and terms of the Series A Notes. The Notes evidence the same debt as
the Series A Notes and were issued under and are entitled to the benefits
of the Indenture governing the Series A Notes.
An integral part of Southwest's 1997 business strategy in conjunction
with the 10.5% Senior note issuance, involved the successful investment of
the approximately $27 million of additional working capital into both the
development and exploitation of its existing oil and gas properties and the
possible acquisition of additional producing oil and gas properties. It
was imperative to increase production volumes to meet the ongoing cash flow
needs and requirements of the Company. Southwest had made substantial
capital expenditures of $16.7 million and $32.1 million for 1996 and 1995
respectively and had budgeted additional capital spending of approximately
$45 million for the remainder of 1997 and 1998. Management believed that
the successful investment of the additional working capital would have
increased production levels thereby supplying additional cash flow to the
Company to meet requirements and continue to fund additional capital
expenditure projects.
In the last quarter of 1997, oil and gas prices began a dramatic
decrease that continued throughout 1998 and currently. In response, early
in 1998, Southwest implemented an alternate budget that limited capital
investment into the planned developmental and acquisition projects and
eventually suspended almost all investment as prices continued to decrease
and remained depressed.
Throughout 1998, as oil and gas prices remained depressed, Southwest
continually reduced expenditures including corporate general and
administrative and lease operating expenses. General and administrative
expenses decreased 26% comparing the twelve month periods ended December
31, 1997 and 1998 and decreased 96% comparing the three month periods ended
December 31, 1997 and 1998. The average oil and gas operating expense was
$7.03 per Boe in 1998, a decrease of 15% from $8.23 per Boe for the same
period in 1997. Southwest also initiated and completed $5.7 million in
sales of non-strategic and relatively high cost oil and gas properties in
1998 to effectively expand margins and increase efficiencies.
The harsh decline in commodity pricing has had a double impact on
Southwest's cash flow by severely reducing proceeds associated with current
production levels and reducing Southwest's investment into undeveloped
reserves. The inability to replace the existing, depleting reserve base
ultimately and systematically creates lower revenues and margins.
As net revenues fell due to declining price and production, an
increasingly larger portion of the Company's cash flow was necessary to
meet debt interest expense. As prices continue to remain depressed, the
existing cash balance is being depleted in an effort to meet current debt
interest requirements.
As opposed to the originally budgeted $45 million of capital
investment, only approximately $10 million was invested for development,
exploration, and acquisitions in 1998. Without the ability to follow the
original investment strategy and thereby increase production, Southwest's
cash flow will probably be inadequate to meet its needs and requirements in
1999 and beyond.
<PAGE>
Drilling Activities. The Company has historically complemented it's
oil and gas reserves, production and cash flow by concentrating on drilling
low-risk development wells and by conducting additional development
activities such as recompletions. During 1998, the Company was involved in
drilling 16 gross (6.2 net) wells of which 15 gross (5.7 net) wells were
successfully completed as productive.
Exploratory Activities. The Company decreased its spending for
exploratory activities from $2.8 million in 1997 to $834,000 in 1998.
Exploratory drilling involves greater risks of dry holes or failure to find
commercial quantities of hydrocarbons than development drilling or enhanced
recovery activities. See "Item 1. - Operating Hazards and Risks."
Red Oak
Red Oak was formed by the Company in 1992 to acquire and manage
neighborhood and community shopping centers, other retail and commercial
properties and office buildings. These properties are primarily leased, on
a long-term basis, to major retail companies, local specialty retailers and
professional and business tenants throughout secondary urban markets in the
southwestern United States. As of December 31, 1998, Red Oak owned and
managed fifteen shopping centers, eight office buildings and raw land held
for future development.
Red Oak's primary objective has historically been to acquire, own and
manage a portfolio of commercial properties that provides opportunity to
increase net operating income and results in significant capital
appreciation. Consistent with this strategy, Red Oak focused its activities
primarily in secondary markets in the southwestern United States, including
San Antonio, Austin, Abilene, Midland and San Angelo, Texas; Tucson,
Arizona; and Tulsa and Oklahoma City, Oklahoma.
From December 1993 through December 31, 1998, Red Oak completed the
acquisition of fifteen regional shopping centers and eight office buildings
for a total acquisition cost of $129.1 million.
Red Oak is currently experiencing financial difficulties. Red Oak has
generated losses for the years ended December 31, 1998, 1997 and 1996 and
is experiencing difficulties in meeting its obligations when they become
due. The capital structure of Red Oak is highly leveraged with $12.5
million and $12.3 million of principal and cash interest payments,
respectively, due in 1999. Management is currently in the process of
renegotiating the terms of Red Oak's various obligations with its lenders
and/or seeking new lenders or equity investors. Additionally, management
would consider disposing of certain assets in order to meet its
obligations.
Employees
As of December 31, 1998, the Company employed 239 people. Of this
total, 102 people were employed by Southwest, and 137 by Red Oak. The
Company's future success will depend partially on its ability to attract,
retain and motivate qualified personnel in spite of its current financial
difficulties. The Company is not a party to any collective bargaining
agreements and has not experienced any strikes or work stoppages. The
Company considers its relations with its employees to be satisfactory.
Competition
The oil and natural gas industry is highly competitive. The Company's
oil and gas business competes for the acquisition of oil and natural gas
properties, primarily on the basis of the price to be paid for such
properties, with numerous entities including major oil companies, other
independent oil and natural gas concerns and individual producers and
operators. Many of these competitors are large, well established companies
and have financial and other resources substantially greater than those of
the Company.
<PAGE>
The Company's ability to acquire additional oil and gas properties and
to discover reserves in the future will depend upon its ability to
restructure debt facilities and/or procure non-recourse funding as well as
its ability to evaluate and select suitable properties and to consummate
transactions in a highly competitive environment. The Company's real
estate business also competes for the acquisition of desirable commercial
real estate properties, primarily on the basis of price.
Operating Hazards and Risks
The oil and natural gas business involves a variety of operating
risks, including the risk of fire, explosions, blow outs, pipe failure,
abnormally pressured formations and environmental hazards such as oil
spills, gas leaks, ruptures or discharges of toxic gases. Any of these
occurrences could result in substantial losses to the Company due to injury
or loss of life, severe damage to or destruction of property, natural
resources and equipment, environmental damage, clean-up responsibilities,
regulatory investigation and penalties and suspension of operations.
Drilling activities are subject to many risks, including the risk that
no commercially productive reservoirs will be encountered. There can be no
assurance that new wells drilled by the Company will be productive or that
the Company will recover all or any portion of its investment. Drilling for
oil and gas may involve unprofitable efforts, not only from dry wells, but
from wells that are productive but do not produce sufficient net revenues
to return a profit after drilling, operating or other costs. The cost of
drilling, completing and operating wells is often uncertain. The Company's
drilling operations may be curtailed, delayed or canceled as a result of
numerous factors, many of which are beyond the Company's control, including
title problems, weather conditions, mechanical problems, compliance with
governmental requirements and shortages and delays in the delivery of
equipment and services. The Company's future drilling activities may not be
successful and, if unsuccessful, such failure may have a material adverse
effect on the Company's future results of operations and financial
condition.
Although the Company maintains insurance coverage considered to be
customary in each industry in which it participates, it is not fully
insured against certain risks, either because insurance is not available or
because of the high premium costs. The Company's real estate business
carries business interruption insurance. The Company does maintain physical
damage, employer's liability, comprehensive commercial general liability
and workers' compensation insurance. There can be no assurance that any
insurance obtained by the Company will be adequate to cover any losses or
liabilities, or that such insurance will continue to be available or
available on terms which are acceptable to the Company.
Regulation
General. Various aspects of the Company's oil and natural gas
operations are subject to extensive and continually changing regulation, as
legislation affecting the oil and natural gas industry is under constant
review for amendment or expansion. Numerous departments and agencies, both
federal and state, are authorized by statute to issue, and have issued,
rules and regulations binding upon the oil and natural gas industry and its
individual members. The Federal Energy Regulatory Commission ("FERC")
regulates the transportation and sale for resale of natural gas in
interstate commerce pursuant to the Natural Gas Act of 1938 ("NGA") and the
Natural Gas Policy Act of 1978 ("NGPA"). In the past, the Federal
government has regulated the prices at which oil and natural gas could be
sold. While sales by producers of natural gas and all sales of crude oil,
condensate and natural gas liquids can currently be made at uncontrolled
market prices, Congress could reenact price controls in the future.
Deregulation of wellhead sales in the natural gas industry began with the
enactment of the NGPA in 1978. In 1989, Congress enacted the Natural Gas
Wellhead Decontrol Act (the "Decontrol Act"). The Decontrol Act removed all
remaining NGA and NGPA price and nonprice controls affecting wellhead sales
of natural gas effective January 1, 1993.
<PAGE>
Regulation of Sales and Transportation of Natural Gas. The Company's
sales of natural gas are affected by the availability, terms and cost of
transportation. The price and terms for access to pipeline transportation
are subject to extensive regulation. In recent years, the FERC has
undertaken various initiatives to increase competition within the natural
gas industry. As a result of initiatives like FERC Order No. 636, issued in
April 1992, the interstate natural gas transportation and marketing system
has been substantially restructured to remove various barriers and
practices that historically limited non-pipeline natural gas sellers,
including producers, from effectively competing with interstate pipelines
for sales to local distribution companies and large industrial and
commercial customers. The most significant provisions of Order No. 636
require that interstate pipelines provide firm and interruptible
transportation service on an open access basis that is equal for all
natural gas supplies. In many instances, the results of Order No. 636 and
related initiatives have been to substantially reduce or eliminate the
interstate pipelines' traditional role as wholesalers of natural gas in
favor of providing only storage and transportation services. While the
United States Court of Appeals upheld most of Order No. 636 last year,
certain related FERC orders, including the individual pipeline
restructuring proceedings, are still subject to judicial review and may be
reversed or remanded in whole or in part. While the outcome of these
proceedings cannot be predicted with certainty, the Company does not
believe that it will be affected materially differently than its
competitors.
The FERC has also announced several important transportation-related
policy statements and proposed rule changes, including a statement of
policy and a request for comments concerning alternatives to its
traditional cost-of-service rate making methodology to establish the rates
interstate pipelines may charge for their services. A number of pipelines
have obtained FERC authorization to charge negotiated rates as one such
alternative. In February 1997, the FERC announced a broad inquiry into
issues facing the natural gas industry to assist the FERC in establishing
regulatory goals and priorities in the post-Order No. 636 environment.
Similarly, the Texas Railroad Commission has been reviewing changes to its
regulations governing transportation and gathering services provided by
intrastate pipelines and gatherers. While the changes being considered by
these federal and state regulators would affect the Company only
indirectly, they are intended to further enhance competition in natural gas
markets. The Company cannot predict what further action the FERC or state
regulators will take on these matters, however, the Company does not
believe that it will be affected by any action taken materially differently
than other natural gas producers with which it competes.
Additional proposals and proceedings that might affect the natural gas
industry are pending before Congress, the FERC, state commissions and the
courts. The natural gas industry historically has been very heavily
regulated; therefore, there is no assurance that the less stringent
regulatory approach recently pursued by the FERC and Congress will
continue.
Oil Price Controls and Transportation Rates. Sales of crude oil,
condensate and gas liquids by the Company are not currently regulated and
are made at market prices. The price the Company receives from the sale of
these products may be affected by the cost of transporting the products to
market.
<PAGE>
Environmental. Extensive federal, state and local laws regulating the
discharge of materials into the environment or otherwise relating to the
protection of the environment affect Southwest's oil and natural gas
operations. Numerous governmental departments issue rules and regulations
to implement and enforce such laws, which are often difficult and costly to
comply with and which carry substantial civil and even criminal penalties
for failure to comply. Some laws, rules and regulations relating to
protection of the environment may, in certain circumstances, impose strict
liability for environmental contamination, rendering a person liable for
environmental damages and cleanup costs without regard to negligence or
fault on the part of such person. Other laws, rules and regulations may
restrict the rate of oil and natural gas production below the rate that
would otherwise exist or even prohibit exploration and production
activities in sensitive areas. In addition, state laws often require
various forms of remedial action to prevent pollution, such as closure of
inactive pits and plugging of abandoned wells. The regulatory burden on the
oil and natural gas industry increases the Company's cost of doing business
and consequently affects the Company's profitability. The Company believes
that it is in substantial compliance with current applicable environmental
laws and regulations and that continued compliance with existing
requirements will not have a material adverse impact on the Company's
operations. However, environmental laws and regulations have been subject
to frequent changes over the years, and the imposition of more stringent
requirements could have a material adverse effect upon the capital
expenditures, earnings or competitive position of the Company.
In addition, Red Oak's real estate management activities are subject
to federal, state and local laws, rules and regulations pertaining to
protection of the environment which may, in certain circumstances, impose
strict liability for environmental contamination, thus rendering Red Oak
liable for environmental damages and clean up costs without regard to
negligence or fault on the part of Red Oak. Asbestos-containing materials
may be present at Red Oak's real estate holdings which may dictate costly
remediation to abate asbestos or which may increase the cost of renovations
to property when they become necessary. Further, activities on adjacent
properties, such as dry cleaning, gasoline retailing, and automobile
maintenance, may result in subsurface soil and groundwater contamination
that could impair Red Oak's use or sale of real estate holdings or cause
Red Oak to incur costs to remediate any contamination caused by activities
of lessors or adjacent properties.
The Comprehensive Environmental Response, Compensation and Liability
Act ("CERCLA") imposes liability, without regard to fault on certain
classes of persons that are considered to be responsible for the release of
a "hazardous substance" into the environment. These persons include the
current or former owner or operator of the disposal site or sites where the
release occurred and companies that disposed or arranged for the disposal
of hazardous substances. Under CERCLA such persons may be subject to joint
and several liability for the costs of investigating and cleaning up
hazardous substances that have been released into the environment, for
damages to natural resources and for the costs of certain health studies.
In addition, companies that incur liability frequently also confront third
party claims because it is not uncommon for neighboring landowners and
other third parties to file claims for personal injury and property damage
allegedly caused by hazardous substances or other pollutants released into
the environment from a polluted site.
<PAGE>
The Federal Solid Waste Disposal Act, as amended by the Resource
Conservation and Recovery Act of 1976 ("RCRA"), regulates the generation,
transportation, storage, treatment and disposal of hazardous wastes and can
require cleanup of hazardous waste disposal sites. RCRA currently excludes
drilling fluids, produced waters and other wastes associated with the
exploration, development or production of oil and natural gas from
regulation as "hazardous waste." Disposal of such non-hazardous oil and
natural gas exploration, development and production wastes usually are
regulated by state law. Other wastes handled at exploration and production
sites or used in the course of providing well services may not fall within
this exclusion. Moreover, stricter standards for waste handling and
disposal may be imposed on the oil and natural gas industry in the future.
From time to time legislation is proposed in Congress that would revoke or
alter the current exclusion of exploration, development and production
wastes from the RCRA definition of "hazardous wastes" thereby potentially
subjecting such wastes to more stringent handling, disposal and cleanup
requirements. If such legislation were enacted it could have a significant
impact on the operating costs of Southwest and Sierra, as well as the oil
and natural gas industry and well servicing industry in general. The impact
of future revisions to environmental laws and regulations cannot be
predicted.
The Company's operations are also subject to the Clean Air Act ("CAA")
and comparable state and local requirements. Amendments to the CAA were
adopted in 1990 and contain provisions that may result in the gradual
imposition of certain pollution control requirements with respect to air
emissions from operations of Southwest. Southwest may be required to incur
certain capital expenditures in the next several years for air pollution
control equipment in connection with obtaining and maintaining operating
permits and approvals for air emissions. However, Southwest believes its
operations will not be materially adversely affected by any such
requirements, and the requirements are not expected to be any more
burdensome to Southwest than to other similarly situated companies involved
in oil and natural gas exploration and production activities or well
servicing activities.
Southwest maintains insurance against "sudden and accidental"
occurrences which may cover some, but not all, of the risks described
above. Most significantly, the insurance maintained by Southwest will not
cover the risks described above which occur over a sustained period of
time. Further, there can be no assurance that such insurance will continue
to be available to cover all such costs or that such insurance will be
available at premium levels that justify its purchase. The occurrence of a
significant event not fully insured or indemnified against could have a
material adverse effect on Southwest's financial condition and operations.
Regulation of Oil and Natural Gas Exploration and Production.
Exploration and production operations of the Company are subject to various
types of regulation at the federal, state and local levels. Such
regulations include requiring permits and drilling bonds for the drilling
of wells, regulating the location of wells, the method of drilling and
casing wells, and the surface use and restoration of properties upon which
wells are drilled. Many states also have statutes or regulations addressing
conservation matters, including provisions for the utilization or pooling
of oil and natural gas properties, the establishment of maximum rates of
production from oil and natural gas wells and the regulation of spacing,
plugging and abandonment of such wells. Some state statutes limit the rate
at which oil and natural gas can be produced from Southwest's properties.
See "Risk Factors-Compliance with Governmental Regulations."
<PAGE>
Risks Associated with Business Activities
Adverse Financial Condition. The Company is currently experiencing a
period of adverse financial conditions and due to cash flow shortfalls, the
Company's auditors have added an explanatory paragraph to their report
which states their concerns about the Company's ability to continue as a
going concern. The Company incurred a net loss for the twelve months ended
December 31, 1998 of $96.1 million compared with a net loss of $11.5
million during the twelve months ended December 31, 1997. In addition, due
to significant decreases in oil and gas prices, the Company's PV-10 value
has declined from approximately $172 million at December 31, 1997 to
approximately $72 million at December 31, 1998.
The Company had a stockholders' deficit of $107.8 million as of
December 31, 1998. Such deficit will likely seriously impair the Company's
ability to raise additional equity capital in the future. For further
information about financial condition, please read "Item 7. Management's
Discussion and Analysis of Financial Condition and Results of Operations."
The expected shortfalls in cash flow from operating activities limit
the Company's financial flexibility, including its ability to pay interest,
to access capital markets and to acquire and develop oil and gas
properties. The expected cash flow shortfalls may also impede the
Company's ability to refinance its debt obligations in the event industry
conditions improve. For additional information on our financial condition
please read "Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations" and "Item 8. Financial Statements and
Supplementary Data."
Substantial Leverage. Because of the Company's substantial level of
indebtedness, a significant portion of the Company's cash flow is dedicated
to the payment of interest. The Company cannot ensure that it will be able
to make the future payments required by it's indebtedness. As of December
31, 1998, the Company's total indebtedness was $335.1 million.
Certain holders, who collectively own approximately 12% of SRH's
common stock, have an option to cause SRH to redeem such holders' common
stock at any time beginning December 31, 2001, five years from the date of
issuance of such common stock, subject to the terms of a subscription
agreement under which SRH sold the common stock (the "Subscription
Agreement") and subject to any restrictions imposed by law. The
Subscription Agreement provides that this redemption right terminates on
the effective date of any registration statement under the Securities Act
filed with the Commission relative to the offer and sale of any amount of
SRH's common stock to the public. SRH is unable to predict the amount of
money it would be required to pay if the redemption right is exercised. In
addition, the Company is subject to an Indenture pursuant to its 10.5%
Senior Notes due 2004 (the "Indenture") which may also restrict SRH's
ability to make such payments. In addition, SRH can give no assurance that
it will be able to cause a registration statement to become effective under
the Securities Act in order to terminate the redemption option.
During 1994 and 1995, Red Oak sold 102,000 shares of common stock
through a private placement offering for approximately $2,550,000 and
subsequently repurchased 4,000 shares at $32 per share. This stock is
redeemable at the stockholder's option at a price equal to the purchase
price of $25 per share, plus a 6% annual return computed on a cumulative,
but not compounded, basis between December 1, 1996 and December 1, 1999.
Redemptions are to be paid out of future earnings of Red Oak. If there are
no future earnings, redemptions will be paid out of Red Oak's additional
paid-in-capital. The 6% annual return is accrued as an increase to
redeemable common stock. At December 31, 1998, Red Oak's potential
redemption liability for the remaining 98,000 shares is $2,978,576. In the
event of dissolution, liquidation or winding up of Red Oak, the holders of
common stock are to share ratably in all assets remaining after payment of
liabilities.
<PAGE>
Payment Upon a Change of Control. Upon the occurrence of a "change of
control", as defined in the Indenture, of the Company, each holder of the
Notes may require Southwest to purchase all or a portion of such holder's
Notes at 101% of the principal amount of the Notes, together with accrued
and unpaid interest, if any, to the date of purchase. If a change of
control were to occur, Southwest may not have the financial resources to
repay all of the Notes and the other indebtedness that might become payable
upon the occurrence of such change of control.
Adequacy of Collateral; Risks of Foreclosure. SRH has pledged to the
Trustee (under the Indenture), for the ratable benefit of the holders of
the Notes, all of the Sierra common stock and Red Oak common stock directly
owned by SRH as security for the Parent Guarantee (collectively, the
"Collateral").
In the event of a default under the Indenture, there can be no
assurance that the Trustee would be able to foreclose on or dispose of any
of the Collateral without substantial delays and other risks or that the
proceeds obtained therefrom would be sufficient to pay all amounts owing to
holders of the Notes. SRH would be required to file a shelf registration
statement and any of SRH's other subsidiaries whose stock is pledged to the
Trustee would be required to grant registration rights with respect to such
stock, in each case to allow the Trustee to be able to sell the pledged
shares of their common stock publicly. Circumstances beyond the control of
the Company, however, may delay the availability of a current prospectus.
There is currently no public market for the shares of SRH common stock and
there can be no assurance that there will be any public market for the
common stock of any subsidiary of SRH.
In addition, if Southwest becomes a debtor in a case under the United
States Bankruptcy Code ("The Bankruptcy Code"), the automatic stay imposed
by the Bankruptcy Code would prevent the Trustee from selling or otherwise
disposing of the Collateral without bankruptcy court authorization. In
that case, the foreclosure might be delayed indefinitely. Moreover, the
bankruptcy of any entity related to the Southwest might result in a similar
delay if Southwest were "substantively consolidated" with the related
entity.
Possible Limitations on Enforceability of Subsidiary Guarantees.
Southwest's obligations under the Notes may under certain circumstances be
guaranteed on a senior basis by certain subsidiaries of Southwest as set
forth in the Indenture. Various fraudulent conveyance laws have been
enacted for the protection of creditors and may be utilized by a reviewing
court to subordinate or void a subsidiary guaranty. It is also possible
that under certain circumstances a court could hold that the direct
obligations of a subsidiary guarantor could be superior to the obligations
under a subsidiary guaranty.
To the extent that a court were to find that at the time a subsidiary
guaranty was entered into either (1) the subsidiary guaranty was incurred
with the intent to hinder, delay or defraud any present or future creditor
or that the subsidiary guarantor contemplated insolvency with a design to
favor one or more creditors to the exclusion in whole or in part of others
or (2) the subsidiary guarantor did not receive fair consideration or
reasonably equivalent value for issuing the subsidiary guaranty and, at the
time it issued the guaranty, the subsidiary guarantor (i) was insolvent or
rendered insolvent by reason of the issuance of the subsidiary guaranty,
(ii) was engaged or about to engage in a business or transaction for which
the remaining assets of the subsidiary guarantor constituted unreasonably
small capital, or (iii) intended to incur, or believed that it would incur,
debts beyond its ability to pay such debts as they matured, the court could
void or subordinate the subsidiary in favor of the subsidiary guarantor's
other creditors. Among other things, a legal challenge of a subsidiary
guaranty issued on fraudulent conveyance grounds may focus on the benefits,
if any, realized by the subsidiary guarantor as a result of the issuance by
Southwest of the Notes. To the extent that proceeds from the Private
Placement were used to refinance the indebtedness of the Company, a court
might find that a subsidiary guarantor did not benefit from incurrence of
the indebtedness represented by the Notes.
<PAGE>
The measure of insolvency for purposes of determining whether a
transfer is voidable as a fraudulent transfer varies depending upon the law
of the jurisdiction that is being applied. Generally, however, a debtor
would be considered insolvent if the sum of all its debts, including
contingent liabilities, was greater than the value of all its assets at a
fair valuation or if the present fair saleable value of the debtor's assets
was less than the amount required to repay its probable liability on its
debts, including contingent liabilities, as they become absolute and
mature.
To the extent that a subsidiary guaranty is voided as a fraudulent
conveyance or found unenforceable for any other reason, holders of the
Notes would cease to have any claim in respect to the applicable
subsidiary. In such event, the claims of the holders of the Notes against
such subsidiary would be subject to the prior payment of all liabilities
and preferred stock claims of such subsidiary guarantor. There can be no
assurance that, after providing for all prior claims and referred stock
interests, if any, there would be sufficient assets to satisfy the claims
of the holders of the Notes relating to any voided portion of such
subsidiary guaranty.
Voting Control. As of December 31, 1998, H. H. Wommack, III, Chairman
of the Board, President and Chief Executive Officer of SRH and Southwest,
owned 73.2% of the outstanding voting shares of common stock of SRH, which
owns 100% of the common stock of Southwest. Therefore, Mr. Wommack has the
ability to elect all of the directors of SRH and Southwest and, directly
and indirectly, influence all decisions made by SRH and Southwest.
Dependence on Key Personnel. The Company depends to a large extent on
the services of H. H. Wommack, III and certain other senior management
personnel. The loss of the services of Mr. Wommack and other senior
management personnel could have a material adverse effect on the Company's
operations. The Company does not currently have an employment contract with
any senior management or key personnel. The Company believes that its
success is also dependent upon its ability to continue to employ and retain
skilled technical personnel. The inability of the Company to employ or
retain skilled technical personnel could have a material adverse effect on
the Company's operations. Although the Company maintains key man life
insurance on the life of Mr. Wommack in the amount of $15 million, the
existence of such insurance does not mean that the death or disability of
Mr. Wommack would not have a materially adverse effect upon the Company.
Volatility of Oil and Gas Prices. Revenues from the Company's
operations are highly dependent on the price of oil and gas. The markets
for oil and gas are volatile and prices for oil and gas are subject to wide
fluctuations in response to relatively minor changes in the supply of and
demand for oil and gas and a variety of additional factors that are beyond
the Company's control. These factors include the level of consumer demand,
weather conditions, domestic and foreign governmental regulations, market
uncertainty, the price and availability of alternative fuels, political
conditions in the Middle East, foreign supply of oil and gas, price of
foreign imports and overall economic conditions. It is impossible for the
Company to predict future oil and gas prices with any certainty.
Throughout 1998 and into the first quarter of 1999, the oil and gas
industry has experienced severe declines in prices. The Company's average
realized price per barrel of oil produced in 1998 was $12.73, a decrease of
33% from 1997. The Company's average realized price per Mcf of gas
produced in 1998 was $1.85 per Mcf, a decrease of 17% from 1997. The
severe decrease in oil and gas prices has drastically reduced revenues and
cash flows and has reduced the amount of oil and gas that the Company can
produce economically.
In order to reduce the Company's exposure to price risks in the sale
of its oil and gas, the Company enters into hedging arrangements from time
to time. The hedging arrangements, however, only generally apply to a
portion of the Company's production and provide only limited price
protection against fluctuations in the oil and gas markets. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations - Liquidity and Capital Resources" and "Hedging Activities" and
"Business."
<PAGE>
Southwest uses the full cost method of accounting for its investment
in oil and gas properties. Under the full cost method of accounting, all
costs of acquisition, exploration and development of oil and gas reserves
are capitalized into a "full cost pool" as incurred, and properties in the
pool are depleted and charged to operations using the gross revenues method
based on the ratio of current gross revenues to total proved future gross
revenues, computed based on current prices. Significant downward revisions
of quantity estimates or declines in oil and gas prices that are not offset
by other factors could result in a writedown for impairment of oil and gas
properties. Once incurred, a writedown of oil and gas properties is not
reversible at a later date, even if oil or natural gas prices increase.
During most of 1996 and 1997, the Company benefited from higher oil prices
as compared to previous years. However, during 1998, oil prices were
significantly lower causing the Company to incur a $64.0 million noncash
charge. Also, further declines in oil prices could result in additional
decreases in the carrying value of the Company's oil and gas properties.
Replacement of Reserves. The Company may not be able to replace its
existing reserves as they are depleted. In general, the volume of
production from oil and gas properties declines as reserves are depleted.
Unless the Company acquires additional properties containing proved
reserves or conducts successful development and exploration activities on
existing properties, or both, proved reserves will decline as reserves are
depleted and, as a result, cash flow will correspondingly decline. The
Company's future oil and gas production is, therefore, highly dependent
upon its success in finding or acquiring additional reserves. Exploring
for, developing or acquiring new reserves requires substantial amounts of
capital. Because cash flow from operations has been reduced and external
sources of capital have become limited or unavailable, the Company's
ability to make the capital investments necessary to maintain or expand its
reserves has been impaired. In addition, the Company cannot ensure that
future development, acquisition and exploration activities will result in
additional proved reserves or that the Company will be able to drill
productive wells at acceptable costs.
Uncertainty of Reserve Information and Future Net Revenue Estimates.
There are numerous uncertainties inherent in estimating oil and natural gas
reserves and their estimated values, including many factors beyond the
control of Southwest. The reserve data set forth herein represent only
estimates. Reservoir engineering is a subjective process of estimating
underground accumulations of oil and natural gas that cannot be measured in
an exact manner. Estimates of economically recoverable oil and natural 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 natural gas prices, future operating costs, severance and
excise taxes, development costs and workover and remedial costs, all of
which may in fact vary considerably from actual results. For these reasons,
estimates of the economically recoverable quantities of oil and natural gas
attributable to any particular group of properties, classifications of such
reserves based on risk recovery and estimates of the future net cash flows
expected therefrom prepared by different engineers or by the same engineers
at different times may vary substantially and such reserve estimates may be
subject to downward or upward adjustment based upon such factors. Actual
production, revenues and expenditures with respect to Southwest's reserves
will likely vary from estimates, and such variances may be material. See
"Item 2. Properties-Oil and Gas Reserves."
<PAGE>
The present values of estimated future net cash flows referred to
herein should not be construed as the current market value of the estimated
oil and natural gas reserves attributable to Southwest's properties. In
accordance with applicable requirements of the Commission, the estimated
discounted future net cash flows from proved reserves are generally based
on prices and costs as of the date of the estimate, whereas actual future
prices and costs may be materially higher or lower. Actual future net cash
flows also will be affected by factors such as the amount and timing of
actual production, supply and demand for oil and natural gas, curtailments
or increases in consumption by gas purchasers and changes in governmental
regulations or taxation. The timing of actual future net cash flows from
proved reserves, and their actual present value, will be affected by the
timing of both the production and the incurrence of expenses in connection
with development and production of oil and natural gas properties. In
addition, the calculation of the present value of the future net revenues
using a 10% discount, as required by the Commission, is not necessarily the
most appropriate discount factor based on interest rates in effect from
time to time and risks associated with Southwest's reserves or the oil and
natural gas industry in general.
Drilling Risks. Drilling involves numerous risks, including the risk
that no commercially productive oil or natural gas reservoirs will be
encountered. The cost of drilling, completing and operating wells is often
uncertain, and drilling operations may be curtailed, delayed or canceled as
a result of a variety of factors, including unexpected drilling conditions,
pressure or irregularities in formations, equipment failures or accidents,
adverse weather conditions, title problems and shortages or delays in the
delivery of equipment. Southwest's future drilling activities may not be
successful and, if unsuccessful, such failure will have an adverse effect
on Southwest's future results of operations and financial condition.
Marketability of Production. The marketability of Southwest's oil and
natural gas production depends upon the availability and capacity of oil
and gas gathering systems, pipelines and processing facilities, and the
unavailability or lack of capacity thereof could result in the shut-in of
producing wells or the delay or discontinuance of development plans for
properties. In addition, federal and state regulation of oil and natural
gas production and transportation, general economic conditions and changes
in supply and demand could adversely affect Southwest's ability to produce
and market its oil and natural gas on a profitable basis.
Operating Risks of Oil and Natural Gas Operations. The oil and
natural gas business involves a variety of operating risks, including the
risk of fire, explosions, blowouts, pipe failure, casing collapse,
abnormally pressured formations and hazards such as oil spills, natural gas
leaks, ruptures or discharges of toxic gases. The occurrence of any of
these operating risks could result in substantial losses to Southwest due
to injury or loss of life, severe damage to or destruction of property and
equipment, pollution or other environmental damage, including damage to
natural resources, clean-up responsibilities, penalties and suspension of
operations. In accordance with customary industry practice, Southwest
maintains insurance against some, but not all, of the risks described
above. There can be no assurance that any insurance obtained by Southwest
will be adequate to cover any losses or liabilities. Southwest cannot
predict the continued availability of insurance or the availability of
insurance at premium levels that justify its purchase.
<PAGE>
Compliance with Governmental Regulations. The Company's oil and
natural gas and well service operations are subject to various federal,
state and local governmental laws and regulations that may be changed from
time to time in response to economic or political conditions. Matters
subject to regulation include discharge permits for drilling operations,
drilling and abandonment bonds or other financial responsibility
requirements, reports concerning operations, the spacing of wells,
utilization and pooling of properties and taxation. From time to time,
regulatory agencies have imposed price controls and limitations on
production by restricting the rate of flow of oil and natural gas wells
below actual production capacity to conserve supplies of oil and natural
gas. In addition, the production, handling, storage, transportation and
disposal of oil and natural gas, by-products thereof and other substances
and materials produced or used in connection with oil and natural gas
operations are subject to regulation under federal, state and local laws
and regulations primarily relating to protection of human health and the
environment. These laws and regulations may impose increasingly strict
requirements for water and air pollution control and solid waste management
and can result in the imposition of civil and even criminal penalties.
The Company's commercial real estate properties are subject to various
federal, state and local regulatory requirements, such as laws with respect
to access by disabled persons and state and local fire and life safety
requirements. Failure to comply with these requirements could result in the
imposition of fines by governmental authorities or awards of damages to
private litigants. The Company believes that the properties are currently
in compliance in all material respects with all such regulatory
requirements. However, there can be no assurance that these requirements
will not be changed or that new requirements will not be imposed which
would require significant unanticipated expenditures by the Company's real
estate business and could have an adverse effect on expected distributions
by the Company's real estate business.
Substantial Competition. The Company experiences intense competition
in its markets. Such markets are highly competitive and no one competitor
is dominant. Southwest competes with major and independent oil and natural
gas companies for the acquisition of desirable oil and natural gas
properties, as well as for the equipment and labor required to develop and
operate such properties. Southwest also competes with major and independent
oil and natural gas companies in the marketing and sale of oil and natural
gas to marketers and end-users. Red Oak competes with other companies for
the acquisition of desirable real estate properties principally on the
basis of price. Although the Company believes that it has certain
advantages over these competitors, many of these competitors have greater
financial and other resources than the Company. See "Item 1.
Business-Competition."
Environmental Risks. The Company is subject to a variety of federal,
state and local governmental regulations related to the storage, use,
discharge and disposal of toxic, volatile or otherwise hazardous materials.
The Company does not currently anticipate any material adverse effect on
its business, financial condition or results of operations as a result of
the Company's required compliance with U.S. federal, state, provincial,
local or foreign environmental laws or regulations or remediation costs.
However, some risk of environmental liability and other costs is inherent
in the nature of the Company's business. Moreover, the Company anticipates
that such laws and regulations will become increasingly stringent in the
future, which could lead to material costs for environmental compliance and
remediation by the Company. See "Item 1. Business-Regulation."
<PAGE>
Any failure by the Company to obtain required permits for, control the
use of, or adequately restrict the discharge of, hazardous substances under
present or future regulations could subject the Company to substantial
liability or could cause its operations to be suspended. Such liability or
suspension of operations could have a material adverse effect on the
Company's business, financial condition and results of operations.
Red Oak Operations. Real estate property investments are subject to
varying degrees of risk. The economic performance and values of real estate
can be affected by many factors, including changes in the national,
regional and local economic climates, local conditions such as an
oversupply of space or a reduction in demand for real estate in the area,
the attractiveness of the properties to tenants, competition from other
available space, the ability of the owner to provide adequate maintenance
and insurance and increased operating costs. In recent years, there has
been a proliferation of new retailers and a growing consumer preference for
value-oriented shopping alternatives that have, among other factors,
heightened competitive pressures. In certain areas of the country, there
may also be an oversupply of retail space. As a consequence, many companies
in all sectors of the retailing industry have encountered significant
financial difficulties. A substantial portion of Red Oak's income is
derived from rental revenues from retailers in neighborhood and community
shopping centers. Red Oak's income would be adversely affected if a
significant number of Red Oak's tenants were unable to meet their
obligations to Red Oak or if Red Oak were unable to lease a significant
amount of space in its properties on economically favorable lease terms.
Accordingly, no assurance can be given that Red Oak's financial results
will not be adversely affected by these developments in the retail
industry.
Removal as General Partner. The limited partners have the ability to
remove the Company as the general partner of approximately 32 limited
partnerships and such removal would decrease the Company's cash flow and
proved reserves. The Company is the general partner of 32 limited
partnerships. Most of the limited partnership agreements provide that a
majority in interest of the limited partners may remove the Company as the
general partner and elect a replacement general partner. However, under
three of the limited partnership agreements the Company may only be removed
with the Company's consent. As the general partner, the Company receives
management and administrative fees from the partnerships, totaling an
aggregate of approximately $3.8 million and has an ownership interest in
each partnership. The Company's portion of partnership properties
contribute 9.8% of its proved non-producing reserves and 4% of PV-10 value.
Therefore, the Companys removal as the general partner of some or all of
the limited partnerships would decrease its cash flow and proved reserves.
However, any losses in cash flow would be offset to some degree by
decreasing administrative and operating expense.
<PAGE>
Glossary of Oil and Gas Terms
The following are abbreviates and definitions of terms commonly used
in the oil and gas industry that are used in this Report. All volumes of
natural gas referred to herein are stated at the legal pressure base to the
state or area where the reserves exit and at 60 degrees Fahrenheit and in
most instances are rounded to the nearest major multiple.
Bbl. One stock tank barrel, or 42 U.S. gallons liquid volume.
Bcf. Billion cubic feet.
Boe. Barrel of oil equivalent, determined using the ratio of one Bbl
of crude oil, condensate or natural gas liquids to six Mcf of natural gas.
Bopd. Barrels of oil per day.
Completion. The installation of permanent equipment for the production
of oil and natural gas, or in the case of a dry hole, the reporting of
abandonment to the appropriate agency.
Development well. A well drilled within the proved area of an oil or
natural gas reservoir to the depth of a stratigraphic horizon known to be
productive.
Dry hole or well. A well found to be incapable of producing
hydrocarbons in sufficient quantities such that proceeds from the sale of
such production exceed production expenses and taxes.
Exploratory well. A well drilled to find and produce oil or natural
gas reserves not classified as proved, to find a new reservoir in a field
previously found to be productive of oil or natural gas in another
reservoir or to extend a known reservoir.
Field. An area consisting of a single reservoir or multiple reservoirs
all grouped on or related to the same individual geological structural
feature and/or stratigraphic condition.
Gross acres or gross wells. The total acres or wells, as the case may
be, in which a working interest is owned.
Horizontal drilling. A drilling technique that permits the operator to
contact and intersect a larger portion of the producing horizon than
conventional vertical drilling techniques and can result in both increased
production rates and greater ultimate recoveries of hydrocarbons.
MBbls. One thousand barrels.
MBoe. One thousand barrels of oil equivalent, determined using the
ratio of one Bbl of crude oil, condensate or natural gas liquids to six Mcf
of natural gas.
Mcf. One thousand cubic feet.
Mcfd. One thousand cubic feet per day.
Mcfe. One thousand cubic feet equivalent, determined using the ratio
of six Mcf of natural gas to one Bbl of crude oil, condensate or natural
gas liquids.
MMBbls. One million barrels of crude oil or other liquid hydrocarbons.
<PAGE>
MMBoe. One million barrels of oil equivalent, determined using the
ratio of one Bbl of crude oil, condensate or natural gas liquids to six Mcf
of natural gas.
MMcf. One million cubic feet.
Net acres or net wells. The sum of the fractional working interests
owned in gross acres or gross wells, as the case may be.
Oil. Crude oil, condensate and natural gas liquids.
Present value and PV-10 Value. When used with respect to oil and
natural gas reserves, the estimated future net revenue to be generated from
the production of proved reserves, determined in all material respects in
accordance with the rules and regulations of the Securities and Exchange
Commission (generally using prices and costs in effect as of the date
indicated) without giving effect to non-property related expenses such as
general and administrative expenses, debt service and future income tax
expenses or to depreciation, depletion and amortization, discounted using
an annual discount rate of 10%.
Productive well. A well that is found to be capable of producing
hydrocarbons in sufficient quantities such that proceeds from the sale of
such production exceed production expenses and taxes.
Proved developed producing reserves. Proved developed reserves that
are expected to be recovered from completion intervals currently open in
existing wells and capable of production.
Proved developed reserves. Proved reserves that are expected to be
recovered from existing wellbores, whether or not currently producing,
without drilling additional wells. Production of such reserves may require
a recompletion.
Proved reserves. The estimated quantities of crude oil, natural gas,
and natural gas liquids that 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 location. A site on which a development well can be
drilled consistent with spacing rules for purposes of recovering proved
undeveloped reserves.
Proved undeveloped reserves. Proved reserves that are expected to be
recovered from new wells on undrilled acreage.
Recompletion. The completion for production of an existing wellbore in
another formation from that in which the well has been previously
completed.
Reserve life. A ratio determined by dividing the existing reserves by
production from such reserves for the prior twelve month period.
Reservoir. A porous and permeable underground formation containing a
natural accumulation of producible oil and/or natural gas that is confined
by impermeable rock or water barriers and is individual and separate from
other reserves.
Royalty interest. An interest in an oil and natural gas property
entitling the owner to a share of oil or natural gas production free of
costs of production.
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 natural gas regardless of whether such
acreage contains proved reserves.
<PAGE>
Wellbore. The hole drilled by the bit.
Working interest. The operating interest that gives the owner the
right to drill, produce and conduct operating activities on the property
and a share of production.
Workover. Operations on a producing well to restore or increase
production.
ITEM 2. PROPERTIES.
Facilities
The principal offices of SRH, Southwest and Red Oak are located in
Midland, Texas. SRH, Southwest, and Red Oak believe that their leased and
owned properties, none of which individually is material to any of the
companies, are adequate for current needs.
Title to Properties
The Company believes it has satisfactory title to all of its
properties in accordance with standards generally accepted in the oil and
gas, well servicing and real estate industries. As is customary in the oil
and natural gas industry, Southwest makes only a cursory review of title to
farmout acreage and to undeveloped oil and natural gas leases upon
execution of any contracts. Prior to the commencement of drilling
operations, a thorough title examination is conducted and curative work is
performed with respect to significant defects. To the extent title opinions
or other investigations reflect title defects, Southwest, rather than the
seller of the undeveloped property, is typically responsible to cure any
such title defects at its expense. If Southwest were unable to remedy or
cure any title defect of a nature such that it would not be prudent to
commence drilling operations on the property, Southwest could suffer a loss
of its entire investment in the property. Southwest 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 natural gas industry. Prior to completing
an acquisition of producing oil and natural gas leases, Southwest obtains
title opinions on a majority of all leases. Southwest's oil and natural gas
properties are subject to customary royalty interests, liens for current
taxes and other burdens that Southwest believes do not materially interfere
with the use of or affect the value of such properties.
<PAGE>
Oil and Gas Properties
Southwest's Principal Oil and Gas Properties
The Company's oil and gas properties are primarily located in the
Permian Basin of West Texas and southeastern New Mexico. Over 90% of the
Company's PV-10 Value is concentrated in this region. The region is
characterized by numerous known producing horizons, providing significant
opportunities to increase reserves, production and ultimate recoveries
through additional development, horizontal drilling, recompletions,
enhanced recovery methods, and the use of 3-D seismic, reprocessed 2-D
seismic data and other advanced technologies. As of December 31, 1998, the
Company operated properties comprising approximately 66% of its PV-10
Value. The following table provides information for the Company's ten
largest fields which contribute 62.5% of its reserves and PV-10 Value as of
December 31, 1998.
As of December 31, 1998
--------------------------------------
Net Proved PV-10 % of Total
Reserves Value PV-10
Field (Mboe) (in thousands) Value
----- ---------------------- --------
Foster 4,551 $10,962 15.2%
Huntley 2,576 7,829 10.9%
Halley 2,833 5,120 7.1%
Ackerly 1,698 4,141 5.8%
Jo-Mill 1,950 4,020 5.6%
Huntley East 1,683 3,723 5.2%
Flying M 1,961 3,472 4.8%
Amacker Tippett 808 2,668 3.7%
Rhoda Walker 970 1,672 2.3%
Crittendon 323 1,351 1.9%
------ ------ ----
Total Top Ten Fields 19,353 $44,958 62.5%
Foster Field. The Foster Field is located in Ector County, Texas. The
field was discovered in 1936 and produces from the Grayburg and Queen
formations in the Gist Unit. Southwest owns working interests ranging from
59.5% to 100% and operates 64 producing and 33 injection wells.
Huntley Field. The Huntley Field is located in Garza County, Texas.
The field was discovered in 1953 and produces from the San Andres and
Glorieta reservoirs. Southwest owns an 87% working interest and operates
33 producing and 12 injection wells.
Halley Field. The Halley Field is located in Winkler County, Texas and
consists of two leases totaling 7,608 gross acres, of which 3,190 gross
acres have been developed. Southwest acquired working interests ranging
from 43% to 70% in this field in 1995 and currently operates 109 active
producing wells and 32 water injection wells. The field was discovered in
1937 and produces from multiple zones ranging from 2,400 to 3,000 feet in
depth. To date, Southwest has performed 62 workovers, increasing average
daily production from approximately 200 Bopd and 280 Mcfd of natural gas in
1995 to 321 Bopd and 3,500 Mcfd of natural gas in 1998. Development plans,
which have commenced, include the drilling of 48 proved undeveloped
locations and 32 workovers.
Ackerly (Dean) Field. The Ackerly (Dean) Field is located in Dawson
County, Texas and produces from the Dean Sand oil reservoir. The field was
discovered in 1954 with the drilling and completion of the Pan American
Graves "A" No. 1 well. Southwest owns a 60% working interest in the East
Ackerly Dean Unit-Phase II, along with interests in two additional leases.
Henry Petroleum operates 70 producing and 30 injection wells.
<PAGE>
Jo-Mill Field. The Jo-Mill Field is located in Borden County, Texas.
The field was discovered in 1954, unitized in 1969, and produces from the
Upper Spraberry, Lower Spraberry and Dean Sand reservoirs. Southwest owns a
6% working interest in the Jo-Mill Unit. Texaco, Inc. operates 172
producing and 73 injection wells.
Huntley East Field. The Huntley East Field is located in Garza County,
Texas. The field was discovered in 1956 and produces from a low-relief
anticline which covers approximately 1,400 surface acres. Southwest has a
100% working interest in the Huntley East San Andres Unit, which comprises
substantially all of the field, and a 100% working interest in the Harold
L. Davies lease, and operates 37 producing and 7 injection wells.
Flying M Field. The Flying M Field is located in northern Lea County,
New Mexico and produces from the San Andres oil reservoir. The field was
discovered in 1964 and was unitized in 1967 when water injection commenced.
In 1997, Southwest acquired working interests ranging from 83% to 100% in
6,160 gross acres of the field area, of which 2,240 gross acres are
undeveloped. Southwest operates all 46 producing wells and nine active
water injection wells, including wells that are not contained within the
unitized portion of the field. Development plans for this field include the
drilling of ten undrilled 40-acre proved undeveloped locations and the
conversion of ten wells to water injection. Further development of the
field, including the reduction to 20-acre spacing from the current 40-acre
spacing, is presently under evaluation.
The Amacker Tippett Field. The Amacker Tippett Field is located in
Upton County, Texas and produces from the Devonian, Fusselman, Strawn,
Wolfcamp and Bend formations. The Amacker Tippett Devonian field was
discovered in September of 1955. The Amacker Tippett South Bend Field was
discovered in December of 1961 and the Amacker Tippett Wolfcamp field was
discovered in October of 1954. Southwest owns working interests ranging
from 10% to 64.7% and operates 11 of the 17 producing wells and a salt
water disposal well.
Rhoda Walker Field. The Rhoda Walker Field is located in Ward County,
Texas and produces from 18 different reservoirs ranging in depth from 4,700
to 7,000 feet. Southwest acquired its working interests in this field,
ranging from 1% to 34%, in 1990. Southwest operates 37 producing wells and
five water disposal wells and also owns non-operated interests in 46 wells.
The field was discovered in 1971 and contains significant proved developed
locations and infill drilling.
Crittendon Field. The Crittendon Field is a multi-pay field located in
Winkler County, Texas. Production from the field was first reported in
1968. The field has produced 1.9 MMBO and 144 BCF from 1968 to 1998, with
the latest reported production of 7 MBOPM, and 166 MMCFPM. Currently there
are three active oil wells and ten active gas wells, producing from eight
different reservoirs within the Crittendon field group. Southwest owns
from 2% to 20% working interests in the wells.
<PAGE>
Oil and Gas Reserves. The following table summarizes the estimates of
Southwest's historical net proved reserves and the related present values
of such reserves at the dates shown. The reserve and present value data for
the Company's existing properties as of December 31, 1998 have been
prepared by Ryder Scott Petroleum Engineers for properties representing
96.4% of the Company's PV-10 Value at such date, with the remaining 3.6%
being prepared by independent petroleum engineer, Donald R. Creamer. The
reserve and present value data for the Company's existing properties as of
December 31, 1997 have been prepared by Ryder Scott Petroleum Engineers.
The reserve and present value date for the Company's existing properties as
of December 31, 1996 have been prepared by independent petroleum engineer,
Donald R. Creamer.
As of December 31,
-----------------------------
1998 1997 1996
---- ---- ----
Proved Reserves:
Oil and Condensate (MBbls) 20,944 29,666 18,806
Natural Gas (MMcf) 58,273 64,725 76,776
Total (MBoe) 30,656 40,453 31,602
Proved Developed Reserves:
Oil and Condensate (MBbls) 12,006 18,472 10,302
Natural Gas (MMcf) 37,481 46,585 58,961
Total (MBoe) 18,253 26,236 20,129
PV-10 Value (in thousands)(1) $ 71,900 $172,304 $252,170
Discounted Future Cash Flows (2)
Future cash inflows $315,709 $620,418 $735,100
Future production and development costs (181,627) (303,406)
(283,894)
------- ------- -------
Future net cash flows before income taxes 134,082 317,012
451,206
Future income tax expense - (59,764) (142,017)
------- ------- -------
Future net cash flows, net of tax 134,082 257,248 309,189
10% annual discount for estimated
timing of cash flows (62,182) (117,427) (130,648)
------- ------- -------
Standardized measure of discounted future
net cash flows, net of tax $ 71,900 $139,821 $178,541
======= ======= ======
(1) The present value of future net revenues attributable to
Southwest's reserves was prepared using prices in effect at the end of the
respective periods presented, discounted at 10% per annum on a pre-tax
basis.
(2) Discounted future cash flows, including taxes, 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 rate, changes in development and
production costs and production costs and risks associated with future
production. Because of these considerations, any estimate of fair value is
necessarily subjective and imprecise.
In accordance with applicable requirements, estimates of Southwest's
proved reserves and future net revenues are made using oil and natural gas
sales prices estimated to be in effect as of the date of such reserve
estimates and are held constant throughout the life of the properties
(except to the extent a contract specifically provides for escalation.)
The average prices used in the reserve report were $10.25 per Bbl of oil
and $1.73 per Mcf of natural gas, $16.30 per Bbl of oil and $2.11 per Mcf
of natural gas and $23.89 per Bbl of oil and $3.67 per Mcf of natural gas
as of December 31, 1998, 1997 and 1996, respectively.
<PAGE>
Estimated quantities of proved reserves and future net revenues
therefrom are affected by oil and natural gas prices, which have fluctuated
widely in recent years. There are numerous uncertainties inherent in
estimating oil and natural gas reserves and their values, including many
factors beyond the control of the producer. Reservoir engineering is a
subjective process of estimating underground accumulations of oil and
natural gas that cannot be measured in an exact manner. The accuracy of any
reserve estimate is a function of the quality of available data and of
engineering and geological interpretation and judgment. As a result,
estimates of different engineers, including those used by Southwest, may
vary. In addition, estimates of reserves are subject to revision based upon
actual production, results of future development and exploration
activities, prevailing oil and natural gas prices, operating costs and
other factors, which revisions may be material. Accordingly, reserve
estimates are often different from the quantities of oil and natural gas
that are ultimately recovered and are highly dependent upon the accuracy of
the assumptions upon which they are based.
In general, the volume of production from oil and natural gas
properties declines as reserves are depleted. Except to the extent
Southwest acquires properties containing proved reserves or conducts
successful exploration and development activities, or both, the proved
reserves of Southwest will decline as reserves are produced. Southwest's
future oil and natural gas production is, therefore, highly dependent upon
its level of success in finding or acquiring additional reserves.
Exploring for, developing or acquiring new reserves requires substantial
amounts of capital. Because cash flow from operations has been reduced and
external sources of capital have become limited or unavailable, the
Company's ability to make the capital investments necessary to maintain or
expand its reserves has been impaired.
Net Production, Unit Prices and Costs. The following table presents
certain information with respect to oil and gas production, prices and
costs attributable to all oil and gas property interests owned by Southwest
for the years ended December 31, 1998, 1997 and 1996:
As of December 31,
-----------------------------
1998 1997 1996
---- ---- ----
Production Volumes:
Oil and condensate (MBbls) 1,689 1,308 1,001
Natural gas (MMcf) 5,556 5,639 5,403
Total (MBoe) 2,615 2,248 1,901
Average Daily Production:
Oil and condensate (Bbls) 4,628 3,584 2,735
Natural Gas (Mcf) 15,222 15,449 14,762
Total (Boe) 7,165 6,159 5,194
Average Realized Prices:
Oil and condensate (per Bbl) $ 12.73 $ 19.12 $ 20.44
Natural gas (per Mcf) 1.85 2.24 2.22
Per Boe 12.16 16.75 17.07
Expenses (per Boe):
Lease operating (including production taxes)$ 7.03 $ 8.23 $
7.81
Oil and gas depletion 5.97 5.52 3.38
General and administrative, net 1.04 1.63 1.28
<PAGE>
Producing Wells. The following table sets forth the number of
productive wells in which Southwest owned an interest as of December 31,
1998:
Gross Net
Wells Wells
------ ------
Oil 6,951 540
Natural Gas 542 60
----- ---
Total 7,493 600
Productive wells consist of producing wells and wells capable of
production, including gas wells awaiting pipeline connections and oil wells
awaiting connection to production facilities. Wells that are completed in
more than one producing horizon are counted as one well. A gross well is a
well in which an interest is owned. A net well is the fractional working
interest in a gross well. The number of net wells is the sum of the
fractional interest owned in gross wells.
Acreage. The following table sets forth Southwest's developed and
undeveloped gross and net leasehold acreage as of December 31, 1998:
Gross Net
------ ------
Developed 1,739,000 208,000
Undeveloped 551,000 63,000
--------- -------
Total 2,290,000 271,000
Undeveloped acreage includes leased acres 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 or not such
acreage contains proved reserves. A gross acre is an acre in which an
interest is owned. A net acre is the fractional working interest in a gross
acre. The number of net acres is the sum of the fractional interests owned
in gross acres.
<PAGE>
Drilling Activities. The table below sets forth the drilling activity
of Southwest on its properties for the periods ending December 31, 1998,
1997 and 1996.
Year Ended December 31,
-----------------------------------
1998 1997 1996
-------------------- ----------
Gross Net Gross Net GrossNet
-------------------- ----------
Development wells:
Productive 15 5.7 53 27.3 14 5.7
Non-productive 1 .5 3 2.4 - -
-- ---- -- --- -- ---
Total 16 6.2 56 29.7 14 5.7
Exploratory wells:
Productive 7 2.5 10 3.3 1 0.1
Non-productive 1 1.0 4 1.4 6 -
-- ---- -- --- -- ---
Total 8 3.5 14 4.7 7 0.1
Oil and Natural Gas Marketing and Hedging. The revenues generated by
Southwest's operations are highly dependent upon the prices of and demand
for oil and natural gas. The price received by Southwest for its oil and
natural gas production depends on numerous factors beyond Southwest's
control. Historically the markets for oil and natural gas have been
volatile and are likely to continue to be volatile in the future. Prices
for oil and natural gas are subject to wide fluctuation in response to
relatively minor changes in the supply and demand for oil and natural gas,
market uncertainty and a variety of additional factors. These factors
include the level of consumer product demand, weather conditions, domestic
and foreign governmental regulations, the price and availability of
alternative fuels, political conditions in the Middle East, the actions of
OPEC, the foreign supply of oil and natural gas and overall economic
conditions. It is impossible to predict future oil and natural gas price
movements with any certainty.
During 1998, the Company did not have any significant customers. The
Company does not believe the loss of any purchaser would have a material
adverse effect on its operations, revenues or cash flow.
The Company, from time to time, uses option contracts to mitigate the
volatility of price changes on commodities the Company produces and sells
as well as to lock in prices to protect the economics related to certain
capital projects. In August 1998, the Company purchased an additional put
option on a total of 15,000 MMBtu of natural gas per day based on the El
Paso Natural Gas Co. - Permian Basin Index. The option is for the period
from November 1, 1998 through March 31, 1999 and has a strike price $2.00
per MMBtu. After this option expires, if the Company chooses not to pursue
additional hedging agreements, all of Southwest's natural gas production
will be sold at spot market prices, under various short-term and
intermediate term contracts. In March 1999, Southwest entered into a
hedging agreement whereby Southwest is contracted to sell 1,000 barrels of
oil per day with a strike price of $14.67 per Bbl, based on West Texas
Intermediate - NYMEX. The contract is for the period Aril 1, 1999 through
June 30, 1999, but can be extended to September 30, 1999 at the option of
the counter-party.
<PAGE>
Red Oak Properties
As of December 31, 1998, Red Oak owned and managed fifteen shopping
centers, eight office buildings and raw land held for future development.
Red Oak's holdings are located primarily in secondary markets in the
southwestern United States. Red Oak's existing property portfolio is shown
in the table below.
Gross Leasable
Area
Shopping Centers Location (Square Feet)
----------------- --------------- ---------------
Plaza Oaks Midland, TX 94,779
Southwest Plaza San Angelo, TX 198,983
Town & Country Odessa, TX 120,855
State Bank Plaza Tulsa, OK 35,748
The Plaza Tulsa, OK 116,889
Madera Village Tucson, AZ 96,702
Bear Canyon Tucson, AZ 70,941
Bears Path Tucson, AZ 40,728
Plaza Palomino Tucson, AZ 98,634
River Oaks Abilene, TX 140,899
San Miguel Square Midland, TX 77,582
Colonnade at Polo Park Midland, TX 105,749
Crossroads San Antonio, TX 710,724
Northcross Mall Austin, TX 298,762
Victoria Mall Victoria, TX 632,466
Office Building
----------------
Woodhill Midland, TX 45,920
Independence Plaza Midland, TX 148,417
50 Penn Place Oklahoma City, OK 311,363
La Placita Village Tucson, AZ 216,446
Reunion Center Tulsa, OK 89,265
Century Plaza Midland, TX 95,443
Trinity Professional Midland, TX 23,918
405 N. Marienfeld Midland, TX 20,750
Land Acres
------ --------
Red Oak (residential) Midland, TX 398.3
Lewisville (residential) Lewisville, TX 95.3
ITEM 3. LEGAL PROCEEDINGS.
From time to time, the Company is party to litigation or other legal
proceedings that each company considers to be a part of the ordinary course
of its business. The Company is not involved in any legal proceedings nor
is it party to any pending or threatened claims that could reasonably be
expected to have a materially adverse effect on its financial condition,
cash flow or results of operations.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
None.
<PAGE>
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS.
Holders
Southwest has one class of common equity securities outstanding, its
Common Stock, par value $.10 per share.
On March 31, 1999, all 100 outstanding shares of Southwest's Common
Stock were held by SRH. SRH has one class of common equity securities, its
Common Stock, par value $.10 per share. On March 31, 1999, 1,075,868
shares of SRH's Common Stock were held by 382 holders of record. SRH's and
Southwest's Common Stock are collectively referred to hereafter as the
"Common Stock."
Market
There is currently no public market for the Common Stock and the
Company does not anticipate that any such market will develop. The Common
Stock has not been registered under the Securities Act. The stockholders
have no rights to require registration of the Common Stock under the
Securities Act or other applicable securities laws. The Common Stock may
not be sold, transferred or otherwise disposed of except in a transaction
that is either registered or exempt from registration under the Securities
Act and all applicable state securities laws. In addition, the Common
Stock is subject to transfer restrictions contained in SRH's and
Southwest's By-Laws. Both SRH's and Southwest's By-Laws prohibit the
transfer of its Common Stock except to a spouse, family member or affiliate
of a stockholder. Any other transfer by a stockholder requires the prior
written consent of the Company. In addition, SRH and H.H. Wommack, III
have the option to purchase the shares in the event of a third party offer
to purchase any of the Common Stock.
Dividends
Southwest and SRH have never paid cash dividends on the Common Stock
and do not anticipate paying cash dividends in the foreseeable future. The
Company intends to retain any future earnings to finance the expansion and
continuing development of the Company's business. The future payment of
dividends, if any, on the common Stock is within the discretion of the
Company's Board of Directors and will depend upon the Company's earnings,
capital requirements, and financial position, future loan covenants,
general economic conditions and other relevant factors. There is no
assurance that the Company will pay any dividends.
There are several restrictions on the Company's ability to pay
dividends, including (i) the provisions of the Delaware Corporation Laws,
(ii) certain restrictive provisions in the Indenture executed in connection
with Southwest's 10.5% Senior Notes due 2004 (the "Indenture"), and (iii) a
restrictive covenant in the Company's Restated Senior Secured Loan
Agreement dated October 9, 1997 with Bank One, Texas, N.A. (the "Southwest
Credit Facility"). Under the Indenture, the Company must meet several
financial tests before it can pay cash dividends. These requirements work
together to effectively prohibit the payment of cash dividends. In
addition, the Southwest Credit Facility expressly prohibits the payment of
cash dividends on Southwest's common stock.
<PAGE>
Recent Sales of Unregistered Securities
On October 14, 1997, Southwest completed a $200 million private
placement sale of 10.5% Senior Notes due 2004, Series A (the "Series A
Notes") to Jefferies & Company, Inc., Banc One Capital Corporation, and
Paribas Corporation (the "Underwriters"). The Underwriters then offered
and sold the Series A Notes to qualified institutional buyers. The offer
and sale of the Series A Notes was exempt from registration under the
Securities Act pursuant to Section 4(2) and Rule 144A.
Southwest concluded an offer to exchange the Series A Notes for 10.5%
Series B, Senior Notes due 2004, which had been registered under the
Securities Act on March 11, 1998. The Exchange Offer was conducted
pursuant to Securities Act Registration Statement No. 333-41915, which
became effective February 9, 1998. All of the Series A Notes were
exchanged for Notes prior to the termination of the Exchange Offer. The
Company did not receive any cash proceeds from the issuance of the Notes.
In 1996, Southwest issued 45,628 warrants, to purchase common stock of
Southwest, to Joint Energy Development Investments Limited Partnership
pursuant to an $8 million loan to Southwest which was repaid with the
issuance of the Series A Notes. The issue of the warrants was exempt from
registration pursuant to Section 4(2) of the Securities Act. The warrants
are presently exercisable upon payment of a prescribed purchase price. In
connection with the reorganization in 1997, these warrants were exchanged
for warrants in SRH.
In 1996, Southwest issued 129,046 shares of its Common Stock, par
value $.10, solely to accredited investors for $68 a share. The aggregate
offering price of the shares was $8,624,000 and the aggregate commissions
for the offering were $333,000. The offer and sale of the stock was exempt
from registration under the Securities Act pursuant to Regulation D
thereunder. Such stock was exchanged for SRH stock in conjunction with the
reorganization in July 1997.
<PAGE>
ITEM 6. SELECTED FINANCIAL DATA.
The following tables set forth selected historical and pro forma
financial information of the Company for the periods shown. The following
information should be read in conjunction with "Item 7. Management's
Discussion and Analysis of Financial Condition and Results of Operations,''
and the Company's Financial Statements and Notes thereto included in "Item
8. Financial Statements and Supplementary Data."
Year Ended December 31,
1998 1997 (a) 1996 1995 1994
------- --------- ------- ------- -------
(in thousands, except per share data)
Consolidated Income Statement Data:
Operating revenues:
Oil and gas $ 32,467 $ 38,500 $ 33,787 $ 21,211 $ 15,083
Well service - 7,789 8,013 4,218 2,377
Real estate 25,650 9,338 4,487 3,213 605
Other 1,392 1,227 614 344 318
------ ------ ------ ------ ------
Total operating revenue 59,509 56,854 46,901 28,986 18,383
------ ------ ------ ------ ------
Operating expenses:
Oil and gas 18,395 18,500 14,846 11,511 7,879
Well service - 5,600 6,145 3,315 2,136
Real estate 13,242 4,138 1,887 1,414 195
General and administrative 4,450 5,745 5,436 3,504 3,047
Depreciation, depletion and
amortization 19,240 15,034 8,430 6,719 4,437
Impairment of oil and gas
properties 64,000 - - - -
Other 1,235 1,342 554 228 105
------- ------ ------ ------ ------
Total operating expenses 120,562 50,359 37,298 26,691 17,799
------- ------ ------ ------ ------
Operating income (loss) (61,053) 6,495 9,603 2,295 584
------- ------ ------ ------ ------
Other income (expense):
Interest expense (36,490) (18,894) (10,016) (5,635) (1,975)
Interest income 1,478 1,002 441 269 229
Other 370 145 561 (78) 1,687
------- ------ ------ ------ ------
(34,642) (17,747) (9,014) (5,444) (59)
------- ------ ------ ------ ------
Income (loss) before income
taxes, minority interest,
equity loss and
extraordinary item (95,695) (11,252) 589 (3,149) 525
Income tax benefit (provision) 2,348 2,641 (365) 1,044 (171)
Minority interest in
subsidiaries, net of tax 913 430 181 (15) (1)
Equity in loss of subsidiary and
partnerships, net of tax (3,620) (203) - - -
Extraordinary item, net of tax - (3,109) - - -
------- ------ ------ ------ ------
Net income (loss) $(96,054) $(11,493) $ 405 $ (2,120) $ 353
======= ====== ====== ====== ======
Income (loss) per common share
before extraordinary item $ (89.28) $ (7.78) $ 0.42 $ (2.19) $ 0.37
<PAGE>
Year Ended December 31,
1998 1997 (a) 1996 1995 1994
------- --------- ------- ------- -------
(in thousands, except per share data)
Consolidated Balance Sheet Data:
Cash and cash equivalents $ 13,801 $ 27,365 $ 8,284 $ 3,364 $ 3,095
Net property and equipment 213,493 237,675 100,176 78,231 36,886
Total assets 257,550 305,443 130,284 95,434 49,709
Long-term debt, including
current portion 335,084 283,642 93,805 73,486 33,723
Consolidated Cash Flow Statement
Data:
Net cash provided by (used in)
operating activities (5,976) 6,034 10,280 5,634 5,222
Net cash used in investing
activities (56,283) (173,902) (33,225) (44,532) (9,641)
Net cash provided by
financing activities 48,695 186,949 27,865 39,166 5,054
(a) Sierra was deconsolidated on July 1, 1997. Earnings for the six
months ended June 30, 1997 are included in the Company's consolidated
statement of operations. Subsequent to June 30, 1997, any earnings (loss)
associated with Sierra are reflected in equity in loss of subsidiary.
Selected Operating Data
The following table sets forth selected information with respect to
the Company's operating data for the periods shown.
Year Ended December 31,
1998 1997 1996 1995 1994
------- -------- ------- ------- -------
Production volumes:
Oil and condensate (Mbbls) 1,689 1,308 1,001 814 629
Natural gas (MMcf) 5,556 5,639 5,403 4,639 3,178
Total (Mboe) 2,615 2,248 1,901 1,587 1,159
Average daily production:
Oil and condensate (Bbls) 4,628 3,584 2,735 2,230 1,723
Natural gas (Mcf) 15,222 15,449 14,762 12,709 8,707
Total (Boe) 7,165 6,159 5,194 4,348 3,174
Average realized prices (a):
Oil and gas condensate
(per Bbl) $ 12.73 $ 19.12 $ 20.44 $ 16.40 $ 14.30
Natural gas (per Mcf) 1.85 2.24 2.22 1.51 1.72
Per Boe 12.16 16.75 17.07 12.83 12.47
Expenses (per Boe):
Lease operating(including
production taxes) $ 7.03 $ 8.23 $ 7.81 $ 7.25 $ 6.80
Oil and gas depletion 5.97 5.52 3.38 3.19 3.03
Oil and gas general and
administrative, net (b) 1.04 1.63 1.28 1.20 1.73
(a) Reflects the actual realized prices received by the Company, including
the results of the Company's hedging activities. See "Item 7.
Management's Discussion and Analysis of Financial Condition and
Results of Operations."
(b) Certain related party management fees received from oil and gas
partnerships have been reclassified as a reduction of general and
administrative expenses for all periods presented.
<PAGE>
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS.
General
Southwest Royalties Holdings, Inc., a Delaware corporation, was formed
in 1997 to serve as a holding company for Southwest Royalties, Inc., Sierra
Well Service, Inc. and Midland Red Oak Realty, Inc. SRH is an independent
oil and gas company engaged in the acquisition, development and production
of oil and gas properties, primarily in the Permian Basin of West Texas and
southeastern New Mexico, through its wholly-owned subsidiary, Southwest.
Since 1983, Southwest has grown primarily through selective acquisitions of
producing oil and gas properties, both directly and through the oil and gas
partnerships it manages. SRH also participates in the well servicing
industry through its affiliate, Sierra, and owns and manages real estate
properties through its subsidiary, Red Oak. SRH has grown over the last
several years primarily through acquisitions in each of its businesses.
Southwest has historically complemented its oil and gas reserves and
production by concentrating on drilling low-risk development wells and by
conducting additional development activities such as recompletions. During
1998, Southwest was involved in drilling 16 gross (6.2 net) developmental
wells and 8 gross (3.5 net) exploratory wells, achieving an approximate
success rate of 94% and 88% on its development and exploration activities,
respectively.
On October 14, 1997, Southwest completed a $200 million private
placement of 10.5% Senior Notes due 2004, to among other things, provide
approximately $69 million for acquisitions and approximately $27 million of
working capital. An integral part of the Southwest business strategy in
conjunction with the 10.5% Senior Note issuance, involved the successful
investment of the additional working capital into both the development and
exploitation of its existing oil and gas properties and the acquisition of
additional producing oil and gas properties. It was imperative to increase
production volumes to meet the necessary ongoing cash flow needs and
requirements of Southwest. The successful investment of the additional
working capital would dramatically increase production levels thereby
supplying additional cash flow to Southwest to meet requirements and
continue to fund additional capital expenditure projects.
In the last quarter of 1997, oil and gas commodity prices began a
dramatic decrease that continued throughout 1998 and currently. In
response, early in 1998, Southwest implemented its alternate budget that
limited capital investment into the planned developmental and acquisition
projects and eventually suspended almost all investment as prices continued
to decrease and remained depressed. As opposed to the originally budgeted
$45 million of capital investment only approximately $10 million was
invested for development, exploration and acquisitions in 1998.
Throughout 1998, as oil and gas prices remained depressed, Southwest
continually reduced expenditures including corporate general and
administrative and lease operating expenses. On a per unit of production
basis, Southwest has reduced lease operating expenses to $7.03/BOE in 1998,
from $8.23/BOE in 1997, due primarily to management efforts to cut expenses
through more efficient operations and by selectively eliminating high
operating expense properties from its oil and gas portfolio. Southwest
also reduced general and administrative expenses to $1.04/BOE in 1998, from
$1.63/BOE in 1997, primarily due to staff reductions initiated by Southwest
early in the oil price downturn. Southwest also initiated and completed
$5.7 million in sales of non-strategic and relatively high cost oil and gas
properties in 1998 to effectively expand margins, increase efficiencies,
and supply additional working capital.
The harsh decline in commodity pricing has had a double impact on
Southwest's cash flow by severely reducing proceeds associated with current
production levels and reducing Southwest's investment into undeveloped
reserves. The inability to replace the existing, depleting reserve base
ultimately and systematically creates lower revenues and margins.
<PAGE>
As net revenues fell due to these circumstances of declining price and
production, an increasingly larger portion of cash flow was necessary to
meet debt interest expense. As prices continue to remain depressed, the
existing cash balance is being depleted in an effort to meet current debt
interest requirements.
Southwest uses the full cost method of accounting for its investment
in oil and gas properties. Under the full cost method of accounting, all
costs of acquisition, exploration and development of oil and gas reserves
are capitalized into a ''full cost pool'' as incurred, and properties in
the pool are depleted and charged to operations using the future gross
revenues method based on the ration of current gross revenues to total
proved future gross revenues, computed based on current prices.
Significant downward revisions of quantity estimates or declines in oil and
gas prices that are not offset by other factors could result in a writedown
for impairment of oil and gas properties. Once incurred, a writedown of
oil and gas properties is not reversible at a later date, even if oil or
gas prices increase. During most of 1996 and 1997, Southwest benefited
from higher oil prices as compared to previous years. During 1998,
however, oil prices were significantly lower causing the Company to incur a
$64.0 million noncash charge. Further declines in oil prices could result
in additional decreases in the carrying value of Southwest's oil and gas
properties.
The severe decrease in the commodity prices has drastically affected
revenue and cash flows from operations received by Southwest. The
resulting inability to successfully employ the initial business and
investment plan of Southwest, which was to be initiated immediately after
the $200 million 10.5% Senior Note issuance, and the necessary use of cash
balances and operating cash flows to meet debt interest obligations
therefrom, makes it probable Southwest will not be able to meet its
operating and debt obligations beyond 1999, unless Southwest can
successfully restructure its debt obligations.
Red Oak. Red Oak acquires and manages neighborhood and community
shopping centers, other retail and commercial properties and office
buildings. These properties are primarily leased, on a long-term basis, to
major retail companies, local specialty retailers and professional and
business tenants throughout secondary urban markets. As of December 31,
1998, Red Oak owned and managed fifteen shopping centers, eight office
buildings and raw land held for future development. Red Oak's revenue,
profitability and cash flows are substantially dependent upon the ability
of Red Oak to lease its properties on economically favorable lease terms.
Red Oak is currently experiencing financial difficulties. Red Oak has
generated losses for the years ended December 31, 1998, 1997 and 1996 and
is experiencing difficulties in meeting its obligations when they become
due. The capital structure of Red Oak is highly leveraged with $12.5
million and $12.3 million of principal and cash interest payments,
respectively, due in 1999. Management is currently in the process of
renegotiating the terms of Red Oak's various obligations with its lenders
and /or seeking new lenders or equity investors. Additionally, management
would consider disposing of certain assets in order to meet its
obligations.
Sierra. Effective July 1, 1997 Sierra was deconsolidated from SRH's
financial statements and SRH has subsequently accounted for its ownership
in Sierra as an investment in an unconsolidated subsidiary, consistent with
the equity method of accounting under GAAP. As such, comparisons of
Sierra's revenue and expenses for the years ended December 31, 1998 and
1997 are not relevant, and therefore, no discussion of such results of
operations are provided herein.
Sierra has a highly leveraged capital structure with primarily all of
its outstanding debt due on March 31, 1999. Sierra does not have the
available working capital to meet this obligation, but has recently
executed a restructuring of its debt with the lender. Although the
restructuring has been executed, it will not become final until the proper
Hart-Scott-Rodino filings have been successfully completed. If such
efforts are unsuccessful, Sierra may be unable to meet its obligations,
making it necessary to undertake actions as may be appropriate to preserve
asset values.
<PAGE>
Results of Operations
Year Ended December 31, 1998 Compared to Year Ended December 31, 1997
Revenues. Consolidated revenues for SRH increased $2.7 million, or
5%, for the year ended December 31, 1998. An increase in revenues at Red
Oak was partially offset by a decrease in revenues at Southwest and Sierra,
which was deconsolidated July 1, 1997.
The following table summarizes production volumes and average sales
prices for SRH's oil and gas operations, including the effect on revenues,
for the periods indicated:
Year Ended 1998 Compared
December 31, to 1997
----------------- ---------------------
% Revenue
Increase Increase
1998 1997 (Decrease)(Decrease)
------ ------ --------- ---------
(in thousands)
Production volumes:
Oil and condensate (MBbls) 1,689 1,308 29% $ 7,285
Natural gas (MMcf) 5,556 5,639 (1%) (186)
Average sales prices:
Oil and condensate (per Bbl) $ 12.73 $ 19.12 (33%) $
(10,793)
Natural gas (per Mcf) 1.85 2.24 (17%) (2,167)
Oil and gas revenues decreased $6.0 million, or 16%, from 1997 to
1998, due primarily to decreases in oil and gas sales prices during 1998.
Oil production increased 29% for the year while gas production decreased
1%. The increase in oil production is due principally to the full-year
effect in 1998 of a large oil and gas acquisition in October 1997. Changes
in production added $7.1 million to Southwest's revenues. The average
sales price per barrel of oil was $12.73 and the average sales price of
natural gas was $1.85 per Mcf in 1998, representing a 33% and 17% decrease,
respectively, compared to prior year sales price levels. These lower oil
and gas prices resulted in a $13.0 million decrease in Southwest's
revenues, offsetting the revenue increase due to increased production.
Real estate revenues increased $16.3 million, or 175%, in 1998
compared to the prior year, due primarily to acquisitions completed in the
last half of 1997 and in 1998. Other operating revenues increased
$165,000.
Operating Expenses. Operating expenses, before general and
administrative expense, impairment of oil and gas properties, depreciation,
depletion and amortization increased $3.3 million, or 11%, in 1998. The
increase is due primarily to acquisition-related growth in SRH's real
estate business, and is partially offset by lower expenses due to the
deconsolidation of Sierra from SRH on July 1, 1997.
Oil and gas operating expense decreased $105,000, or 1%, in 1998, due
primarily to management efforts to cut expenses through more efficient
operations, and by selectively eliminating high operating expense
properties from its oil and gas portfolio. The average operating expense
was $7.03 per Boe in 1998, a decrease of 15% from $8.23 per Boe for the
same period in 1997.
Real estate operating expense increased $9.1 million, or 220%, for
1998, due primarily to acquisitions. Other operating expenses decreased
$107,000.
<PAGE>
General and Administrative ("G&A") Expense. Consolidated G&A expense
for SRH decreased $1.3 million, or 23%, for 1998. The decrease is due
primarily to the deconsolidation of Sierra from SRH, which contributed $1.3
million of G&A expense in the first half of 1997. Oil and gas G&A expense
decreased approximately $942,000, or 26%, in 1998 compared to 1997, and
averaged $1.04 per Boe in 1998, a 36% decrease compared to 1997, due
primarily to reductions in oil and gas technical and administrative staff
in response to significant decreases in oil and gas prices experienced in
the last quarter of 1997 and in 1998. Real estate G&A expense increased
$533,000, or 41%, in 1998 due primarily to administrative staff increases
necessitated by Red Oak's growth during the year.
Depreciation, Depletion and Amortization ("DD&A") Expense.
Consolidated DD&A expense for SRH increased $4.2 million, or 28%, for the
year ended December 31, 1998 due to growth in each of SRH's businesses.
Oil and gas DD&A expense increased approximately $3.3 million, or 26%, in
1998, compared to the prior year. Oil and gas depletion was $5.97 per Boe
in 1998, an increase of 8% compared to 1997. The increase in oil and gas
DD&A expense on an overall basis and per Boe is due primarily to a decrease
in oil and gas price used in the year-end reserve reports for 1998 compared
to 1997, which resulted in a higher depletion rate under the units of
revenue method. Real estate DD&A expense increased approximately $2.1
million, or 261%, in 1998 compared to 1997, attributable primarily to the
impact of acquisitions.
Impairment of Oil and Gas Properties. As of December 31, 1998, the
net capitalized cost exceeded the estimated present value of Southwest's
oil and gas reserves, thus SRH incurred a non-cash charge of $64.0 million
in 1998.
Interest Expense. Consolidated interest expense for SRH increased
$17.6 million, or 93%, in 1998, primarily as a result of increased
borrowings incurred to fund a portion of SRH's acquisitions and oil and gas
development. Oil and gas interest expense increased approximately $10.2
million, or 83%, as a result of increased borrowings for development
drilling and acquisitions made in the fourth quarter of 1997 and in 1998.
Real estate interest expense increased $7.6 million, or 121%, due to
increased borrowing with proceeds used to finance acquisitions as compared
to the prior years. As evidenced by the 93% increase in interest expense,
SRH is extremely leveraged with approximately 61% of its total operating
revenues being used to service interest expense. Based on current
commodity prices, production, rent revenues and current structure, SRH
probably will not be able to make interest payments and meet its operating
and capital needs as they become due beyond 1999.
Other Income (Expense). Other income (expense) increased $225,000, or
155%, due primarily to the sale of land held for investment by Red Oak.
Equity in Loss of Subsidiary and Partnerships. Equity in Loss of
Subsidiary and Partnerships resulted in a net charge $3.6 million for 1998.
Net Income. Due to the factors described above, consolidated net
income for SRH decreased $84.6 million to a loss of $96.1 million for the
year ended December 31, 1998. Included in the $96.1 million loss for the
year ended December 31, 1998 was a non-cash charge of $64.0 million for the
writedown of oil and gas properties.
<PAGE>
Year Ended December 31, 1997 Compared to Year Ended December 31, 1996
Revenues. Consolidated revenues for SRH increased $10.0 million, or
21%, for the year ended December 31, 1997, reflecting increased revenues in
each of SRH's businesses.
The following table summarizes production volumes, average sales
prices and period to period comparisons for SRH's oil and gas operations,
including the effect on revenues, for the periods indicated:
Year Ended 1997 Compared
December 31, to 1996
----------------- ---------------------
% Revenue
Increase Increase
1997 1996 (Decrease)(Decrease)
------ ------ --------- ---------
(in thousands)
Production volumes:
Oil and condensate (MBbls) 1,308 1,001 31% $ 6,275
Natural gas (MMcf) 5,639 5,403 4% 524
Average sales prices:
Oil and condensate (per Bbl) $ 19.12 $ 20.44 (6)% $
(1,727)
Natural gas (per Mcf) 2.24 2.22 1% 113
Oil and gas revenues increased $4.7 million, or 14%, from 1996 to
1997, due primarily to increases in oil production. Oil and gas production
increased 31% and 4%, respectively, due principally to several acquisitions
completed in the fourth quarter of 1996 and throughout 1997. Increases in
production contributed $6.8 million to increased oil and gas revenues. The
average sale price per barrel of oil was $19.12 in 1997, a decrease of 6%
compared to 1996, and the average sale price of natural gas was $2.24 per
Mcf in 1997, an increase of 1% compared to 1996. Increased gas prices and
increased oil and gas production for the year offset decreased revenues due
to lower oil prices during 1998.
Real estate revenues increased $4.9 million, or 108%, for 1997, due
primarily to acquisitions completed in the last half of 1996 and in 1997.
Other operating revenues increased $613,000.
Operating Expenses. Operating expenses, before general and
administrative expense and depreciation, depletion and amortization,
increased $6.1 million, or 26%, in 1997 compared to the prior year, due
primarily to growth in each SRH's businesses through acquisitions.
Oil and gas operating expense increased $3.7 million, or 25%, in 1997,
due primarily to an increase in the number of oil and gas properties owned
by Southwest during the period as compared to the prior year. The average
operating expense per Boe was $8.23 in 1997, an increase of 5% from $7.81
per Boe in 1996. The increase in operating expense on a Boe basis is due
to costs incurred from non-operated properties, which comprise
approximately 35% of SRH's oil and gas properties.
Real estate operating expense increased $2.3 million, or 119%, in
1997, due primarily to acquisitions completed during the year. Other
operating expenses increased $788,000.
General and Administrative ("G&A") Expense. Consolidated G&A expense
for SRH increased $309,000, or 5%, in 1997, due primarily to an increase in
SRH's activities resulting from recent acquisitions. Oil and gas G&A
expense increased approximately $1.2 million, or 50%, in 1997, and was
$1.63 per Boe, an increase of 27% compared to 1996. The increase in G&A
expense on a per Boe basis was due primarily to additions to oil and gas
technical and administrative staff in conjunction with planned increases in
oil and gas acquisition and development activities. Real estate G&A
expense increased $161,000, or 25%, in 1997.
<PAGE>
Depreciation, Depletion and Amortization ("DD&A") Expense.
Consolidated DD&A expense for SRH increased $6.6 million, or 78%, for the
year ended December 31, 1997 due to growth in the businesses at Southwest
and Red Oak. Oil and gas DD&A expense increased approximately $6.0 million
in 1997, or approximately 90%, compared to 1996. Oil and gas depletion was
$5.52 per Boe in 1997, an increase of 63% from 1996. The increase in DD&A
expense in 1997 is due primarily to decreases in oil and gas price used in
the year-end reserve reports for 1997 compared to 1996, which resulted in a
higher depletion rate under the units of revenue method. Real estate DD&A
expense increased approximately $653,000, or 99%, in 1997 compared to 1996,
attributable primarily to the impact of acquisitions.
Interest Expense. Consolidated interest expense for SRH increased
$8.9 million, or 89%, for 1997, primarily as a result of increased
borrowings incurred to fund a portion of Southwest's acquisitions and oil
and gas development. Oil and gas interest expense increased approximately
$4.4 million, or 55%, as a result of increased borrowings for development
drilling and acquisitions made in the last quarter of 1996 and in 1997.
Real estate interest expense increased $4.4 million, or 232%, due to
increased borrowing as compared to the prior year, with proceeds used to
finance acquisitions.
Other Income (Expense). Other income (expense) decreased $416,000, or
74%, due primarily to the receipt of an insurance settlement in 1996.
Net Income. Due to the factors described above, consolidated net
income for SRH decreased $11.9 million to a loss of $11.5 million for the
year ended December 31, 1997. Included in the $11.5 million loss for the
year ended December 31, 1997 was an extraordinary loss of $3.1 million, net
of tax, for the early extinguishment of debt. See note 7 of Notes to
Consolidated Financial Statements for Southwest Royalties Holdings, Inc.
included in "Item 8. Financial Statements and Supplementary Data."
<PAGE>
Liquidity and Capital Resources
Management is constantly monitoring its cash position and its ability
to meet its financial obligations as they become due, and in this effort,
is exploring various strategies for addressing its current and future
liquidity needs. During 1998, for instance, Southwest sold $5.7 million of
oil and gas properties in an ongoing effort to decrease its production
costs and improve its cash position. As of December 31, 1998, SRH's
consolidated cash balance was $13.8 million, of which $12.4 million was
available to Southwest.
SRH financial statements have been prepared on a going concern basis,
which contemplates the realization of assets and the satisfaction of
liabilities in the normal course of business. The consolidated financial
statements do not include any adjustments relating to the recoverability
and classification of liabilities that might be necessary should SRH be
unable to continue as a going concern.
SRH has a highly leveraged capital structure with $21.0 million of
interest payments due in 1999 on its 10.5% Senior Notes and approximately
$12.7 million of principal and approximately $12.3 million of cash interest
payments due in 1999 on its other obligations (principally related to Red
Oak). Due to severely depressed commodity prices and lagging rental
property utilization, SRH is experiencing difficulty in generating
sufficient cash flow to meet its obligations and sustain its operations.
Management is currently in the process of renegotiating the terms of SRH's
various obligations with its note holders and/or attempting to seek new
lenders or equity investors. Additionally, management would consider
disposing of certain assets in order to meet its obligations.
There can be no assurance that SRH's debt restructuring efforts will
be successful or that the note holders will agree to a course of action
consistent with SRH's requirements in restructuring the obligations. Even
if such agreement is reached, it may require approval of additional note
holders, or possibly, agreements of other creditors of SRH, none of which
is assured. Furthermore, there can be no assurance that the sales of
assets can be successfully accomplished on terms acceptable to SRH. Under
current circumstances, SRH's ability to continue as a going concern depends
upon its ability to (1) successfully restructure its 10.5% Senior Notes and
other obligations or obtain additional financing as may be required, (2)
maintain compliance with all debt covenants, (3) generate sufficient cash
flow to meet its obligations on a timely basis, and (4) achieve
satisfactory levels of future earnings. If SRH is unsuccessful in its
efforts, it may be unable to meet its obligations on the 10.5% Senior
Notes, as well as other obligations, making it necessary to undertake such
other actions as may be appropriate to preserve asset values.
Cash flow information for Sierra is reported through June 30, 1997,
the date prior to its deconsolidation from SRH, but for periods thereafter,
cash flow information has been reported using the equity method of
accounting under GAAP.
Net Cash Provided By (Used By) Operating Activities. In 1998, SRH's
operating activities used $6.0 million of cash flow. In 1997 and 1996,
SRH's operating activities provided $6.0 million and $10.3 million of cash
flow, respectively. SRH's ability to generate cash flow from operating
activities was severely restricted in 1998, primarily due to historically
low oil and gas prices during the year and a 93% increase in interest
expense compared to 1997. Decreased cash flow provided by operating
activities in 1997 compared to 1996 was due to lower oil and gas prices and
higher operating and G&A expenses in 1997 compared to 1996.
Net Cash Used in Investing Activities. Cash flows used in SRH's
investing activities were $56.3 million, $173.9 million and $33.2 million
for 1998, 1997 and 1996, respectively. Oil and gas acquisitions and
development activities and commercial real estate acquisitions were the
primary uses of funds in each year.
<PAGE>
The following table sets forth capital expenditures, including
acquisitions, made by SRH during the periods indicated.
Year Ended December 31,
-----------------------------------
1998 1997 1996
----- ----- -----
(in thousands)
Oil and gas
Development $ 7,897 $ 19,639 $ 13,322
Exploration 834 2,769 184
Acquisitions 1,315 80,797 3,234
Well servicing - - 3,826
Real estate 52,141 53,184 13,947
------ ------- ------
Total $ 62,187 $156,389 $ 34,513
====== ======= ======
In response to the substantial decrease in oil prices during 1998, SRH
has initiated a short-term alternate business plan that delays certain
development and exploratory projects until oil and gas industry conditions
improve. Based on this plan, SRH has tentatively budgeted $8 million in
capital expenditures at Southwest for oil and gas development projects.
This budget is subject to change based on financial strategies currently
being developed, including hedging strategies, divestitures and debt
restructuring, as well as the level of oil and gas prices in the future.
Net Cash Provided by Financing Activities. Cash provided by SRH's
financing activities, on a consolidated basis, was $48.7 million (including
additional net borrowings of $49.1 million), $186.9 million (including
additional net borrowings of $185.0 million and $1.0 million from issuance
of additional equity securities) and $27.9 million (including additional
net borrowings of $17.9 million and $9.9 million net proceeds from issuance
of additional equity securities) for 1998, 1997 and 1996, respectively.
Net cash provided by financing activities was primarily used to fund real
estate activities in 1998.
Senior Notes due 2004. In October 1997, Southwest completed a $200
million Senior Notes due 2004. Proceeds from the Offering were used
primarily for acquisitions, repayment of debt, an equity investment by SRH
in Red Oak and for working capital. The Senior Notes bear interest at
10.5% per annum and mature on October 15, 2004.
MROP and Red Oak Acquisition Facilities. In April 1997 MRO Properties
Inc. ("MROP"), a 100% owned subsidiary of Red Oak entered into a $42
million credit facility maturing in April 2000 with an institutional lender
(the "MROP Facility"). The MROP Facility was executed in order to
consolidate nine mortgage loans, originally incurred to complete the
acquisition of certain Red Oak properties and to finance the acquisition of
an additional real estate property. Borrowings under the facility bear
interest at a rate of 13%, with 10% payable in cash and the remaining 3%
payable in cash or additional notes. The facility contains a number of
covenants that, among other things, restrict the ability of MROP to incur
additional indebtedness and dispose of assets. The facility is secured by
a first lien on substantially all of MROP's properties. In September 1997,
the Company negotiated an additional $30.5 million in loan proceeds which
was used to acquire a retail shopping center and office building in
Oklahoma City, Oklahoma and a retail shopping center in San Antonio, Texas.
The loan is collateralized by the properties purchased, and by properties
contributed by the Company. MROP's obligations under the facility are non-
recourse to SRH, Southwest, Red Oak and Sierra. Simultaneous with
increasing the size of the MROP facility to $72 million, Red Oak entered
into two additional mortgage facilities with separate lenders (the "Red Oak
Acquisition Facilities") to partially fund acquisitions. The MROP facility
and Red Oak Acquisition Facilities are secured by a first lien on the
properties acquired. The Red Oak Acquisition Facilities contain a number
of covenants that, among other things, restrict the ability of Red Oak to
incur additional indebtedness and dispose of assets. The Red Oak
Acquisition Facilities bear interest at 9.25% and obligations thereunder
are non-recourse to SRH and Southwest.
<PAGE>
Under the capital reserve clause of the Credit Facility Agreement,
MROP was required to deposit in escrow with the creditor $1 million by
September 30, 1998 and an additional $1 million by October 23, 1998, to be
used for future capital improvements to the properties. Subsequently, the
lender extended the deposit due dates until December 1, 1998. At December
31, 1998, MROP had not made the $2 million deposits required which resulted
in a technical default with the credit facility therefore defaulting the
interest rate to 18%, with 10% payable in cash and the remaining 8% payable
in cash or additional notes, at year-end. On February 15, 1999, MROP
negotiated a deal with the lender borrowing an additional $2 million,
therefore curing the default and increasing interest an additional .5% from
13% to 13.5%.
As of December 31, 1998, Red Oak was in default on approximately
$1,900,000 of notes payable due certain of its shareholders, for failure to
pay principal and interest payments on the stated due dates. Additionally,
as a result of these defaults, Red Oak violated a covenant requirement on a
term note payable with a balance outstanding of approximately $6,700,000 at
December 31, 1998. These notes may be callable by the lenders and, as
such, are classified as current in the Company's consolidated balance sheet
at December 31,1998.
Southwest Credit Facility. At December 31, 1998, Southwest had
$40,000 outstanding. Southwest currently has no availability under its
Credit Facility. See "Item 8, Financial Statements and Supplementary Data
- - Note 7."
Hedging Activities. From time to time, Southwest purchases option
contracts to mitigate the volatility of oil and gas commodity prices. SRH
also periodically sells production forward in order to lock in prices so as
to protect the economics related to certain capital projects. In August
1998, Southwest purchased an option to sell 15,000 MMBtu of natural gas per
day based on the El Paso Natural Gas Co. - Permian Basin Index. The option
is for the period from November 1, 1998 through March 31, 1999 and has a
strike price of $2.00 per MMBtu. In March 1999, Southwest entered into a
hedging agreement whereby SRH is contracted to sell 1,000 barrels of oil
per day with a strike price of $14.67 per Bbl., based on West Texas
Intermediate - NYMEX. The contract is for the period April 1, 1999 through
June 30, 1999, but can be extended to September 30, 1999 at the option of
the counter-party.
Other Issues
Information Systems for the Year 2000. SRH is continuing in its
effort to identify and assess its exposure to the potential Year 2000
software and inbedded chip processing and date sensitivity issue. Through
Red Oak and its data processing subsidiary, Midland Southwest Software,
Inc., SRH proactively initiated a plan to identify applicable hardware and
software, assess impact and effect, estimate costs, construct and implement
corrective actions, and prepare contingency plans.
Identification & Assessment. SRH currently believes it has identified
the internal and external software and hardware that may have date
sensitivity problems. Five critical systems and/or functions were
identified: (i) the proprietary software of Southwest (OGAS) that is used
for oil & gas property management and financial accounting functions, (ii)
the proprietary software of Red Oak (Yardi) that is used for real estate
property management and financial accounting functions (iii) DEC VAX/VMS
hardware and operating system, (iv) various third-party application
software including lease economic analysis, fixed asset management,
geological applications, and payroll and human resource programs and (v)
External Agents.
<PAGE>
The proprietary software of Southwest is currently in the process of
meeting compliance requirements with an estimated completion date of mid-
year 1999. Since this is an internally generated software package, SRH has
estimated the cost to be approximately $25,000 by estimating the necessary
man-hours. These modifications are being made by internal staff and do not
represent additional costs to SRH. SRH has not made contingency plans at
this time since the conversion is ahead of schedule and being handled by
Company controlled internal programmers. Given the complexity of the
systems being modified, it is anticipated that some problems may arise, but
with an expected early completion date, SRH feels that adequate time is
available to overcome unforeseen delays.
DEC has released a fully compliant version of its operating system
that is used by Southwest on the DEC VAX system. It will be installed in
August 1999, SRH believes that this will solve any potential problems on
the DEC VAX system.
SRH has identified various third-party software that may have date
sensitivity problems and is working with the vendors to secure solutions as
well as prepare contingency plans. After review and evaluation of the
vendor plans and status, SRH believes that the problems will be resolved
prior to the year 2000 or the alternate contingency plan will sufficiently
and adequately remediate the problem so that there is no material
disruption to business functions.
The External Agents of SRH include suppliers, customers, owners,
vendors, banks, product purchasers including pipelines, and other oil and
gas property operators. SRH is in the process of identifying and
communicating with each critical External Agent about its plan and progress
thereof in addressing the Year 2000 issue. This process is on schedule and
SRH, at this time, believes that there should be no material interference
or disruption associated with any of the critical External Agent's
functions necessary to SRH's business. SRH estimates completion of this
audit by mid-year 1999 and believes that alternate plans can be devised to
circumvent any material problems arising from critical External Agent
noncompliance.
Cost. To date, SRH has incurred only minimal internal man-hour costs
for identification, planning, and maintenance. SRH believes that the
necessary additional costs will also be minimal and most will fall under
normal and general maintenance procedures and updates. An accurate cost
cannot be determined at this time, but it is expected that the total cost
to remediate all systems to be less than $60,000.
Risks and Contingency. The failure to correct critical systems of
SRH, or the failure of a material business partner or External Agent to
resolve critical Year 2000 issues could have a serious adverse impact on
the ability of SRH to continue operations and meet obligations. Based on
SRH's evaluation and assessment to date, it is believed that any
interruption in operation will be minor and short-lived and pose no
material monetary loss, safety, or environmental risk to SRH. However,
until all assessment is complete, it is impossible to accurately identify
the risks, quantify potential impacts or establish a final contingency
plan. SRH believes that its assessment and contingency planning will be
complete no later than mid-year 1999.
<PAGE>
Worst Case Scenario. The Securities and Exchange Commission requires
that public companies must forecast the most reasonably likely worst case
Year 2000 scenario, assuming that SRH's Year 2000 plan is not effective.
Analysis of the most reasonably likely worst case Year 2000 scenarios SRH
may face leads to contemplation of the following possibilities which,
though considered highly unlikely, must be included in any consideration of
worst cases: widespread failure of electrical, gas, and similar supplies by
utilities serving SRH; widespread disruption of the services of
communications common carriers; similar disruption to means and modes of
transportation for SRH and its employees, contractors, suppliers, and
customers; significant disruption to SRH's ability to gain access to, and
continue working in, office buildings and other facilities; and the
failure, of third-parties systems, the effects of which would have a
cumulative material adverse impact on SRH's critical systems. SRH could
experience an inability by customers, traders, and others to pay, on a
timely basis or at all, obligations owed to SRH. Under these
circumstances, the adverse effect on SRH, and the diminution of Company
revenues, could be material, although not quantifiable at this time.
Derivative Instruments and Hedging Activities. In June 1998, The FASB
issued Statement of Financial Accounting Standards No. 133 "Accounting for
Derivative Instruments and Hedging Activities" which establishes accounting
and reporting standards for derivative instruments, including certain
derivative instruments embedded in other contracts, (collectively referred
to as derivatives) and for hedging activities. It requires that an entity
recognize all derivatives as either assets or liabilities in the statement
of financial position and measure those instruments at fair value. If
certain conditions are met, a derivative may be specifically designated as
(a) a hedge of the exposure to charges 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.
<PAGE>
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The following quantitative and qualitative information is provided
about financial instruments to which the Company is a party as of December
31, 1998, and from which the Company may incur future earnings gains or
losses from changes in market interest rates or commodity prices.
Quantitative Disclosures
Interest rate sensitivity. The following table provides information
about the Company's debt obligations which are sensitive to changes in
interest rates. The table presents cash maturities by expected maturity
dates together with the weighted average interest rates expected to be paid
on the debt, given current contractual terms and market conditions. For
fixed rate debt, the weighted average interest rate represents the
contractual fixed rates that the Company is obligated to periodically pay
on the debt; for variable rate debt, the average interest rate represents
the average rates being paid on the debt at December 31, 1998.
As of December 31, 1998
1999 2000 2001 2002 2003ThereafterTotalFair
Value
---- ---- ---- ---- --------------------------
- ---
Total Debt
maturities $12,716 $ 73,186 $36,257 $ 2,045 $ 659 $210
,221 $ 335,084 $ 216,354
Fixed rate debt $10,938 $ 72,791 $ 59 $ 80 $ 17 $198,789 $
282,674 $ 163,944
Weighted average
interest rate 11.29% 10.49% 10.49% 10.49% 10.49%
10.50%
Variable rate debt $1,778 $ 395 $ 36,198 $ 1,965 $ 642 $11,432
52,410 52,410
Average interest rate 7.48% 7.48% 8.40% 8.34% 8.31% 9.13%
Commodity price sensitivity. See Notes 1 and 13 of Notes to
Consolidated Financial Statements included in "Item 8. Financial
Statements and Supplementary Data" for a description of the accounting
procedures followed by SRH relative to hedge derivative financial
instruments and for specific information regarding the terms of the
Company's derivative financial instrument which is sensitive to changes in
natural gas and crude oil commodity prices.
The Company, from time to time, uses option contracts to mitigate the
volatility of price changes on commodities the Company produces and sells
as well as to lock in prices to protect the economics related to certain
capital projects. These contracts are sensitive to changes in natural gas
crude oil commodity prices. In August 1998, the Company purchased a put
option contract on a total notional amount of 15,000 MMBtu of natural gas
per day with a strike price of $2.00 per MMBtu for approximately $374,000.
The option is based on the El Paso Natural Gas Co. - Permian Basin Index
and is for the period from November 1, 1998 through March 31, 1999.
Subsequent to December 31, the company entered into a hedging
agreement whereby the Company is contracted to sell 1,000 barrels of oil
per day, approximately 25% of its oil production, with a strike price of
$14.67 per Bbl., based on West Texas Intermediate - NYMEX. The contract is
for the period April 1, 1999 through June 30, 1999, but can be extended to
September 30, 1999 at the option of the counter-party.
Qualitative Disclosures
Non-derivative financial instruments. The Company is a borrower under
fixed rate and variable rate debt instruments that give rise to interest
rate risk. The Company's objective in borrowing under fixed or variable
rate debt is to satisfy capital requirements while minimizing the Company's
costs of capital. To realize its objectives, the Company borrows under
fixed and variable rate debt instruments, based on the availability of
capital and market conditions. See Note 7 of Notes to Consolidated
Financial Statement included in "Item 8. Financial Statements and
Supplementary Date" for a discussion relative to the Company's debt
instruments.
<PAGE>
Derivative financial instruments. Revenues from the Company's
operations are highly dependent on the price of oil and gas. The markets
for oil and natural gas are volatile and prices for oil and gas are subject
to wide fluctuations in response to relatively minor changes in the supply
of and demand for oil and gas and a variety of additional factors that are
beyond SRH's control. These factors include the level of consumer demand,
weather conditions, domestic and foreign governmental regulations, market
uncertainty, the price and availability of alternative fuels, political
conditions in the Middle East, foreign imports and overall economic
conditions. It is impossible for SRH to predict future oil and gas prices
with any certainty. In order to reduce the Company's exposure to oil and
gas price risks, from time to time the Company enters into commodity price
derivative contracts to hedge commodity price risks.
As of December 31, 1998, the Company has hedged all of its gas
production with an option contract that establishes a floor price for the
notional sales volumes of the contract. If the price for natural gas (El
Paso Natural Gas Co. - Permian Basin Index) is above the strike price
indicated in the contract, the Company receives payment from the counter-
party for the difference between the market price and the strike price,
based on the notional amount of the contract. If the price of natural gas
falls below the strike price, the Company has no liability to the counter-
party. The premium paid for the option contract is amortized to natural
gas revenue over the term of the contract. Additionally, any amount
received from the counter-party is recorded to natural gas revenues.
Subsequent to December 31, 1998, the Company hedged a portion of its
oil production with a swap contract that establishes a strike price based
on NYMEX. If the price of crude oil is above the strike price, the Company
receives a payment from the counter-party for the difference between the
market price the strike price, based on the notional amount of the
contract. Conversely, if the strike price falls below the market price,
the Company pays the counter-party. All amounts received or paid under the
contract will be recorded to crude oil revenues.
As of December 31, 1998, the Company's primary risk exposures
associated with financial instruments to which it is a party include
natural gas and crude oil price volatility and interest rate volatility.
The Company's primary risk exposures associated with financial instruments
have not changed significantly since December 31, 1998.
<PAGE>
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
Index to Consolidated Financial Statements
Page
-----
Consolidated Financial Statements of Southwest Royalties
Holdings, Inc. and Subsidiaries
Independent Auditors' Reports 47
Consolidated Balance Sheets as of December 31, 1998 and 1997 48
Consolidated Statements of Operations for the Years Ended
December 31, 1998, 1997 and 1996 50
Consolidated Statements of Stockholders' Equity for the Years
Ended December 31, 1998, 1997 and 1996 52
Consolidated Statements of Cash Flows for the Years Ended
December 31, 1998, 1997 and 1996 53
Notes to Consolidated Financial Statements 56
<PAGE>
INDEPENDENT AUDITORS' REPORT
The Board of Directors and Stockholders
Southwest Royalties Holdings, Inc.:
We have audited the accompanying consolidated balance sheets of
Southwest Royalties Holdings, Inc. and subsidiaries as of December 31, 1998
and 1997, and the related consolidated statements of operations,
stockholders' equity and cash flows for each of the years in the three-year
period ended December 31, 1998. These consolidated financial statements
are the responsibility of the Company's management. Our responsibility is
to express an opinion on these 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
Southwest Royalties Holdings, Inc. and subsidiaries as of December 31, 1998
and 1997, and the results of their operations and their cash flows for each
of the years in the three-year period ended December 31, 1998 in conformity
with generally accepted accounting principles.
The accompanying consolidated financial statements have been prepared
assuming that the Company will continue as a going concern. As discussed
in Note 2 to the consolidated financial statements, the Company is
experiencing difficulty in generating sufficient cash flow to meet its
obligations and sustain its operations which raises substantial doubt about
its ability to continue as a going concern. Management's plans in regard
to these matters are also described in Note 2. The consolidated financial
statements do not include any adjustments that might result from the
outcome of this uncertainty.
KPMG LLP
Midland, Texas
March 1, 1999
<PAGE>
SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(in thousands)
December 31,
------------------------
ASSETS 1998 1997
- ---------------------------------------------------------- ----- -----
Current assets
Cash and cash equivalents $ 13,801 $ 27,365
Accounts receivable, net of allowance of
$342 and $254, respectively 5,248 8,376
Receivables from related parties 1,594 2,556
Other current assets 1,624 1,209
------- -------
Total current assets 22,267 39,506
------- -------
Oil and gas properties, using the full cost
method of accounting
Proved 194,096 188,432
Unproved 3,230 4,554
-------- -------
197,326 192,986
Less accumulated depletion, depreciation
and amortization 121,841 42,240
-------- -------
Oil and gas properties, net 75,485 150,746
-------- -------
Rental property, net 132,120 81,373
-------- -------
Other property and equipment, net 5,888 5,556
-------- -------
Other assets
Restricted cash 5,050 8,064
Equity investment in subsidiary and partnerships 931
4,545
Real estate investments 4,019 4,203
Deferred debt costs, net of accumulated
amortization of $3,136 and $903, respectively 8,725
9,382
Noncompete covenants, net of accumulated
amortization of $269 1,335 -
Other, net 1,730 2,068
------- -------
Total other assets 21,790 28,262
------- -------
Total assets $257,550 $305,443
======= =======
(continued)
The accompanying notes are an integral part of these
consolidated financial statements.
<PAGE>
SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS - (continued)
(in thousands, except per share data)
December 31,
LIABILITIES, MINORITY INTEREST, REDEEMABLE ------------------------
COMMON STOCK AND STOCKHOLDERS' EQUITY 1998 1997
- ---------------------------------------------------------- ----- -----
Current liabilities
Current maturities of long-term debt $ 12,716 $ 1,878
Accounts payable 7,116 7,119
Accounts payable to related parties 173 64
Accrued expenses 9,737 9,450
Deferred income taxes - 254
------- -------
Total current liabilities 29,742 18,765
------- -------
Long-term debt 322,368 281,764
------- -------
Other long-term liabilities 1,797 1,809
------- -------
Deferred income taxes - 2,094
------- -------
Minority interest 206 1,861
------- -------
Redeemable common stock of subsidiary 2,979 2,666
------- -------
Redeemable common stock 8,290 8,290
------- -------
Stockholders' equity
Preferred stock - $1 par value; 5,000,000 shares
authorized; none issued - -
Common stock - $.10 par value; 5,000,000 shares
authorized; 1,161,037 issued at December 31, 1998
and December 31, 1997 116 116
Additional paid-in capital 2,196 2,196
Accumulated deficit (105,375) (9,321)
Note receivable from an officer and stockholder (1,679)
(1,707)
Less: treasury stock - at cost; 214,215 shares at
December 31, 1998 and 1997 (3,090) (3,090)
------- -------
Total stockholders' deficit (107,832) (11,806)
------- -------
Total liabilities, minority interest, redeemable
common stock and stockholders' equity $257,550 $305,443
======= =======
The accompanying notes are an integral part of these
consolidated financial statements.
<PAGE>
SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
For the years ended December 31,
----------------------------------
1998 1997 1996
----- ----- -----
Operating revenues
Oil and gas $ 32,467 $ 38,500 $ 33,787
Well servicing, including related party
revenues of $0, $8 and $112,
respectively - 7,789 8,013
Real estate 25,650 9,338 4,487
Other 1,392 1,227 614
--------- --------- -------
Total operating revenues 59,509 56,854 46,901
--------- --------- -------
Operating expenses
Oil and gas production 18,395 18,500 14,846
Well servicing - 5,600 6,145
Real estate 13,242 4,138 1,887
General and administrative, net of
related party management and
administrative fees of $3,789,
$3,538 and $3,648, respectively 4,450 5,745 5,436
Depreciation, depletion and amortization 19,240 15,034
8,430
Impairment of oil and gas properties 64,000 -
- -
Other 1,235 1,342 554
--------- --------- -------
Total operating expenses 120,562 50,359 37,298
--------- --------- -------
Operating income (loss) (61,053) 6,495 9,603
--------- --------- -------
Other income (expense)
Interest and dividend income 1,478 1,002 441
Interest expense (36,490) (18,894) (10,016)
Other 370 145 561
--------- --------- -------
(34,642) (17,747) (9,014)
--------- --------- -------
(continued)
<PAGE>
SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS - (continued)
(in thousands, except per share data)
For the years ended December 31,
----------------------------------
1998 1997 1996
----- ----- -----
Income (loss) before income taxes, minority
interest, equity loss and extraordinary
item (95,695) (11,252) 589
Income tax benefit (provision) 2,348 2,641 (365)
--------- --------- -------
Income (loss) before minority interest,
equity loss and extraordinary item (93,347) (8,611) 224
Minority interest in subsidiaries,
net of tax 913 430 181
Equity loss in subsidiary and
partnerships, net of tax (3,620) (203) -
--------- --------- -------
Income (loss) before extraordinary item (96,054) (8,384)
405
Extraordinary loss from early
extinguishment of debt, net of tax - (3,109)
- -
--------- --------- -------
Net income (loss) $(96,054) $(11,493) $ 405
========= ========= =======
Income (loss) per common share
Income (loss) per common share before
extraordinary item $ (89.28) $ (7.78) $ .42
Extraordinary loss from early
extinguishment of debt, net of tax - (2.88)
- -
--------- --------- -------
Income (loss) per common share $ (89.28) $ (10.66) $ .42
========= ========= =======
Weighted average shares outstanding 1,075,868 1,077,808 964,009
========= ========= =======
The accompanying notes are an integral part of these
consolidated financial statements
<PAGE>
SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
For the years ended December 31, 1998, 1997 and 1996
(in thousands, except share data)
Note
Common StockAdditional ReceivableTreasury Stock
--------------Paid-InAccumulated from ---------------
Shares AmountCapital DeficitStockholderShares Amount
------- ------------- ---------------------------------
- -
Balance -
January 1, 19961,160,537 $116 $1,305 $ 1,767 $(1,760)194,575 $(1,869)
Payments received on note
receivable - - - - 25 - -
Issuance of common stock
warrants - - 857 - - - -
Issuance of stock options
as additional
compensation - - 34 - - - -
Purchase of treasury stock - - - - - 10,000
(639)
Net income - - - 405 - - -
--------- ---- ----- ------- ------ ------- ------
Balance -
December 31, 19961,160,537 116 2,196 2,172 (1,735) 204,575
(2,508)
Stock option exercised 500 - - - - - -
Payments received on
note receivable - - - - 28 - -
Purchase of treasury stock - - - - - 9,640
(582)
Net loss - - - (11,493) - - -
--------- ---- ----- ------- ------ ------- ------
Balance -
December 31, 19971,161,037 116 2,196 (9,321) (1,707)
214,215 (3,090)
Payments received on
note receivable - - - - 28 - -
Net loss - - - (96,054) - - -
--------- ---- ----- ------- ------ ------- ------
Balance -
December 31, 19981,161,037 $ 116 $ 2,196 $ (105,375) $ (1,679)
214,215 $ (3,090)
========= ==== ===== ======= ====== ======= ======
The accompanying notes are an integral part of these
consolidated financial statements.
<PAGE>
SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
For the years ended December 31,
----------------------------------
1998 1997 1996
----- ----- -----
Cash flows from operating activities
Net income (loss) $(96,054) $(11,493) $ 405
Adjustments to reconcile net income
(loss) to net cash provided by (used in)
operating activities:
Depreciation, depletion and amortization 19,240 15,034
8,430
Impairment of oil and gas properties 64,000 -
- -
Noncash interest expense 2,963 1,311 1,902
Extraordinary loss from early
extinguishment of debt - 1,411 -
Gain (Loss) on sale of assets (275) 84 226
Equity loss of subsidiary and partnerships 3,620 203
- -
Other noncash items 187 (176) 257
Bad debt expense 501 241 168
Deferred income taxes (2,348) (2,606) 747
Minority interest in income
of subsidiary (913) (430) (181)
Changes in operating assets and liabilities-
Accounts receivable 3,709 (6,029) (1,128)
Income tax receivable - - 270
Other current assets (226) (594) (379)
Deferred lease costs (773) (402) -
Accounts payable and accrued expenses 166 6,612
(467)
Accrued interest payable 227 2,898 -
Income taxes payable - (30) 30
------- ------- ------
Net cash provided by (used in) operating
activities (5,976) 6,034 10,280
------- ------- ------
Cash flows from investing activities
Proceeds from sale of oil and gas properties 5,706 1,538
1,081
Additions to oil and gas properties (10,046) (103,205) (16,740)
Purchase of other property and equipment
and rental property (54,462) (61,645) (14,443)
Purchase of other assets (712) (3,121) (1,095)
Purchase of noncompete covenants (1,604) - -
Proceeds from sale of other assets 1,317 219 196
Proceeds from sale of other property
and equipment 50 209 274
Purchase of real estate investments (333) (91) (2,569)
Change in restricted cash 3,014 (8,064) -
Proceeds from sale of real estate investment 765 -
- -
Other 22 258 71
------- ------- ------
Net cash used in investing activities (56,283) (173,902) (33,225)
------- ------- ------
(continued)
<PAGE>
SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS - (continued)
(in thousands)
For the years ended December 31,
----------------------------------
1998 1997 1996
----- ----- -----
Cash flows from financing activities
Proceeds from borrowings 54,589 309,870 29,094
Payments on debt (3,877) (113,381) (9,379)
Payments on other long-term liabilities (99) (2,166)
(512)
Increase in other long-term liabilities 87 841
46
Cash received on subscriptions receivable - 2,807
- -
Purchase of treasury stock - (582) (250)
Deferred debt costs (1,576) (9,842) (1,333)
Issuance of stock warrants - - 857
Issuance of redeemable common stock, net
of issue costs - 32 5,451
Net proceeds from sale of subsidiaries
common stock - 1,007 4,158
Prepayment penalty on early
extinguishment of debt - (341) -
Dividends paid to minority interest owners (120) (122)
(139)
Purchase of minority interest in subsidiary (309) -
- -
Purchase of treasury stock by subsidiary - (1,174)
(128)
------- ------- ------
Net cash provided by financing activities 48,695 186,949
27,865
------- ------- ------
Net increase (decrease) in unrestricted
cash and cash equivalents (13,564) 19,081 4,920
Unrestricted cash and cash equivalents -
beginning of period 27,365 8,284 3,364
------- ------- ------
Unrestricted cash and cash equivalents -
end of period $ 13,801 $ 27,365 $ 8,284
======= ======= ======
<PAGE>
SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS - (continued)
(in thousands)
For the years ended December 31,
----------------------------------
1998 1997 1996
----- ----- -----
Supplemental disclosures of cash flow
information
Interest paid $ 31,695 $ 14,802 $ 7,780
Supplemental schedule of noncash investing
and financing activities-
Long-term debt and liabilities assumed
in acquisition of real estate $ - $ - $ 150
Increase in other long-term liabilities
from general partner contribution to
partnership $ - $ - $ 198
Debt issued for other property and equipment $ - $ - $
604
Increase in other long-term liabilities
from purchase of treasury stock $ - $ - $ 389
Transfer oil and gas properties as debt
issue costs $ - $ - $ 204
Increase in subscription receivable
from sale of redeemable common stock $ - $ - $
2,807
The accompanying notes are and integral part of these
consolidated financial statements.
<PAGE>
SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Organization and Summary of Significant Accounting Policies
Business
Southwest Royalties Holdings, Inc. ("SRH"), a Delaware corporation was
formed in June 1997 to serve as a holding company for Southwest Royalties
Inc. ("Southwest"), Sierra Well Service Inc. ("Sierra") and Midland Red Oak
Realty, Inc. ("Red Oak") (collectively, the "Company"). Each shareholder
of Southwest was issued one share in SRH for each share of Southwest stock
held. Prior to the formation of SRH, Red Oak and Sierra were subsidiaries
of Southwest. Southwest paid a dividend of the shares it owned in Red Oak
and Sierra to SRH. After the formation of SRH, Southwest and Red Oak became
subsidiaries of SRH and, as of July 1, 1997, Sierra was deconsolidated.
Southwest is principally involved in the business of oil and gas
development and production, as well as organizing and serving as managing
general partner for various public and private limited partnerships engaged
in oil and gas acquisitions, exploration, development and production.
Southwest is also the general partner of Southwest Partners II and III,
which own common stock in Sierra. Southwest sells its oil and gas
production to a variety of purchasers, with the prices it receives being
dependent upon the oil and gas commodity prices. Red Oak is principally
involved in real estate investment and development. Sierra is principally
involved in the business of oil and gas well services.
Principles of Consolidation
The consolidated financial statements include the accounts of SRH and
its subsidiaries. As of December 31, 1998 and 1997, the Company owned
approximately 81% of Red Oak, 39% of Sierra as well as 99% and 98%,
respectively of Midland Southwest Software ("MSS") and Threading Products
International, LLC ("TPI"), both of which are subsidiaries of Southwest.
Effective July 1, 1997, Sierra was deconsolidated and is accounted for
using the equity method (see Note 3). The consolidated financial
statements include the Company's proportionate share of the assets,
liabilities, income and expenses of oil and gas limited partnerships for
which it serves as managing general partner. The Company accounts for its
investments in Southwest Partners II and III using the equity method, as
the Company exercises significant influence over the operations of these
partnerships. All significant intercompany transactions have been
eliminated.
Estimates and Uncertainties
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 disclosures 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
The Company considers all highly liquid debt instruments purchased
with a maturity of three months or less to be cash equivalents. In
addition, the Company maintains its excess cash in several interest bearing
accounts in various financial institutions.
<PAGE>
SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
Restricted Cash
Restricted cash represents amounts required to be reserved in separate
accounts by financial lenders. These reserves are principally for real
estate activity and are held in the names of Red Oak and its various
subsidiaries, but withdrawals from such accounts require the signature or
authorization of the lender.
Restricted cash accounts, principally for Red Oak and its
subsidiaries, have been established for the following purposes (in
thousands):
1998 1997
---- ----
Property liens $ - 54
Certificate of Deposits 105 -
Tenant security deposits 412 365
Interest reserves 707 694
Capital expenditures account 1,229 5,112
Tax and insurance reserve 1,009 518
Tenant bankruptcy reserve 767 753
Lockbox 217 -
Customer service reserve 10 -
Escrow fund 594 568
----- -----
$ 5,050 8,064
===== =====
Concentrations of Credit Risk
The Company is subject to credit risk through oil and gas trade
receivables and real estate lease receivables. Although a substantial
portion of its customers' ability to pay is dependent upon conditions in
the oil and gas industry as well as general economic conditions, credit
risk is reduced due to a large customer base.
Commodity Hedging and Derivative Financial Instruments
The Company has only limited involvement with derivative financial
instruments and generally does not use them for trading purposes. They are
used to manage commodity price risks. The Company is exposed to credit
losses in the event of nonperformance by the counter-parties to its
commodity hedges. The Company anticipates, however, that such counter-
parties 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 counter-parties.
The derivative financial instruments that the Company accounts for as
hedging contracts must meet the following criteria: the underlying asset
must expose the Company to price risk that is not offset in another asset
or liability, the hedging contract must reduce that price 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 such that
changes in the market value of the financial instrument will be offset by
the effect of price changes on the exposed items.
Premiums paid for commodity option contracts which qualify as hedges
are amortized to oil and gas sales over the term of the agreements.
Unamortized premiums are included in other assets in the consolidated
balance sheet. Amounts receivable under the commodity option contracts are
accrued as an increase in oil and gas sales for the applicable periods.
<PAGE>
SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
Oil and Gas Properties
All of the Company's oil and gas properties are located in the United
States and are accounted for at cost under the full cost method. Under
this method, all productive and nonproductive costs incurred in connection
with the acquisition, exploration and development of oil and gas reserves
are capitalized. No gain or loss is recognized on the sale of oil and gas
properties unless nonrecognition would significantly alter the relationship
between capitalized costs and remaining proved reserves for the affected
amortization base. When gain or loss is not recognized, the amortization
base is reduced by the amount of sales proceeds.
Net capitalized costs of oil and gas properties, including the
estimated future costs to develop proved reserves, are amortized using the
units of revenue method, whereby the provision is computed on the basis of
current gross revenues from production in relation to future gross
revenues, based on current prices, from estimated production of proved oil
and gas reserves. Should the net capitalized costs net of related deferred
income taxes exceed the estimated present value of oil and gas reserves
discounted at 10% and adjusted for related income taxes, such excess costs
would be charged to expense in the Consolidated Statements of Operations.
Once incurred, a writedown of oil and gas properties is not reversible at a
later date, even if oil or natural gas prices increase. As of June 30,
1998 and December 31, 1998, the net capitalized costs of oil and gas
properties exceeded the estimated present value of oil and gas reserves,
resulting in a total noncash charge of $64.0 million.
It is reasonably possible that the estimates of anticipated future
gross revenues, the remaining estimated economic life of the product, or
both could change significantly in the near term due to the fluctuation of
oil and gas prices or production. Depletion estimates would also be
affected by such changes.
Property and Equipment
Rental property and other property and equipment is stated at cost.
Repairs and maintenance are charged to expense as incurred, with additions
and improvements being capitalized. Upon sale or other retirement of
depreciable property, the cost and accumulated depreciation are removed
from the related accounts and any gain or loss is reflected in the
Consolidated Statements of Operations.
Depreciation is provided on the straight-line method based on the
estimated useful lives of the depreciable assets as follows:
Building and improvements 20 to 30 years
Rental property and improvements 5 to 30 years
Leasehold improvements 2 to 10 years
Machinery and equipment 3 to 5 years
Furniture and fixtures 3 to 5 years
Equipment under capital lease 3 to 5 years
Impairment of Long-Lived Assets and Long-Lived Assets to Be Disposed Of
The Company adopted the provisions of SFAS No. 121, Accounting for the
Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed
Of, on January 1, 1996. This Statement requires that long-lived assets,
excluding oil and gas properties accounted for using the full cost method
of accounting and including rental property and well servicing equipment,
and certain identifiable intangibles be reviewed for impairment whenever
events or changes in circumstances indicate that the carrying amount of an
asset may not be recoverable. Adoption of this Statement did not have an
impact on the Company's financial position, results of operations, or
liquidity.
<PAGE>
SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
Deferred Debt Costs
The Company capitalizes certain costs incurred in connection with
issuing debt. These costs are being amortized to interest expense on the
straight-line method over the term of the related debt.
Gas Balancing
The Company utilizes the sales method of accounting for over or under
deliveries of natural gas. Under this method, the Company recognizes sales
revenue on all natural gas sold. As of December 31, 1998, 1997 and 1996,
the Company was underproduced by approximately 620 MMcf, 697 MMcf and 693
MMcf, respectively.
Income Taxes
Deferred tax assets and liabilities are recognized for the estimated
future tax effects attributable to differences between the financial
statement carrying amount 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.
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.
Deferred tax assets are reduced, if necessary, by a valuation allowance for
the amount of tax benefits that may not be realized.
SRH and its eligible subsidiaries file a consolidated U.S. federal
income tax return. Sierra (through June 30, 1997) and Red Oak are
consolidated for financial reporting purposes, but beginning January 1,
1996, were not eligible to be included in the consolidated U.S. federal
income tax return. Separate provisions for income taxes have been
determined for these entities.
Reclassifications
Certain reclassifications have been made to the 1997 and 1996 amounts
to conform to the 1998 presentation.
<PAGE>
SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
Income (loss) per share
In February, 1997 the Financial Accounting Standards Board issued
Statement of Financial Accounting Standards No. 128, "Earnings per Share"
("SFAS 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 SFAS 128, the Company adopted SFAS 128 in
its year ended December 31, 1997 consolidated financial statements and all
prior period EPS information (including interim EPS) have been restated.
Under SFAS 128, primary EPS is replaced by "basic" EPS 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. The computation of diluted net income (loss) per share was
antidilutive for all periods presented; therefore, the amounts reported for
basic and diluted net income (loss) per share were the same.
Noncompete covenants
Noncompete covenants are carried at cost less accumulated
amortization. The covenants are being amortized over their contractual
lives, generally three to five years.
Reporting Comprehensive income
In June 1997, the FASB issued Statement of Financial Accounting
Standards No. 130 "Reporting Comprehensive Income" ("SFAS 130") which
establishes standards for reporting and display of comprehensive income and
its components in a full set of general-purpose financial statements.
Specifically, SFAS 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
currently has no effect on the Company.
Segment Reporting
In June 1997, the FASB issued Statement of Financial Accounting
Standards No. 131 "Disclosures about Segments of an Enterprise and Related
Information" ("SFAS 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 establishes standards for related
disclosures about products and services, geographic areas, and major
customers. The Company implemented SFAS 131 during 1997.
<PAGE>
SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
2. Liquidity
The accompanying consolidated financial statements have been prepared
on a going concern basis, which contemplates the realization of assets and
the satisfaction of liabilities in the normal course of business. The
consolidated financial statements do not include any adjustments relating
to the recoverability and classification of liabilities that might be
necessary should the Company be unable to continue as a going concern.
The Company has a highly leveraged capital structure with $21.0
million of interest payments due in 1999 on its 10.5% Senior Notes and
approximately $12.7 million of principal and approximately $12.3 million of
cash interest payments due in 1999 on its other obligations (principally
related to Red Oak). Due to severely depressed commodity prices and
lagging rental property utilization, the Company is experiencing difficulty
in generating sufficient cash flow to meet its obligations and sustain its
operations. Management is attempting to renegotiate the terms of the
Company's various obligations with its note holders and lenders and/or
attempting to seek new lenders or equity investors. Additionally,
management would consider disposing of certain assets in order to meet its
obligations.
There can be no assurance that the Company's debt restructuring
efforts will be successful or that the note holders or lenders will agree
to a course of action consistent with the Company's requirements in
restructuring the obligations. Even if such agreement is reached, it may
require approval of additional note holders, or possibly, agreements of
other creditors of the Company, none of which is assured. Furthermore,
there can be no assurance that the sales of assets can be successfully
accomplished on terms acceptable to the Company. Under current
circumstances, the Company's ability to continue as a going concern depends
upon its ability to (1) successfully restructure its 10.5% Senior Notes and
other obligations or obtain additional financing as may be required, (2)
maintain compliance with all debt covenants, (3) generate sufficient cash
flow to meet its obligations on a timely basis, and (4) achieve
satisfactory levels of future earnings. If the Company is unsuccessful in
its efforts, it may be unable to meet its obligations on the 10.5% Senior
Notes, as well as other obligations, making it necessary to undertake such
other actions as may be appropriate to preserve asset values.
3. Subsidiaries, Acquisitions and Dispositions
During 1994, Red Oak sold 62,384 shares of redeemable common stock for
approximately $1,560,000 million through a private placement offering.
During 1995, Red Oak sold an additional 39,616 shares of redeemable common
stock for approximately $990,000 and 34,611 shares of its Series A
cumulative convertible preferred stock, for approximately $1,731,000. The
redeemable common stock is redeemable at the stockholder's option at a
price equal to the purchase price plus a 6% annual return computed on a
cumulative, but not compounded, basis between December 1, 1996 and December
1, 1999. Redemptions are to be paid out of future earnings of Red Oak. If
there are no future earnings, redemptions will be paid out of additional
paid-in capital.
On September 26, 1996, Red Oak formed a subsidiary with an unrelated
third party. On October 15, 1996, the subsidiary acquired three shopping
centers for a total purchase price of $12.5 million. The transaction was
funded through a $2.3 million contribution from Red Oak and a $1.2 million
contribution from the unrelated third party. In April 1997 Red Oak
purchased the interest of the unrelated third party and merged the
subsidiary into Red Oak.
<PAGE>
SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
On October 14, 1997, the Southwest acquired various working interests
in 431 producing oil and gas wells, located in seven oil and gas fields in
the Permian Basin of West Texas and southeastern New Mexico for $72.3
million. Southwest operates 133 of these wells. Southwest funded this
acquisition through the issuance of 10.5% Senior Notes (see Note 7). The
results of operations of the properties acquired are included in the
Consolidated Statement of Operations beginning October 14, 1997.
In 1997, Red Oak acquired five shopping centers and two office
buildings in Texas, Oklahoma and Arizona for a total cost of $50.9 million.
The transactions were accounted for using the purchase method. The results
of operations of the properties acquired are included in the Consolidated
Statements of Operations as of the close of each acquisition.
In June 1998, Red Oak acquired a retail shopping center in Texas for
$13.5 million. The acquisition was financed by the variable note payable
due July 2001 described in Note 7. The operations of the retail shopping
center from the date of acquisition through December 31, 1998 have been
included in the Consolidated Statement of Operations for the year ended
December 31, 1998.
In December 1998, Red Oak acquired a retail shopping center in Texas
for $21.0 million. The acquisition was financed by the variable note
payable due December 2001 described in Note 7. The operations of the
retail shopping center from the date of acquisition through December 31,
1998 have been included in the Consolidated Statement of Operations for the
year ended December 31, 1998.
Pro Forma Results of Operations - (unaudited)
The following table reflects the pro forma results of operations as
though the 1997 acquisitions had occurred on January 1, 1997. The pro
forma amounts are not necessarily indicative of the results that may be
reported in the future.
Year Ended
December 31,
1997
-----
Revenues $ 71,066
Net loss (11,706)
Net loss per share (10.86)
4. Equity Investment in Subsidiary and Partnerships
As of December 31, 1998, the investment in subsidiary held by the
Company consists of a 29% direct ownership interest in Sierra as well as an
additional 10% indirect interest the Company obtained through limited
partnerships, Southwest Partners II and Southwest Partners III, for which
Southwest serves as the general partner. The investment is accounted for
using the equity method. Effective July 1, 1997, Southwest Partner III
purchased additional shares of Sierra stock, decreasing Southwest's total
direct and indirect ownership percentage below 50%. Therefore, with the
change of Southwest's ownership percentage from a majority to a minority
interest, Sierra was deconsolidated. The deconsolidation of Sierra
required an adjustment to the investment account to reflect the change in
accounting from the consolidation method to the equity method.
<PAGE>
SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
The Company's investment in Sierra is subject to possible future
dilution as a result of common stock warrants held by Sierra's lender.
Sierra has a highly leveraged capital structure with primarily all of its
outstanding debt due on March 31, 1999. Sierra does not have the available
working capital to meet this obligation, but has recently executed a
restructuring of its debt with the lender. Although the restructuring has
been executed, it will not become final until the proper Hart-Scott-Rodino
filings have been successfully completed. If such efforts are
unsuccessful, Sierra may be unable to meet its obligations, making in
necessary to undertake actions as may be appropriate to preserve asset
values.
Pertinent financial information for Sierra Well Service, Inc. as of
December 31, 1998 and 1997 and for the year ended December 31, 1998 and the
six months ended December 31, 1997 is as follows (in thousands):
December 31, December 31,
1998 1997
---- ----
Balance Sheets
Assets $ 74,606 $ 87,119
====== ======
Liabilities $ 60,581 $ 63,759
Equity 14,025 23,360
------ ------
Total liabilities and equity $ 74,606 $ 87,119
====== ======
For the year Six months
ended ended
December 31, December 31,
1998 1997
---- ----
Statements of Operations
Revenues $ 45,319 $ 18,370
Expenses 53,262 19,163
Impairment of long lived assets 1,392 -
------ ------
Net Income/(Loss) (9,335) (793)
====== ======
Company's share of net loss $ (3,620) $ (309)
====== ======
<PAGE>
SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
5. Property and Equipment
Property and equipment, including rental property and other, consists of
the following (in thousands):
Years Ended December 31,
------------------------
1998 1997
----- -----
Land $ 2,287 $ 2,157
Building and improvements 1,419 1,413
Machinery and equipment 3,048 2,277
Furniture and fixtures 2,367 1,743
Equipment under capital lease 93 614
Rental property 137,059 83,696
------- ------
146,273 91,900
Less accumulated depreciation 8,265 4,971
------- ------
$138,008 $ 86,929
======= ======
6. Future Lease Receivables
Red Oak leases office and retail shopping centers under noncancelable
operating leases that expire at various dates through 2035. The following
is a summary of minimum future rentals expected to be received under
noncancelable operating leases as of December 31, 1998 (in thousands):
1999 $ 18,473
2000 15,349
2001 11,792
2002 8,979
2003 6,381
Thereafter 23,551
------
$ 84,525
======
The preceding future minimum rentals do not include percentage rents
or reimbursements.
<PAGE>
SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
7. Long-term Debt
Long-term debt consists of the following (in thousands):
December 31,
-------------------
1998 1997
----- -----
10.5% Senior Notes, interest payable semi-annually due
October 15, 2004, net of discount of $2,116 and
$2,346, respectively $197,884 $197,654
13.5% Notes payable, due April 2000. Cash interest of
10.5% payable monthly with additional interest payable
based on excess cash flow or through the issuance of
additional notes. Collateralized by real estate. 72,273
70,628
Revolving line of credit with variable-rate
interest, due February 1999. Collateralized by
oil and gas properties 40 100
Capital lease obligations 418 473
Notes payable due July 2001. Variable rate interest
due and payable monthly with additional 1 % payable
based on the lock box agreement. Net of discount
of $1,611 13,891 -
Note payable due December 2001. Variable rate interest
due and payable monthly with additional 1% payable
base on lock box agreement. Net of discount $3,889 21,806
- -
Other 28,772 14,787
------- -------
335,084 283,642
Less current maturities 12,716 1,878
------- -------
$322,368 $281,764
======= =======
10.5% Senior Notes
In October 1997, the Company issued $200 million aggregate principal
amount of 10.5% Senior Notes due October 15, 2004 (the "Notes"). The Notes
were sold at a discount and interest is payable April 15 and October 15 of
each year, commencing April 15, 1998. 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 issuer. Net
proceeds from the issuance of the Notes were used primarily to repay
existing debt of approximately $84 million, purchase oil and gas properties
for approximately $72 million, purchase additional stock in Red Oak for
approximately $10 million, invest $1.7 million in an affiliate, with the
remaining balance used for working capital.
The Indenture imposes certain limitations on the ability of the
Company and its restricted subsidiaries to, among other things, incur
additional indebtedness or issue disqualified capital stock, make payments
in respect to capital stock, enter into transactions with affiliates, incur
liens, sell assets, change the nature of its business, merge or consolidate
with any other person and sell, lease, transfer or otherwise dispose of
substantially all of its properties or assets. The indenture requires the
issuer to repurchase notes under certain circumstances with the excess cash
of certain asset sales. The limitations are subject to a number of
important qualifications and exceptions. The issuer must report to the
Trustee on compliance with such limitations on a quarterly basis.
<PAGE>
SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
13.5% Note Payable
In April 1997 MRO Properties Inc. ("MROP"), a 100% owned subsidiary of
Red Oak entered into a $42 million credit facility maturing in April 2000
with an institutional lender (the "MROP Facility"). The MROP Facility was
executed in order to consolidate nine mortgage loans, originally incurred
to complete the acquisition of certain Red Oak properties and to finance
the acquisition of an additional real estate property. Borrowings under
the facility bear interest at a rate of 13%, with 10% payable in cash and
the remaining 3% payable in cash or additional notes. The facility
contains a number of covenants that, among other things, restrict the
ability of MROP to incur additional indebtedness and dispose of assets.
The facility is secured by a first lien on substantially all of MROP's
properties. In September 1997, the Company negotiated an additional $30.5
million in loan proceeds which was used to acquire a retail shopping center
and office building in Oklahoma City, Oklahoma and a retail shopping center
in San Antonio, Texas. The loan is collateralized by the properties
purchased, and by properties contributed by the Company. Under the capital
reserve clause of the Agreement, MROP was required to deposit in escrow
with the creditor $1 million by September 30, 1998 and an additional $1
million by October 23, 1998, to be used for future capital improvements to
the properties. Subsequently, the lender extended the deposit due dates
until December 1, 1998. At December 31, 1998, MRO Properties had not made
the $2 million deposits required which resulted in a technical default with
the credit facility therefore defaulting the interest rate to 18%, with 10%
payable in cash and the remaining 8% payable in cash or additional notes,
at year-end. On February 15, 1999, MROP negotiated a deal with the lender
borrowing an additional $2 million to fund the escrow, therefore curing the
default and increasing interest an additional .5% from 13% to 13.5%.
Revolving Line of Credit
Southwest Credit Facility. The Southwest Credit Facility was amended
to provide for a $75 million revolving line of credit due upon demand,
subject to semi-annual borrowing base redetermination. The initial
borrowing base of $40 million is subject to a $15 million available sub-
limit for oil and gas acquisitions, with the balance of the borrowing base
available for general corporate purposes. Borrowings accrue interest at
LIBOR plus a margin ranging from 1.75% to 2.50% and the facility incurs a
quarterly commitment fee of three-eighths of one percent (3/8%) per annum
on the daily average of the unadvanced amount of the borrowing base. The
Southwest Credit Facility is secured by substantially all of Southwest's
proved oil and gas properties. The facility contains a number of covenants
that limit loans and advances, investments, and dividends, as well as
setting a minimum interest coverage ratio for SRH. During the second
quarter, in response to the sustained low oil price environment, the lender
issued lower pricing parameters for the computation of the borrowing base
for all of its oil and gas customers. Using the new price parameters,
Southwest has no current availability under its line of credit. The lender
schedules quarterly reviews of its pricing policy and should oil prices
strengthen, the Company can request a redetermination at that time. At
December 31, 1998, Southwest is in violation of the minimum interest
coverage ratio. Southwest will not seek a waiver as the violation does not
create a cross default on any other debt and the $40,000 outstanding on the
credit facility is already classified as current on the Company's balance
sheet.
<PAGE>
SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
Variable Rate Notes Payable
In June 1998, MRO N Cross, Inc., a wholly owned subsidiary of Red Oak
negotiated two notes payable in the amount of $13.5 million, net of a $2
million discount, and $2.5 million. The $13.5 million note was used for the
acquisition of rental property in the amount of $12.9 million with the
remaining $600,000 to be used for capital improvements to the rental
property purchased. The $2.5 million note is for capital improvements to
the rental property purchased and has not been utilized as of December 31,
1998. The notes are collateralized by the property purchased.
In December 1998, MRO Commercial, Inc., a wholly owned subsidiary of
Red Oak negotiated two notes payable in the amount of $21.7 million, net of
a $4 million discount, and $9.7 million. The $21.7 million note was used
for the acquisition of rental property. The $9.7 million note is for
capital improvements to the rental property purchased and has not been
utilized as of December 31, 1998. The notes are collateralized by the
property purchased.
As of December 31, 1998, Red Oak was in default on approximately
$1,900,000 of notes payable due certain of its shareholders, for failure to
pay principal and interest payments on the stated due dates. Additionally,
as a result of these defaults, Red Oak violated a covenant requirement on a
term note payable with a balance outstanding of approximately $6,700,000 at
December 31, 1998. These notes may be callable by the lenders and, as
such, are classified as current in the Company's consolidated balance sheet
at December 31,1998.
Extinguishment of Debt
In 1997, the Company repaid certain notes payable with proceeds from
the 10.5% Senior Notes. The remaining unamortized deferred debt costs
associated with these notes resulted in an extraordinary charge of
$3,109,000, net of $1,241,000 of tax benefit, or $2.88 per share.
Aggregate maturities of all long-term debt as of December 31, 1998,
including capital leases, are as follows (in thousands):
1999 $ 12,716
2000 73,186
2001 36,257
2002 2,045
2003 659
Thereafter 210,221
-------
$335,084
=======
<PAGE>
SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
8. Income Taxes
Income tax provision (benefit) and amounts separately allocated were
as follows (in thousands):
December 31,
----------------------------
1998 1997 1996
----- ----- -----
Income (loss) before minority interest, equity loss
and extraordinary item $(2,348) $(2,641) $
365
Equity loss in subsidiary - (106) -
Extraordinary loss from early extinguishment - (1,241)
- -
------ ----- -----
$(2,348) $(3,988) $
365
====== ===== =====
The U.S. Federal tax provision (benefit) attributable to income (loss)
before income taxes, minority interest and extraordinary item consists of
the following (in thousands):
December 31,
----------------------------
1998 1997 1996
----- ----- -----
Current $ - $(35) $(382)
Benefit of net operating loss carryforward (14,165)
(7,340) (913)
Deferred (20,237) 3,341 1,660
Valuation allowance 32,054 1,393 -
------ ----- -----
$(2,348) $(2,641) $
365
====== ===== =====
Reconciliation's between the amount determined by applying the U.S.
federal statutory rate to income (loss) before income taxes, minority
interest and extraordinary item with the income tax provision (benefit) is
as follows (in thousands):
December 31,
----------------------------
1998 1997 1996
----- ----- -----
Computed "expected" tax expense using the
U.S. federal statutory rate $(34,510) $(3,826) $
206
Reduction in available net operating loss
carryforwards resulting from certain
subsidiaries which became ineligible for
inclusion in the consolidated return - - 143
Meals and entertainment 16 16 32
Change in valuation allowance 32,054 1,156 -
Other 92 13 (16)
------ ----- -----
Provision (benefit) for income taxes $(2,348) $(2,641) $
365
====== ===== =====
<PAGE>
SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
The tax effects of temporary differences that give rise to significant
portions of the deferred tax assets and deferred tax liabilities were as
follows (in thousands):
December 31,
-------------------
1998 1997
Deferred tax assets: ----- -----
Net operating loss carry forwards $ 21,862 $ 9,662
Alternative minimum tax credit carryforwards 170 170
Receivables 152 -
Oil and gas properties, principally due to differences in
the tax and book basis and depletion methods and the
deduction of intangible drilling costs for tax purposes 7,833
- -
Equity investment in subsidiary 1,103 250
Other long term assets 1,817 1,561
Other long term liabilities 463 480
Covenant not to complete 57 -
Other 29 38
------ -------
Total gross deferred tax assets 33,486 12,161
------ -------
Deferred tax liabilities:
Oil and gas properties, principally due to differences in
the tax and book basis and depletion methods and the
deduction of intangible drilling costs for tax purposes -
(11,918)
Other property and equipment (663) (763)
Real estate investments (21) (88)
Accounts payable and accrued expenses (7) (250)
Other (109) (97)
------ -------
Total gross deferred tax liabilities (800) (13,116)
------ -------
Net deferred tax asset (liability) before
valuation allowance 32,686 (955)
Less valuation allowance:
Income (loss) before minority interest, equity
loss and extraordinary item (33,447) (1,393)
Equity loss in subsidiary 1,231 -
Minority interest in subsidiary (470) -
------ -------
Net deferred tax liability $ - $(2,348)
====== =======
A valuation allowance is provided when it is more likely than not that
some portion of the deferred tax assets will not be realized. Based on
expectations for the future, management has determined that taxable income
of Southwest will likely not be sufficient to fully utilize available
carryforwards prior to their ultimate expiration. As such, Southwest has
recorded a valuation allowance of $29,325,000 to reflect the realizability
of its net deferred tax assets. The amount of the valuation allowance
could be reduced if estimates of future taxable income during the
carryforward period are increased.
As of December 31, 1998, Southwest had net operating loss
carryforwards for U.S. federal income tax purposes of approximately
$56,107,000, which are available to offset future regular taxable income,
if any. The net operating loss carryforwards expire in various periods
from 2010 through 2012. Southwest has alternative minimum tax credit
carryforwards totaling $170,000 to offset regular income tax, which have no
scheduled expiration date.
<PAGE>
SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
Red Oak files an independent return exclusive of Southwest and has net
operating loss carryforwards of $8,198,000 expiring in various periods from
2010 through 2013. Based on expectations for the future, management has
determined that taxable income of Southwest will likely not be sufficient
to fully utilize available carryforwards prior to their ultimate
expiration. Approximately $3,361,000 of the valuation allowance relates
primarily to the uncertainty of the realizability of Red Oak's
carryforwards, the amount of the valuation allowance could be reduced if
estimates of future taxable income during the carryforward period are
increased.
9. Profit Sharing Plan
On January 1, 1991, the Company adopted an employee profit sharing
plan that is intended to provide participating employees with additional
income upon retirement. Employees may contribute between 1% and 15% of
their base salary up to a maximum of $10,000 for the year 1998 and $9,500
for the years ended December 31, 1997 and 1996. For the years ended
December 31, 1998, 1997 and 1996, the Company matched 20% of the employees'
contributions. For the year ended December 31, 1999, the Company will
match 20% of the employees' contributions. For subsequent years, the
Company will make contributions to the plan on a discretionary basis.
Employee contributions are fully vested at all times. Employer
contributions are fully vested upon retirement or after five years of
service. For the years ended December 31, 1998, 1997 and 1996, the Company
contributed approximately $61,000, $66,000 and $60,000, respectively, to
the plan.
10. Redeemable Common Stock
In August 1996, the Company issued 129,046 shares of redeemable common
stock through a private placement offering for $68 per share. The stock is
redeemable at the stockholder's option at any time beginning five years
from the issuance of the stock (December 31, 2001) at a purchase price
determined as follows:
(i) The Company shall review no less than five and no more than
ten publicly traded oil and gas companies each with a market
capitalization between $50 million and $150 million ("Public
Company"). The Company shall determine the ratio of each Public
Company's market capitalization to EBITDA for the most recent
fiscal year. The Company shall then average such multiples and
take this averaged multiple and apply it to the Company's EBITDA
for the most recent fiscal year, to estimate a value for the
Company's common stock.
(ii) The Company will determine the multiple of the market
capitalization of each Public Company relating to the present
value of such Public Company's oil and gas reserves. Present
value will be determined by discounting the expected net cash
flow from the oil and gas reserves by 10%. The Company will then
take the average multiple based on this methodology and apply it
to the present value of the Company's oil and gas reserves
discounted by 10% to determine a value for the expected net cash
flow from the Company's common stock.
The Company will then take the average of (i) and (ii) to
determine the value of the Company's common stock. The
redemption right terminates on the effective date of any
registration statement filed with the Securities and Exchange
Commission relative to the offer and sale of the Company's common
stock to the public.
<PAGE>
SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
11. Stockholders' Equity
During 1994, the Company issued a 6% note to a stockholder. The note
requires semi-monthly payments of $5,500 and is collateralized by the
Company's common stock held by the stockholder.
12. Commitments and Contingencies
The partnership agreements relating to certain limited partnerships
for which Southwest serves as managing general partner provide for
Southwest to offer to repurchase such limited partner units. Under the
terms of three of the partnership agreements, Southwest is obligated to
repurchase a maximum of $100,000 annually of the units of limited
partnerships' interests originally outstanding. Under the terms of nine
other partnership agreements, Southwest's obligation to repurchase units in
any one year is limited to 10% of the capital contributed by all of the
respective limited partners. The repurchase price is based on the
discounted future revenues from oil and gas reserves of the respective
partnership and the value of other partnership assets. Such amounts
required for repurchase in connection with the acceptance by a portion of
the limited partners is approximately $4,468,000 at December 31, 1998. The
total amount of limited partner unit repurchases for the years ended
December 31, 1998 and 1997 was approximately $287,000 and $1,041,000,
respectively.
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 expensed
when environmental assessment and/or remediation is probable and the costs
can be reasonably estimated.
Management recognizes a financial exposure that may require future
expenditures presently existing for oil and gas properties and other
operations. Current accrued expenses and other long-term liabilities at
December 31, 1998 include $159,000 and $504,000, respectively, for
estimated future remedial actions and cleanup costs. As of December 31,
1998, the Company has not been fined, cited or notified of any
environmental violations which would have a material adverse effect upon
capital expenditures, earnings or the competitive position in the oil and
gas industry. However, management does recognize that by the very nature of
its business, significant costs could be incurred to bring the Company into
total compliance. The amount of such future expenditures is not readily
determinable due to several factors, including the unknown magnitude of
possible contaminations, the unknown timing and extent of the corrective
actions which may be required, the determination of the Company's liability
in proportion to other responsible parties and the extent to which such
expenditures are recoverable from insurance or indemnifications from prior
owners of the Company's properties. It is reasonably possible this
estimate could change materially in the near term.
In the normal course of its business, the Company is subject to
pending or threatened legal actions; in the opinion of management, any such
matters will be resolved without material effect on the Company's
operations, cash flow or financial position.
<PAGE>
SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
13. Commodity Hedging and Derivative Financial Instruments
The Company, from time to time, uses option contracts to mitigate the
volatility of price changes on commodities the Company produces and sells
as well as to lock in prices to protect the economics related to certain
capital projects. In August 1998, the Company purchased a put option on a
total of 15,000 MMBtu of natural gas per day with a strike price of $2.00
per MMBtu. The option is based on the El Paso Natural Gas Co. - Permian
Basin Index and is for the period from November 1, 1998 through March 31,
1999.
On March 15, 1999, Southwest entered into a commodity swap agreement
to hedge a portion of its crude oil sales. The agreement is for a notional
amount of 1,000 BBls of oil a day, approximately 25% of total oil
production, with a strike price of $14.67, based on West Texas Intermediate
- - NYMEX. The contract is for the period April 1, 1999 through June 30,
1999, but can be extended to September 30, 1999, at the option of the
counter-party.
14. Related Party Transactions
Southwest is the managing general partner for several public and
private oil and gas limited partnerships, with an officer of Southwest also
serving as a general partner for certain of the limited partnerships. As
is usual in the oil and gas industry, the operator is paid an amount for
administrative overhead attributable to operating such properties and
management fees attributable to serving as managing general partner. As
provided for in the partnership agreements, such amounts paid by the
partnerships to Southwest approximated $3,789,000, $3,538,000 and
$3,648,000 for the years ended December 31, 1998, 1997 and 1996,
respectively. Included in these amounts, an affiliate of Southwest paid
management fees of approximately $147,000, for the year ended December 31,
1998 and approximately $54,000, for the six months ended December 31, 1997.
In addition, Southwest and certain officers and employees may have an
interest in some of the partnership properties.
An affiliate of the company performs various oilfield services for
limited partnerships managed by Southwest. Such services aggregated
$115,000, $155,000 and $112,000 for the years ended December 31, 1998, 1997
and 1996. The same affiliate performed services for Southwest that
aggregated approximately $121,000, for the year ended December 31, 1998 and
approximately $47,000, for the six months ended December 31, 1997.
15. Disclosures About Fair Value of Financial Instruments
The carrying amount of cash and cash equivalents, accounts receivable,
accounts payable and accrued expenses, other current assets and other
current liabilities approximates fair value because of the short maturity
of these instruments.
<PAGE>
SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
The fair value of the Company's 10.5% Senior Notes is estimated based
on the quoted market price for the notes.
1998 1997
----- -----
Carrying Fair Carrying Fair
Amount Value Amount Value
------- ------ ------- ------
10.5% Senior notes, net discount of
$2,116 and 2,346, respectively $197,884 $79,154 $197,654 $197,654
The fair value of all other long-term debt approximates the carrying
amount as of December 31, 1998 and 1997, based on the borrowing rates
currently estimated to be available to the Company for loans with similar
terms.
The fair value of the natural gas put option at December 31, 1998, is
approximately $247,000, based on a quote from the counter-party. The
carrying value of the natural gas put option, at December 31, 1998, is
approximately $223,000.
The carrying amount of investment in subsidiary at December 31, 1998
is recorded at zero because the investor's proportionate share of the
investee's net loss exceeded the original investment. The fair value of
SRH's investment in Sierra is undeterminable at December 31, 1998, as
Sierra is highly leveraged and is not publicly traded.
16. Lines of Business
The Company operates in three major segments: Oil and Gas Activities
(oil and gas acquisition, development, exploration and production, as well
as organizing and serving as managing general partner for various public
and private limited partnerships engaged in oil and gas development and
production), Oil and Gas Well Servicing (provides well completion,
recompletion and production equipment, transportation services, tank supply
rental services and other support and well maintenance services to
operating oil and gas companies) and Real Estate Investment and Management
(owns and manages retail shopping centers and office buildings). Other
items include eliminations, manufacturing, computer service and
broker/dealer and the holding Company. Effective July 1, 1997, Sierra, the
oil and gas well servicing business, was deconsolidated, therefore only six
months of income statement information is displayed in the tables and no
balance sheet information is displayed as of December 31, 1998 (see Note
4.)
1998 1997 1996
----- ----- -----
(in thousands)
Operating Revenue
Oil and gas $32,599 $ 38,662 $33,956
Well service - 7,833 8,273
Real estate 25,650 9,338 4,487
Other and eliminations 1,260 1,021 185
------ ------ ------
$59,509 $ 56,854 $46,901
====== ====== ======
Operating profit (loss)
Oil and gas $(68,633) $ 3,654 $
9,676
Well service - 184 (506)
Real estate 7,605 3,074 1,288
Other and eliminations (25) (417) (855)
------ ------ ------
$(61,053) $ 6,495 $
9,603
====== ====== ======
<PAGE>
SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
1998 1997 1996
----- ----- -----
(in thousands)
Interest Expense
Oil and gas $22,536 $ 12,329 $ 7,966
Well Service - 184 82
Real Estate 13,969 6,320 1,904
Other and eliminations (15) 61 64
------ ------ -----
$36,490 $ 18,894 $10,016
====== ====== =====
Depreciation, depletion and amortization
Oil and gas $16,118 $ 12,803 $ 6,734
Well Service - 747 863
Real Estate 2,935 1,313 660
Other and eliminations 187 171 173
------- ------ ------
$19,240 $ 15,034 $ 8,430
======= ====== ======
Identifiable assets
Oil and gas $111,876 $ 205,054
$ 95,042
Well service - - 6,585
Real estate 148,340 98,890 35,365
Other and eliminations (2,666) 1,499 (6,708)
------- ------ ------
$257,550 $ 305,443
$ 130,284
======= ====== ======
Capital expenditures
Oil and gas $10,046 $103,205 $16,740
Well service - - 3,826
Real estate 52,141 53,184 13,947
------- ------ ------
$62,187 $156,389 $34,513
======= ====== ======
17. Condensed Issuer Financial Data
Summarized consolidated financial information for Southwest is as
follows (in thousands):
December 31,
---------------------------------
1998 1997 1996
----- ----- -----
Consolidated Balance Sheet Data:
Current assets $ 20,486 $35,545 $18,439
Net property and equipment 81,373 156,302 66,348
Other assets, net 8,417 11,789 4,021
------- ------- ------
$ 110,276 $203,636 $88,808
======= ======= ======
Current liabilities $ 12,299 $14,614 $15,402
Long-term debt 199,058 198,938 58,534
Other liabilities 1,361 1,412 2,968
Deferred income taxes - 2,522 6,450
Minority interest 7 202 183
Stockholders equity (102,449) (14,052) 5,271
------- ------- ------
$ 110,276 $203,636 $88,808
======= ======= ======
<PAGE>
SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
December 31,
---------------------------------
1998 1997 1996
----- ----- -----
Consolidated Cash Flow Data:
Net cash provided by (used in) operating
activities $ (5,283) $ 5,488 $ 8,139
Net cash used in investing activities (5,829) (105,480)
(16,658)
Net cash provided by (used in) financing
activities (770) 116,680 12,956
------- ------- ------
Net increase (decrease) in restricted
cash and cash equivalents $(11,882) $16,688 $ 4,437
======= ======= ======
Consolidated Statement of Operations Data (in thousands):
SRH SouthwestSierraRed Oak ElimConsolidated
---- ---------------------------------------
For the year ended December 31, 1998:
Operating revenues $ - $33,879 $ - $25,650 $ 20 $
59,509
Depreciation, depletion
and amortization - 16,305 - 2,935 - 19,240
Impairment of properties - 64,000 - - - 64,000
Operating income (loss) (44) (68,614) - 7,605 -
(61,053)
Interest expense - 22,544 - 13,969 23
36,490
Loss before taxes, minority interest,
equity loss and extraordinary item (28) (89,769) -
(5,806) 92 (95,695)
Net loss (2,645) (88,425) - (5,858)
(874) (96,054)
For the year ending December 31, 1997:
Operating revenues $ - $39,727 $7,833 $9,338 $ (44) $
56,854
Depreciation, depletion
and amortization - 12,974 747 1,313 - 15,034
Operating income - 3,237 184 3,074 - 6,495
Interest expense - 12,372 184 6,320 18 18,894
Income (loss) before taxes, minority
interest, equity loss and
extraordinary item 15,249 (8,097) (5) (3,125)
(15,274) (11,252)
Net income (loss) 15,046 (7,733) (4) (3,987)
(14,815) (11,493)
For the year ended December 31, 1996:
Operating revenues $ - $34,488 $8,273 $4,487 $ (347)$
46,901
Depreciation, depletion
and amortization - 6,907 863 660 - 8,430
Operating income (loss) - 8,824 (506) 1,288 (3) 9,603
Interest expense - 8,030 82 1,904 - 10,016
Income (loss) before taxes, minority
interest, equity loss and
extraordinary item - 1,823 (608) (607) (19) 589
Net income (loss) - 1,152 (448) (441) 142 405
18. Subsequent Events
On March 25, 1999, SRH entered into an agreement to sell various
interest in certain oil and gas properties to an unrelated third party for
approximately $4.2 million. The sale closed on April 5, 1999.
<PAGE>
SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
19. Supplemental Financial Data - Oil and Gas Producing Activities
(unaudited):
The following information is presented in accordance with Statement of
Financial Accounting Standards No. 69, "Disclosure about Oil and Gas
Producing Activities," (SFAS No. 69), except as noted.
Costs incurred in connection with oil and gas producing activities are as
follows (in thousands):
Years ended December 31,
--------------------------------
1998 1997 1996
----- ----- -----
Acquisition of properties $ 1,315 $ 80,797 $ 3,234
Exploration costs 834 2,769 184
Development costs 7,897 19,639 13,322
------- ------ ------
Total costs incurred $ 10,046 $103,205 $ 16,740
======= ====== ======
Results of operations for oil and gas producing activities are as follows
(in thousands):
Years ended December 31,
--------------------------------
1998 1997 1996
----- ----- -----
Revenues $ 32,467 $ 38,500 $ 33,787
------- ------ ------
Production costs 18,395 18,500 14,846
Depletion 15,601 12,419 6,434
Impairment of oil and gas
properties 64,000 - -
------- ------ ------
(65,529) 7,581 12,507
Income tax provision - 2,578 4,253
------- ------ ------
Results of operations from oil and
gas producing activities
(excluding corporate overhead) $ (65,529) $ 5,003 $
8,254
======= ====== ======
Reserve Quantity Information
The estimates of the Company's proved oil and gas reserves, which are
located in the United States, are based on evaluations reviewed by
independent petroleum engineers. Reserves were estimated in accordance
with guidelines established by the U. S. Securities and Exchange Commission
and the Financial Accounting Standards Board, 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 reserve estimates at December 31, 1998 assume an average
oil price of 10.25 per Bbl (reflecting adjustments for oil quality and
gathering and transportation costs) and an average gas price of $1.73 per
Mcf (reflecting adjustments for BTU content, gathering and transportation
costs and gas processing and shrinkage).
<PAGE>
SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
Oil and gas reserve quantity estimates are subject to numerous
uncertainties inherent in the estimation of quantities of proved reserves
and 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, engineering and geological interpretation
and judgement. 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 the
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.
Oil and Natural Barrels of
Condensate Gas Oil Equivalent
(MBbls) (MMcf) (MBOE)
------ ------ -------
Total Proved Reserves:
Balance, January 1, 1996 16,580 70,590 28,345
Purchase of minerals-in-place 2,843 6,844 3,983
Sales of minerals-in-place (989) (466) (1,067)
Revisions of previous estimates 1,373 5,211 2,242
Production (1,001) (5,403) (1,901)
------ ------ ------
Balance, December 31, 1996 18,806 76,776 31,602
Extensions and discoveries 474 1,230 679
Purchase of minerals-in-place 16,419 7,274 17,631
Sales of minerals-in-place (83) (91) (98)
Revisions of previous estimates (4,642) (14,825)
(7,113)
Production (1,308) (5,639) (2,248)
------ ------ ------
Balance, December 31, 1997 29,666 64,725 40,453
Extensions and discoveries 27 1,526 282
Purchase of minerals-in-place 288 895 437
Sales of minerals-in-place (1,024) (6,132) (2,046)
Revisions of previous estimates (6,324) 2,815
(5,855)
Production (1,689) (5,556) (2,615)
------ ------ ------
Balance, December 31, 1998 20,944 58,273 30,656
====== ====== ======
Total proved developed reserves
January 1, 1996 7,349 51,296 16,003
December 31, 1996 10,302 58,961 20,129
December 31, 1997 18,472 46,585 26,236
December 31, 1998 12,006 37,481 18,253
Standardized Measure of Discounted Future Net Cash Flows
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, discounted using a rate of
10% per year to reflect the estimated timing of the future cash flows.
Future income taxes are calculated by comparing discounted future cash
flows to the tax basis of oil and gas properties plus available
carryforwards and credits and applying the current tax rates to the
difference.
<PAGE>
SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
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, any estimate of
fair value is necessarily subjective and imprecise.
During most of 1996 and 1997, the Company benefited from higher oil
and gas prices as compared to previous years. However, during the fourth
quarter of 1997 and the year 1998, oil prices began a downward trend that
has continued throughout 1998. A continuation of the oil price environment
experienced throughout 1998 will have an adverse affect on the Company's
revenues and operating cash flow, and may result in a downward adjustment
to the Company's current 1999 capital budget. Also, a continuing decline
in oil prices could result in an additional decrease in the carrying value
of the Company's oil and gas properties.
December 31,
---------------------------------------
1998 1997 1996
----- ----- -----
(in thousands)
Future cash inflows $ 315,709 $620,418 $ 735,100
Future production and development
costs (181,627) (303,406) (283,894)
-------- -------- --------
Future net cash flows before
income taxes 134,082 317,012 451,206
Future income tax expense - (59,764) (142,017)
-------- -------- --------
Future net cash flows 134,082 257,248 309,189
10% annual discount for estimated
timing of cash flows (62,182) (117,427) (130,648)
-------- -------- --------
Standardized measure of discounted
future net cash flows $ 71,900 $139,821 $ 178,541
======== ======== ========
<PAGE>
SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
The principal sources of change in the standardized measure of
discounted future net cash flows are as follows:
December 31,
---------------------------------------
1998 1997 1996
----- ----- -----
(in thousands)
Sales of oil and gas produced,
net of production costs $(14,072) $(20,000) $(18,941)
Net change in sales prices net of production
costs (76,234) (119,553) 92,332
Extensions and discoveries, net of future
production and development costs 1,195 3,540 -
Revisions to estimated future development
costs 3,103 (4,833) 1,854
Purchases of minerals-in-place 1,334 80,690 38,480
Revisions of previous quantity estimates (18,054) (37,403)
19,794
Accretion of discount 17,230 25,217 11,790
Net change in income taxes 32,483 46,887 (39,268)
Sales of minerals-in-place (5,899) (384) (2,439)
Changes in production rates, timing
and other (9,007) (12,881) (9,167)
------- ------- ------
(67,921) (38,720) 94,435
Discounted future net cash flows -
Beginning of period 139,821 178,541 84,106
------- ------- ------
End of period $ 71,900 $139,821 $ 178,541
======= ======= ======
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE.
The Company previously disclosed its change of accountants on S-4
Registration Statement No. 333-41915, which became effective February 9,
1998.
<PAGE>
SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
The directors and executive officers of SRH and Southwest are as
follows:
Name Age Position
----- ---- ---------
H. H. Wommack, III 43 Chairman, President, Chief Executive
Officer and Director
H. Allen Corey 42 Secretary and Director
Bill E. Coggin 44 Vice President and Chief Financial
Officer
J. Steven Person 40 Vice President, Marketing
Paul L. Morris 57 Director
Set forth below is a description of the backgrounds of the directors
and executive officers of SRH and Southwest.
H. H. Wommack, III has served as Chairman of the Board, President,
Chief Executive Officer and a director of SRH since it was formed in July
1997 and of Southwest since its founding in 1983. Mr. Wommack has served
as a director of Red Oak since 1992. Prior to the formation of Southwest,
Mr. Wommack was a self-employed independent oil and gas producer engaged in
the purchase and sale of royalty and working interests in oil and gas
leases and the drilling of wells.
H. Allen Corey has served as Secretary and a director of SRH since it
was formed in July 1997 and of Southwest since its founding in 1983. Mr.
Corey has served as a director and Assistant Secretary of Red Oak since
1992. Since January 1997, Mr. Corey has been president of Trolley Barn
Brewery, Inc., a brew pub restaurant chain based in the southeastern United
States and of counsel to the law firm of Baker, Donelson, Bearman &
Caldwell, P.C. From 1986 to 1997, Mr. Corey was a partner at the law firm
of Miller & Martin in Chattanooga, Tennessee.
Bill E. Coggin has served as Vice President and Chief Financial
Officer of SRH since it was formed in July 1997. Mr. Coggin has served as
Vice President and Chief Financial Officer of Southwest since 1985. Mr.
Coggin has served as a director and Vice President, Finance of Red Oak
since 1995. Previously, Mr. Coggin was controller for an oil and gas
drilling company and an independent oil and gas operator.
J. Steven Person has served as Vice President, Marketing of SRH since
it was formed in July 1997. Mr. Person has served as Vice President,
Marketing for Southwest since 1989 and as Vice President, Marketing of Red
Oak since 1996. Prior to joining Southwest, Mr. Person was involved in the
syndication of mortgage-based securities.
Paul L. Morris has served as a director of SRH since August 1998 and
Southwest since September 1998. Mr. Morris is President and CEO of Wagner
& Brown, Ltd., one of the largest independently owned oil and gas companies
in the United States. Prior to his position with Wagner & Brown, Mr.
Morris served as President of Banner Energy and in various managerial
positions with Columbia Gas System, Inc.
<PAGE>
SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES
Other key employees of Southwest and Red Oak include:
Southwest.
Jon P. Tate, age 41, has served as Vice President, Land and Assistant
Secretary of Southwest since 1989. From 1981 to 1989, Mr. Tate was employed
by C.F. Lawrence & Associates, Inc., an independent oil and gas company, as
land manager. Mr. Tate is a member of the Permian Basin Landman's
Association.
R. Douglas Keathley, age 43, has served as Vice President, Operations
of Southwest since 1992. Before joining Southwest, Mr. Keathley worked as a
senior drilling engineer for ARCO Oil and Gas Company and in similar
capacities for Reading & Bates Petroleum Co. and Tenneco Oil Co.
Red Oak.
W. Neil McClung, age 48, has served as President and a director of Red
Oak since 1994. Prior to his involvement with Red Oak, Mr. McClung was
senior vice president of Heitman Properties, Ltd. from 1989 through 1993
where he was responsible for marketing, budget development and leasing for
three million square feet of high-rise office building and industrial
center space in several metropolitan and secondary markets. Mr. McClung has
also served as a property and leasing manager for Heitman in Midland,
Texas.
J. Wesley Tune, age 39, has served as Vice President and Secretary of
Red Oak since 1994. Mr. Tune was employed by Heitman Properties, Ltd. as
property and leasing manager from 1992 until 1994 in Midland, Texas. Prior
to his involvement with Heitman, Mr. Tune was a property manager for Mike
Lewis & Associates in Midland, Texas, from 1990 to 1992, and manager and
controller for Mission Country Club from 1988 to 1990.
<PAGE>
SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES
Item 11. Executive Compensation.
The following table sets forth certain information for fiscal years
1997 and 1998 with respect to the compensation paid to Mr. Wommack, the
Chairman and President, and the four other most highly compensated
executive officers of Southwest. No other executive officers of Southwest
received annual compensation (including salary and bonuses earned) that
exceeded $100,000 for the years ended December 31, 1997 and 1998. Mr.
Wommack determines the compensation of Southwest's executive officers. No
compensation has been paid to the executive officers of SRH for their
services to SRH.
All Other
Name and Principal Position Year Salary Bonus(2)Compensati
on(1)
- -------------------------------------------------------------------- -----
- ---------------
H. H. Wommack, III, President and Treasurer (3) 1998 $ 667,026
$ 130,006 $44,625
1997 623,884 113,600
116,869
---- ------- -------
- -------
Bill E. Coggin, Vice President and Chief 1998 188,219 30,387
7,180
Financial Officer 1997 183,753 101,659
7,764
---- ------- -------
- -------
J. Steven Person, Vice President, Marketing 1998 163,589 14,540
8,036
1997 112,078 73,153
7,464
---- ------- -------
- -------
R. Douglas Keathley, Vice President, 1998 106,800 2,764
7,316
Operations 1997 101,567 17,556
6,771
---- ------- -------
- -------
Jon Tate, Vice President, Land 1998 98,719 3,514
5,343
1997 - -
- -
---- ------- -------
- -------
Carried
Profit Interest in
Insurance Sharing/401(k)Oil and Gas
Name Year Premiums ContributionProperties(3)
- ------ ---- -----------------------------------
H. H. Wommack, III 1998 $ 6,599 $2,000 $ 36,026
1997 5,864 1,900 109,105
---- ----- ----- -------
Bill E. Coggin 1998 5,180 2,000 -
1997 5,864 1,900 -
---- ----- ----- -------
J. Steven Person 1998 6,244 1,612 -
1997 5,864 1,600 -
---- ----- ----- -------
R. Douglas Keathley 1998 6,355 961 -
1997 5,864 907 -
---- ----- ----- -------
Jon Tate 1998 4,109 1,234 -
1997 - - -
---- ----- ----- -------
<PAGE>
SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES
(1) Reflects (i) Southwest's contributions to the Southwest
Royalties, Inc. Employee Profit Sharing and 401(k) Plan and premium
payments made by Southwest for health, disability and life insurance
policies for the referenced individuals and (ii) net cash received from
carried interests in Oil and Gas Properties.
(2) Amount includes club dues and automobiles furnished by Southwest.
(3) Mr. Wommack has acted as a general partner of the income funds
and certain of the drilling funds sponsored by Southwest since 1983,
holding a 1% interest in these partnerships.
In 1998 there were two non-employee directors who received $10,000
each for their services as directors of Southwest. In 1997 there was one
non-employee director who received $20,000 as a director of Southwest.
Item 12. Security Ownership of Certain Beneficial Owners and Management.
The following table sets forth information with respect to the
beneficial ownership of the common stock, excluding treasury shares, of SRH
by each person who is known by the Company to own beneficially 5% or more
of the common stock of SRH, by each director, and by all officers and
directors of SRH as a group. Southwest is a wholly-owned subsidiary of SRH.
Number of
Name and Address of Shares Percentage
Beneficial Owner Owned of Class
- --------------------- --------- ----------
H. Allen Corey 48,968 4.6%
c/o Southwest Royalties Holdings, Inc.
Southwest Royalties Building
407 N. Big Spring
Midland, TX 79701-4326
George H. Jewell 61,855 5.7%
Baker & Botts, L.L.P.
One Shell Plaza
910 Louisiana
Houston, Texas 77002
H. H. Wommack, III 787,977 73.2%
c/o Southwest Royalties Holdings, Inc.
Southwest Royalties Building
407 N. Big Spring
Midland, TX 79701-4326
Directors and officers as a group (four persons)848,925 78.9%
<PAGE>
SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES
Item 13. Certain Relationships and Related Transactions.
The descriptions set forth below do not purport to be complete and are
qualified in their entirety by reference to the applicable agreements.
On December 15, 1994, H. H. Wommack, III borrowed approximately $1.7
million on an unsecured basis from Southwest for the purpose of purchasing
the Southwest common stock held by a certain stockholder. The note held by
Southwest was amended on March 15, 1995 to include $35,225 of accrued but
unpaid interest. The note carries a 6% interest rate and is being amortized
over 30 years with payments of $5,500 semi-monthly. As of December 31,
1998, the outstanding balance of this loan was $1.7 million. Mr. Wommack
serves as a general partner of substantially all of the oil and gas limited
partnerships sponsored by Southwest since 1983, and he holds an interest in
these partnerships of approximately 1%.
PART IV
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K.
Financial Statements
The following financial statements of the Company are included in
"Item 8. Financial Statements and Supplementary Data":
Independent Auditors' Report
Consolidated Balance Sheets as of December 31, 1998 and 1997
Consolidated Statements of Operations from the years ended December
31, 1998, 1997 and 1996
Consolidated Statements of Stockholders' Equity for the years ended
December 31, 1998, 1997 and 1996
Consolidated Statements of Cash Flows for the years ended December 31,
1998, 1997 and 1996
Notes to Consolidated Financial Statements
All other statements and schedules for which provision is made in the
applicable accounting regulations of the Securities and Exchange Commission
have been omitted because they are not required under related instructions
or are inapplicable, or the information is shown in the financial
statements.
Reports on Form 8-K
The Company has not filed any reports on Form 8-K.
<PAGE>
Exhibits
The following instruments and documents are included as Exhibits to
this Report. Exhibits incorporated by reference are so indicated by
parenthetical information.
Exhibit Number Description
- -------------- -------------
3.1 Certificate of Incorporation for Southwest Royalties, Inc.
dated as of August 18, 1983, as amended March 30, 1987 and
November 20, 1989, incorporated by reference to Exhibit 3.1 to S-
4 Registration Statement No. 333-41915 filed December 10, 1997.
3.2 Certificate of Incorporation for Southwest Royalties
Holdings, Inc. dated as of July 1, 1997, incorporated by
reference to Exhibit 3.2 to S-4 Registration Statement No. 333-
41915 filed December 10, 1997.
3.3 By-Laws of Southwest Royalties, Inc. dated as of August 12,
1996 as amended, incorporated by reference to Exhibit 3.3 to S-4
Registration Statement No. 333-41915 filed December 10, 1997.
3.4 By-Laws of Southwest Royalties Holdings, Inc. adopted as of
July 1, 1997, incorporated by reference to Exhibit 3.4 to S-4
Registration Statement No. 333-41915 filed December 10, 1997.
4.1 Indenture dated as of October 14, 1997 among Southwest
Royalties, Inc., as Issuer, Southwest Royalties Holdings, Inc.,
as Guarantor, and State Street Bank and Trust Co., as Trustee,
incorporated by reference to Exhibit 4.1 to S-4 Registration
Statement No. 333-41915 filed December 10, 1997.
4.2 Registration Rights Agreement dated as of October 14, 1997
by and between Southwest Royalties, Inc., Southwest Royalties
Holdings, Inc., Jefferies & Company, Inc., Banc One Capital
Corporation and Paribas Corporation, incorporated by reference to
Exhibit 4.2 to S-4 Registration Statement No. 333-41915 filed
December 10, 1997.
4.3 Warrant issued by Southwest Royalties Holdings, Inc. to
Joint Energy Development Investments Limited Partnership dated as
of October 14, 1997, incorporated by reference to Exhibit 4.3 to
S-4 Registration Statement No. 333-41915 filed December 10, 1997.
4.4 Registration Rights Agreement by Southwest Royalties
Holdings, Inc. and Joint Energy Development Investments Limited
Partnership dated as of October 14, 1997, incorporated by
reference to Exhibit 4.4 to S-4 Registration Statement No. 333-
41915 filed December 10, 1997.
10.1 Purchase and Sale Agreement dated as of September 10, 1997
between Conoco, Inc. and Southwest Royalties, Inc., incorporated
by reference to Exhibit 10.1 to S-4 Registration Statement No.
333-41915 filed December 10, 1997.
10.2 Securities Purchase Agreement dated October 14, 1997 between
Southwest Royalties Holdings, Inc. and Joint Energy Development
Investments Limited Partnership, incorporated by reference to
Exhibit 10.2 to S-4 Registration Statement No. 333-41915 filed
December 10, 1997.
10.3 Restated Senior Loan Agreement among Southwest Royalties,
Inc., as borrower and certain subsidiaries of borrower, as
guarantors and Bank One, Texas, N.A. and Banque Paribus, as
Banks, and Bank One, Texas as agent dated as of October 9, 1997,
incorporated by reference to Exhibit 10.3 to S-4 Registration
Statement No. 333-41915 filed December 10, 1997.
21 List of Subsidiaries, incorporated by reference to Exhibit
21 to Amendment No. 1 to S-4 Registration Statement No. 333-41915
filed January 30, 1997.
27* Financial Data Schedule.
* Filed herewith.
<PAGE>
SIGNATURES
SOUTHWEST ROYALTIES, INC.
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be
signed on its behalf by the undersigned, thereto duly authorized.
SOUTHWEST ROYALTIES, INC.
By: /s/ H. H. Wommack, III
----------------------------------------
H.H. Wommack, III, Chairman, President,
and Chief Executive Officer
Date: April 13, 1999
Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.
SIGNATURE TITLE DATE
--------- ----- -----
/s/ H. H. Wommack, III
------------------------ Chairman/President/ April 13, 1999
H. H. Wommack, III Chief Executive Officer
/s/ Bill E. Coggin
-------------------------Vice President/Chief April 13, 1999
Bill E. Coggin Financial Officer
/s/ H. Allen Corey
-------------------------
H. Allen Corey Director/Secretary April 13, 1999
<PAGE>
SIGNATURES
SOUTHWEST ROYALTIES HOLDINGS, INC.
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be
signed on its behalf by the undersigned, thereto duly authorized.
SOUTHWEST ROYALTIES HOLDINGS, INC.
By: /s/ H. H. Wommack, III
----------------------------------------
H.H. Wommack, III, Chairman, President,
and Chief Executive Officer
Date: April 13, 1999
Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.
SIGNATURE TITLE DATE
--------- ----- -----
/s/ H. H. Wommack, III
------------------------ Chairman/President/ April 13, 1999
H. H. Wommack, III Chief Executive Officer
/s/ Bill E. Coggin
------------------------ Vice President/Chief April 13, 1999
Bill E. Coggin Financial Officer
/s/ H. Allen Corey
------------------------
H. Allen Corey Director/Secretary April 13, 1999
<PAGE>
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
This schedule contains summary financial information extraced from the
Balance Sheet at December 31, 1998 and the Statement of Operations for
the Year Ended December 31, 1998 and is qualified in its entirety by
reference to such financial statements.
</LEGEND>
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-END> DEC-31-1998
<CASH> 13,801,000
<SECURITIES> 0
<RECEIVABLES> 5,248,000
<ALLOWANCES> (342,000)
<INVENTORY> 1,041,000
<CURRENT-ASSETS> 22,267,000
<PP&E> 343,600,000
<DEPRECIATION> (130,107,000)
<TOTAL-ASSETS> 257,550,000
<CURRENT-LIABILITIES> 29,742,000
<BONDS> 322,368,000
11,269,000
0
<COMMON> 116,000
<OTHER-SE> 107,948,000
<TOTAL-LIABILITY-AND-EQUITY> 257,550,000
<SALES> 32,467,000
<TOTAL-REVENUES> 59,509,000
<CGS> 18,395,000
<TOTAL-COSTS> 32,872,000
<OTHER-EXPENSES> 83,240,000
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 36,490,000
<INCOME-PRETAX> (95,695,000)
<INCOME-TAX> (2,348,000)
<INCOME-CONTINUING> (96,054,000)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (96,054,000)
<EPS-PRIMARY> (89.28)
<EPS-DILUTED> (89.28)
</TABLE>
