MALLON RESOURCES CORP, 424B1, 2000-09-28

MALLON RESOURCES CORP
424B1, 2000-09-28
CRUDE PETROLEUM & NATURAL GAS

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<PAGE> 1

Filed Pursuant to Rule 424(b)(1)
Registration No. 333-44278

P R O S P E C T U S

2,500,000 Shares

[MALLON RESOURCES LOGO]
Common Stock
------------------------

Mallon Resources Corporation is offering all of the shares to be sold in
this offering. Our common stock is quoted in the Nasdaq National Market under
the symbol "MLRC." The last reported sale price of our common stock on September
27, 2000, was $6.625 per share.

We are an oil and gas exploration, development and production company.
Substantially all of our estimated proved reserves are located in the San Juan
and Delaware Basins in New Mexico, where we have been active since 1982.

INVESTING IN OUR COMMON STOCK INVOLVES RISKS, INCLUDING THOSE THAT ARE
DESCRIBED IN THE "RISK FACTORS" SECTION BEGINNING ON PAGE 7 OF THIS PROSPECTUS.
------------------------

<TABLE>
<CAPTION>
PER
SHARE TOTAL
----- -----
<S> <C> <C>
Public offering price.................................... $6.25 $15,625,000
Underwriting discounts and commissions................... 0.4375 1,093,750
Proceeds, before expenses, to Mallon..................... 5.8125 14,531,250
</TABLE>

The underwriters may also purchase up to an additional 375,000 shares from
us at the public offering price, less the underwriting discount, within 30 days
from the date of this prospectus to cover over-allotments.

Neither the Securities Exchange Commission nor any state securities
commission has approved or disapproved of these securities or determined if this
prospectus is truthful or complete. Any representation to the contrary is a
criminal offense.

The shares of common stock will be ready for delivery on or about October
2, 2000.

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

McDonald Investments Inc.
------------------------

The date of this prospectus is September 27, 2000

<PAGE> 2

TABLE OF CONTENTS

<TABLE>
<CAPTION>
PAGE
----
<S> <C>
Forward-Looking Statements........... 1
Prospectus Summary................... 2
Risk Factors......................... 7
Use of Proceeds...................... 14
Price Range of Common Stock.......... 14
Dividend Policy...................... 14
Capitalization....................... 15
Selected Consolidated Financial
Data............................... 16
Management's Discussion and Analysis
of Financial Condition and Results
of Operations...................... 18
Business and Properties.............. 27
</TABLE>

<TABLE>
<CAPTION>
PAGE
----
<S> <C>
Management........................... 32
Principal Shareholders............... 34
Description of Capital Stock and
Other Securities................... 36
Underwriting......................... 41
Legal Matters........................ 42
Experts.............................. 43
Where You Can Find More
Information........................ 43
Incorporation of Certain Documents by
Reference.......................... 44
Glossary of Terms.................... 45
Index to Consolidated Financial
Statements......................... F-1
</TABLE>

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

As used in this prospectus or in the information incorporated by reference
into this prospectus, any reference to "Mallon," "we," "our" or the "Company"
means Mallon Resources Corporation and its subsidiaries unless the context
suggests otherwise. The term "you" refers to a prospective investor. We have
included definitions of technical terms and abbreviations important to an
understanding of our business under "Glossary of Terms" on page 45.
---------------------

You should rely only on the information contained in or incorporated by
reference in this prospectus. We have not authorized anyone to provide you with
different information. We are not making an offer to sell our common stock in
any jurisdiction where the offer or sale is not permitted. You should not assume
that the information contained in this prospectus or the documents incorporated
by reference is accurate as of any date other than the date on the front of
those documents. Information included in those documents has not been updated or
changed since their respective dates, and our business, financial condition,
results of operations and prospects may have changed since those dates.
---------------------

FORWARD-LOOKING STATEMENTS

This prospectus and the documents incorporated by reference in this
prospectus contain forward-looking statements within the meaning of section 27A
of the Securities Act of 1933 and section 21E of the Securities Exchange Act of
1934, including statements regarding, among other items, our growth strategies,
the potential for the recovery of additional volumes of hydrocarbons,
anticipated trends in our business and our future results of operations, market
conditions in the oil and gas industry, our ability to make and integrate
acquisitions and the impact of governmental regulation. These forward-looking
statements are based largely on our expectations and are subject to a number of
risks and uncertainties, many of which are beyond our control. Actual results
could differ materially from these forward-looking statements as a result of,
among other things:

- a decline in oil or natural gas production or oil or natural gas prices,

- incorrect estimates of required capital expenditures,

- increases in the cost of drilling, completion and gas gathering or other
costs of production and operations,

- an inability to meet growth projections, and

- other risk factors set forth under "Risk Factors" in this prospectus.

In addition, the words "believe," "may," "will," "estimate," "continue,"
"anticipate," "intend," "expect" and similar expressions, as they relate to
Mallon, our business or our management, are intended to identify forward-looking
statements. We undertake no obligation to publicly update or revise any forward-
looking statements, whether as a result of new information, future events or
otherwise after the date of this prospectus. In light of these risks and
uncertainties, the forward-looking events and circumstances discussed in this
prospectus may not occur and actual results could differ materially from those
anticipated or implied in the forward-looking statements.

1
<PAGE> 3

PROSPECTUS SUMMARY

This summary highlights information contained elsewhere in this prospectus
or in the documents incorporated by reference in this prospectus. This summary
is not complete and does not contain all of the information that you should
consider before investing in our common stock. You should read the entire
prospectus and the documents incorporated by reference in this prospectus
carefully, especially the risks of investing in our common stock discussed under
"Risk Factors," beginning on page 7.

ABOUT MALLON

We are an independent energy company engaged in oil and natural gas
exploration, development and production. Substantially all of our oil and gas
reserves are located in the San Juan and Delaware Basins in New Mexico, where we
have been active since 1982. We own significant acreage positions in these two
basins, where we believe our technical and operational experience and our
database of information enable us to effectively exploit and develop our
properties. At June 30, 2000, we had 124.9 Bcfe of estimated proved reserves,
approximately 89% of which were natural gas. Our reserves are relatively
long-lived, as evidenced by the ratio of our estimated proved reserves as of
June 30, 2000, to our 1999 production of 18.8 years.

OUR EAST BLANCO GAS PROJECT

Since early 1999, we have drilled a total of 20 wells on the recently
acquired southern field extension portion of our East Blanco acreage. At least
79% of our acreage in this field has yet to be developed. Based on our
operations to date, we have identified more than 200 remaining drilling and
recompletion opportunities on our East Blanco acreage, all of which contain
multiple targets. In addition, we currently have an application pending to
acquire another 31,360 acres contiguous to our existing East Blanco acreage. We
intend to continue the aggressive development of this field.

In April 2000, we received permission to commingle the gas produced from
different zones in our East Blanco wells. Prior to this approval, wells in the
field were limited to producing from not more than two zones at a time.
Commingling, which permits us to produce gas from multiple producing formations
at the same time, results in substantial improvements in well economics. On
average, initial production rates in our commingled wells are more than 50%
higher than the rates of similar wells with dual completions. Since receiving
commingling approval, we have increased our net production in recent weeks to
approximately 22.3 million cubic feet equivalent per day (MMcfed) from our
second quarter 2000 average of 16.1 MMcfed. We plan to commingle the production
from most new wells that we drill at East Blanco, and to recomplete at least 23
of our older wells in order to commingle their production.

NATURAL GAS HEDGING

For the year 2000, we hedged 15 million Btus (MMBtu) of our daily natural
gas production at a price of $2.02 per MMbtu. For the six months ended June 30,
2000, this hedge, which expires December 31, 2000, cost us approximately
$1,869,000, or $0.70 per Mcf produced. For the year 2001, we have hedges in
place for 6,600 MMBtu of our daily natural gas production at an average price of
$2.80 per MMbtu.

OTHER ACTIVITIES

We also have significant oil and gas interests in the Delaware Basin of
southeast New Mexico, where we own interests in approximately 34,050 gross
(13,170 net) acres, containing 181 gross (62 net) wells. At

2
<PAGE> 4

June 30, 2000, our estimated proved reserves in the Delaware Basin were 42.4
Bcfe. Our Delaware Basin properties are located primarily in fields with
established production histories, which typically contain multiple productive
geologic formations and zones. Based upon our operations to date, we have
identified 76 drilling locations on our Delaware Basin acreage. While we intend
to allocate the substantial majority of our capital to continue developing our
East Blanco properties in the San Juan Basin, we will remain active in the
Delaware Basin.

In addition to our established conventional natural gas production in East
Blanco Field, it may be possible to produce coal-bed methane gas in the field.
The Fruitland Coal Seam is pervasive throughout our acreage at a depth of
approximately 3,800 feet. Other companies are currently producing coal-bed
methane gas from the Fruitland Coal in the unit adjacent to East Blanco Field.
We are seeking joint venture partners who can provide both capital and expertise
to help develop our potential Fruitland Coal methane.

THE OFFERING

Shares offered............. 2,500,000 shares (1)

Shares to be outstanding
after this offering........ 10,381,643 shares (1)(2)

Use of proceeds............ Primarily to finance exploitation and development
activities in the East Blanco Field. Pending
application of the net proceeds for these projects,
we will invest the net proceeds in short-term,
investment grade, interest-bearing securities.

Nasdaq National Market
symbol..................... MLRC
---------------

(1) Does not include up to 375,000 shares that the underwriters may purchase if
they exercise their over-allotment option.

(2) Excludes 706,103 shares of common stock issuable upon exercise of
outstanding options and warrants, and 146,479 shares of common stock, as
adjusted to reflect this offering, issuable upon conversion of our
outstanding Series B Mandatorily Redeemable Convertible Preferred Stock and
convertible note payable.

3
<PAGE> 5

SUMMARY FINANCIAL DATA

The following table sets forth, for the periods and at the dates indicated,
our summary historical financial data. The financial data for each of the three
fiscal years ended December 31, 1997, 1998 and 1999 is derived from our audited
Consolidated Financial Statements. The financial data for the six months ended
June 30, 1999 and 2000 is derived from our unaudited interim consolidated
financial statements, which, in the opinion of management, have been prepared on
the same basis as our annual Consolidated Financial Statements and include all
adjustments (consisting of only normal recurring adjustments) necessary for a
fair presentation of the financial data. The information in this table should be
read in conjunction with "Management's Discussion and Analysis of Financial
Condition and Results of Operations" and the Consolidated Financial Statements
and the notes thereto included elsewhere in this prospectus. The results for the
six month period ended June 30, 2000 are not necessarily indicative of results
for the full year.

<TABLE>
<CAPTION>
SIX MONTHS
YEAR ENDED DECEMBER 31, ENDED JUNE 30, 1999
---------------------------- --------------------
1997 1998 1999 1999 2000
-------- ------- ------- --------- --------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C> <C>
Statements of Operations Data:
Total revenues..................... $ 8,651 $13,178 $13,298 $ 5,978 $7,233
Oil and gas production expense..... 3,037 5,273 5,107 2,520 3,206
Depreciation, depletion and
amortization expense............ 2,725 5,544 4,822 2,357 2,719
Impairment of oil and gas
properties...................... 24 16,842 -- -- --
General and administrative
expense......................... 2,274 2,562 2,915 1,282 2,046
Interest and other expense......... 701 1,143 3,126 1,162 2,789
Net loss........................... (3,704) (18,186) (2,777) (1,343) (3,527)
Net loss attributable to common
shareholders.................... (4,292) (18,306) (3,013) (1,403) (3,776)
Per Share Data:
Loss attributable to common
shareholders before
extraordinary item.............. $ (0.92) $ (2.61) $ (0.40) $ (0.20) $(0.48)
Extraordinary loss................. -- -- (0.01) -- --
-------- ------- ------- ------- ------
Net loss attributable to common
shareholders.................... $ (0.92) $ (2.61) $ (0.41) $ (0.20) $(0.48)
======== ======= ======= ======= ======
Weighted average shares
outstanding..................... 4,682 7,015 7,283 7,024 7,854
Other Data:
Net cash provided by (used in)
operating activities............ $ 5,738 $ 5,065 $ 2,438 $(1,350) $1,720
Net cash used in investing
activities...................... (17,354) (36,008) (9,821) (3,860) (8,952)
Net cash provided by financing
activities...................... 15,586 25,935 6,880 4,627 7,612
EBITDA(1).......................... 56 5,343 5,251 2,176 1,945
Capital expenditures............... 20,169 36,354 9,852 3,882 9,337
</TABLE>

<TABLE>
<CAPTION>
JUNE 30, 2000
-------------------------
ACTUAL AS ADJUSTED(2)
-------- --------------
<S> <C> <C>
Balance Sheet Data:
Working capital (deficit)................................. $ (2,517) $11,764
Total assets.............................................. 72,120 86,401
Long-term obligations(3).................................. 44,785 44,785
Mandatorily redeemable convertible preferred stock........ 794 794
Mandatorily redeemable common stock(4).................... 3,649 3,649
Shareholders' equity...................................... 16,362 30,643
</TABLE>

(footnotes on following page)

4
<PAGE> 6

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

(1) EBITDA is earnings before income taxes, interest expense, depreciation,
depletion and amortization, impairment, and extraordinary loss. EBITDA is a
financial measure commonly used in our industry and should not be considered
in isolation or as a substitute for net income, cash flow provided by
operating activities or other income or cash flow data prepared in
accordance with generally accepted accounting principles or as a measure of
a company's profitability or liquidity. We believe that EBITDA may provide
additional information about our ability to meet our future requirements for
debt service, capital expenditures and working capital. When evaluating
EBITDA, investors should consider, among other factors, (i) increasing or
decreasing trends in EBITDA, (ii) whether EBITDA has remained at positive
levels historically and (iii) how EBITDA compares to levels of interest
expense. Other companies may define EBITDA differently, and as a result,
such measures may not be comparable to our EBITDA.

(2) As adjusted to reflect our receipt of estimated net proceeds from the
issuance of common stock in this offering and the application of such
proceeds. See "Use of Proceeds" and "Capitalization."

(3) Long-term obligations is net of current maturities.

(4) Represents the obligation to purchase 420,000 shares of common stock from a
shareholder for a price of $12.50 per share in September 2003.

SUMMARY OIL AND GAS RESERVE DATA

The following table sets forth summary information concerning our estimated
proved oil and gas reserves as of December 31, 1999 and June 30, 2000, based on
reports prepared by Reed W. Ferrill & Associates, Inc., independent petroleum
engineers. Reed W. Ferrill & Associates, Inc. is sometimes referred to herein as
the "Independent Engineer," and its reports are sometimes referred to herein as
the "Reserve Reports." All calculations in the Reserve Reports have been made in
accordance with the rules and regulations of the Securities and Exchange
Commission and give no effect to federal or state income taxes otherwise
attributable to estimated future net revenues from the sale of oil and gas. The
present value of estimated future net revenues has been calculated using a
discount factor of 10%. The commodity prices used in these calculations (which
do not include the effects of hedging) were $2.10 per Mcf for natural gas and
$23.94 per barrel for oil for the December 31, 1999 calculation, and $3.71 per
Mcf for natural gas and $31.03 per barrel for oil for the June 30, 2000
calculation.

<TABLE>
<CAPTION>
DECEMBER 31, 1999 JUNE 30, 2000
----------------- -------------
<S> <C> <C>
PROVED RESERVES:
Natural gas (MMcf)........................................ 92,525 111,174
Oil (MBbl)................................................ 1,896 2,294
Total (MMcfe)............................................. 103,901 124,937
PROVED DEVELOPED RESERVES:
Natural gas (MMcf)........................................ 38,539 49,137
Oil (MBbl)................................................ 1,204 1,602
Total (MMcfe)............................................. 45,763 58,746
PV-10 (in thousands):....................................... $ 72,364 $177,509
</TABLE>

5
<PAGE> 7

SUMMARY OPERATING DATA

<TABLE>
<CAPTION>
SIX MONTHS ENDED
YEAR ENDED DECEMBER 31, JUNE 30,
------------------------ -----------------
1997 1998 1999 1999 2000
------ ------ ------ ------- -------
<S> <C> <C> <C> <C> <C>
Net Production:
Natural gas (MMcf).............................. 2,350 5,852 5,600 2,989 2,662
Oil (MBbl)...................................... 196 230 172 91 84
Total (MMcfe)................................... 3,526 7,232 6,632 3,535 3,166
Average Sales Price Realized(1):
Natural gas (per Mcf)........................... $ 2.04 $ 1.72 $ 1.81 $ 1.57 $ 1.91
Oil (per Bbl)................................... $19.31 $12.99 $17.38 $13.64 $24.05
Total (per Mcfe)................................ $ 2.43 $ 1.81 $ 1.98 $ 1.68 $ 2.24
Average Cost Data (per Mcfe):
Production tax and marketing expense............ $ 0.32 $ 0.26 $ 0.25 $ 0.24 $ 0.36
Lease operating expense......................... $ 0.54 $ 0.47 $ 0.52 $ 0.47 $ 0.65
Depletion....................................... $ 0.74 $ 0.73 $ 0.65 $ 0.61 $ 0.73
</TABLE>

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

(1) Reflects effects of hedging and price adjustments for transportation for gas
produced from East Blanco Field. For the six months ended June 30, 2000, a
natural gas hedge, which expires December 31, 2000, cost us approximately
$1,869,000, or $0.70 per Mcf produced.

6
<PAGE> 8

RISK FACTORS

You should carefully consider the following risk factors, in addition to
the other information set forth in this prospectus, before purchasing shares of
our common stock. Each of these risk factors could adversely affect our
business, operating results and financial condition, as well as adversely
affecting the value of an investment in our common stock. This investment
involves a high degree of risk.

OIL AND GAS PRICES ARE VOLATILE, AND AN EXTENDED DECLINE IN PRICES COULD
ADVERSELY AFFECT OUR REVENUE, CASH FLOWS AND PROFITABILITY.

Our revenues, operating results, profitability, future rate of growth and
the carrying value of our oil and gas properties depend substantially upon
prevailing market prices for oil and natural gas. Prices also affect the amount
of cash flow available for capital expenditures as well as impacting our ability
to borrow money or raise additional capital. We expect the markets for oil and
gas to continue to be volatile. Any substantial or extended decline in the price
of oil or gas would have a material adverse effect on our financial condition
and results of operations. It could reduce our cash flow and borrowing capacity,
as well as the value and the amount of our reserves. At June 30, 2000,
approximately 89% of our estimated proved reserves were natural gas.
Accordingly, we are impacted more directly by volatility in the price of natural
gas.

We cannot predict future oil and natural gas prices. Various factors beyond
our control that could affect prices of oil and gas include:

- worldwide and domestic supplies of oil and gas,

- the ability of the members of the Organization of Petroleum Exporting
Countries to agree to and maintain oil price and production controls,

- political instability or armed conflict in oil or gas producing regions,

- the price and level of foreign imports,

- worldwide economic conditions,

- marketability of production,

- the level of consumer demand,

- the price, availability and acceptance of alternative fuels,

- the availability of pipeline capacity,

- weather conditions, and

- actions of federal, state, local and foreign authorities.

These external factors and the volatile nature of the energy markets make
it difficult to estimate future prices of oil and gas.

We enter into energy swap agreements and other financial arrangements at
various times to attempt to minimize the effect of oil and natural gas price
fluctuations. We cannot assure you that such transactions will reduce risk or
minimize the effect of any decline in oil or natural gas prices. Any substantial
or extended decline in oil or natural gas prices would have a material adverse
effect on our business and financial results. Energy swap arrangements may limit
the risk of declines in prices, but such arrangements may also limit revenues
from price increases.

LOWER OIL AND GAS PRICES MAY CAUSE US TO RECORD CEILING LIMITATION WRITEDOWNS.

We use the full cost method of accounting to report our oil and gas
operations. Accordingly, we capitalize the cost to acquire, explore for and
develop oil and gas properties. Under full cost accounting rules, the net
capitalized cost of oil and gas properties may not exceed a "ceiling limit" that
is based upon the present value of estimated future net revenues from proved
reserves, discounted at 10%, plus the lower of
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<PAGE> 9

cost or fair market value of unproved properties. If net capitalized costs of
oil and gas properties exceed the ceiling limit, we must charge the amount of
the excess to earnings. This is called a "ceiling limitation writedown." This
charge does not impact cash flow from operating activities, but does reduce our
shareholders' equity. The risk that we will be required to write down the
carrying value of our oil and gas properties increases when oil and gas prices
are low or volatile. In addition, writedowns may occur if we experience
substantial downward adjustments to our estimated proved reserves. Once
incurred, a writedown of oil and gas properties is not reversible at a later
date. We recorded a $16.8 million writedown of the carrying value of our oil and
gas properties in December 1998. We cannot assure you that we will not
experience ceiling limitation writedowns in the future.

OUR OPERATIONS REQUIRE LARGE AMOUNTS OF CAPITAL.

Our current development plans will require us to make large capital
expenditures for the exploration and development of our properties.
Historically, we have funded our capital expenditures through a combination of
funds generated internally from sales of production, equity offerings, and long
and short-term debt financing arrangements. We currently do not have any sources
of additional financing other than our credit facility and our equipment leases.
We currently rely on Aquila Energy Capital Corporation ("Aquila") to fund our
development operations. As a result, Aquila retains substantial discretion over
whether to fund our proposed development operations. We cannot be sure that any
additional financing will be available to us on acceptable terms. Future cash
flows and the availability of financing will be subject to a number of
variables, such as:

- the level of production from existing wells,

- prices of oil and natural gas, and

- our success in locating and producing new reserves and the results of our
natural gas development project at East Blanco Field.

Issuing equity securities to satisfy our financing requirements could cause
substantial dilution to our existing shareholders. Debt financing could lead to:

- a substantial portion of our operating cash flow being dedicated to the
payment of principal and interest,

- our being more vulnerable to competitive pressures and economic
downturns, and

- restrictions on our operations.

If our revenues were to decrease due to lower oil and natural gas prices,
decreased production or other reasons, and if we could not obtain capital
through our credit facility or otherwise, our ability to execute our development
plans, replace our reserves or maintain production levels could be greatly
limited.

ESTIMATES IN THIS PROSPECTUS CONCERNING OUR OIL AND GAS RESERVES AND FUTURE NET
REVENUE ESTIMATES ARE UNCERTAIN.

There are numerous uncertainties inherent in estimating quantities of
proved oil and natural gas reserves and their values, including many factors
beyond our control. Estimates of proved undeveloped reserves, which comprise a
significant portion of our reserves, are by their nature uncertain. The reserve
information included or incorporated by reference in this prospectus are only
estimates and are based upon various assumptions, including assumptions required
by the Commission, relating to oil and gas prices, drilling and operating
expenses, capital expenditures, taxes and availability of funds. Although we
believe they are reasonable, actual production, revenues and expenditures will
likely vary from estimates, and these variances may be material.

Estimates of oil and natural gas reserves, by necessity, are projections
based on geologic and engineering data, and there are uncertainties inherent in
the interpretation of such data as well as the projection of future rates of
production and the timing of development expenditures. Reserve engineering is a
subjective process

8
<PAGE> 10

of estimating underground accumulations of oil and natural gas that are
difficult to measure. The accuracy of any reserve estimate is a function of the
quality of available data, engineering and geological interpretation and
judgment. Estimates of economically recoverable oil and natural gas reserves and
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 governing 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 of recovery, and
estimates of the future net cash flows expected therefrom may vary
substantially. Any significant variance in the assumptions could materially
affect the estimated quantity and value of the reserves. Actual production,
revenues and expenditures with respect to our reserves will likely vary from
estimates, and such variances may be material.

In addition, you should not construe PV-10 as the current market value of
the estimated oil and natural gas reserves attributable to our properties. We
have based the estimated discounted future net cash flows from proved reserves
on prices and costs as of the date of the estimate, in accordance with
applicable regulations, whereas actual future prices and costs may be materially
higher or lower. Many factors will affect actual future net cash flow,
including:

- prices for oil and natural gas,

- the amount and timing of actual production,

- supply and demand for oil and natural gas,

- curtailments or increases in consumption by crude oil and natural gas
purchasers, and

- changes in governmental regulations or taxation.

The timing of the production of oil and natural gas properties and of the
related expenses affect the timing of actual future net cash flow from proved
reserves and, thus, their actual present value. In addition, the 10% discount
factor, which we are required to use to calculate PV-10 for reporting purposes,
is not necessarily the most appropriate discount factor given actual interest
rates and risks to which our business or the oil and natural gas industry in
general are subject.

OUR LONG-TERM FINANCIAL SUCCESS WILL DEPEND ON OUR ABILITY TO REPLACE THE
RESERVES WE PRODUCE.

In general, the volume of production from oil and gas properties declines
as reserves are depleted. The decline rates depend on reservoir characteristics.
Our reserves will decline as they are produced unless we acquire properties with
proved reserves or conduct successful development and exploration activities.
Our future natural gas and oil production is highly dependent upon our level of
success in finding or acquiring additional reserves. The business of exploring
for, developing or acquiring reserves is capital intensive and uncertain. We may
be unable to make the necessary capital investment to maintain or expand our oil
and gas reserves if cash flow from operations is reduced and external sources of
capital become limited or unavailable. In addition, competition for producing
oil and gas properties is intense and many of our competitors have financial and
other resources that are substantially greater than those available to us. We
cannot assure you that our future development, acquisition and exploration
activities will result in additional proved reserves or that we will be able to
drill productive wells at acceptable costs.

WE DEPEND HEAVILY ON SUCCESSFUL DEVELOPMENT OF OUR SAN JUAN BASIN PROPERTIES.

Our future success depends in large part on our ability to develop
additional natural gas reserves on our San Juan Basin properties that are
economically recoverable. Most of our proved reserves are in the San Juan Basin,
and our development plans make our future growth highly dependent on increasing
production and reserves in the San Juan Basin. Our proved reserves will decline
as reserves are depleted, except to the extent we conduct successful exploration
or development activities or acquire other properties containing proved
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<PAGE> 11

reserves. Our development plan includes increasing our reserve base through
continued drilling and development of our existing properties in the San Juan
Basin. Our San Juan Basin properties can only be effectively developed and
evaluated by drilling activities and the evaluation of drilling results. Less
costly means of evaluation, such as 3-D seismic, are not helpful on properties
such as ours. We cannot be sure that our planned projects will lead to
significant additional reserves or that we will be able to continue drilling
productive wells at acceptable finding and development costs.

THE OIL AND GAS EXPLORATION BUSINESS INVOLVES A HIGH DEGREE OF BUSINESS AND
FINANCIAL RISK.

The business of exploring for and, to a lesser extent, developing oil and
gas properties is an activity that involves a high degree of business and
financial risk. Property acquisition decisions generally are based on various
assumptions and subjective judgments that are speculative. Although available
geological and geophysical information can provide information about the
potential of a property, it is impossible to predict accurately the ultimate
production potential, if any, of a particular property or well. Moreover, the
successful completion of an oil or gas well does not ensure a profit on
investment. A variety of factors, both geological and market-related, can cause
a well to become uneconomic or only marginally economic.

OUR INDUSTRY IS SUBJECT TO NUMEROUS OPERATING RISKS.

The oil and natural gas industry involves operating risks. These operating
risks include the risk of well blowouts, craterings, explosions, uncontrollable
flows of oil, natural gas or well fluids, fires, formations with abnormal
pressures, pipeline ruptures or spills, pollution, releases of toxic gas and
other environmental hazards and risks, any of which could cause us substantial
losses. Substantial losses may be caused by injury or loss of life, severe
damage to or destruction of property, natural resources and equipment, pollution
or other environmental damage, clean-up responsibilities, regulatory
investigation and penalties and suspension of operations. Such losses may reduce
or eliminate funds available for exploration, development or acquisitions or
cause us to incur additional losses or liabilities. In accordance with industry
practice, we maintain insurance against some, but not all, of the risks
described above. An event that is not fully covered by insurance -- for
instance, losses resulting from pollution and environmental risks, which are not
fully insurable -- could have a material adverse effect on our financial
condition and results of operations. Further, our insurance may not be adequate
to cover losses or liabilities and the insurance we do have may not continue to
be available at premium levels that justify its purchase.

EXPLORATORY DRILLING IS AN UNCERTAIN PROCESS WITH MANY RISKS.

Exploratory drilling involves numerous risks, including the risk that we
will not find any commercially productive natural gas or oil reservoirs. The
cost of drilling, completing and operating wells is often uncertain, and a
number of factors can delay or prevent drilling operations, including:

- unexpected drilling conditions,

- pressure or irregularities in formations,

- equipment failures or accidents,

- adverse weather conditions,

- compliance with governmental requirements, and

- shortages or delays in the availability of drilling rigs and the delivery
of equipment.

Our future drilling activities may not be successful, nor can we be sure
that our overall drilling success rate, or our drilling success rate for
activity within a particular area, will not decline. Unsuccessful drilling
activities could have a material adverse effect on our results of operations and
financial condition. Also, we may not be able to obtain any options or lease
rights in potential drilling locations that we identify. Although we have
identified numerous potential drilling locations, we cannot be sure that we will
ever drill them or that we will produce oil or natural gas from them or any
other potential drilling locations.

10
<PAGE> 12

OUR KEY ASSETS ARE CONCENTRATED IN A SMALL GEOGRAPHIC AREA.

At December 31, 1999, approximately 76% of our average daily production, on
a Mcfe basis, was processed through our East Blanco gas sweetening plant. Our
production, revenue and cash flow will be adversely affected if this plant's
operation is shut down, curtailed or limited for any reason. Substantially all
of our operations are currently located in two geologic basins in New Mexico.
Because of this geographic concentration, any regional events that increase
costs, reduce availability of equipment or supplies, reduce demand or limit
production, including weather and natural disasters, may impact us more than if
our operations were more geographically diversified.

The availability of markets for our natural gas is beyond our control.
Substantially all of our gas is produced in the San Juan Basin in the State of
New Mexico and, consequently, we are particularly sensitive to marketing
constraints that exist or may arise in the future in that area. Historically,
due to the San Juan Basin's relatively isolated location and the resulting
limited access of its natural gas production to the marketplace, natural gas
produced in the San Juan Basin has tended to command prices that are lower than
natural gas prices that prevail in other areas.

The areas in which we are active have recently experienced shortages of oil
and gas equipment, particularly drilling and completion rigs. The inability to
obtain required equipment in a timely fashion could adversely effect the timing
of our proposed operations and cause the postponement of drilling schedules.

THE MARKETABILITY OF OUR PRODUCTION DEPENDS IN PART UPON THE AVAILABILITY,
PROXIMITY AND CAPACITY OF GAS GATHERING SYSTEMS, PIPELINES AND PROCESSING
FACILITIES.

The marketability of our production depends in part on the availability,
proximity and capacity of oil and natural gas gathering systems, pipelines and
processing facilities. Although we have some contractual control over the
transportation of our product, material changes in these business relationships
could materially affect our operations. Federal and state regulation of gas and
oil production and transportation, general economic conditions and changes in
supply and demand all could adversely affect our ability to produce and market
our oil and natural gas. If market factors change dramatically, the financial
impact on us could be substantial. The availability of markets for our
production is beyond our control.

WE FACE MARKETING, TRADING AND CREDIT RISKS.

In addition, the marketing of our oil and natural gas requires us to assess
and respond to changing market conditions, including credit risks. If we are
unable to respond accurately to changing conditions in the commodity markets,
our results of operations could be materially adversely affected. We try to
limit our exposure to price risk by entering into various hedging arrangements.
We are exposed to credit risk because the counterparties to agreements might not
perform their contractual obligations.

OUR HEDGING ARRANGEMENTS MIGHT LIMIT THE BENEFIT OF INCREASES IN COMMODITY
PRICES.

To reduce our exposure to short-term fluctuations in the price of oil and
natural gas, we enter into hedging arrangements from time to time with regard to
a portion of our oil and natural gas production. These hedging arrangements
limit the benefit of increases in the price of oil or natural gas while
providing only partial protection against declines in prices. Under our Credit
Agreement with Aquila, we may be, at Aquila's sole discretion, required to
maintain price hedging arrangements in place with respect to up to 65% of our
oil and gas production. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations -- Liquidity and Capital Resources."

OUR OIL AND GAS OPERATIONS ARE SUBJECT TO VARIOUS GOVERNMENTAL REGULATIONS THAT
MATERIALLY AFFECT OUR OPERATIONS.

Our oil and gas operations are subject to various Federal, state and local
governmental regulations. These regulations may be changed in response to
economic or political conditions. Matters regulated include permits for the
discharge of wastewaters and other substances generated in connection with
drilling and production

11
<PAGE> 13

operations, bonds or other financial responsibility requirements to cover
drilling contingencies and well plugging and abandonment costs, reports
concerning operations, the spacing of wells and unitization and pooling of
properties and taxation. At various times, regulatory agencies have imposed
price controls and limitations on oil and gas production. In order to conserve
supplies of oil and gas, theses agencies have restricted the rates of flow of
oil and gas wells below actual production capacity. Federal, state and local
laws regulate production, handling, storage, transportation and disposal of oil
and gas, byproducts from oil and gas and other substances and materials produced
or used in connection with oil and gas operations. Our failure to comply with
applicable laws and regulations could result in the assessment of
administrative, civil or criminal penalties. While we carry insurance to
mitigate the cost of environmental cleanup and third-party liability, we cannot
predict the ultimate cost of compliance with these requirements or their effect
on our operations.

OUR INDUSTRY IS HIGHLY COMPETITIVE.

We operate in a highly competitive environment. Major oil companies,
independent producers, and institutional and individual investors are actively
seeking oil and gas properties throughout the world, along with the equipment,
labor and materials required to operate properties. Many of our competitors have
financial and technological resources vastly exceeding those available to us.
Many oil and gas properties are sold in competitive bidding processes, as to
which we may lack technological information or expertise available to other
bidders. We cannot be sure that we will be successful in acquiring and
developing profitable properties in the face of this competition.

WE DEPEND ON KEY PERSONNEL.

Our success will continue to depend on the continued services of our
executive officers and a limited number of other senior management and technical
personnel. Loss of the services of any of these people could have a material
adverse effect on our operations. Unlike many other companies in our industry,
we do not maintain "key man" insurance on the lives of any of our employees. We
have employment agreements with our three most senior executive officers.

OUR SHARES THAT ARE ELIGIBLE FOR FUTURE SALE MAY HAVE AN ADVERSE EFFECT ON THE
PRICE OF OUR STOCK.

After this offering, 10,381,643 shares of common stock will be outstanding
(10,756,643 shares if the underwriters' over-allotment option is exercised in
full). In addition, options and warrants to purchase 706,103 shares are
outstanding, of which 481,014 are currently exercisable. These options and
warrants are exercisable at prices ranging from $0.01 to $8.50 per share. Our
officers and directors have entered into lock-up agreements under which they
have agreed not to offer or sell any shares of common stock or similar
securities for a period of 90 days from the date of this prospectus without the
prior written consent of McDonald Investments Inc. (except that we may issue or
grant additional shares, warrants or options under our employee benefit plans).
McDonald Investments Inc. may at any time waive the terms of these lock-up
agreements as specified in the underwriting agreement. Sales of substantial
amounts of common stock, or a perception that such sales could occur, and the
existence of options or warrants to purchase shares of common stock at prices
that may be below the then current market price of the common stock could
adversely affect the market price of the common stock and could impair our
ability to raise capital through the sale of our equity securities.

OUR OPERATIONS HAVE NOT BEEN PROFITABLE.

We recorded net losses for 1995, 1996, 1997, 1998, 1999 and the six months
ended June 30, 2000, of $1,929,000, $1,837,000, $3,704,000, $18,186,000,
$2,777,000 and $3,527,000, respectively. Our ability to continue in business and
maintain our financing arrangements may be adversely affected by a continued
lack of profitability.

12
<PAGE> 14

WE DO NOT PAY DIVIDENDS.

We have never declared or paid any cash dividends on our common stock and
have no intention to do so in the foreseeable future.

OUR ARTICLES OF INCORPORATION AND SHAREHOLDERS RIGHTS PLAN HAVE PROVISIONS THAT
DISCOURAGE CORPORATE TAKEOVERS AND COULD PREVENT SHAREHOLDERS FROM REALIZING A
PREMIUM ON THEIR INVESTMENT.

Our articles of incorporation contain provisions that may have the effect
of delaying or preventing a change in control. Our articles of incorporation
authorize the board of directors to issue up to 10,000,000 shares of preferred
stock without shareholder approval and to set the rights, preferences and other
designations, including voting rights, of those shares as the board may
determine. These provisions, alone or in combination with each other and with
the rights plan described below, may discourage transactions involving actual or
potential changes of control, including transactions that otherwise could
involve payment of a premium over prevailing market prices to shareholders for
their common stock. Our board of directors adopted a shareholder rights
agreement designed to enhance the board's ability to prevent an acquirer from
depriving shareholders of the long-term value of their investment and to protect
shareholders against attempts to acquire us by means of unfair or abusive
takeover tactics. However, the existence of the rights plan may impede a
takeover of us not supported by the board, including a takeover that may be
desired by a majority of our shareholders or involving a premium over the
prevailing stock price.

IN CERTAIN CIRCUMSTANCES, THE HOLDERS OF OUR SERIES B PREFERRED STOCK MAY HAVE
THE RIGHT TO ELECT MEMBERS OF OUR BOARD OF DIRECTORS.

Under the terms of our Series B Preferred Stock, if we do not pay dividends
on the Series B Preferred Stock for three quarterly dividend periods, then,
until such dividends have been paid in full, the holders of Series B Preferred
Stock have the right to elect two additional members to our board of directors.
While any such directors would not constitute a majority of our board, it is
probable that they would attempt to influence the board, as a whole, to support
the satisfaction of the claims of the holders of the Series B Preferred Stock.

13
<PAGE> 15

USE OF PROCEEDS

The net proceeds to us from the sale of the shares of common stock being
offered hereby will be $14.3 million ($16.5 million if the underwriters'
over-allotment option is exercised in full) after deducting underwriting
discounts and estimated offering expenses.

We intend to use substantially all of the net proceeds of this offering to
finance our oil and gas exploitation and development activities at East Blanco
Field in the San Juan Basin of New Mexico. A portion of the net proceeds may be
used to make strategic acquisitions of oil and gas interests. Pending
application of the net proceeds for these projects, we will invest the net
proceeds in short-term, investment grade, interest-bearing securities.

PRICE RANGE OF COMMON STOCK

Our common stock is quoted on the Nasdaq National Market under the symbol
"MLRC." The following table sets forth, for the periods indicated, the high and
low prices of the common stock as reported on the Nasdaq National Market.

<TABLE>
<CAPTION>
HIGH LOW
---- ---
<S> <C> <C>
Year Ended December 31, 1998:
First Quarter............................................. $ 9 15/32 $ 7 1/4
Second Quarter............................................ 12 7/8 9
Third Quarter............................................. 12 5/8 7 7/8
Fourth Quarter............................................ 9 1/2 6 3/8
Year Ended December 31, 1999:
First Quarter............................................. $ 8 3/4 $ 5 15/16
Second Quarter............................................ 9 7/16 5 3/4
Third Quarter............................................. 9 1/8 6 5/8
Fourth Quarter............................................ 8 1/2 4
Year Ending December 31, 2000:
First Quarter............................................. $ 6 1/4 $ 3 13/16
Second Quarter............................................ 9 3/4 5 1/4
Third Quarter (through September 27, 2000)................ 8 3/4 6 3/16
</TABLE>

On September 27, 2000, the last reported sale price of the common stock as
reported by the Nasdaq National Market was $6.625. As of September 27, 2000,
there were approximately 600 shareholders of record of the common stock.

DIVIDEND POLICY

We do not intend to pay cash dividends on our common stock in the
foreseeable future. We instead intend to retain any earnings to support our
growth. Any future cash dividends would depend on future earnings, capital
requirements, our financial condition and other factors deemed relevant by our
board of directors. Under the terms of our credit facility with Aquila Energy
Capital Corporation, we may not pay dividends without the consent of Aquila. For
a description of the credit facility, see "Management's Discussion and Analysis
of Financial Condition and Results of Operations -- Liquidity and Capital
Resources."

14
<PAGE> 16

CAPITALIZATION

The following table sets forth our consolidated capitalization as of June
30, 2000, and as adjusted to reflect application of the net proceeds from this
offering. The following table should be read in conjunction with our
Consolidated Financial Statements and the related notes and other financial
information included elsewhere in this prospectus.

<TABLE>
<CAPTION>
JUNE 30, 2000
----------------------
ACTUAL AS ADJUSTED
-------- -----------
(IN THOUSANDS)
<S> <C> <C>
Long-term debt, net of current maturities(1)................ $ 44,785 $ 44,785
Series B Mandatorily Redeemable Convertible Preferred Stock,
$0.01 par value, 500,000 shares authorized, 80,000 shares
issued and outstanding, liquidation preference and
mandatory redemption of $800,000.......................... 794 794
Mandatorily Redeemable Common Stock, $0.01 par value,
420,000 shares authorized, issued and outstanding,
mandatory redemption of $5,250,000(2)..................... 3,649 3,649
Shareholders' equity:
Common stock, $0.01 par value, 25,000,000 shares
authorized; 7,458,976 shares issued and outstanding and
9,958,976 shares as adjusted(3)........................ 75 100
Additional paid-in capital................................ 77,805 92,061
Accumulated deficit....................................... (58,644) (58,644)
Notes receivable from related party shareholders.......... (2,776) (2,776)
Accounts receivable from shareholders..................... (98) (98)
-------- --------
Total shareholders' equity........................ 16,362 30,643
-------- --------
Total capitalization.............................. $ 65,590 $ 79,871
======== ========
</TABLE>

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

(1) Long-term debt includes notes payable less unamortized discount of $2,814
and lease obligations.

(2) Represents the obligation to purchase 420,000 shares of common stock from a
shareholder for a price of $12.50 per share in September 2003.

(3) Does not include 706,103 shares of common stock issuable upon exercise of
outstanding options and warrants, or 146,479 shares of common stock, as
adjusted to reflect this offering, issuable upon conversion of our
outstanding Series B Mandatorily Redeemable Convertible Preferred Stock and
convertible note payable. See "Description of Capital Stock and Other
Securities."

15
<PAGE> 17

SELECTED CONSOLIDATED FINANCIAL DATA

The following table sets forth, for the periods and at the dates indicated,
our selected historical financial data. The financial data for each of the five
years ended December 31, 1995, 1996, 1997, 1998 and 1999 is derived from our
audited Consolidated Financial Statements. The financial data for the six months
ended June 30, 1999 and 2000 is derived from our unaudited interim consolidated
financial statements, which, in the opinion of our management, have been
prepared on the same basis as the annual Consolidated Financial Statements and
include all adjustments (consisting of only normal recurring adjustments)
necessary for a fair presentation of the financial data for such periods. The
information in this table should be read in conjunction with "Management's
Discussion and Analysis of Financial Condition and Results of Operations" and
the Consolidated Financial Statements and the notes thereto included elsewhere
in this prospectus. The results for the six month period ended June 30, 2000,
are not necessarily indicative of results for the full year.

<TABLE>
<CAPTION>
SIX MONTHS ENDED
YEAR ENDED DECEMBER 31, JUNE 30,
------------------------------------------------ -----------------
1995(1) 1996(1) 1997 1998 1999 1999 2000
------- ------- ------- -------- ------- ------- -------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C> <C> <C> <C>
Statements of Operations Data:
Revenues:
Oil and gas sales.................. $ 4,800 $ 5,854 $ 8,582 $ 13,069 $13,138 $ 5,933 $ 7,100
Other.............................. 470 512 69 109 160 45 133
------- ------- ------- -------- ------- ------- -------
5,270 6,366 8,651 13,178 13,298 5,978 7,233
------- ------- ------- -------- ------- ------- -------
Costs and expenses:
Oil and gas production............. 1,868 2,249 3,037 5,273 5,107 2,520 3,206
Mining project expenses............ 838 1,014 -- -- -- -- --
Depreciation, depletion and
amortization..................... 2,340 2,095 2,725 5,544 4,822 2,357 2,719
Impairment of oil and gas
properties....................... -- 264 24 16,842 -- -- --
Impairment of mining properties.... -- -- 350 -- -- -- --
General and administrative, net.... 1,467 1,845 2,274 2,562 2,915 1,282 2,046
Interest and other................. 433 842 701 1,143 3,126 1,162 2,789
------- ------- ------- -------- ------- ------- -------
6,946 8,309 9,111 31,364 15,970 7,321 10,760
------- ------- ------- -------- ------- ------- -------
Minority interest in loss of
consolidated subsidiary............ -- 266 -- -- -- -- --
Equity in loss of affiliate.......... -- -- (3,244) -- -- -- --
------- ------- ------- -------- ------- ------- -------
Loss before extraordinary item....... (1,676) (1,677) (3,704) (18,186) (2,672) (1,343) (3,527)
Extraordinary loss on early
retirement of debt................. (253) (160) -- -- (105) -- --
------- ------- ------- -------- ------- ------- -------
Net loss............................. (1,929) (1,837) (3,704) (18,186) (2,777) (1,343) (3,527)
Dividends on preferred stock and
accretion.......................... (360) (376) (185) (120) (120) (60) (50)
Gain on redemption of preferred
stock.............................. -- 3,743 -- -- -- -- --
Preferred stock conversion
inducement......................... -- -- (403) -- -- -- --
Accretion of mandatorily redeemable
common stock....................... -- -- -- -- (116) -- (199)
------- ------- ------- -------- ------- ------- -------
Net income (loss) attributable to
common shareholders(2)............. $(2,289) $ 1,530 $(4,292) $(18,306) $(3,013) $(1,403) $(3,776)
======= ======= ======= ======== ======= ======= =======
Per Share Data(3):
Loss attributable to common
shareholders before extraordinary
item............................. $ (1.05) $ (0.82) $ (0.92) $ (2.61) $ (0.40) $ (0.20) $ (0.48)
Extraordinary loss................. (0.13) (0.06) -- -- (0.01) -- --
------- ------- ------- -------- ------- ------- -------
Net loss attributable to common
shareholders(2).................. $ (1.18) $ (0.88) $ (0.92) $ (2.61) $ (0.41) $ (0.20) $ (0.48)
======= ======= ======= ======== ======= ======= =======
Weighted average shares
outstanding...................... 1,947 2,512 4,682 7,015 7,283 7,024 7,854
Other Data:
Capital expenditures............... $ 3,995 $ 6,339 $20,169 $ 36,354 $ 9,852 $ 3,882 $ 9,337
</TABLE>

(footnotes on following page)

16
<PAGE> 18

<TABLE>
<CAPTION>
DECEMBER 31,
----------------------------------------------- JUNE 30,
1995 1996 1997 1998 1999 2000
------- ------- ------- ------- ------- --------
<S> <C> <C> <C> <C> <C> <C>
Balance Sheet Data:
Working capital (deficit)................... $ (476) $ 5,365 $ 1,190 $(3,782) $(2,678) $(2,517)
Total assets................................ 31,635 41,400 51,426 58,452 65,426 72,120
Long-term obligations(4).................... 10,037 3,511 1 27,183 34,874 44,785
Mandatorily redeemable preferred stock...... 3,844 3,900 1,317 1,329 1,341 794
Mandatorily redeemable common stock(5)...... -- -- -- -- 3,450 3,649
Shareholders' equity........................ 11,760 21,904 40,196 22,164 19,490 16,362
</TABLE>

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

(1) The financial information for 1995 and 1996 is consolidated information that
includes the accounts of Laguna Gold Company. See Note 3 to our Consolidated
Financial Statements.

(2) The gain on the redemption of the Series A Convertible Preferred Stock in
the fourth quarter of 1996 resulted in net income attributable to common
shareholders for the year ended December 31, 1996 of $1,530,000. However,
because the Series A Stock is reflected as if converted, the gain on
redemption is deducted from net income attributable to common shareholders
for purposes of calculating per share data, resulting in a net loss
attributable to common shareholders for the year ended December 31, 1996 of
$2,213,000 or $0.88 per share.

(3) As adjusted for the four to one reverse stock split that occurred on
September 9, 1996.

(4) Long-term obligations include long-term debt net of current maturities,
unamortized discount, notes payable-other and capital lease and installment
obligations net of current portions.

(5) Represents the obligation to purchase 420,000 shares of common stock from a
shareholder for a price of $12.50 per share in September 2003.

17
<PAGE> 19

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

The following discussion is intended to assist in understanding our
historical consolidated financial position at June 30, 2000, December 31, 1999
and 1998, and results of operations and cash flows for the six months ended June
30, 2000 and 1999, and for each of the years ended December 31, 1999, 1998 and
1997. Our historical Consolidated Financial Statements and notes thereto
included elsewhere in this prospectus contain detailed information that should
be referred to in conjunction with the following discussion.

OVERVIEW

Our revenues, profitability and future growth rates will be substantially
dependent upon our drilling success in the San Juan and Delaware Basins, and
prevailing prices for oil and gas, which are in turn dependent upon numerous
factors that are beyond our control, such as economic, political and regulatory
developments and competition from other sources of energy. The energy markets
have historically been volatile, and oil and gas prices can be expected to
continue to be subject to wide fluctuations in the future. A substantial or
extended decline in oil or gas prices could have a material adverse effect on
our financial position, results of operations and access to capital, as well as
the quantities of oil and gas reserves that we may produce economically.

LIQUIDITY AND CAPITAL RESOURCES

Our operations are capital intensive. Historically, our principal sources
of capital have been cash flow from operations, long and short term debt
financing arrangements and proceeds from sales of common and preferred stock.
Our principal uses of capital have been for the exploration and development of
oil and gas properties and construction of related facilities.

During the first half of 2000, our capitalized costs incurred in oil and
gas producing activities were $8.9 million. Our 2000 capital expenditure budget
is $23.4 million. During the first half of 2000, we drilled 18 wells of the 50
wells we had planned to drill or recomplete during the year. We are currently
reevaluating our drilling program for the remainder of 2000 based on the
positive effects of commingling and the availability of drilling rigs, which
have become more difficult to secure. We expect to fund our capital requirements
for the next 12 months out of cash flow from operations, borrowings, and the
proceeds of this offering.

Although we drilled 14 wells during first quarter 2000, we delayed
completing 13 of them pending approval of commingling by the Jicarilla Apache
Tribe, which owns the land covering most of our acreage in our East Blanco
Field. The approval was granted in April 2000 and we were able to begin
completion operations in May. Most of our wells in the East Blanco Field contain
three or more pay zones at depths ranging from 1,200 to 4,000 feet. Prior to the
approval of our request to commingle, wells in the field were limited to
producing from no more than two zones at a time. By commingling the gas
production from multiple zones, we should be able to substantially increase
initial production rates and reduce drilling, completion and operating costs,
which would in turn increase the value of our reserves.

In September 1999, we established a credit agreement with Aquila. The
initial amount available under the agreement was $45.7 million, which may be
increased to as much as $60 million as new reserves are added through our
development drilling program. As of September 22, 2000, we had drawn $47.3
million, including accrued interest, under the Aquila credit agreement. In July
2000, Aquila committed to increase the amount available under the credit
agreement by $6.7 million, making the total available $52.4 million. Our planned
capital expenditures during 2000 anticipate that this increase will be available
as our drilling program proceeds. Principal payments on the four-year loan are
based on our cash flow from operations, as defined in the Aquila Credit
Agreement, less advances for our drilling program. Because we expect drilling
expenditures to equal or surpass defined cash flow from operations, we do not
anticipate making any principal payments for the next 12 months. The Aquila
Credit Agreement is secured by liens on substantially all of our oil and gas
properties. Interest on the Aquila Credit Agreement accrues at prime plus 2% and
will be added to the loan balance. The outstanding loan balance is due in full
on September 9, 2003. As part of the transaction,

18
<PAGE> 20

we also entered into a four year agency agreement with Aquila under which we pay
a marketing fee equal to 1% of the net proceeds, as defined in the Aquila Credit
Agreement, from the sale of all of our oil and gas production. In addition, we
also issued to Aquila 420,000 shares of common stock. In conjunction with
Aquila's agreement to increase the borrowing base under the Aquila Credit
Agreement in July 2000, we agreed to issue to Aquila an additional 70,000 shares
of common stock. Aquila will also have a one-time right to require us to
purchase 490,000 of our common shares from Aquila at $12.50 per share during the
30-day period beginning September 9, 2003.

In September 1999, we also entered into a five year, $5.5 million master
rental contract with Universal Compression, Inc. ("Universal Compression") to
refinance our East Blanco gas sweetening plant. The master rental contract bears
interest at an imputed rate of 12.8%. Payments under the master rental contract
commenced in September 1999. We made principal payments totaling $110,000 to
Universal Compression during 1999. During the six months ended June 30, 2000,
the Company repaid $187,000 of the lease obligation under the master rental
contract to Universal Compression.

In July 1998, we negotiated an unsecured term loan for up to $205,000 with
Bank One, Colorado, N.A. to finance the purchase of land and a building for our
field office. We drew $155,000 on this loan during 1998. Principal and interest
(at 8.5%) is payable quarterly beginning October 1, 1998. We repaid $11,000 and
$5,000 of this loan during 1999 and 1998, respectively. In March 1999, the due
date of the loan was extended from July 1999 to April 2002.

In April 2000, the Government of Costa Rica awarded us a concession to
explore for oil and natural gas on approximately 2.3 million acres in the
northeast quadrant of Costa Rica. The concession acreage is contained in six
large contiguous onshore acreage blocks. We have completed an environmental
assessment of our proposed operations and expect approval by the end of 2000. We
expect to sign final contracts thereafter. The work program will require the
expenditure of approximately $8.8 million (including the drilling of six wells)
over a three-year period, with a possible extension of three more years.

In April 2000, we redeemed 55,200 shares of our Series B Mandatorily
Redeemable Convertible Preferred Stock at the mandatory redemption price of $10
per share by issuing a convertible promissory note for $552,000 to the Series B
holder, a company in which one of our directors is also a director. Interest on
the note accrues at 11.3% and is payable quarterly beginning on June 30, 2000.
The note and all unpaid accrued interest is payable in full on April 15, 2001.
The holder of the note may at any time cause any part of the unpaid principal
and accrued interest due to be converted into shares of our common stock using
the same conversion price applicable to the remaining Series B Preferred Stock
shares, currently $10.30. After this transaction, 80,000 shares of Series B
Preferred Stock remain outstanding, all of which are required to be redeemed in
April 2001 at $10 per share. We plan to finance our redemption obligation out of
cash flow or borrowings.

19
<PAGE> 21

RESULTS OF OPERATIONS

<TABLE>
<CAPTION>
SIX MONTHS ENDED
YEAR ENDED DECEMBER 31, JUNE 30,
-------------------------- -----------------
1997 1998 1999 1999 2000
------ ------- ------- ------- -------
(IN THOUSANDS, EXCEPT PER UNIT DATA)
<S> <C> <C> <C> <C> <C>
OPERATING RESULTS FROM OIL AND GAS OPERATIONS:
Oil and gas revenues.............................. $8,582 $13,069 $13,138 $5,933 $7,100
Production tax and marketing expense.............. $1,122 $ 1,901 $ 1,682 $ 856 $1,131
Lease operating expense........................... $1,915 $ 3,372 $ 3,425 $1,664 $2,075
Depletion......................................... $2,604 $ 5,303 $ 4,319 $2,152 $2,311
Depreciation...................................... $ 21 $ 140 $ 268 $ 135 $ 122
Impairment........................................ $ 24 $16,842 $ -- $ -- $ --
NET PRODUCTION:
Natural gas (MMcf)................................ 2,350 5,852 5,600 2,989 2,662
Oil (MBbl)........................................ 196 230 172 91 84
Total (MMcfe)..................................... 3,526 7,232 6,632 3,535 3,166
AVERAGE SALES PRICE REALIZED (1):
Natural gas (per Mcf)............................. $ 2.04 $ 1.72 $ 1.81 $ 1.57 $ 1.91
Oil (per Bbl)..................................... $19.31 $ 12.99 $ 17.38 $13.64 $24.05
Per Mcfe.......................................... $ 2.43 $ 1.81 $ 1.98 $ 1.68 $ 2.24
AVERAGE COST DATA (PER MCFE):
Production tax and marketing expense.............. $ 0.32 $ 0.26 $ 0.25 $ 0.24 $ 0.36
Lease operating expense........................... $ 0.54 $ 0.47 $ 0.52 $ 0.47 $ 0.65
Depletion......................................... $ 0.74 $ 0.73 $ 0.65 $ 0.61 $ 0.73
</TABLE>

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

(1) Includes effects of hedging. For the six months ended June 30, 2000, a
natural gas hedge, which expires December 31, 2000, cost us approximately
$1,869,000, or $0.70 per Mcf produced. See "Hedging Activities."

Six Months Ended June 30, 2000 Compared with Six Months Ended June 30, 1999

Revenues. Total revenues increased 21% to $7,233,000 for the six months
ended June 30, 2000 from $5,978,000 for the six months ended June 30, 1999. Oil
and gas sales increased 20% to $7,100,000 for the six months ended June 30, 2000
from $5,933,000 for the six months ended June 30, 1999, due to higher oil and
gas prices which were somewhat offset by lower oil and gas production and the
effects of hedging. Average oil prices realized per barrel increased 76% to
$24.05 for the six months ended June 30, 2000, from $13.64 for the comparable
1999 period, and average gas prices realized per Mcf increased 22% to $1.91 in
the 2000 period from $1.57 for the six months ended June 30, 1999. Oil
production decreased 8%, to 84,000 barrels for the six months ended June 30,
2000 from 91,000 barrels for the six months ended June 30, 1999, and gas
production decreased 11% to 2,662,000 Mcf for the six months ended June 30, 2000
from 2,989,000 Mcf for the same period a year ago. The oil production decreases
are due to natural declines. We have been focusing on drilling gas wells. The
gas production declines are due to the planned delay in new well completions
pending approval of commingling, as discussed above.

Oil and Gas Production Expenses. Oil and gas production expenses, including
production tax and marketing expenses, increased 27% to $3,206,000 for the six
months ended June 30, 2000 from $2,520,000 for the comparable 1999 period, due
to new wells coming on line as a result of our drilling program. Oil and gas
production expenses per Mcfe increased $0.30, or 42%, to $1.01 for the six
months ended June 30, 2000 from $0.71 for the six months ended June 30, 1999.
Production tax and marketing expense increased $0.12 per Mcfe, or 50%, during
the six months ended June 30, 2000 as a result of higher oil and gas prices. LOE
per Mcfe for the six months ended June 30, 2000 increased 38% to $0.65 from
$0.47 for the 1999 period. The increase in LOE per Mcfe in the 2000 period is
partially due to lower production and partially due to increased personnel and
increases in salary, compression and workover costs.

20
<PAGE> 22

Depreciation, Depletion and Amortization. Depreciation, depletion and
amortization increased 15% to $2,719,000 for the six months ended June 30, 2000
from $2,357,000 for the six months ended June 30, 1999. Depletion per Mcfe
increased 20% to $0.73 for the six months ended June 30, 2000 from $0.61 for the
six months ended June 30, 1999 due to a higher ratio of increases in capital
expenditures to increases in reserves.

General and Administrative Expenses. Net general and administrative
expenses increased 60% to $2,046,000 for the six months ended June 30, 2000 from
$1,282,000 for the same period in 1999 as a result of the issuance of employee
stock options with a below market strike price and increased costs for contract
and consulting services related to special projects.

Interest and Other Expenses. Interest and other expenses increased 140% to
$2,789,000 for the six months ended June 30, 2000 from $1,162,000 for the six
months ended June 30, 1999. The increase was primarily due to a higher
outstanding debt balance and higher interest rates in the 2000 period.

Income Taxes. We incurred net operating losses for U.S. Federal income tax
purposes in 2000 and 1999, which can be carried forward to offset future taxable
income. Statement of Financial Accounting Standards No. 109 requires that a
valuation allowance be provided if it is more likely than not that some portion
or all of a deferred tax asset will not be realized. Our ability to realize the
benefit of our deferred tax asset will depend on the generation of future
taxable income through profitable operations and the expansion of our oil and
gas producing activities. The market and capital risks associated with achieving
the above requirement are considerable, resulting in our decision to provide a
valuation allowance equal to the net deferred tax asset. Accordingly, we did not
recognize any tax benefit in the consolidated statements of operations for the
six months ended June 30, 2000 and 1999.

Net Loss. Net loss increased 163% to $3,527,000 for the six months ended
June 30, 2000 from $1,343,000 for the same period a year ago, as a result of the
factors discussed above. We paid the 8% dividend of $45,000 and $54,000 on our
Series B Mandatorily Redeemable Convertible Preferred Stock ("Series B Preferred
Stock") and realized accretion of $4,000 and $6,000 during the six month periods
ended June 30, 2000 and 1999, respectively. Net loss attributable to common
shareholders increased 169% to $3,776,000 for the six months ended June 30, 2000
from $1,403,000 for the six months ended June 30, 1999.

Year Ended December 31, 1999 Compared with Year Ended December 31, 1998

Revenues. Total revenues for the year ended December 31, 1999 increased 1%
to $13,298,000 from $13,178,000 for the year ended December 31, 1998. Oil and
gas sales for the year ended December 31, 1999 increased 1% to $13,138,000 from
$13,069,000. The increase was due to higher oil and gas prices. Oil production
for the year ended December 31, 1999 decreased 25% to 172,000 barrels from
230,000 barrels for the year ended December 31, 1998 and gas production for the
year ended December 31, 1999 decreased 4% to 5,600,000 Mcf from 5,852,000 Mcf
for the year ended December 31, 1998. Production for 1999 was down from 1998
because our 1999 drilling and recompletion program was delayed pending the
receipt of additional financing, which we received in September 1999. During
fourth quarter 1999, we drilled or recompleted 19 wells with funds from the
refinancing. Production decreases were offset by increases in average oil and
gas prices realized in 1999 from those realized in 1998. Average oil prices for
the year ended December 31, 1999 increased 34% to $17.38 per barrel from $12.99
per barrel for the year ended December 31, 1998 and average gas prices for the
year ended December 31, 1999 increased 5% to $1.81 per Mcf from $1.72 per Mcf
for the year ended December 31, 1998.

Oil and Gas Production Expenses. Oil and gas production expenses for the
year ended December 31, 1999 decreased 3% to $5,107,000 from $5,273,000 for the
year ended December 31, 1998. The decrease was primarily attributable to
one-time production tax credits. Production tax and marketing expense per Mcfe
decreased $.01, or 4%, to $0.25 for the year ended December 31, 1999 from $0.26
for the year ended December 31, 1998. Lease operating expense per Mcfe increased
$0.05, or 11%, to $0.52 for the year ended December 31, 1999 from $0.47 for the
year ended December 31, 1998. Our lease operating expense per Mcfe in 1999 is
higher primarily due to workovers.

21
<PAGE> 23

Depreciation, Depletion and Amortization. Depreciation, depletion and
amortization for the year ended December 31, 1999 decreased 13% to $4,822,000
from $5,544,000 for the year ended December 31, 1998, primarily due to lower
depletion expense. Depletion per Mcfe for the year ended December 31, 1999
decreased 11% to $0.65 from $0.73 for the year ended December 31, 1998, due
primarily to a lower cost base resulting from the write-down of oil and gas
properties of $16.8 million in fourth quarter 1998, discussed below.

Impairment of Oil and Gas Properties. Under the full cost accounting rules
of the Securities and Exchange Commission (the "Commission"), we review the
carrying value of our oil and gas properties each quarter on a
country-by-country basis. Net capitalized costs of oil and gas properties, less
related deferred income taxes, may not exceed the present value of estimated
future net revenues from proved reserves, discounted at 10%, plus the lower of
cost or fair market value of unproved properties, as adjusted for related tax
effects. Application of these rules generally requires pricing future production
at the unescalated oil and gas prices in effect at the end of each fiscal
quarter and requires a write-down if the "ceiling" is exceeded, even if prices
declined for only a short period of time. We made a non-cash charge in fourth
quarter 1998 to write down our U.S. oil and gas properties by $16,842,000. In
applying the "ceiling test," we used December 31, 1998 oil and gas prices of
$10.03 per barrel of oil and $1.43 per Mcf of gas. We currently operate only in
the continental United States.

General and Administrative Expenses. General and administrative expenses
for the year ended December 31, 1999 increased 14% to $2,915,000 from $2,562,000
for the year ended December 31, 1998. The increase is primarily due to stock
compensation expense of $217,000 recognized in fourth quarter 1999 related to
the extension of the expiration date of certain warrants to purchase our common
stock. In addition, in fourth quarter of 1999 we expensed $177,000 of costs
related to an equity offering which we did not consummate.

Interest and Other Expenses. Interest and other expenses for the year ended
December 31, 1999 increased 173% to $3,126,000 from $1,143,000 for the year
ended December 31, 1998. The increase is primarily due to higher outstanding
borrowings.

Income Taxes. We incurred net operating losses for U.S. Federal income tax
purposes in 1999 and 1998, which can be carried forward to offset future taxable
income. Statement of Financial Accounting Standards No. 109 requires that a
valuation allowance be provided if it is more likely than not that some portion
or all of a deferred tax asset will not be realized. Our ability to realize the
benefit of our deferred tax asset will depend on the generation of future
taxable income through profitable operations and the expansion of our oil and
gas producing activities. The market and capital risks associated with achieving
the above requirement are considerable, resulting in our decision to provide a
valuation allowance equal to the net deferred tax asset. Accordingly, we did not
recognize any tax benefit in our consolidated statements of operations for the
years ended December 31, 1999 and 1998. At December 31, 1999, we had a net
operating loss carryforward for U.S. Federal income tax purposes of $28,000,000,
which will begin to expire in 2001.

Extraordinary Loss. We incurred an extraordinary loss of $105,000 during
the year ended December 31, 1999, as a result of the refinancing of our debt
with a new lender.

Net Loss. Net loss for the year ended December 31, 1999 decreased 85% to
$2,777,000 from $18,186,000 for the year ended December 31, 1998 as a result of
the factors discussed above. The net loss for the year ended December 31, 1998,
includes $16,842,000 relating to a non-cash writedown of oil and gas properties
discussed above. We paid the 8% dividend of $108,000 on $1,341,000 and
$1,329,000 face amount Series B Mandatorily Redeemable Convertible Preferred
Stock in each of the years ended December 31, 1999 and 1998, respectively, and
realized accretion of $12,000 in each year. In 1999, we issued 420,000 shares of
mandatorily redeemable common stock, in conjunction with a refinancing. The
difference between the value of the shares at the redemption price of $12.50 per
share and the market value of the shares at the date of issuance will be
accreted over a period of 49 months. During 1999, we realized accretion of
$116,000 related to these shares. Net loss attributable to common shareholders
for the year ended December 31, 1999 was $3,013,000 compared to net loss
attributable to common shareholders of $18,306,000 for the year ended December
31, 1998.
22
<PAGE> 24

Year Ended December 31, 1998 Compared to Year Ended December 31, 1997

Revenues. Total revenues for the year ended December 31, 1998 increased 52%
to $13,178,000 from $8,651,000 for the year ended December 31, 1997. Oil and gas
sales for the year ended December 31, 1998 increased 52% to $13,069,000 from
$8,582,000. The increase was due to higher oil and gas production due to our
drilling and recompletion program in 1998. Oil production for the year ended
December 31, 1998 increased 17% to 230,000 barrels from 196,000 barrels for the
year ended December 31, 1997 and gas production for the year ended December 31,
1998 increased 149% to 5,852,000 Mcf from 2,350,000 Mcf for the year ended
December 31, 1997. These increases were somewhat offset by a decline in average
oil and gas prices realized in 1998 from those realized in 1997. Average oil
prices for the year ended December 31, 1998 decreased 33% to $12.99 per barrel
from $19.31 per barrel for the year ended December 31, 1997 and average gas
prices for the year ended December 31, 1998 decreased 16% to $1.72 per Mcf from
$2.04 per Mcf for the year ended December 31, 1997.

Oil and Gas Production Expenses. Oil and gas production expenses for the
year ended December 31, 1998 increased 74% to $5,273,000 from $3,037,000 for the
year ended December 31, 1997. The increase was primarily attributable to
increased operating costs related to new wells drilled in 1998 and expansion and
operation of our gas sweetening plant. Production tax and marketing expense per
Mcfe decreased $0.06, or 19%, to $0.26 for the year ended December 31, 1998 from
$0.32 for the year ended December 31, 1997. Lease operating expense per Mcfe
decreased $0.07, or 13%, to $0.47 for the year ended December 31, 1998 from
$0.54 for the year ended December 31, 1997. Our lease operating expense per Mcfe
in 1998 is lower due to higher average production rates per well for new wells
and a higher proportion of gas production in 1998, which is less costly to
produce than oil.

Depreciation, Depletion and Amortization. Depreciation, depletion and
amortization for the year ended December 31, 1998 increased 103% to $5,544,000
from $2,725,000 for the year ended December 31, 1997 due to increased oil and
gas production. Depletion per Mcfe for the year ended December 31, 1998
decreased slightly to $0.73 from $0.74 for the year ended December 31, 1997, due
to a higher ratio of reserve increases to capital expenditures in 1998. Due to
the impairment of oil and gas properties in fourth quarter 1998, discussed
below, the depletion rate per Mcfe is expected to decline in future periods.

Impairment of Oil and Gas Properties. Impairment of oil and gas properties
was $16,842,000 for the year ended December 31, 1998 compared to $24,000 for the
year ended December 31, 1997. Under the full cost accounting rules of the
Commission, we review the carrying value of our oil and gas properties each
quarter on a country-by-country basis. Net capitalized costs of oil and gas
properties, less related deferred income taxes, may not exceed the present value
of estimated future net revenues from proved reserves, discounted at 10%, plus
the lower of cost or fair market value of unproved properties, as adjusted for
related tax effects. Application of these rules generally requires pricing
future production at the unescalated oil and gas prices in effect at the end of
each fiscal quarter and requires a write-down if the "ceiling" is exceeded. We
recorded a non-cash charge in fourth quarter 1998 to write down our oil and gas
properties by $16,842,000. In applying the "ceiling test," we used December 31,
1998 oil and gas prices of $10.03 per barrel of oil and $1.43 per Mcf of gas.
The full cost ceiling is not intended to represent an estimate of the fair
market value of our oil and gas properties. It is possible that we may incur
additional ceiling test write-downs in the future. The impairment amount of
$24,000 in 1997 relates to additional charges that came in after we impaired the
costs incurred in 1996 related to an exploration venture in Belize, which
drilled a dry hole. We currently operate only in the continental United States.

Impairment of Mining Properties. In second quarter 1997, we reduced a note
receivable from Laguna Gold Company ("Laguna"), at the time our majority-owned
consolidated subsidiary, by $350,000, including accrued interest, in exchange
for an overriding royalty interest in Laguna's mineral properties. Due to
continued depressed gold prices, in fourth quarter 1997, we impaired this
amount.

General and Administrative Expenses. General and administrative expenses
for the year ended December 31, 1998 increased 13% to $2,562,000 from $2,274,000
for the year ended December 31, 1997 due to the hiring of additional personnel
because of expanded operations. For the year ended December 31, 1998,

23
<PAGE> 25

we capitalized $884,000 more of general and administrative expenses directly
related to our drilling program than was capitalized for the year ended December
31, 1997.

Interest and Other Expenses. Interest and other expenses for the year ended
December 31, 1998 increased 63% to $1,143,000 from $701,000 for the year ended
December 31, 1997. The increase is primarily due to higher outstanding
borrowings under our revolving line of credit and term loans in 1998.

Equity in Loss of Affiliate. As a result of reducing our ownership interest
in Laguna, for the years ended December 31, 1998 and 1997, we accounted for our
investment in Laguna using the equity method of accounting. Our share of
Laguna's 1997 net loss was in excess of the carrying value of our investment in
and advances to Laguna by $2,733,000. Our share of Laguna's 1997 losses, up to
the carrying amount of our investment in and advances to Laguna, totaled
$3,244,000. We will not reflect our share of Laguna's future losses and may only
reflect our share of Laguna's future earnings to the extent that they exceed our
share of Laguna's 1997 and future net losses not recognized.

Income Taxes. We incurred net operating losses for U.S. Federal income tax
purposes in 1998 and 1997, which can be carried forward to offset future taxable
income. Statement of Financial Accounting Standards No. 109 requires that a
valuation allowance be provided if it is more likely than not that some portion
or all of a deferred tax asset will not be realized. Our ability to realize the
benefit of our deferred tax asset will depend on the generation of future
taxable income through profitable operations and the expansion of our oil and
gas producing activities. The market and capital risks associated with achieving
the above requirement are considerable, resulting in our decision to provide a
valuation allowance equal to the net deferred tax asset. Accordingly, we did not
recognize any tax benefit in our consolidated statement of operations for the
years ended December 31, 1998 and 1997. At December 31, 1998, we had a net
operating loss carryforward for U.S. Federal income tax purposes of $19,000,000,
which will begin to expire in 2001.

Net Loss. Net loss for the year ended December 31, 1998 increased 391% to
$18,186,000 from $3,704,000 for the year ended December 31, 1997 as a result of
the factors discussed above. Of the net loss for the year ended December 31,
1998, $16,842,000 relates to a non-cash writedown of oil and gas properties
discussed above. Of the net loss for the year ended December 31, 1997,
$3,634,000 relates to Laguna losses and impairments. As discussed above, we will
not reflect our share of Laguna's losses in the future and may only reflect our
share of Laguna's future earnings to the extent that they exceed our share of
Laguna's 1997 and future losses not recognized. We paid the 8% dividend of
$108,000 and $161,000 on our $1,329,000 and $1,317,000 face amount Series B
Mandatorily Redeemable Convertible Preferred Stock in each of the years ended
December 31, 1998 and 1997, respectively, and realized accretion of $12,000 and
$24,000, respectively. Beginning in April 1997, preferred dividend payments were
reduced as a result of the conversion into common stock and redemption of Series
B Preferred Stock, as discussed in Note 6 of the consolidated financial
statements. The excess of the fair value of the common stock issued at the $9.00
conversion price over the fair value of the common stock that would have been
issued at the $11.31 conversion price, totaling $403,000, has been reflected on
the consolidated statement of operations for the year ended December 31, 1997 as
an increase to the net loss attributable to common shareholders. Net loss
attributable to common shareholders for the year ended December 31, 1998 was
$18,306,000 compared to net loss attributable to common shareholders of
$4,292,000 for the year ended December 31, 1997.

HEDGING ACTIVITIES

We use hedging instruments to manage commodity price risks. We have used
energy swaps and other financial arrangements to hedge against the effects of
fluctuations in the sales prices for oil and natural gas. Gains and losses on
such transactions are matched to product sales and charged or credited to oil
and gas sales when that product is sold. Management believes that the use of
various hedging arrangements can be a prudent means of protecting our financial
interests from the volatility of oil and gas prices. Under our Aquila Credit
Agreement, we may be required to maintain price hedging arrangements in place
with respect to up to 65% of our oil and gas production upon terms satisfactory
to us and Aquila. We recognized hedging (losses) gains of $(2,186,000) and
$379,000 in the six months ended June 30, 2000 and 1999, respectively. These
amounts are included in oil and gas sales in our consolidated statements of
operations.

24
<PAGE> 26

COMMODITY PRICE RISK

We use commodity derivative financial instruments, including swaps, to
reduce the effect of natural gas price volatility on a portion of our natural
gas production. Commodity swap agreements are generally used to fix a price at
the natural gas market location or to fix a price differential between the price
of natural gas at Henry Hub and the price of gas at its market location.
Settlements are based on the difference between a fixed and a variable price as
specified in the agreement. The following table summarizes our derivative
financial instrument position on our natural gas and crude oil production as of
June 30, 2000. The fair value of these instruments reflected below is the
estimated amount that we would receive (or pay) to settle the contracts as of
June 30, 2000. Actual settlement of these instruments when they mature will
differ from these estimates reflected in the table. Gains or losses realized
from these instruments hedging our production are expected to be offset by
changes in the actual sales price received by us for our natural gas and crude
oil production. See "Hedging Activities" above.

NATURAL GAS:

<TABLE>
<CAPTION>
FIXED PRICE
YEAR MMBTU PER MMBTU FAIR VALUE
---- --------- ----------- -----------
<S> <C> <C> <C>
2000.............................................. 2,700,000 $2.02 $(5,666,000)
2001.............................................. 1,452,000 $2.55 $(1,582,000)
2002.............................................. 1,188,000 $2.55 $ (602,000)
2003.............................................. 996,000 $2.55 $ (302,000)
2004.............................................. 852,000 $2.55 $ (197,000)
</TABLE>

CRUDE OIL:

<TABLE>
<CAPTION>
FIXED PRICE
YEAR BBLS PER BBL FAIR VALUE
---- ------ ------------- ----------
<S> <C> <C> <C>
2000.............................................. 42,000 $18.73-$19.68 $(499,000)
2001.............................................. 60,000 $17.38-$18.61 $(495,000)
2002.............................................. 60,000 $17.40 $(340,000)
2003.............................................. 48,000 $17.40 $(181,000)
2004.............................................. 48,000 $17.40 $(115,000)
</TABLE>

Under the Aquila Credit Agreement, we may be required to maintain price
hedging arrangements in place with respect to up to 65% of our oil and gas
production. Accordingly, the instruments described above include agreements to
hedge a total of 258,000 barrels of oil related to production for the remainder
of 2000-2004 at fixed prices ranging from $17.38-$19.68 per barrel and to hedge
a total of 7,188,000 MMBtu of gas related to production for the remainder of
2000-2004 at fixed prices ranging from $2.02-$2.55 per MMBtu. In addition, we
entered into a basis swap to fix the differential between the NYMEX price and
the index price at which the hedged gas is to be sold for 4,488,000 MMBtu for
2001-2004 with a fair value of $(137,000).

In August 2000, we entered into an agreement to hedge an additional
1,310,000 MMBtu of gas related to production for 2001-2002 at fixed prices
ranging from $3.27 - $4.68 per MMBtu. In addition, we entered into a basis swap
to fix the differential between the NYMEX price and the index price at which
this hedged gas is to be sold.

25
<PAGE> 27

INTEREST RATE RISK

The table below provides information about our financial instruments
sensitive to changes in interest rates, including debt obligations at June 30,
2000. The table presents principal cash flows and related weighted average
interest rates by expected maturity dates.

EXPECTED MATURITY
(IN THOUSANDS)

<TABLE>
<CAPTION>
2000 2001 2002 2003 2004 THEREAFTER FAIR VALUE
----- ----- ----- ------- ------ ---------- ----------
<S> <C> <C> <C> <C> <C> <C> <C>
Long-term debt:
Fixed rate.................... $ 204 $ 455 $ 609 $ 569 $3,497 -- $ 5,334
Average interest rate......... 12.7% 12.7% 12.1% 12.8% 12.8% --
Variable rate................. $ -- $ -- $ -- $42,692 $ -- -- $42,692
Average interest rate......... -- -- -- 11.5% -- --
</TABLE>

MISCELLANEOUS

Our oil and gas operations are significantly affected by certain provisions
of the Internal Revenue Code that are applicable to the oil and gas industry.
Current law permits our intangible drilling and development costs to be deducted
currently, or capitalized and amortized over a five year period. We, as an
independent producer, are also entitled to a deduction for percentage depletion
with respect to the first 1,000 Bbls per day of domestic crude oil (and/or
equivalent units of domestic natural gas) produced (if such percentage depletion
exceeds cost depletion). Generally, this deduction is 15% of gross income from
an oil and gas property, without reference to the taxpayer's basis in the
property. The percentage depletion deduction may not exceed 100% of the taxable
income from a given property. Further, percentage depletion is limited in the
aggregate to 65% of our taxable income. Any depletion disallowed under the 65%
limitation, however, may be carried over indefinitely.

Inflation has not historically had a material impact on our financial
statements, and management does not believe that we will be materially more or
less sensitive to the effects of inflation than other companies in the oil and
gas industry.

26
<PAGE> 28

BUSINESS AND PROPERTIES

GENERAL HISTORY

We are an independent energy company engaged in oil and natural gas
exploration, development and production. We conduct our operations through our
wholly-owned subsidiary, Mallon Oil Company. We operate primarily in the State
of New Mexico where substantially all of our estimated proved reserves are
located in the San Juan and Delaware Basins. We have accumulated significant
acreage positions in these two basins, in which we have been active since 1982.
We believe our technical and operational experience and our database of
information enable us to effectively exploit and develop our properties.

BUSINESS STRATEGIES

Our primary business objective is to increase our proven oil and gas
reserves and cash flows. We pursue this objective by:

- Conducting Exploration through Exploitation. Our primary operating
strategy is to increase our proved reserves through relatively low-risk
activities such as development drilling, recompletions, multi-zone
completions and enhanced recovery activities. Numerous potentially
productive geologic formations tend to be stacked atop one another in the
San Juan and Delaware Basins. This allows us to target multiple potential
pay zones in most wells, thus reducing drilling risks, and to conduct
exploration operations in conjunction with our development drilling.
Wells drilled to one horizon offer opportunities to examine up-hole zones
or can be drilled to deeper prospective formations for relatively little
additional cost. The recent increases in our estimated proved reserves
and rates of production are attributable primarily to oil and gas fields
discovered or extended by our exploration through exploitation
activities.

- Controlling Our Operations. For the year ended December 31, 1999,
approximately 91% of our production was from properties that we operate.
We believe that this level of operating control, combined with our
operating experience in the San Juan and Delaware Basins, allow us to
better control ongoing operations and costs, field development decisions,
and the timing and nature of capital expenditures.

- Developing and Controlling Our Infrastructure. By owning and controlling
our critical infrastructure, such as gas gathering systems gas sweetening
plants and saltwater disposal facilities, we believe that we can reduce
costs. We continue to consider plans to construct our own pipeline to
deliver our East Blanco natural gas production to a main line
approximately 50 miles from the field, in order to reduce transportation
charges. However, we have no immediate plans to do so and we will not use
the proceeds of this offering for such purpose.

- Making Strategic Acquisitions. We also make acquisitions of properties
located within our core areas of operations. We believe that our
knowledge of the San Juan and Delaware Basins allow us to effectively
identify and evaluate acquisition opportunities.

HISTORICAL HIGHLIGHTS

In September 1993, we purchased our core group of Delaware Basin properties
from Pennzoil Exploration and Production Company. In January 1997, we acquired
additional interests in our key San Juan Basin gas property, East Blanco Field,
and became operator of the field. In October 1996 and December 1997, we
completed public financings in which we sold an aggregate of 4.6 million shares
of our common stock for combined net proceeds of $32.8 million. These financings
enabled us to accelerate the pace of our development of our inventory of oil and
gas properties.

In early 1999, we began testing the southern portion of our East Blanco
acreage in an effort to extend the field limits. We have now drilled a total of
20 wells in this effort, which has successfully confirmed that East Blanco Field
extends to the south. Based on our operations to date, we have identified more
than 200

27
<PAGE> 29

remaining drilling and recompletion opportunities on our East Blanco acreage. In
addition, we currently have an application pending to acquire another 31,360
acres contiguous to our existing East Blanco acreage.

OUR OIL AND GAS PROPERTIES

We are active in the San Juan Basin of northwestern New Mexico and in the
Delaware Basin of southeastern New Mexico. At June 30, 2000, these areas
accounted for substantially all of our estimated proved reserves, with 82.4 Bcfe
attributable to our San Juan Basin properties and 42.4 Bcfe attributable to our
Delaware Basin properties.

SAN JUAN BASIN, NORTHWESTERN NEW MEXICO

We have been active in the San Juan Basin since 1984, where our primary
area of interest is our East Blanco natural gas field. We own interests in
approximately 67,830 gross (64,820 net) acres of oil and gas properties in the
San Juan Basin. Wells on this acreage produce from a variety of zones in the San
Jose, Nacimiento, Ojo Alamo, Pictured Cliffs, Mesaverde, Mancos and Dakota
formations. We are actively involved in efforts to acquire additional acreage in
the East Blanco area and other portions of the San Juan Basin.

East Blanco Field, Rio Arriba County, New Mexico

We took over operation of East Blanco natural gas field on the eastern
flank of the San Juan Basin in 1997. We own interests in approximately 60,760
contiguous gross (59,860 net) acres in the field, 39,360 of which we acquired in
1998. Our drilling activities at East Blanco have established commercial natural
gas production from the San Jose, Ojo Alamo, Nacimiento, and Pictured Cliffs
formations. The San Jose Formation is at approximately 1,500 feet, the
Nacimiento Formation is at approximately 2,000 feet, the Ojo Alamo Sandstone is
at approximately 3,000 feet, and the Pictured Cliffs Sandstone is at
approximately 4,000 feet. Many of our wells also penetrate the Fruitland Coal
Formation at approximately 3,800 feet. East Blanco wells typically contain
reserves in one or more productive zones. We operate all of our 110 wells in the
field, with an average working interest of 95% and an average net revenue
interest of 75%. All production in the field has been natural gas. At June 30,
2000, the estimated proved reserves net to our interest at East Blanco were 80.3
Bcfe, or 64% of our total estimated proved reserves.

Since early 1999, we have drilled 20 wells on what we believe is field
extension acreage we acquired under a Minerals Development Agreement with the
Jicarilla Apache Tribe. The wells have encountered commercial quantities of
natural gas, which we believe confirms that East Blanco Field extends onto the
new acreage. Under the terms of the agreement by which we obtained the acreage,
we are required to drill at least two wells in each of the four acreage tracts
covered by the agreement each year in order to retain our interests in all of
the acreage. Based on our operations to date, we have identified more than 200
remaining drilling and recompletion opportunities on our East Blanco acreage,
all of which contain multiple targets. In addition, we currently have an
application pending to acquire another 31,360 acres contiguous to our existing
East Blanco acreage. We intend to continue the aggressive development of this
field.

28
<PAGE> 30

gas from the Fruitland Coal in the unit adjacent to East Blanco Field. We are
seeking joint venture partners who can provide both capital and expertise to
help develop our potential Fruitland Coal methane.

Other San Juan Basin Fields

Gavilan Field, Rio Arriba County, New Mexico. We own and operate seven
wells in this field, in which our average working interest is 38%. We have
leasehold interests in approximately 2,440 gross (1,260 net) acres in this
field. Current production is primarily natural gas from the Mancos Shale at
approximately 6,900 feet and from the Mesaverde Formation at approximately 5,400
feet. In 2000, we plan to recomplete additional wells in this field in the
Mesaverde. As of June 30, 2000, Gavilan Field contained 2.0 Bcfe or 2% of our
total estimated proved reserves.

Otero Field, Rio Arriba County, New Mexico. We own and operate three wells
in this field, in which our average working interest is 80%. We have leasehold
interests in approximately 4,620 gross (3,700 net) acres in this field. The
wells produce oil from the Mancos Shale at approximately 4,700 feet. As of
December 31, 1999, Otero Field contained only a nominal portion of our total
estimated proved reserves.

DELAWARE BASIN, SOUTHEASTERN NEW MEXICO

The Delaware Basin of southeast New Mexico, where we own interests in
approximately 34,050 gross (13,170 net) acres, containing 181 gross (62 net)
wells, has been an area of significant activity for us since 1982. Our Delaware
Basin properties are located primarily in fields with established production
histories, which typically contain multiple productive geologic formations and
zones. Our wells in the Delaware Basin produce from a variety of formations, the
principal of which are the Cherry Canyon, Brushy Canyon, Bone Spring, Strawn and
Morrow Formations. The Cherry Canyon, Brushy Canyon and Bone Spring Formations
primarily produce oil at shallow to medium drilling depths, while the deeper
Strawn and Morrow generally produce natural gas. Our primary properties in the
Delaware Basin are in the White City, Black River, South Carlsbad, Lea
Northeast, and Quail Ridge Fields. We also continue to assess potential in our
Shipp, Lovington Northeast and Brushy Draw properties. Based upon our operations
to date, we have identified 76 drilling locations on our Delaware Basin acreage.

White City, Black River, and Carlsbad Fields, Eddy County, New Mexico. We
have leasehold interests in 8,480 gross (4,560 net) acres in these adjacent
fields. They were the focus of much of our recompletion and development
activities from 1993 through 1997. As of June 30, 2000, our estimated proved
reserves in these three fields were 18.8 Bcfe, or 15% of our total estimated
proved reserves. Because greater drilling densities were recently approved in
this area, much of our developed acreage in these fields now contain additional
drilling opportunities for Morrow Formation natural gas.

Lea Northeast Field, Lea County, New Mexico. We own and operate
approximately 560 gross (320 net) acres in this field. Our working interest
averages 71% in this field. Our Cherry Canyon play in this field began in 1994.
During 2000, we plan to initiate a pilot waterflood project in this field. As of
June 30, 2000, our estimated proved reserves in Lea Northeast Field were 3.5
Bcfe or 3% of our total estimated proved reserves.

Quail Ridge, Lea County, New Mexico. Adjacent to Lea Northeast, we control
an approximate 4,450 gross (2,175 net) acre block on which we operate wells
producing from the Bone Spring and Morrow. The Quail Ridge Field has primarily
produced gas from the Morrow at depths of approximately 13,500 feet. We
currently have an interest in 11 wells in this area and operate six of them. We
control an approximate 55% working interest in this acreage. As of June 30,
2000, our estimated proved reserves in Quail Ridge Field were 11.1 Bcfe or 9% of
our total estimated proved reserves. Because greater drilling densities were
recently approved in this area, much of our developed acreage in this field now
offers additional drilling opportunities for Morrow Formation natural gas. Our
acreage also has additional Bone Spring Formation drilling opportunities.

Shipp and Lovington Northeast Fields, Lea County, New Mexico. Shipp and
Lovington Fields are comprised of a collection of individual reservoirs, or
algal mounds, in a Strawn Formation interval at depths

29
<PAGE> 31

of approximately 11,500 feet. The mounds range in size from 100 to 700 acres. We
have interests in 30 wells and operate 20 wells in these adjacent fields. During
1996, we initiated a low cost pilot waterflood project on one of these mounds,
which has yet to show a significant response. Our working interest averages 41%
in Lovington Northeast and 63% in Shipp. As of June 30, 2000, these fields
contained only a nominal portion of our total estimated proved reserves.

Brushy Draw Field, Eddy County, New Mexico. Our initial drilling and field
development began here in 1982. Current production is from the base of the
Cherry Canyon Formation, at a depth of approximately 5,000 feet. We operate 14
wells with an average working interest of 66%. As of June 30, 2000, Brushy Draw
Field contained only a nominal portion of our total estimated proved reserves.

OTHER AREAS

All of our oil and gas operations are currently conducted on-shore in the
United States. In addition to the properties described above, we have properties
in the states of Colorado, Oklahoma, Wyoming, North Dakota and Alabama. While we
intend to continue to produce our existing wells in those states, we currently
do not expect to engage in any development activities in those areas.

GAS SWEETENING PLANT

We designed, constructed, own and operate an amine plant to remove the
hydrogen sulfide from the gas produced at East Blanco. This plant treats
substantially all of the natural gas we produce at East Blanco. The plant's
current capacity is 32 MMcf per day. With added compression, the plant's
capacity can be increased to approximately 60 MMcf per day, without requiring
substantial expansion.

ACREAGE

The following table summarizes our oil and gas acreage holdings as of June
30, 2000:

<TABLE>
<CAPTION>
DEVELOPED UNDEVELOPED
--------------- ---------------
AREA GROSS NET GROSS NET
---- ------ ------ ------ ------
<S> <C> <C> <C> <C>
San Juan Basin..................................... 20,151 17,488 47,676 47,333
Delaware Basin..................................... 28,046 9,224 6,000 3,943
Other.............................................. 10,979 1,096 1,927 324
------ ------ ------ ------
Total.................................... 59,176 27,808 55,603 51,600
====== ====== ====== ======
</TABLE>

DRILLING ACTIVITY

The following table sets forth our development drilling activities for each
of the last three years and for 2000 through June 30:

<TABLE>
<CAPTION>
GROSS WELLS NET WELLS
------------------------ -------------------------
PRODUCTIVE DRY TOTAL PRODUCTIVE DRY TOTAL
---------- --- ----- ---------- ---- -----
<S> <C> <C> <C> <C> <C> <C>
1997(1).............................. 23 3 26 12.99 0.84 13.83
1998(2)(3)........................... 37 7 44 32.64 5.59 38.23
1999(4).............................. 21 1 22 18.05 1.00 19.05
2000................................. 17 1 18 16.67 1 17.67
</TABLE>

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

(1) Includes 1 gross (0.0225 net) dry exploratory well.

30
<PAGE> 32

(2) Includes 2 gross (2 net) dry exploratory wells.

(3) Includes 3 gross (3 net) productive exploratory wells.

(4) Includes 3 gross (3 net) productive exploratory wells.

RECOMPLETION ACTIVITY

The following table contains information concerning our well recompletion
activities for each of the last three years and for 2000 through June 30:

<TABLE>
<CAPTION>
GROSS WELLS NET WELLS
------------------------ -------------------------
PRODUCTIVE DRY TOTAL PRODUCTIVE DRY TOTAL
---------- --- ----- ---------- ---- -----
<S> <C> <C> <C> <C> <C> <C>
1997................................. 19 3 22 13.76 1.90 15.66
1998................................. 28 2 30 25.10 1.83 26.93
1999(1).............................. 6 1 7 5.67 0.92 6.59
2000................................. 0 0 0 0 0 0
</TABLE>

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

(1) Includes 1 gross (1 net) productive exploratory well.

PRODUCTIVE WELLS

The following table summarizes our gross and net interests in productive
wells at June 30, 2000. Net interests represented in the table are net "working
interests" which bear the cost of operations.

<TABLE>
<CAPTION>
GROSS WELLS NET WELLS
--------------------- ------------------------
NATURAL NATURAL
OIL GAS TOTAL OIL GAS TOTAL
--- ------- ----- ----- ------- ------
<S> <C> <C> <C> <C> <C> <C>
San Juan Basin........................ 4 112 116 3.32 101.09 104.41
Delaware Basin........................ 111 70 181 47.53 14.64 62.17
Other................................. 13 8 21 0.75 0.64 1.39
--- --- --- ----- ------ ------
Total....................... 128 190 318 51.89 116.37 167.97
=== === === ===== ====== ======
</TABLE>

In addition, we own interests in four waterflood units in the Delaware
Basin, which contain a total of 550 gross wells (8.5 net wells), and 6 gross
(3.31 net) salt water disposal wells.

MARKETING

Our natural gas is generally sold on the spot market or pursuant to
short-term contracts. Oil and liquids are generally sold on the open market to
unaffiliated purchasers, generally pursuant to purchase contracts that are
cancelable on 30 days notice. The price paid for this production is generally an
established or posted price that is offered to all producers in the field, plus
any applicable differentials. Prices paid for crude oil and natural gas
fluctuate substantially.

Because future prices are difficult to predict, we hedge a portion of our
oil and gas sales to protect against market downturns. The nature of hedging
transactions is such that producers forego the benefit of some price increases
that may occur after the hedging arrangement is in place. We nevertheless
believe that hedging is prudent in certain circumstances in order to minimize
the risk of falling prices. Under the Aquila Credit Agreement, we are required
to maintain price hedging arrangements in place with respect to up to 65% of our
oil and gas production. In addition, we also entered into an agency agreement
with Aquila under which we pay a marketing fee equal to 1% of the net proceeds,
as defined, from the sale of our oil and gas production.

31
<PAGE> 33

MANAGEMENT

CORPORATE OFFICES; OFFICERS, DIRECTORS AND KEY EMPLOYEES

Our executive offices are located at 999 18th Street, Suite 1700, Denver,
Colorado 80202, where our phone number is (303) 293-2333. We employ 21 employees
at this office. We maintain field operations offices in Durango, Colorado, and
in Carlsbad, New Mexico, where we employ a total of 21 individuals.

The following are the members of Mallon's board of directors and its
executive officers:

<TABLE>
<CAPTION>
NAME AGE TITLE(S)
---- --- --------
<S> <C> <C>
George O. Mallon, Jr. ................ 56 Director, Chairman of the Board, CEO
and President
Kevin M. Fitzgerald................... 45 Director, COO and Executive Vice
President
Roy K. Ross........................... 49 Director, Executive Vice President,
Secretary and General Counsel
Frank Douglass........................ 66 Director
Roger R. Mitchell..................... 67 Director
Francis J. Reinhardt, Jr. ............ 70 Director
Peter H. Blum......................... 43 Director
Alfonso R. Lopez...................... 51 Vice President -- Finance and
Treasurer
</TABLE>

The directors serve until the next annual meeting of shareholders.
Following are brief descriptions of the business experience of our directors and
executive officers:

George O. Mallon, Jr. has been the President and Chairman of the Board of
Mallon since December 1988, when it was organized. He formed Mallon Oil in 1979
and was a co-founder of Laguna Gold Company in 1980. Mr. Mallon earned a B.S.
degree in Business from the University of Alabama in 1965 and an M.B.A. degree
from the University of Colorado in 1977.

Kevin M. Fitzgerald has been Executive Vice President of Mallon since June
1990. He joined Mallon Oil in 1983 as Petroleum Engineer and served as Vice
President of Engineering from 1987 through December 1988, when he became
President of Mallon Oil and a Vice President of Mallon. Mr. Fitzgerald earned a
B.S. degree in Petroleum Engineering from the University of Oklahoma in 1978.

Roy K. Ross has been Executive Vice President and General Counsel of Mallon
since 1992. He was named Secretary of Mallon in 1997. From June 1976 through
September 1992, Mr. Ross was an attorney in private practice with the
Denver-based law firm of Holme Roberts & Owen. Mr. Ross is also Executive Vice
President, Secretary, General Counsel and a director of Mallon Oil. He earned
his B.A. degree in Economics from Michigan State University in 1973 and his J.D.
degree from Brigham Young University in 1976.

Frank Douglass has been a director of Mallon since its formation in 1988.
In 1998, he retired as a Senior Partner in the Texas law firm of Scott, Douglass
& McConnico, LLP, where he had been a partner since 1976. Mr. Douglass earned a
B.B.A. degree from Southwestern University in 1953 and a L.L.B. degree from the
University of Texas School of Law in 1958.

Roger R. Mitchell has been a director of Mallon since 1990. Prior to 1989,
Mr. Mitchell served as a co-general partner with Mallon of a series of private
oil and gas drilling limited partnerships sponsored by Mallon. Mr. Mitchell has
participated in or managed a number of real estate, insurance and investment
companies, including Mitchell Management Company, which he currently owns. He
earned a B.S. degree in Business from Indiana University in 1954 and an M.B.A.
degree from Indiana University in 1956.

Francis J. Reinhardt, Jr. has been a director of Mallon since 1994. He is
with the New York investment banking firm of Carl H. Pforzheimer & Co., where he
has been a partner since 1966. He is a member and past president of the National
Association of Petroleum Investment Analysts. Mr. Reinhardt is also a director
of The Exploration Company of Louisiana. Mr. Reinhardt holds a B.S. degree from
Seton Hall University and an M.B.A. from New York University.

32
<PAGE> 34

Peter H. Blum became a director of Mallon in January 1998. Since October
1998, Mr. Blum, a financial consultant, has been President of Bear Ridge Capital
LLC. From April 1997 to October 1998, Mr. Blum was Senior Managing Director,
head of investment banking, for the investment banking firm GBI Capital Markets.
From 1995 to 1997, Mr. Blum held the position of Managing Director, head of
energy banking, with the investment banking firm Rodman & Renshaw, Inc. From
1992 to 1995, Mr. Blum held various positions with the investment banking firm
Mabon Securities, Inc. Mr. Blum is also a director of Mitcham Industries, Inc.
Mr. Blum earned a B.B.A. degree in accounting from the University of Wisconsin
in 1979.

Alfonso R. Lopez joined Mallon in July 1996 as Vice President-Finance and
Treasurer. He was Vice President -- Finance for Consolidated Oil & Gas, Inc.
(now Chesapeake Energy Corporation) from 1993 to 1995. Mr. Lopez was a
consultant from 1991 to 1992. From 1981 to 1990, he was Controller for Decalta
International Corporation, a Denver-based exploration and production company. He
served as Controller for Western Crude Oil, Inc. (now Texaco Trading and
Transportation, Inc.) from 1978 to 1981. Mr. Lopez is a certified public
accountant and was with Arthur Young & Company (now Ernst & Young) from 1970 to
1978. Mr. Lopez earned his B.A. degree in Accounting and Business Administration
from Adams State College in Colorado in 1970.

Key Employees

Employees who are instrumental to our success include the following
individuals:

Ray E. Jones is Vice President -- Engineering of Mallon Oil. Before joining
Mallon in January 1994, Mr. Jones spent eight years with Jerry R. Bergeson &
Associates (now GeoQuest), an independent consulting firm. Mr. Jones graduated
from Colorado School of Mines in 1979 and is a registered professional engineer.

Wendell A. Bond has been Vice President -- Exploration of Mallon Oil since
December 1996. Prior to joining Mallon on a full-time basis, Mr. Bond was an
independent geological consultant to Mallon since July 1994. Mr. Bond has more
than 25 years of experience in the petroleum industry, both domestically and
internationally. Prior to joining Mallon, he was president of Wendell A. Bond,
Inc., a company specializing in petroleum geological consulting services that he
formed in 1988. Prior to 1988, Mr. Bond had been employed in a variety of
positions for several independent and major oil and gas companies, including
Project Geologist for Webb Resources, District Geologist for Sohio Petroleum and
Chief Geologist for Samuel Gary Jr. & Associates. Mr. Bond earned his B.S.
degree in geology from Capital University, Columbus, Ohio and his M.S. degree in
geology from the University of Colorado.

Donald M. Erickson, Jr. has been Vice President -- Operations of Mallon Oil
since February 1997. Mr. Erickson has more than 20 years of experience in oil
field operations. Prior to joining Mallon, he was Operations Manager for
Presidio Exploration, Inc. (which was merged into Tom Brown Inc.) from December
1988 to January 1997. Mr. Erickson earned a Heating and Cooling Technical Degree
from Central Technical Community College in Hastings, Nebraska in 1975 and has
studied Mechanical Engineering at the University of Denver.

33
<PAGE> 35

PRINCIPAL SHAREHOLDERS

The following table sets forth information concerning the beneficial
ownership of shares of our common stock as of August 18, 2000, by (a) each
shareholder known by us to own of record or beneficially more than 5% of our
outstanding common stock; (b) our chief executive officer (Mr. Mallon); (c) each
of our directors; and (d) all of our directors and executive officers as a
group. The after offering calculations assume that the underwriters'
over-allotment option is not exercised.

<TABLE>
<CAPTION>
NUMBER PERCENT
NAME AND ADDRESS(1) OF SHARES OWNED
------------------- --------- -------
<S> <C> <C>
George O. Mallon, Jr. ...................................... 547,890(2) 6.9%
Kevin M. Fitzgerald......................................... 186,946(3) 2.4%
Roy K. Ross................................................. 96,727(4) 1.2%
Frank Douglass.............................................. 58,344(5) *
Roger R. Mitchell........................................... 63,147(6) *
Francis J. Reinhardt, Jr. .................................. 64,920(7) *
Peter H. Blum............................................... 112,235(8) 1.4%
Centennial Energy Partners, L.L.C. ......................... 756,200(9) 9.7%
Wellington Management Company, LLP.......................... 735,000(9) 9.4%
Robert Fleming Inc. ........................................ 575,385(9) 7.4%
Aquila Energy Capital Corporation........................... 490,000(10) 6.2%
All officers and directors as a group (8 persons)........... 1,152,076(11) 14.0%
</TABLE>

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

* Less than 1%

(1) The address of Messrs. Mallon, Fitzgerald and Ross is 999 18th Street,
Suite 1700, Denver, CO 80202. The address of Mr. Douglass is 10424
Woodford, Dallas, TX 75239. The address of Mr. Mitchell is 113 Cypress Cove
Lane, Mooresville, NC 28117. The address of Mr. Reinhardt is 650 Madison
Ave., 23rd Floor, New York, NY 10022. The address of Mr. Blum is 22
Cortlandt Street, New York, NY 10007. The address of Centennial Energy
Partners L.L.C. is 900 Third Avenue, Suite 1801, New York, NY 10022. The
address of Wellington Management Company, LLP is 75 State Street, Boston,
MA 02109. The address of Robert Fleming Inc. is 320 Park Avenue, 11th
Floor, New York, NY 10022. The address of Aquila Energy Capital Corporation
is 909 Fannin, Suite 1850, Houston, Texas 77010.

(2) Includes 2,166 shares owned by Mr. Mallon's wife and 47,491 shares that
could be acquired by Mr. Mallon upon the exercise of immediately
exercisable stock options and warrants that he holds. A trust created for
the benefit of Mr. Mallon's children owns shares that are not included, as
Mr. Mallon has no voting or other control over the shares in the trust.

(3) Includes 60,882 shares that could be acquired by Mr. Fitzgerald upon the
exercise of immediately exercisable stock options and warrants that he
holds. Does not include 68,948 shares covered by stock options that have
not yet vested.

(4) Includes 33,063 shares that could be acquired by Mr. Ross upon the exercise
of immediately exercisable stock options and warrants that he holds. Does
not include 45,625 shares covered by stock options that have not yet
vested.

(5) Includes 29,740 shares that could be acquired by Mr. Douglass upon the
exercise of immediately exercisable stock options and warrants that he
holds. Does not include 2,666 shares covered by stock options that have not
yet vested.

(6) Includes 25,070 shares that could be acquired by Mr. Mitchell upon the
exercise of immediately exercisable stock options that he holds. Does not
include 2,666 shares covered by stock options that have not yet vested.

(7) Includes 27,735 shares that could be acquired by Mr. Reinhardt upon the
exercise of immediately exercisable stock options and warrants that he
holds. Does not include 2,666 shares covered by stock options that have not
yet vested.

34
<PAGE> 36

(8) Includes 97,735 shares that could be acquired by Mr. Blum upon the exercise
of immediately exercisable stock options and warrants that he holds. Does
not include 42,666 shares covered by stock options and warrants that have
not yet vested.

(9) Based upon information contained in various filings made with the SEC.

(10) Based upon information contained in various public filings made with the
SEC. Includes 70,000 shares that we have agreed to issue to Aquila.

(11) Includes 343,583 shares that could be acquired upon the exercise of
immediately exercisable stock options and warrants. Does not include
173,370 shares covered by stock options and warrants that have not yet
vested.

35
<PAGE> 37

DESCRIPTION OF CAPITAL STOCK AND OTHER SECURITIES

GENERAL

Our Articles of Incorporation authorize us to issue 25,000,000 shares of
common stock, par value $.01 per share, and 10,000,000 shares of Preferred
Stock, par value $.01 per share. The shares of our preferred stock are issuable
from time to time in one or more series and with such designations, powers,
preferences and rights, and qualifications, limitations or restrictions as may
be determined by the board, consistent with the Articles and with the laws of
the State of Colorado.

COMMON STOCK

We had 7,881,643 shares of common stock outstanding prior to this offering,
which were held by approximately 600 shareholders of record. Each share of
common stock entitles the shareholder to one vote. Holders of common stock are
not entitled to cumulative voting in the election of directors and have no
preemptive or subscription rights. Subject to the rights of holders of any
outstanding shares of preferred stock, shares of common stock are entitled to
share equally in dividends paid from the funds legally available for the payment
thereof, when, as and if declared by the board. Subject to the rights of holders
of any outstanding shares of preferred stock, holders of common stock are also
entitled to share ratably in our assets available for distribution to holders of
common stock upon our liquidation or dissolution, whether voluntary or
involuntary. The common stock is listed on the Nasdaq National Market under the
symbol "MLRC." Our transfer agent is Securities Transfer Corporation, Dallas,
Texas.

OPTIONS

At August 21, 2000, options to purchase an aggregate of 506,103 shares of
the common stock were issued and outstanding. These options were issued to
several of our employees and directors, and to various consultants.

WARRANTS

We have outstanding warrants to purchase an aggregate of 200,000 shares of
common stock, as described below.

In October 1996, in connection with a public offering of shares of our
common stock, we issued warrants to purchase 160,000 shares of common stock to
the managing underwriter, with a revised exercise price of $6.875 per share. The
warrants expire December 31, 2002.

In July 1999, we entered into a financial consulting services contract
under which we issued warrants to purchase an aggregate of 40,000 shares of our
common stock at a per share exercise price of $0.01. Warrants covering 10,000
shares vest on July 1, 2001. The remaining warrants do not vest except in the
event of certain corporate transactions. The warrants expire December 31, 2004.

PREFERRED STOCK

Our board of directors is authorized under our Articles of Incorporation to
issue up to 10,000,000 shares of preferred stock from time to time in one or
more series and to fix (without shareholder action) the voting rights and other
special rights, including, without limitation, the conversion rights, rights and
terms of redemption (including sinking fund provisions), and dividend and
liquidation rights of each series.

Shareholders will not have any preemptive rights with respect to any of the
authorized but unissued shares of common stock and preferred stock. Issuance of
shares of preferred stock could impact the voting rights of the holders of
common stock by creating a series of shares with disproportionately higher
voting rights and by the creation of class or series voting rights on particular
matters. The issuance of shares of preferred stock with conversion rights or
which are redeemable for shares of common stock could increase the potential
number of shares of common stock outstanding. It is probable that when shares of
preferred stock are issued they will have rights prior to the common stock as to
dividends and as to the distribution of
36
<PAGE> 38

assets in the event of liquidation. In addition, the board may provide that the
holders of any series of preferred stock will be entitled, in addition to their
preferential rights, to participate with the holders of common stock in
dividends and in distributions in liquidation. The authorized shares of
preferred stock are available for issuance at such times and for such purposes
as the board may deem advisable, without further action by the shareholders. The
board, without shareholder approval, can issue preferred stock with voting and
conversion rights that could adversely affect the voting power of holders of
common stock. The issuance of preferred stock may have the effect of delaying,
deferring or preventing a change in control. We have no present plans to issue
any additional shares of preferred stock.

SERIES B MANDATORILY REDEEMABLE PREFERRED STOCK

At June 30, 2000, 80,000 shares of our Series B preferred stock were
outstanding. The Series B preferred stock is convertible to common stock at any
time at the option of the holder. The conversion price, as adjusted to reflect
this offering, is currently $9.23, which means a total of 146,479 shares of
common stock are issuable upon the conversion of the outstanding shares of
Series B preferred stock. The Series B preferred stock is convertible to common
stock automatically if the common stock trades at a price in excess of 140% of
the conversion price (meaning the target price is currently $12.92 per share)
for each day in a period of 10 consecutive trading days. The Series B preferred
stock provides for a preferential 8% dividend, payable quarterly. The Series B
preferred stock has a preference on liquidation of $10.00. The Series B
preferred stock is redeemable at our election, at any time. The optional
redemption price is $10.00 per preferred share (the original purchase price),
plus a decreasing early redemption premium if it is redeemed before April 1,
2001. We are obligated to redeem 80,000 shares on April 1, 2001. No early
redemption premium is payable in connection with such mandatory redemptions.
Except as otherwise required by law, holders of Series B preferred stock have no
voting rights, except upon default. In the event of a default, holders of the
Series B preferred stock have the right to elect two additional directors to our
board during the duration of the default.

CONVERTIBLE NOTES

MANDATORILY REDEEMABLE COMMON STOCK

In September 1999, in conjunction with the establishment of the Aquila
Credit Agreement, we issued to Aquila 420,000 shares of our common stock, which
were recorded as Mandatorily Redeemable Common Stock in our consolidated balance
sheet, based on the market value of our common stock on the date of issuance. In
July 2000, in connection with an increase in the borrowing base available under
the Aquila Credit Agreement, we agreed to issue Aquila an additional 70,000
shares of our common stock. Aquila has a one-time right to require us to
purchase the 490,000 shares at $12.50 per share during the 30-day period
beginning September 9, 2003. Under the Aquila Credit Agreement, Aquila has the
right to require that its shares of our common stock be included for sale in
this offering. Aquila has waived that right and has also agreed not to sell any
of its shares of our common stock for a period of 90 days after this offering,
without the prior approval of the underwriter.

CERTAIN VOTING REQUIREMENTS

Our Articles of Incorporation (the "Articles") require a super-majority
vote of our shareholders to approve certain business combinations or other
significant corporate transactions involving us and a substantial shareholder.
The Articles require the affirmative vote of the holders of a majority of the
outstanding shares entitled to vote to approve a merger, consolidation or
dissolution of us or a disposition of

37
<PAGE> 39

all or substantially all of our assets, under ordinary circumstances. The
Articles raise the required affirmative vote to 80% of the total number of votes
entitled to be cast to approve these and other significant corporate
transactions ("Business Combinations") if a "9% Shareholder" (as defined) is a
party to the transaction or its percentage equity interest in us will be
increased by the transaction. A majority of the whole board may, in all such
cases, determine not to require such 80% affirmative vote, but only if 80% of
the "Continuing Directors" (as defined) so determine. The required 80% approval
of any such business combination must include at least a majority of all votes
entitled to be cast with respect to voting shares not beneficially owned by any
9% Shareholder.

These provisions are intended to provide safeguards to our public
shareholders in the event another entity first gains working control of us and
then wishes to accomplish a combination of the two businesses, or otherwise
eliminate the holdings of the public. Accordingly, these provisions are intended
to provide some assurance that adequate time and needed information will be
available to the public shareholders and the board in order that a considered
judgment may be made with respect to a business combination, taking into account
such matters as the proposed price and form of consideration, the tax
implications to public shareholders and the impact of the business combination
upon our employees. This result is intended to be accomplished by encouraging
another entity that is interested in a business combination with or acquisition
of us to negotiate the terms of the business combination or acquisition in
advance of its acquisition of a substantial number of our shares.

Under those circumstances in which the provisions would apply, a minority
of our shareholders may prevent the consummation of a transaction favored by a
majority of shareholders. As a practical matter, the requirement of an 80% vote
may also mean that the type of business combination to which these provisions
are addressed might not be accomplished by the controlling entity while there
remains any widely dispersed public market in our voting shares. Because the
affirmative vote of at least 80% of the total votes entitled to be cast (rather
than the votes actually cast at a meeting) would be required, the failure of
shareholders to vote also could result in the defeat of a proposed transaction.
These provisions could operate to the disadvantage of present management by
restricting our flexibility in the conduct of corporate affairs.

These provisions may not be amended, altered, changed or repealed without
the affirmative vote of 80% or more of the votes entitled to be cast by all
holders of voting shares (which 80% vote must include the affirmative vote of a
majority of the votes entitled to be cast by all holders of voting shares not
beneficially owned by any 9% Shareholder). This vote requirement will not apply
to any amendment, alteration, change or repeal recommended to the shareholders
by 75% of the whole board, provided that a majority of the members of the board
acting upon such matter are continuing directors. Under such circumstances, an
amendment, alternation, change or repeal may be approved by a simple majority of
the votes entitled to be cast.

SHAREHOLDER RIGHTS PLAN

In April 1997, the board declared a dividend distribution of one Right for
each outstanding share of our common stock. Each Right entitles the registered
holder to purchase from us one share of common stock at a purchase price of
$40.00 per share, subject to adjustment. The description and terms of the Rights
are set forth in a Shareholder Rights Plan (the "Rights Plan") between us and
Securities Transfer Corporation as Rights Agent.

Initially, the Rights will be attached to all common stock certificates
representing shares then outstanding, and no separate Rights Certificates will
be distributed. The Rights will separate from the common stock and a
Distribution Date will occur upon the earlier of (i) 10 days following a public
announcement that a person or group of affiliated or associated persons (an
"Acquiring Person") has acquired, or obtained the right to acquire, beneficial
ownership of 20% or more of the outstanding shares of common stock (the "Stock
Acquisition Date"), or (ii) 10 business days following the commencement of a
tender offer or exchange offer that would result in a person or group
beneficially owning 20% or more of our outstanding shares of common stock. Until
the Distribution Date, (i) the Rights will be evidenced by the common stock
certificates and will be transferred with and only with such common stock
certificates, and

38
<PAGE> 40

(ii) the surrender for transfer of any certificates for common stock will also
constitute the transfer of the Rights associated with the common stock
represented by such certificate.

The Rights are not exercisable until the Distribution Date and will expire
at the close of business on April 22, 2001, unless earlier redeemed by us as
described below.

As soon as practicable after the Distribution Date, Rights Certificates
will be mailed to holders of record of the common stock as of the close of
business on the Distribution Date and, thereafter, the separate Rights
Certificates alone will represent the Rights. Except as otherwise determined by
the board, only shares of common stock issued prior to the Distribution Date
will be issued with Rights.

If any person becomes an Acquiring Person other than pursuant to a
Qualifying Offer (as defined below), each holder of a Right will thereafter have
the right to receive, upon exercise, common stock (or, in certain circumstances,
cash, property or other securities issued by us) having a value equal to two
times the exercise price of the Right. Notwithstanding any of the foregoing, all
Rights that are, or (under certain circumstances specified in the Rights Plan)
were, beneficially owned by any Acquiring Person will be null and void. However,
Rights are not exercisable in any event until such time as the Rights are no
longer redeemable by us as set forth below.

A "Qualifying Offer" means a tender offer or exchange offer for all
outstanding shares of common stock at a price and on terms determined by at
least a majority of the Continuing Directors (as defined below) who are not our
officers or employees and who are not related (as specified in the Rights Plan)
to the Person making such offer, after receiving advice from one or more
investment banking firms, to be fair to and in the best interests of us and our
shareholders.

If at any time following the Stock Acquisition Date (i) we are acquired in
a merger or other business combination transaction in which the common stock is
changed or exchanged or in which we are not the surviving corporation (other
than a merger that follows a Qualifying Offer and satisfies certain other
requirements), or (ii) 50% or more of our assets or earning power is sold or
transferred, each holder of a Right (except Rights that have been previously
voided as set forth above) shall thereafter have the right to receive, upon
exercise, common stock of the acquiring company having a value equal to two
times the exercise price of the Right. The events set forth in this paragraph
and in the third preceding paragraph are referred to as the "Triggering Events."

The Purchase Price payable, and the number of shares of common stock or
other securities or property issuable, upon exercise of the Rights are subject
to adjustment from time to time to prevent dilution (i) in the event of a stock
dividend on, or a subdivision, combination or reclassification of, the common
stock, (ii) if holders of the common stock are granted certain rights or
warrants to subscribe for common stock or convertible securities at less than
the current market price of the common stock, or (iii) upon the distribution to
holders of the common stock of evidences of indebtedness or assets (excluding
regular quarterly cash dividends) or of subscription rights or warrants (other
than those referred to above).

At any time until ten days following the Stock Acquisition Date, we may
redeem the Rights in whole, but not in part, at a price of $.01 per Right
(payable in cash, common stock or other consideration deemed appropriate by the
board). Under certain circumstances set forth in the Rights Plan, the decision
to redeem shall require the concurrence of a majority of the Continuing
Directors. Immediately upon the action of the board ordering redemption of the
Rights or at such other time as may be specified by the board when it orders
redemption, with, where required, the concurrence of the Continuing Directors,
the Rights will terminate and the only right of the holders of Rights will be to
receive the $.01 redemption price.

The term "Continuing Directors" for purposes of the Rights Plan means any
member of our board who was a member of the board prior to the Stock Acquisition
Date, and any person who is subsequently elected to the board if such person is
recommended or approved by a majority of the Continuing Directors, but shall not
include an Acquiring Person, or an affiliate or associate of an Acquiring
Person, or any representative of the foregoing entities.

39
<PAGE> 41

Until a Right is exercised, the holder thereof, as such, will have no
rights as a shareholder, including, without limitation, the right to vote or to
receive dividends. While the distribution of the Rights will not be taxable to
us or our shareholders, shareholders may, depending upon the circumstances,
recognize taxable income if the Rights become exercisable for our common stock
(or other consideration) or for common stock of the acquiring company as set
forth above.

Other than those provisions relating to the principal economic terms of the
Rights, any of the provisions of the Rights Plan may be amended by the board
prior to the Distribution Date. After the Distribution Date, the Rights Plan may
be amended by the board (in certain circumstances, with the concurrence of the
Continuing Directors) in order to cure any ambiguity, to make changes that do
not adversely affect the interests of holders of Rights (excluding the interests
of any Acquiring Person), or to shorten or lengthen any time period under the
Rights Plan; provided, however, that no amendment to adjust the time period
governing redemption shall be made at a time when the Rights are not redeemable.

40
<PAGE> 42

UNDERWRITING

Subject to the terms and conditions contained in the underwriting agreement
dated the date of this prospectus, McDonald Investments Inc. has agreed to
purchase, and Mallon has agreed to sell to such underwriter, 2,500,000 shares of
common stock.

The underwriting agreement provides that the obligations of the underwriter
to purchase the shares included in this offering are subject to the approval of
certain legal matters by counsel and to certain other conditions. The
underwriter is obligated to purchase all shares, other than those covered by the
over-allotment option described below, if it purchases any of the shares.

The underwriter proposes initially to offer the shares of common stock
directly to the public at the public offering price set forth on the cover page
hereof and to certain dealers at a price that represents a concession not in
excess of $0.26 per share of common stock under the public offering price. The
underwriter may allow, and such dealers may reallow, a concession not in excess
of $0.10 per share of common stock to certain other dealers. If all of the
shares are not sold at the initial offering price, the underwriter may change
the public offering price and the other selling terms.

We have granted to the underwriter an option, exercisable at any time
during the 30-day period from the date of this prospectus, to purchase up to an
aggregate of 375,000 additional shares of common stock at the public offering
price set forth on the cover page hereof less the underwriting discount. The
underwriter may exercise such option to purchase additional shares solely for
the purpose of covering over-allotments, if any, incurred in connection with
this offering. To the extent such option is exercised, the underwriter will
become obligated, subject to certain conditions, to purchase additional shares.

The following table shows the underwriting discounts and commissions we
will pay to the underwriter in connection with this offering. These amounts are
shown assuming both no exercise and full exercise of the underwriter's
over-allotment option to purchase additional shares of our common stock.

<TABLE>
<CAPTION>
NO EXERCISE FULL EXERCISE
----------- -------------
<S> <C> <C>
Per share................................................... 0.4375 0.4375
Total....................................................... $1,093,750 $1,257,813
</TABLE>

We have agreed to indemnify the underwriter against certain liabilities,
including liabilities under the Securities Act, or to contribute payments that
the underwriter may be required to make with respect to these liabilities.

For a period of 90 days from the date of this prospectus, we and our
executive officers and directors and certain of our shareholders have agreed
that, without the prior written consent of McDonald Investments Inc. we will
not:

- offer, pledge, contract to sell or sell any option or contract to
purchase, purchase any option or contract to sell, grant any option,
right or warrant to purchase, lend or otherwise transfer or dispose of,
directly or indirectly, any shares of common stock or any securities
exchangeable for common stock (except through gifts to persons who agree
in writing to be bound by such restrictions), or

- make any demand for or exercise any right with respect to the
registration of any shares of common stock or any securities convertible
into or exercisable or exchangeable for common stock (other than (a) the
sale to the underwriters of the shares of common stock under the
underwriting agreement of (b) our issuance of shares of common stock upon
the exercise of an option sold or granted pursuant to our existing
benefit plans and outstanding on the date of this prospectus.

In connection with this offering, the underwriter may engage in
transactions that stabilize, maintain or otherwise affect the price of the
common stock. Specifically, the underwriter may create a syndicate short
position by making short sales of our common stock and may purchase shares of
our common stock on the open market to cover syndicate short positions created
by short sales. Short sales involve the sale by the underwriter of a greater
number of shares than the underwriter is required to purchase in the offering.
Short

41
<PAGE> 43

sales can be either "covered" or "naked." "Covered" short sales are sales made
in an amount not greater than the underwriter's over-allotment option to
purchase additional shares in the offering. "Naked" short sales are sales in
excess of the over-allotment option. A naked short position is more likely to be
created if the underwriter is concerned that there may be a downward pressure on
the price of the common stock in the open market after pricing that could
adversely affect investors who purchase in the offering. The underwriter may
close out any covered short position by either exercising its over-allotment or
purchasing shares in the open market. In determining the source of shares to
close out the covered short position, the underwriter will consider, among other
things, the price of shares available for purchase in the open market as
compared to the price at which they may purchase shares through the
over-allotment option. The underwriter would close out any naked short position
by purchasing shares in the open market. The underwriting syndicate may reclaim
selling concessions if the syndicate repurchases previously distributed shares
in syndicate covering transactions, in stabilization transactions or in some
other way or if McDonald Investments Inc. receives a report that indicates
clients of such syndicate members have "flipped" the shares. These activities
may had the effect of raising or maintaining the market price of our common
stock or preventing or retarding a decline in the market price of our common
stock. As a result, the price of our common stock may be higher than the price
that might otherwise exist in the open market. The underwriter is not required
to engage in these activities and may end any of these activities at any time.

The underwriter may also impose a penalty bid. Penalty bids permit the
underwriter to reclaim a selling concession from a syndicate member when the
representatives, in covering syndicate short positions or market stabilizing
purchases, repurchase shares originally sold by that syndicate member.

Any of these activities may cause the price of our common stock to be
higher than the price that would otherwise exist in the open market in the
absence of such transactions. These transactions may be effected on the Nasdaq
National Market or in the over-the-counter market, or otherwise and, if
commenced, may be discontinued at any time.

We estimate the total expenses for this offering will be approximately
$250,000.

Neither we nor the underwriter make any representation or prediction as to
the direction or magnitude of any effect that the transactions described above
may have on the price of the common stock. In addition, neither we nor the
underwriter make any representation that the underwriter will engage in such
transactions or that such transactions, once commenced, will not be discontinued
without notice.

In connection with this offering, the underwriter and other selling group
members or their affiliates may engage in passive market making transactions in
the common stock on the Nasdaq Stock Market in accordance with Rule 103 of
Regulation M under the Exchange Act. Rule 103 permits passive market making
during the period when Regulation M would otherwise prohibit market making
activity by the participants in this offering. Passive market making consists of
displaying bids on the Nasdaq National Market limited by the bid prices of
independent market makers and making purchases limited by such prices and
effected in response to order flow. Rule 103 limits the net purchases by a
passive market maker on each day to a specified percentage of the passive market
maker's average daily trading volume in the common stock during a specified
period. The passive market maker must stop its passive market making
transactions for the rest of that day when such limit is reached.

The underwriters may, from time to time, engage in transactions with and
perform services for us in the ordinary course of their business.

LEGAL MATTERS

The validity of the shares of common stock being offered hereby and certain
other legal matters in connection with this offering are being passed upon for
us by Holme Roberts & Owen LLP, Denver, Colorado. Certain legal matters in
connection with this offering will be passed upon for the underwriters by Vinson
& Elkins L.L.P., New York, New York.

42
<PAGE> 44

EXPERTS

The consolidated financial statements as of December 31, 1999, and for each
of the three years then ended included in this prospectus and elsewhere in the
registration statement have been audited by Arthur Andersen LLP, independent
public accountants, as indicated in their report with respect thereto, and are
included herein in reliance upon the authority of said firm as experts in giving
said report.

Information set forth in this prospectus relating to our estimated proved
oil and gas reserves at December 31, 1999 and June 30, 2000, the related
calculations of future net production revenues and net present value thereof
have been derived from an independent petroleum engineering report prepared by
Reed W. Ferrill & Associates, Inc., independent petroleum engineers, and is
included herein in reliance on such firm as an expert in preparing such
information.

WHERE YOU CAN FIND MORE INFORMATION

We have filed with the Commission a registration statement on Form S-2 (the
"Registration Statement," which term encompasses all amendments, exhibits,
annexes and schedules thereto) under the Securities Act with respect to the
common stock offered hereby. This prospectus, which constitutes a part of the
Registration Statement, does not contain all the information set forth in the
Registration Statement, to which reference is hereby made. Statements made in
this prospectus as to the contents of any contract, agreement or other document
referred to are not necessarily complete. With respect to each such contract,
agreement or other document filed as an exhibit to the Registration Statement
and the exhibits thereto, reference is hereby made to the exhibit for a more
complete description of the matter involved, and each statement made herein
shall be deemed qualified in its entirety by such reference.

We are subject to the informational requirements of the Exchange Act and in
accordance therewith file periodic reports, proxy and information statements and
other information filed with the Commission. The Registration Statement filed by
us with the Commission, as well as such reports, proxy and information
statements and other information filed by us with the Commission, are available
at the web site that the Commission maintains at http:www.sec.gov. and can be
inspected and copied at the public reference facilities maintained by the
Commission at Room 1024, Judiciary Plaza, 450 Fifth Street, N.W., Washington,
D.C. 20549, and at the regional offices of the Commission located at 7 World
Trade Center, New York, New York 10048, and the Chicago Regional Office,
Northwestern Atrium Center, 500 West Madison Street, Suite 1400, Chicago,
Illinois 60661. Copies of such material, when filed, may also be obtained from
the Public Reference Section of the Commission at 450 Fifth Street, N.W.,
Washington, D.C. 20549 at prescribed rates. The common stock is quoted on the
Nasdaq National Market and such reports, proxy and information statements and
other information concerning us are available at the offices of the Nasdaq
National Market located at 1735 K Street, N.W., Washington, D.C. 20006.

43
<PAGE> 45

INCORPORATION OF CERTAIN DOCUMENTS BY REFERENCE

Incorporated by reference in this prospectus are (i) our Annual Report on
Form 10-K for the fiscal year ended December 31, 1999, (ii) our Quarterly
Reports on Form 10-Q for the quarters ended March 31 and June 30, 2000, (iii)
our Current Reports on Form 8-K dated February 22, 2000, March 20, 2000, April
11, 2000, April 17, 2000, and September 8, 2000, (iv) our 2000 Proxy Statement
filed previously with the Commission pursuant to Section 13 of the Exchange Act.
Any statement contained in a document incorporated by reference herein shall be
deemed to be modified or superseded for purposes of this prospectus to the
extent that a statement contained herein modifies or supersedes such statement.
Any statement so modified or superseded shall not be deemed, except as so
modified or superseded, to constitute a part of this prospectus.

We will provide without charge to each person, including any beneficial
owner of common stock, to whom a copy of this prospectus has been delivered, on
the written or oral request of such person, a copy of any or all of the
foregoing documents incorporated by reference in this prospectus, other than
exhibits to such documents unless such exhibits are specifically incorporated by
reference into the information that this prospectus incorporates. Written or
oral requests for such copies should be directed to Roy K. Ross, Secretary,
Mallon Resources Corporation, 999 18th Street, Suite 1700, Denver, Colorado
80202 (telephone: (303) 293-2333).

44
<PAGE> 46

GLOSSARY OF TERMS

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

Bcf. Billion cubic feet.

BOE. Barrels of oil equivalent, determined using the ratio of six Mcf of
natural gas (including natural gas liquids) to one Bbl of crude oil or
condensate.

Btu. British thermal unit, which is the heat required to raise the
temperature of a one-pound mass of water from 58.5 to 59.5 degrees Fahrenheit.

Development location. A location on which a development well can be
drilled.

Development well. A well drilled within the proved area of an oil or gas
reservoir to the depth of a stratigraphic horizon known to be productive in an
attempt to recover proved undeveloped reserves.

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

Estimated future net revenues. Revenues from production of oil and gas, net
of all production-related taxes, lease operating expenses and capital costs.

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

Gross acres. An acre in which a working interest is owned.

Gross well. A well in which a working interest is owned.

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

MBOE. One thousand barrels of oil equivalent.

Mcf. One thousand cubic feet.

Mcfe. One thousand cubic feet of natural gas equivalent, determined using
the ratio of six Mcf of natural gas (including natural gas liquids) to one Bbl
of crude oil or condensate.

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

MMBOE. One million barrels of oil equivalent.

MMBtu. One million Btus.

MMcf. One million cubic feet.

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

PV-10 or present value of estimated future net revenues. Estimated future
net revenues discounted by a factor of 10% per annum, before income taxes and
with no price or cost escalation or de- escalation, in accordance with
guidelines promulgated by the Commission.

Production costs. All costs necessary for the production and sale of oil
and gas, including production and ad valorem taxes.

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

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

Proved reserves. The estimated quantities of crude oil, natural gas and
natural gas liquids which geological and engineering data demonstrate with
reasonable certainty to be recoverable in future years from

45
<PAGE> 47

known reservoirs under existing economic and operating conditions, i.e., prices
and costs as of the date the estimate is made. Prices include consideration of
changes in existing prices provided only by contractual arrangements, but not on
escalations based upon future conditions.

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

Recompletion. The completion for production of an existing wellbore in
another formation from that in which the well has previously been completed.

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

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

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<PAGE> 48

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

<TABLE>
<CAPTION>
PAGE
----
<S> <C>
Audited Consolidated Financial Statements
Report of Independent Public Accountants.................. F-2
Consolidated Balance Sheets of as December 31, 1999 and
1998................................................... F-3
Consolidated Statements of Operations for the Years Ended
December 31, 1999, 1998 and 1997....................... F-4
Consolidated Statements of Shareholders' Equity for the
Years Ended December 31, 1999, 1998 and 1997........... F-5
Consolidated Statements of Cash Flows for the Years Ended
December 31, 1999, 1998 and 1997....................... F-6
Notes to Consolidated Financial Statements for the Years
Ended December 31, 1999, 1998 and 1997................. F-7
Unaudited Interim Consolidated Financial Statements
Consolidated Balance Sheets as of June 30, 2000 and
December 31, 1999...................................... F-25
Consolidated Statements of Operations for the Six Months
Ended June 30, 1999 and 1998........................... F-26
Consolidated Statements of Cash Flows for the Six Months
Ended June 30, 1999 and 1998........................... F-27
Notes to Consolidated Financial Statements for the Six
Months Ended June 30, 1999 and 1998.................... F-28
</TABLE>

F-1
<PAGE> 49

REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS

To the Board of Directors and Shareholders of
Mallon Resources Corporation:

We have audited the accompanying consolidated balance sheets of Mallon
Resources Corporation (a Colorado corporation) and subsidiaries as of December
31, 1999 and 1998, and the related consolidated statements of operations,
shareholders' equity and cash flows for each of the three years in the period
ended December 31, 1999. These consolidated financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with auditing standards generally
accepted in the United States. 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 Mallon
Resources Corporation and its subsidiaries as of December 31, 1999 and 1998, and
the results of their operations and their cash flows for each of the three years
in the period ended December 31, 1999, in conformity with accounting principles
generally accepted in the United States.

ARTHUR ANDERSEN LLP

Denver, Colorado
March 17, 2000

F-2
<PAGE> 50

MALLON RESOURCES CORPORATION

CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE DATA)

<TABLE>
<CAPTION>
DECEMBER 31,
-------------------
1999 1998
-------- --------
<S> <C> <C>
ASSETS

Current assets:
Cash and cash equivalents................................. $ 1,230 $ 1,733
Accounts receivable:
Oil and gas sales....................................... 1,315 1,076
Joint interest participants, net of allowance of $43 and
$43, respectively...................................... 559 650
Related parties......................................... 53 89
Other................................................... 153 --
Inventories............................................... 200 375
Other..................................................... 83 32
-------- --------
Total current assets............................... 3,593 3,955
-------- --------
Property and equipment:
Oil and gas properties, full cost method.................. 103,315 93,624
Natural gas processing plant.............................. 8,341 8,275
Other property and equipment.............................. 1,084 989
-------- --------
112,740 102,888
Less accumulated depreciation, depletion and amortization... (53,428) (48,748)
-------- --------
59,312 54,140
-------- --------
Notes receivable - related parties.......................... 84 89
Debt issuance costs......................................... 1,885 61
Other, net.................................................. 552 207
-------- --------
Total Assets................................................ $ 65,426 $ 58,452
======== ========

LIABILITIES AND SHAREHOLDERS' EQUITY

Current liabilities:
Trade accounts payable.................................... $ 4,883 $ 4,424
Undistributed revenue..................................... 934 945
Accrued taxes and expenses................................ 55 149
Deferred revenue.......................................... -- 909
Current portion of long-term debt......................... 399 1,310
-------- --------
Total current liabilities.......................... 6,271 7,737
-------- --------
Long-term debt, net of unamortized discount of $3,146 and
$-0-, respectively........................................ 34,874 27,183
Accrued expenses............................................ -- 39
-------- --------
Total non-current liabilities...................... 34,874 27,222
-------- --------
Total liabilities........................................... 41,145 34,959
-------- --------
Commitments and contingencies (Note 5)
Series B Mandatorily Redeemable Convertible Preferred Stock,
$0.01 par value, 500,000 shares authorized, 135,200 shares
issued and outstanding, liquidation preference and
mandatory redemption of $1,352............................ 1,341 1,329
Mandatorily Redeemable Common Stock, $0.01 par value,
420,000 shares authorized, issued and outstanding,
mandatory redemption of $5,250............................ 3,450 --
Shareholders' equity:
Common Stock, $0.01 par value, 25,000,000 shares
authorized, 7,413,300 and 7,021,065 shares issued and
outstanding, respectively............................... 74 70
Additional paid-in capital................................ 77,013 74,103
Accumulated deficit....................................... (54,914) (52,009)
Notes receivable from shareholders........................ (2,683) --
-------- --------
Total shareholders' equity......................... 19,490 22,164
-------- --------
Total Liabilities and Shareholders' Equity.................. $ 65,426 $ 58,452
======== ========
</TABLE>

The accompanying notes are an integral part of these consolidated financial
statements.
F-3
<PAGE> 51

MALLON RESOURCES CORPORATION

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

<TABLE>
<CAPTION>
FOR THE YEARS ENDED DECEMBER 31,
----------------------------------
1999 1998 1997
--------- ---------- ---------
<S> <C> <C> <C>
Revenues:
Oil and gas sales......................................... $13,138 $ 13,069 $ 8,582
Interest and other........................................ 160 109 69
------- -------- -------
13,298 13,178 8,651
------- -------- -------
Costs and expenses:
Oil and gas production.................................... 5,107 5,273 3,037
Depreciation, depletion and amortization.................. 4,822 5,544 2,725
Impairment of oil and gas properties...................... -- 16,842 24
Impairment of mining properties........................... -- -- 350
General and administrative, net........................... 2,915 2,562 2,274
Interest and other........................................ 3,126 1,143 701
------- -------- -------
15,970 31,364 9,111
------- -------- -------
Equity in loss of affiliate................................. -- -- (3,244)
------- -------- -------
Loss before extraordinary item.............................. (2,672) (18,186) (3,704)
Extraordinary loss on early retirement of debt.............. (105) -- --
------- -------- -------
Net loss.................................................... (2,777) (18,186) (3,704)
Accretion of mandatorily redeemable common stock............ (116) -- --
Dividends and accretion on preferred stock.................. (120) (120) (185)
Preferred stock conversion inducement....................... -- -- (403)
------- -------- -------
Net loss attributable to common shareholders................ $(3,013) $(18,306) $(4,292)
======= ======== =======
Basic loss per share:
Loss attributable to common shareholders before
extraordinary item..................................... $ (0.40) $ (2.61) $ (0.92)
Extraordinary loss........................................ (0.01) -- --
------- -------- -------
Net loss attributable to common shareholders................ $ (0.41) $ (2.61) $ (0.92)
======= ======== =======
Basic weighted average common shares outstanding............ 7,283 7,015 4,682
======= ======== =======
</TABLE>

The accompanying notes are an integral part of these consolidated financial
statements.

F-4
<PAGE> 52

MALLON RESOURCES CORPORATION

CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
(IN THOUSANDS, EXCEPT SHARE AMOUNTS)

<TABLE>
<CAPTION>
NOTES
COMMON STOCK ADDITIONAL RECEIVABLE
------------------ PAID-IN ACCUMULATED FROM
SHARES AMOUNT CAPITAL DEFICIT SHAREHOLDERS TOTAL
--------- ------ ---------- ----------- ------------ -------
<S> <C> <C> <C> <C> <C> <C>
Balance, December 31, 1996.................. 4,384,562 $44 $56,707 $(34,847) $ -- $21,904
Employee stock options exercised.......... 3,650 -- -- -- -- --
Stock issued to directors................. 1,305 -- 6 -- -- 6
Employee stock options granted............ -- -- 82 -- -- 82
Issuance of common stock in public
offering................................ 2,300,000 23 19,566 -- -- 19,589
De-consolidation of Laguna Gold Company... -- -- (4,808) 4,764 -- (44)
Issuance of restricted common stock to
officers................................ 25,000 -- 62 -- -- 62
Issuance of common stock in exchange for
Series B preferred stock................ 280,747 3 2,483 -- -- 2,486
Dividends on preferred stock.............. -- -- (161) -- -- (161)
Accretion of preferred stock.............. -- -- -- (24) -- (24)
Net loss.................................. -- -- -- (3,704) -- (3,704)
--------- --- ------- -------- ------- -------
Balance, December 31, 1997.................. 6,995,264 70 73,937 (33,811) -- 40,196
Employee stock options granted............ -- -- 195 -- -- 195
Employee stock options exercised.......... 13,657 -- 12 -- -- 12
Stock issued to directors................. 729 -- -- -- -- --
Conversion of warrants.................... 11,415 -- -- -- -- --
Issuance of restricted common stock to
officers................................ -- -- 67 -- -- 67
Dividends on preferred stock.............. -- -- (108) -- -- (108)
Accretion of preferred stock.............. -- -- -- (12) -- (12)
Net loss.................................. -- -- -- (18,186) -- (18,186)
--------- --- ------- -------- ------- -------
Balance, December 31, 1998.................. 7,021,065 70 74,103 (52,009) -- 22,164
Employee stock options granted............ -- -- 66 -- -- 66
Employee stock options exercised.......... 392,235 4 2,673 -- (2,622) 55
Accrued interest receivable on notes from
shareholders............................ -- -- -- -- (61) (61)
Warrants issued to director............... -- -- 25 -- -- 25
Extension of warrants' expiration date.... -- -- 217 -- -- 217
Accretion of mandatorily redeemable common
stock................................... -- -- -- (116) -- (116)
Issuance of restricted common stock to
officers................................ -- -- 37 -- -- 37
Dividends on preferred stock.............. -- -- (108) -- -- (108)
Accretion of preferred stock.............. -- -- -- (12) -- (12)
Net loss.................................. -- -- -- (2,777) -- (2,777)
--------- --- ------- -------- ------- -------
Balance, December 31, 1999.................. 7,413,300 $74 $77,013 $(54,914) $(2,683) $19,490
========= === ======= ======== ======= =======
</TABLE>

The accompanying notes are an integral part of these consolidated financial
statements.

F-5
<PAGE> 53

MALLON RESOURCES CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)

<TABLE>
<CAPTION>
FOR THE YEARS ENDED
DECEMBER 31,
------------------------------
1999 1998 1997
-------- -------- --------
<S> <C> <C> <C>
Cash flows from operating activities:
Net loss.................................................. $ (2,777) $(18,186) $ (3,704)
Adjustments to reconcile net loss to net cash provided by
(used in) operating activities:
Depreciation, depletion and amortization................ 4,822 5,544 2,725
Impairment of mining properties......................... -- -- 350
Impairment of oil and gas properties.................... -- 16,842 24
Accrued interest expense added to long-term debt........ 998 -- --
Accrued interest income added to notes receivable from
shareholders.......................................... (60) -- --
Extraordinary loss...................................... 105 -- --
Equity in loss of affiliate............................. -- -- 3,244
Stock compensation expense.............................. 323 196 101
Amortization of discount on long-term debt and
installment obligation................................ 188 22 22
Provision for losses on accounts receivable............. -- 35 --
Other................................................... -- -- 40
Changes in operating assets and liabilities:
(Increase) decrease in:
Accounts receivable................................ (540) 2,097 (1,098)
Inventory and other current assets................. (22) (169) (176)
Increase (decrease) in:
Trade accounts payable and undistributed revenue... 408 (2,240) 4,579
Accrued taxes and expenses......................... (97) 147 (36)
Deferred revenue................................... (909) 909 --
Drilling advances.................................. (1) (132) (333)
-------- -------- --------
Net cash provided by operating activities................... 2,438 5,065 5,738
-------- -------- --------
Cash flows from investing activities:
Additions to property and equipment....................... (9,826) (35,977) (17,251)
Proceeds from sale of property and equipment.............. -- 40 --
Purchase of subsidiary stock.............................. -- -- (55)
Decrease (increase) in notes receivable-related parties... 5 (71) (1)
Other..................................................... -- -- (47)
-------- -------- --------
Net cash used in investing activities....................... (9,821) (36,008) (17,354)
-------- -------- --------
Cash flows from financing activities:
Proceeds from long-term debt.............................. 43,332 28,714 6,340
Payments of long-term debt................................ (34,404) (222) (9,608)
Payment of installment obligation......................... -- (400) (377)
Payment of lease obligations.............................. -- (2,061) (76)
Debt issuance costs....................................... (1,995) -- --
Net proceeds from sale of common stock in public
offering................................................ -- -- 19,589
Payment of preferred dividends............................ (108) (108) (161)
Redemption of preferred stock............................. -- -- (121)
Proceeds from stock option exercises...................... 55 12 --
-------- -------- --------
Net cash provided by financing activities................... 6,880 25,935 15,586
-------- -------- --------
Net (decrease) increase in cash and cash equivalents........ (503) (5,008) 3,970
Cash and cash equivalents, beginning of year................ 1,733 6,741 2,771
-------- -------- --------
Cash and cash equivalents, end of year...................... $ 1,230 $ 1,733 $ 6,741
======== ======== ========
Supplemental cash flow information:
Cash paid for interest.................................... $ 1,988 $ 1,066 $ 659
======== ======== ========
Non-cash transactions:
Acquisition of equipment under lease obligations.......... $ -- $ 315 $ 1,785
Installment obligation (less unamortized discount) in
exchange for property and equipment..................... -- -- 733
Reduction of note receivable from affiliate in exchange
for mining properties................................... -- -- 350
Sale of common stock in exchange for notes receivable from
shareholders............................................ 2,622 -- --
</TABLE>

The accompanying notes are an integral part of these consolidated financial
statements.

F-6
<PAGE> 54

MALLON RESOURCES CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997

NOTE 1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Organization and Nature of Operations:

Mallon Resources Corporation ("Mallon" or the "Company") was incorporated
on July 18, 1988 under the laws of the State of Colorado. The Company engages in
oil and gas exploration and production through its wholly-owned subsidiary,
Mallon Oil Company ("Mallon Oil"), whose oil and gas operations are conducted
primarily in the State of New Mexico. Mallon operates its business and reports
its operations as one business segment. The Company also has an interest in
Laguna Gold Company ("Laguna"), a company that holds mineral interests in Costa
Rica.

Principles of Consolidation:

The consolidated financial statements include the accounts of Mallon Oil
and all of its wholly-owned subsidiaries. The Company accounts for its
investment in Laguna using the equity method of accounting. All significant
intercompany transactions and accounts have been eliminated from the
consolidated financial statements.

Cash, Cash Equivalents and Short-term Investments:

Cash and cash equivalents include investments that are readily convertible
into cash and have an original maturity of three months or less. All short-term
investments are held to maturity and are reported at cost.

Fair Value of Financial Instruments:

The Company's on-balance sheet financial instruments consist of cash, cash
equivalents, accounts receivable, notes receivable, inventories, accounts
payable, other accrued liabilities and long-term debt. Except for long-term
debt, the carrying amounts of such financial instruments approximate fair value
due to their short maturities. At December 31, 1999 and 1998, based on rates
available for similar types of debt, the fair value of long-term debt was not
materially different from its carrying amount. The Company's off-balance sheet
financial instruments consist of derivative instruments which are intended to
manage commodity price risks (see Note 12).

Inventories:

Inventories, which consist of oil and gas lease and well equipment, are
valued at the lower of average cost or estimated net realizable value.

Oil and Gas Properties:

Oil and gas properties are accounted for using the full cost method of
accounting. Under this method, all costs associated with property acquisition,
exploration and development are capitalized, including general and
administrative expenses directly related to these activities. All such costs are
accumulated in one cost center, the continental United States.

Proceeds on disposal of properties are ordinarily accounted for as
adjustments of capitalized costs, with no gain or loss recognized, unless such
adjustment would significantly alter the relationship between capitalized costs
and proved oil and gas reserves. Net capitalized costs of oil and gas
properties, less related deferred income taxes, may not exceed the present value
of estimated future net revenues from proved reserves, discounted at 10 percent,
plus the lower of cost or fair market value of unproved properties, as adjusted
for related tax effects (see Note 2).

F-7
<PAGE> 55
MALLON RESOURCES CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Depletion is calculated using the units-of-production method based upon the
ratio of current period production to estimated proved oil and gas reserves
expressed in physical units, with oil and gas converted to a common unit of
measure using one barrel of oil as an equivalent to six thousand cubic feet of
natural gas (see Note 2).

Estimated abandonment costs (including plugging, site restoration, and
dismantlement expenditures) are accrued if such costs exceed estimated salvage
values, as determined using current market values and other information.
Abandonment costs are estimated based primarily on environmental and regulatory
requirements in effect from time to time. At December 31, 1999 and 1998, in
management's opinion, the estimated salvage values equaled or exceeded estimated
abandonment costs.

Other Property and Equipment:

Other property and equipment is recorded at cost and depreciated over the
estimated useful lives (generally three to seven years) using the straight-line
method. Costs incurred relating to a natural gas processing plant are being
depreciated over twenty-five years using the straight-line method. The cost of
normal maintenance and repairs is charged to expense as incurred. Significant
expenditures that increase the life of an asset are capitalized and depreciated
over the estimated useful life of the asset. Upon retirement or disposition of
assets, related gains or losses are reflected in operations.

Gas Balancing:

The Company uses the entitlements method of accounting for recording
natural gas sales revenues. Under this method, revenue is recorded based on the
Company's net working interest in field production. Deliveries of natural gas in
excess of the Company's working interest are recorded as liabilities while
under-deliveries are recorded as receivables.

Concentration of Credit Risk:

As an operator of jointly owned oil and gas properties, the Company sells
oil and gas production to numerous oil and gas purchasers and pays vendors for
oil and gas services. The risk of non-payment by the purchaser is considered
minimal and the Company does not generally obtain collateral for sales to them.
Joint interest receivables are subject to collection under the terms of
operating agreements which provide lien rights, and the Company considers the
risk of loss likewise to be minimal.

The Company is exposed to credit losses in the event of non-performance by
counterparties to financial instruments, but does not expect any counterparties
to fail to meet their obligations. The Company generally does not obtain
collateral or other security to support financial instruments subject to credit
risk but does monitor the credit standing of counterparties.

Stock-Based Compensation:

As required, the Company adopted SFAS No. 123, "Accounting for Stock-Based
Compensation" in 1996. As permitted under SFAS No. 123, the Company has elected
to continue to measure compensation cost using the intrinsic value based method
of accounting prescribed by APB Opinion No. 25, "Accounting for Stock Issued to
Employees." The Company has made pro forma disclosures of net income (loss) and
net income (loss) per share as if the fair value based method of accounting as
defined in SFAS No. 123 had been applied (see Note 10).

F-8
<PAGE> 56
MALLON RESOURCES CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

General and Administrative Expenses:

General and administrative expenses are reported net of amounts allocated
to working interest owners of the oil and gas properties operated by the
Company, and net of amounts capitalized pursuant to the full cost method of
accounting.

Hedging Activities:

The Company's use of derivative financial instruments is limited to
management of commodity price and interest rate risks. Gains and losses on such
transactions are accounted for as part of the transaction being hedged. If an
instrument is settled early, any gains or losses are deferred and recognized as
part of the transaction being hedged (see Note 12).

In June 1998, the Financial Accounting Standards Board issued SFAS No. 133,
"Accounting for Derivative Instruments and Hedging Activities." SFAS No. 133
establishes accounting and reporting standards requiring that every derivative
instrument (including certain derivative instruments embedded in other
contracts) be recorded in the balance sheet as either an asset or liability
measured at its fair value. SFAS No. 133 requires that changes in the
derivative's fair value be recognized currently in earnings unless specific
hedge accounting criteria are met. Special accounting for qualifying hedges
allows a derivative's gains and losses to offset related results on the hedged
item in the income statement, and requires that a company must formally
document, designate, and assess the effectiveness of transactions that receive
hedge accounting. SFAS No. 133 is effective for all fiscal quarters of fiscal
years beginning after June 15, 2000, but early adoption is permitted. SFAS No.
133 cannot be applied retroactively.

The Company has not yet quantified the impact of adopting SFAS No. 133 on
its financial statements and has not determined the timing or method of adoption
of SFAS No. 133. However, SFAS No. 133 could increase volatility in earnings and
other comprehensive income.

Comprehensive Income:

There are no components of comprehensive income which have been excluded
from net income and, therefore no separate statement of comprehensive income has
been presented.

Per Share Data:

Basic earnings per share is computed by dividing income available to common
shareholders by the weighted average number of common shares outstanding for the
period. Diluted earnings per share reflects the potential dilution that could
occur if the Company's outstanding stock options and warrants were exercised
(calculated using the treasury stock method) or if the Company's Series B
Convertible Preferred Stock were converted to common stock. The consolidated
statement of operations for 1999, 1998 and 1997 reflect only basic earnings per
share because the Company was in a loss position for all years presented and all
common stock equivalents are anti-dilutive.

Use of Estimates and Significant Risks:

The preparation of consolidated financial statements in conformity with
generally accepted accounting principles requires management to make significant
estimates and assumptions that affect the amounts reported in these financial
statements and accompanying notes. The more significant areas requiring the use
of estimates relate to oil and gas reserves, fair value of financial
instruments, valuation allowance for deferred tax assets, and useful lives for
purposes of calculating depreciation, depletion and amortization. Actual results
could differ from those estimates.

F-9
<PAGE> 57
MALLON RESOURCES CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

The Company and its operations are subject to numerous risks and
uncertainties. Among these are risks related to the oil and gas business
(including operating risks and hazards and the regulations imposed thereon),
risks and uncertainties related to the volatility of the prices of oil and gas,
uncertainties related to the estimation of reserves of oil and gas and the value
of such reserves, the effects of competition and extensive environmental
regulation, and many other factors, many of which are necessarily out of the
Company's control. The nature of oil and gas drilling operations is such that
the expenditure of substantial drilling and completion costs are required well
in advance of the receipt of revenues from the production developed by the
operations. Thus, it will require more than several quarters for the financial
success of that strategy to be demonstrated. Drilling activities are subject to
numerous risks, including the risk that no commercially productive oil or gas
reservoirs will be encountered.

Reclassifications:

Certain prior year amounts in the consolidated financial statements have
been reclassified to conform to the presentation used in 1999.

NOTE 2. OIL AND GAS PROPERTIES

Under the full cost accounting rules of the Securities and Exchange
Commission, the Company reviews the carrying value of its oil and gas properties
each quarter on a country-by-country basis. Under full cost accounting rules,
net capitalized costs of oil and gas properties, less related deferred income
taxes, may not exceed the present value of estimated future net revenues from
proved reserves, discounted at 10 percent, plus the lower of cost or fair market
value of unproved properties, as adjusted for related tax effects. Application
of these rules generally requires pricing future production at the unescalated
oil and gas prices in effect at the end of each fiscal quarter and requires a
write-down if the "ceiling" is exceeded, even if prices declined for only a
short period of time. The Company recorded a charge in the fourth quarter of
1998 to write down its oil and gas properties by $16,842,000. In applying the
"ceiling test," the Company used December 31, 1998 oil and gas prices of $10.03
per barrel of oil and $1.43 per Mcf of gas.

In January 1997, the Company acquired certain oil and gas properties for
consideration of $1,300,000 in cash and conveyance of its interest in certain
other oil and gas properties. Cash consideration of $500,000 was paid at closing
in January 1997. Installment obligation payments of $400,000 were made on
December 31, 1998 and 1997. The installment obligations included an imputed
interest rate of 6%. There was no gain or loss relative to the conveyance of the
interest in the oil and gas properties.

NOTE 3. LAGUNA GOLD COMPANY

Mallon owns an approximate 35% interest in Laguna and accounts for its
interest in Laguna using the equity method. The Company's share of Laguna's
cumulative net loss is in excess of Mallon's carrying value of its investment in
and advances to Laguna. As a result, the Company will not reflect its share of
Laguna's future losses and may only reflect its share of Laguna's future
earnings to the extent that they exceed the Company's share of Laguna's 1997 and
future net losses not recognized.

F-10
<PAGE> 58
MALLON RESOURCES CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

A summary of the results of operations and assets, liabilities and
shareholders' equity of Laguna follows (unaudited):

<TABLE>
<CAPTION>
1999 1998 1997
------ ------- --------
(IN THOUSANDS)
<S> <C> <C> <C>
Results of operations:
Revenues............................................... $ 120 $ 237 $ 91
Net loss............................................... (295) (1,259) (10,702)
Assets, liabilities and shareholders' equity (end of
period):
Current assets......................................... 886 4,232 485
Other assets........................................... 322 3,624 999
Total assets................................... 1,208 7,856 1,484
Current liabilities.................................... 788 999 62
Other liabilities...................................... -- 6,086 2,167
Shareholders' equity (deficit)......................... 420 771 (745)
</TABLE>

NOTE 4. NOTES PAYABLE AND LONG-TERM DEBT

Long-term debt consists of the following:

<TABLE>
<CAPTION>
1999 1998
------- -------
(IN THOUSANDS)
<S> <C> <C>
Note payable to Aquila Energy Capital Corporation, due
2003...................................................... $32,890 $ --
Less unamortized discount (effective rate of 13.8%)......... (3,146) --
------- -------
29,744 --
Lease obligation to Universal Compression, Inc. ............ 5,390 --
8.5% unsecured note payable to Bank One, Colorado, N.A., due
2002...................................................... 139 150
Bank One revolving line of credit........................... -- 22,060
Bank One equipment loan..................................... -- 6,283
------- -------
35,273 28,493
Less current portion........................................ (399) (1,310)
------- -------
Total............................................. $34,874 $27,183
======= =======
</TABLE>

The Company had a revolving line of credit (the "Bank One Facility") with
Bank One, Texas, N.A. The Bank One Facility consisted of two separate lines of
credit: a primary revolving line of credit and a term loan commitment of $6.5
million (the "Equipment Loan").

In September 1999, the Company established a credit agreement (the "Aquila
Credit Agreement") with Aquila Energy Capital Corporation ("Aquila"). The
initial amount available under the agreement is $45.7 million. The amount
available may be increased to as much as $60 million as new reserves are added
through the Company's planned development drilling program. The borrowing base
is subject to redetermination annually on or before April 30. At December 31,
1999, the Company had drawn $32.9 million, including accrued interest, under the
Aquila Credit Agreement, of which $28.0 million was used to retire the Bank One
Facility. Unamortized loan origination fees of $105,000 related to the Bank One
Facility are included in extraordinary loss on early retirement of debt in the
Company's consolidated statement of operations for 1999. Approximately $1.7
million of the initial funds drawn under the Aquila Credit Agreement was used to
pay transaction costs and $1.0 million was used to pay outstanding accounts
payable. Additional funds will be advanced as the Company's development drilling
program proceeds. Principal payments on the four-year loan began in November
1999 based on the Company's cash flow from operations, as defined, less advances
for the Company's development drilling program. The Company's

F-11
<PAGE> 59
MALLON RESOURCES CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

management does not anticipate making any principal payments for the next 12
months because it expects drilling expenditures to equal or surpass defined cash
flow from operations during that period. The Aquila Credit Agreement is secured
by substantially all of the Company's oil and gas properties and contains
various covenants and restrictions, including ones that could limit the
Company's ability to incur other debt, dispose of assets, or change management.
Interest on the amounts outstanding under the Aquila Credit Agreement accrues at
prime plus 2% and will be added to the loan balance. The weighted average
interest rate for borrowings outstanding under the Aquila Credit Agreement at
December 31, 1999 was 10.5%. The outstanding loan balance is due in full on
September 9, 2003. As part of the transaction, the Company also entered into an
Agency Agreement with Aquila under which the Company pays a marketing fee equal
to 1% of the net proceeds from the sale of the Company's oil and gas production.

The Company paid approximately $2.0 million in debt issue costs in
connection with the establishment of the Aquila Credit Agreement. These costs
are reflected, net of amortization, in the Company's December 31, 1999
consolidated balance sheet, as debt issuance costs. The costs are being
amortized over a 48-month period using the effective interest rate method.
Amortization expense of $109,000 is included in the Company's 1999 consolidated
statement of operations related to these costs.

In conjunction with the establishment of the Aquila Credit Agreement, the
Company issued to Aquila 420,000 shares of the Company's common stock (see Note
7).

In September 1999, the Company also entered into a sale-leaseback agreement
with Universal Compression, Inc. to refinance and retire the Equipment Loan
under the Bank One Facility. The Company also terminated its interest rate swap
agreement related to the Equipment Loan in September 1999 for a gain of $3,500.
The sale-leaseback was recorded as a financing under the provisions of SFAS No.
98, "Accounting for Leases." The $5.5 million obligation has a five-year term
with monthly payments beginning in September 1999. The Company made principal
payments totaling $110,000 to Universal Compression during 1999. The obligation
bears interest at an imputed interest rate of 12.8%. During 1999, prior to its
retirement, the Company made principal payments of $783,000 on the Equipment
Loan.

In July 1998, the Company negotiated an unsecured term loan for up to
$205,000 with Bank One, Colorado, N.A. to finance the purchase of land and a
building for the Company's field office. The Company drew $155,000 on this loan
during 1998. Principal and interest (at 8.5%) is payable quarterly beginning
October 1, 1998. The Company repaid $11,000 and $5,000 of this loan during 1999
and 1998, respectively. In March 1999, the due date of the loan was extended
from July 1999 to April 2002.

Outstanding debt at December 31, 1999 is payable as follows:

<TABLE>
<CAPTION>
(IN THOUSANDS)
<S> <C>
2000........................................................ $ 399
2001........................................................ 455
2002........................................................ 609
2003........................................................ 33,459
2004........................................................ 3,497
Thereafter.................................................. --
-------
$38,419
=======
</TABLE>

F-12
<PAGE> 60
MALLON RESOURCES CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

NOTE 5. COMMITMENTS AND CONTINGENCIES

Operating Leases:

The Company leases office space, office equipment and vehicles under
non-cancelable leases which expire in 2002. Rental expense is recognized on a
straight-line basis over the terms of the leases. The total minimum rental
commitments at December 31, 1999 are as follows:

<TABLE>
<CAPTION>
(IN THOUSANDS)
<S> <C>
2000........................................................ $366
2001........................................................ 315
2002........................................................ 77
2003........................................................ 2
2004........................................................ --
Thereafter.................................................. --
----
$760
====
</TABLE>

Rent expense was $313,000, $233,000 and $156,000 for the years ended
December 31, 1999, 1998 and 1997, respectively.

Contingencies:

In December 1998, Del Mar Drilling Company ("Plaintiff") filed a civil
action against Mallon Oil. Plaintiff seeks damages for an alleged breach of
contract in the amount of $348,100, plus interest, costs and attorney's fees.
The Company believes the Plaintiff's case is without merit, and intends to
defend itself, vigorously. Mediated settlement negotiations have been
unsuccessful and a trial in the late summer of 2000 is anticipated. The final
outcome of this matter cannot yet be predicted, however the Company believes
that the final results of the lawsuit will not have a material adverse effect on
the Company's financial position or results of operations.

In April 1999, Mallon Oil filed a civil action that is now pending. The
action is to collect approximately $265,000 of unpaid joint-interest billings
from Wadi Petroleum, Inc. in certain oil and gas properties operated by the
Company. The defendant has filed counter-claims, in which it alleges fraud and
other claims against the Company. The Company believes that it has reached
agreement with the defendant as to a complete settlement of the matter, but
final documents effectuating the agreement are still being negotiated. The
settlement, if finally implemented, will result in a judgment in favor of the
Company in the amount of $150,000 being entered against the defendant, the
defendant assigning to the Company certain interests it owns in certain oil and
gas properties, and the Company agreeing to refrain from seeking to collect on
the judgement for a period of two years.

In 1992, the Minerals Management Service commenced an audit of royalties
payable on production from certain oil and gas properties in which the Company
owns an interest. The audit was initiated against the predecessor operator of
the properties, but the Company has since undertaken primary responsibility for
resolving matters that arise out of the audit. The Company's liability with
respect to the predecessor operator's liability is limited to $100,000. However,
the Company may have an additional liability with respect to transactions that
have occurred subsequent to its purchase of the oil and gas properties in
question. The audit focused on several matters, the most significant of which
were the manner in which production is measured and the manner in which
royalties are calculated and accounted for. Certain alleged deficiencies
preliminarily suggested by the audit were contested. Determinations contrary to
several of the Company's positions were rendered in June 1999, which the Company
has determined not to appeal. Certain key items relating to the calculation of
royalty issue have yet to be determined. The Company believes it can negotiate a
measurement protocol that is acceptable to all interested parties, which will
not have a material adverse

F-13
<PAGE> 61
MALLON RESOURCES CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

effect on the Company. The Company has recently determined to also attempt to
negotiate a private protocol addressing the manner in which royalties are
calculated and accounted for, as well. Until a final ruling is rendered or a new
protocol is agreed upon, it is not possible for the Company to estimate its
potential liability relating to these issues with any certainty.

NOTE 6. MANDATORILY REDEEMABLE CONVERTIBLE PREFERRED STOCK

In April 1994, the Company completed the private placement of 400,000
shares of Series B Mandatorily Redeemable Convertible Preferred Stock, $0.01 par
value per share (the "Series B Stock"). The Series B Stock bears an 8% dividend
payable quarterly, and is convertible into shares of the Company's common stock
at a current adjusted conversion price of $10.28 per share. Proceeds from the
placement were $3,774,000, net of stock issue costs of $226,000. In connection
with the Series B Stock, dividends of $108,000, $108,000 and $161,000 were paid
in 1999, 1998 and 1997, respectively. Accretion of preferred stock issue costs
was $12,000, $12,000 and $24,000 in 1999, 1998 and 1997, respectively.

Mandatory redemption of the Company's Series B Stock was to begin in April
1997, when 20% of the outstanding shares, or 80,000 shares, were to be redeemed
for $800,000. The Company extended an offer to all holders of the Series B Stock
to convert their shares into shares of the Company's common stock at a
conversion price of $9.00, rather than the $11.31 conversion price otherwise
then in effect. In April 1997, holders of 252,675 shares of Series B Stock
elected to convert their shares into 280,747 shares of the Company's common
stock. The excess of the fair value of the common stock issued at the $9.00
conversion price over the fair value of the common stock that would have been
issued at the $11.31 conversion price, totaling $403,000, is reflected on the
statement of operations for the year ended December 31, 1997 as an increase to
the net loss attributable to common shareholders for preferred stock conversion
inducement. In addition, the Company redeemed 12,125 shares of Series B Stock at
$10.00 per share. After these transactions, 135,200 shares of Series B Stock
remain outstanding. The Company will be required to redeem 55,200 shares in
April 2000 and the remaining 80,000 shares in April 2001. The Company plans to
make the April 2000 redemption with available funds. The Series B Stock is
convertible to common stock automatically if the common stock trades at a price
in excess of 140% of the then applicable conversion price for each day in a
period of 10 consecutive trading days.

NOTE 7. MANDATORILY REDEEMABLE COMMON STOCK

In September 1999, in conjunction with the establishment of the Aquila
Credit Agreement, the Company issued to Aquila 420,000 shares of the Company's
common stock, which were recorded as Mandatorily Redeemable Common Stock in the
accompanying consolidated balance sheet, based on the market value of the
Company's common stock on the date of issuance. Aquila has a one-time right to
require the Company to purchase the 420,000 shares at $12.50 per share during
the 30-day period beginning September 9, 2003. The difference between the value
of the shares at the redemption price of $12.50 per share and the market value
of the shares on the date of issuance will be accreted to the redemption date
using the effective interest method. Accretion of $116,000 was recorded during
the year ended December 31, 1999 as a direct charge to retained earnings and was
included in the net loss attributable to common shareholders in the Company's
consolidated statement of operations for 1999.

NOTE 8. CAPITAL

Preferred Stock:

The Board of Directors is authorized to issue up to 10,000,000 shares of
preferred stock having a par value of $.01 per share, to establish the number of
shares to be included in each series, and to fix the designation, rights,
preferences and limitations of the shares of each series. None of these shares
of preferred stock were outstanding at December 31, 1999 or 1998.

F-14
<PAGE> 62
MALLON RESOURCES CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Common Stock:

The Company has reserved approximately 131,518 shares, as adjusted, of
common stock for issuance upon possible conversion of the remaining Series B
Stock.

In December 1997, the Company sold 2,300,000 shares of its common stock in
a public offering at $9.25 per share. The Company received proceeds of
approximately $19,589,000, net of offering costs of $1,686,000. The net proceeds
were used primarily to finance the drilling and development of the Company's New
Mexico oil and gas properties.

Warrants:

The Company has outstanding warrants to purchase an aggregate of 278,023
shares of common stock, as described below.

In July 1999, the Company entered into a financial consulting services
contract with Bear Ridge Capital LLC. Under the contract, Bear Ridge Capital is
paid a monthly retainer and was issued warrants to purchase an aggregate of
40,000 shares of the Company's common stock at a per share exercise price of
$0.01. Warrants covering 10,000 shares vest on July 1, 2001. The remaining
warrants do not vest except in the event of certain corporate transactions. The
warrants expire December 31, 2004. Bear Ridge Capital is wholly-owned by one of
the Company's directors. During 1999, the Company recorded $25,000 of stock
compensation expense related to these warrants.

Warrants to purchase an aggregate of 78,023 shares of the Company's common
stock at an adjusted exercise price of $8.01 per share were issued in June 1995
to the holders of Laguna's Series A Preferred Stock in connection with the
private placement of that stock. The warrants expire June 30, 2000.

In October 1998, several members of the Company's Board of Directors
purchased from a third party 40,000 (of 160,000) warrants with an exercise price
of $7.80 per share issued by the Company in October 1996. On December 11, 1998,
the exercise price of all 160,000 outstanding warrants was reduced to $6.88 per
share, the closing price of the Company's stock on that day. The repricing of
the warrants was done in conjunction with the repricing of the Company's stock
options as discussed in Note 10. The warrants originally were to expire on
October 16, 2000. In October 1999, the Company extended the expiration date of
all 160,000 outstanding warrants from October 16, 2000 to December 31, 2002. As
a result of the extension, the Company recorded approximately $217,000 of stock
compensation expense in fourth quarter 1999.

In August 1995, the Company issued warrants to purchase an aggregate of
31,824 shares of common stock at an adjusted exercise price of $7.86 per share
to an affiliate of Midland Bank plc, New York Branch, as an "equity kicker" in
connection with the establishment of a now terminated line of credit with that
bank. In May 1998, the holder of the warrants opted to convert them into shares
of common stock through a cashless conversion whereby they received 11,415
shares of common stock, which were the equivalent in value to the difference
between the 31,824 shares of common stock at the defined current market price of
$12.25 per share and the exercise price of $7.86 per share.

NOTE 9. SHAREHOLDER RIGHTS PLAN

In April 1997, the Company's Board of Directors declared a dividend on its
shares of common stock (the "Common Shares") of preferred share purchase rights
(the "Rights") as part of a Shareholder Rights Plan (the "Plan"). The Plan is
designed to insure that all shareholders of the Company receive fair value for
their Common Shares in the event of a proposed takeover of the Company and to
guard against the use of partial tender offers or other coercive tactics to gain
control of the Company without offering fair value to the Company's
shareholders. At the present time, the Company knows of no proposed or
threatened takeover, tender offer or other effort to gain control of the
Company. Under the terms of the Plan, the Rights will be

F-15
<PAGE> 63
MALLON RESOURCES CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

distributed as a dividend at the rate of one Right for each Common Share held.
Shareholders will not actually receive certificates for the Rights, but the
Rights will become part of each Common Share. All Rights expire on April 22,
2001.

Each Right will entitle the holder to buy shares of common stock at an
exercise price of $40.00. The Rights will be exercisable and will trade
separately from the Common Shares only if a person or group acquires beneficial
ownership of 20% or more of the Company's Common Shares or commences a tender or
exchange offer that would result in such a person or group owning 20% or more of
the Common Shares. Only when one or more of these events occur will shareholders
receive certificates for the Rights.

If any person actually acquires 20% or more of Common Shares -- other than
through a tender or exchange offer for all Common Shares that provides a fair
price and other terms for such shares -- or if a 20% or more shareholder engages
in certain "self-dealing" transactions or engages in a merger or other business
combination in which the Company survives and its Common Shares remain
outstanding, the other shareholders will be able to exercise the Rights and buy
Common Shares of the Company having twice the value of the exercise price of the
Rights. In other words, payment of the $40.00 per Right exercise price will
entitle the holder to acquire $80.00 worth of Common Shares. Additionally, if
the Company is involved in certain other mergers where its shares are exchanged,
or certain major sales of assets occur, shareholders will be able to purchase
the other party's common shares in an amount equal to twice the value of the
exercise price of the Rights.

The Company will be entitled to redeem the Rights at $.01 per Right at any
time until the tenth day following public announcement that a person has
acquired a 20% ownership position in Common Shares of the Company. The Company
in its discretion may extend the period during which it can redeem the Rights.

NOTE 10. STOCK COMPENSATION

At December 31, 1999, the Company had two stock-based compensation plans.
As permitted under SFAS No. 123, the Company has elected to continue to measure
compensation costs using the intrinsic value method of accounting prescribed by
APB Opinion No. 25, "Accounting for Stock Issued to Employees." Under that
method, the difference between the exercise price and the estimated market value
of the shares at the date of grant is charged to compensation expense, ratably
over the vesting period, with a corresponding increase in shareholders' equity.
Compensation costs charged against income for all plans were $21,000, $128,000
and $38,000 for 1999, 1998 and 1997, respectively.

Under the Mallon Resources Corporation 1988 Equity Participation Plan (the
"1988 Equity Plan"), 250,000 shares of common stock have been reserved in order
to provide for incentive compensation and awards to employees and consultants.
The 1988 Equity Plan provides that a three-member committee may grant stock
options, awards, stock appreciation rights, and other forms of stock-based
compensation in accordance with the provisions of the 1988 Equity Plan. The
options vest over a period of up to four years and expire over a maximum of 10
years from the date of grant.

In June 1997, the shareholders approved the Mallon Resources Corporation
1997 Equity Participation Plan (the "1997 Plan") under which shares of common
stock have been reserved to provide employees, consultants and directors of the
Company with incentive compensation. The 1997 Plan is administered by a
Committee of the Board of Directors who may, in its sole discretion, select the
participants, and determine the number of shares of common stock to be subject
to incentive stock options, non-qualified options, stock appreciation rights and
other stock awards in accordance with the provisions of the 1997 Plan. The
aggregate number of shares of common stock that may be issued under the 1997
Plan is equal to 11% of the number of outstanding shares of common stock from
time to time. This authorization may be increased from time to time by approval
of the Board of Directors and by the ratification of the shareholders of the
Company. No options were granted under the 1997 Plan during 1999. In 1998, the
Committee approved the grant of

F-16
<PAGE> 64
MALLON RESOURCES CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

271,842 stock options at fair market value. In 1997, the Committee approved the
grant of 501,850 stock options of which 481,850 were granted at fair market
value and 20,000 were granted with an exercise price of $0.01 each. The options
vest over a period of up to five years and expire over a maximum of 10 years
from the date of grant.

On December 11, 1998, the Company's Board of Directors reduced the exercise
price of substantially all outstanding options to purchase shares of the
Company's common stock to $6.88 per share, the closing price of the stock on
that day. A total of 230,629 options with an original exercise price of $7.50
and 478,850 options with an original exercise price of $8.38 were repriced.

The following table summarizes activity with respect to all outstanding
stock options.

<TABLE>
<CAPTION>
WEIGHTED
AVERAGE
SHARES EXERCISE PRICE
-------- --------------
<S> <C> <C>
Outstanding at December 31, 1996............................ 69,577 $0.04
Granted................................................... 501,850 6.88
Exercised................................................. (3,650) 0.04
Forfeited................................................. (19,500) 0.04
-------- -----
Outstanding at December 31, 1997............................ 548,277 6.06
Granted................................................... 282,784 6.36
Exercised................................................. (13,657) 0.89
Forfeited................................................. -- --
-------- -----
Outstanding at December 31, 1998............................ 817,404 6.25
Granted................................................... 3,000 8.50
Exercised................................................. (392,235) 6.82
Forfeited................................................. (10,200) 6.88
-------- -----
Outstanding at December 31, 1999............................ 417,969 $5.71
======== =====
Options exercisable:
December 31, 1997......................................... 160,277 $5.89
======== =====
December 31, 1998......................................... 497,304 $6.16
======== =====
December 31, 1999......................................... 200,017 $4.95
======== =====
</TABLE>

The weighted average remaining contractual life of the options outstanding
under both the 1988 Equity Plan and 1997 Plan at December 31, 1999 is
approximately 7 years.

In 1997, the Company granted to a consultant options to purchase 3,000 of
the Company's common shares at $8.50 per share, exercisable from November 1997
to December 2000. In 1999, the Company granted this same individual additional
options to purchase 3,000 of the Company's common shares at $8.50 per share,
exercisable from January 1999 to December 2001. These options were not part of
either the 1988 Equity Plan or the 1997 Plan. During 1999, the Company recorded
$22,000 of compensation expense related to these options.

In 1992, the Company granted to a consultant an option to purchase 12,500
of the Company's common shares at $26.00 per share, exercisable from November
1993 through October 1997. The options expired unexercised. In 1994, the Company
granted this individual an additional option to purchase 6,250 shares at $16.00
per share, exercisable from January 1995 to December 1998. The option granted in
1994 expired in 1998 unexercised. These options were not part of either the 1988
Equity Plan or the 1997 Plan.

F-17
<PAGE> 65
MALLON RESOURCES CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

The Stock Compensation Plan for Outside Directors ("the Stock Compensation
Plan") provides that the Company's outside directors will be compensated by
periodically granting them shares of the Company's $0.01 par value common stock
worth $1,000 for each board meeting, but no less than $4,000 per year, for each
outside director. The Company expensed $0, $0 and $6,000 for the years 1999,
1998 and 1997, respectively, in relation to the Stock Compensation Plan. In July
1997, the Company started compensating the outside directors in cash and
discontinued the stock grants under this plan. In 1998, 10,942 stock options
under this plan were issued to the outside directors at fair market value. All
available awards under this plan have been granted.

In April 1997, the Company granted a total of 25,000 shares of restricted
common stock to three of its officers as an inducement to continue in its
employ. The fair market value of the shares at the date of grant will be charged
ratably over the vesting period of three years. The Company charged $37,000,
$67,000 and $62,000 against income in 1999, 1998 and 1997, respectively, related
to this grant. The grant of restricted stock is not a part of the Company's
equity plans.

Had compensation expense for the Company's 1999, 1998 and 1997 grants of
stock-based compensation been determined consistent with the fair value based
method under SFAS No. 123, the Company's net loss, net loss attributable to
common shareholders, and the net loss per share attributable to common
shareholders would approximate the pro forma amounts below:

<TABLE>
<CAPTION>
1999 1998 1997
----------------------- ----------------------- -----------------------
AS REPORTED PRO FORMA AS REPORTED PRO FORMA AS REPORTED PRO FORMA
----------- --------- ----------- --------- ----------- ---------
<S> <C> <C> <C> <C> <C> <C>
Net loss................ $(2,777) $(3,266) $(18,186) $(19,107) $(3,704) $(4,048)
Net loss attributable to
common shareholders... (3,013) (3,502) (18,306) (19,227) (4,292) (4,636)
Net loss per share
attributable to common
shareholders.......... (0.41) (0.48) (2.61) (2.74) (0.92) (0.99)
</TABLE>

The fair value of each option is estimated as of the grant date, using the
Black-Scholes option-pricing model, with the following assumptions:

<TABLE>
<CAPTION>
1999 1998 1997
----- ----- -----
<S> <C> <C> <C>
Risk-free interest rate..................................... 6.3% 4.75% 6.0%
Expected life (in years).................................... 5 4 4
Expected volatility......................................... 69.5% 64.6% 59.0%
Expected dividends.......................................... 0.0% 0.0% 0.0%
Weighted average fair value of options granted.............. $5.28 $3.59 $4.49
</TABLE>

In July 1999, the Company adopted a Stock Ownership Encouragement Program
to encourage holders of options to exercise their rights to purchase shares of
the Company's common stock. Under the program, the Company may lend option
holders the funds necessary to exercise their options. Funds advanced are
immediately paid to the Company in connection with the exercise of the options.
As a result, the Company incurs no cash outlay. Loans made under the program
must be approved by the Board of Directors or by its Compensation Committee, and
are represented by secured, interest-bearing, full recourse promissory notes
from the participants.

In September 1999, certain officers of the Company exercised options to
purchase 381,360 shares of common stock at an exercise price of $6.88 per share,
and borrowed funds from the Company to do so. The notes bear interest at 7%,
which is due along with the principal in August 2002. The notes and accrued

F-18
<PAGE> 66
MALLON RESOURCES CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

interest have been reflected as a reduction of shareholders' equity in the
accompanying consolidated balance sheet.

NOTE 11. BENEFIT PLANS

Effective January 1, 1989, the Company and its affiliates established the
Mallon Resources Corporation 401(k) Profit Sharing Plan (the "401(k) Plan"). The
Company and its affiliates match contributions to the 401(k) Plan in an amount
up to 25% of each employee's monthly contributions. The Company may also
contribute additional amounts at the discretion of the Compensation Committee of
the Board of Directors, contingent upon realization of earnings by the Company
which, at the sole discretion of the Compensation Committee, are adequate to
justify a corporate contribution. For the years ended December 31, 1999, 1998
and 1997, the Company made matching contributions of $32,000, $28,000 and
$22,000, respectively. No discretionary contributions were made during any of
the three years ended December 31, 1999.

The Company maintains a program which provides bonus compensation to
employees from oil and gas revenues which are included in a pool to be
distributed at the discretion of the Chairman of the Board. For the years ended
December 31, 1999, 1998 and 1997, a total of $141,000, $130,000 and $89,000,
respectively, was distributed to employees.

NOTE 12. HEDGING ACTIVITIES

The Company periodically enters into commodity derivative contracts and
fixed-price physical contracts to manage its exposure to oil and gas price
volatility. Commodity derivatives contracts, which are generally placed with
major financial institutions or with counterparties of high credit quality that
the Company believes are minimal credit risks, may take the form of futures
contracts, swaps or options. The oil and gas reference prices of these commodity
derivatives contracts are based upon crude oil and natural gas futures which
have a high degree of historical correlation with actual prices received by the
Company. The Company accounts for its commodity derivatives contracts using the
hedge (deferral) method of accounting. Under this method, realized gains and
losses from the Company's price risk management activities are recognized in oil
and gas revenue when the associated production occurs and the resulting cash
flows are reported as cash flows from operating activities. Gains and losses
from commodity derivatives contracts that are closed before the hedged
production occurs are deferred until the production month originally hedged. In
the event of a loss of correlation between changes in oil and gas reference
prices under a commodity derivatives contract and actual oil and gas prices, a
gain or loss would be recognized currently to the extent the commodity
derivatives contract did not offset changes in actual oil and gas prices.

Under the Aquila Credit Agreement, the Company is required to maintain
price hedging arrangements in place with respect to up to 65% of its oil and gas
production. Accordingly, in September 1999, the Company entered into agreements
to hedge a total of 300,000 barrels of oil related to production for 2000-2004
at fixed prices ranging from $17.40-$22.35 per barrel and to hedge a total of
4,488,000 MMBtus of gas related to production for 2001-2004 at a fixed price of
$2.55 per MMBtu. In addition, the Company entered into a basis swap to fix the
differential between the NYMEX price and the index price at which the hedged gas
is to be sold for 4,488,000 MMBtu for 2001-2004.

F-19
<PAGE> 67
MALLON RESOURCES CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

The following table indicates the Company's outstanding energy swaps at
December 31, 1999:

<TABLE>
<CAPTION>
ANNUAL
PRODUCT PRODUCTION FIXED PRICE DURATION MARKET PRICE REFERENCE
------- ---------- ----------- ---------- ----------------------
<S> <C> <C> <C> <C>
Gas (MMbtu).......... 5,400,000 $2.02 1/00-12/00 El Paso Natural Gas (San Juan)
Gas (MMbtu).......... 1,452,000 $2.55 1/01-12/01 NYMEX (Henry Hub)
Gas (MMbtu).......... 1,188,000 $2.55 1/02-12/02 NYMEX (Henry Hub)
Gas (MMbtu).......... 996,000 $2.55 1/03-12/03 NYMEX (Henry Hub)
Gas (MMbtu).......... 852,000 $2.55 1/04-12/04 NYMEX (Henry Hub)
Oil (Bbls)........... 84,000 $18.73-$22.35 1/00-12/00 NYMEX
Oil (Bbls)........... 60,000 $17.38-$18.61 1/01-12/01 NYMEX
Oil (Bbls)........... 60,000 $17.40 1/02-12/02 NYMEX
Oil (Bbls)........... 48,000 $17.40 1/03-12/03 NYMEX
Oil (Bbls)........... 48,000 $17.40 1/04-12/04 NYMEX
</TABLE>

For the years ended December 31, 1999, 1998 and 1997, the Company's
(losses) gains under its swap agreements were $(102,000), $481,000 and
$(615,000), respectively, and are included in oil and gas sales in the Company's
consolidated statements of operations. At December 31, 1999, the estimated net
amount the Company would have paid to terminate its outstanding energy swaps and
basis swaps, described above, was approximately $1,181,000.

In December 1998, the Company terminated an energy swap entered into
earlier in the year for 1999 production and received proceeds of $909,000, all
of which is included in deferred revenue on the Company's December 31, 1998
balance sheet and is included in oil and gas sales in the Company's 1999
consolidated statement of operations.

NOTE 13. MAJOR CUSTOMERS

Sales to customers in excess of 10% of total revenues for the years ended
December 31, 1999, 1998 and 1997 were:

<TABLE>
<CAPTION>
1999 1998 1997
------ ------ ------
(IN THOUSANDS)
<S> <C> <C> <C>
Customer A................................................. $4,087 $ -- $ --
Customer B................................................. 2,368 6,610 --
Customer C................................................. 2,347 -- --
Customer D................................................. 2,025 2,155 1,887
Customer E................................................. -- -- 1,335
</TABLE>

NOTE 14. INCOME TAXES

The Company incurred a loss for book and tax purposes in all periods
presented. There is no income tax benefit or expense for the years ended
December 31, 1999, 1998 or 1997.

F-20
<PAGE> 68
MALLON RESOURCES CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Deferred tax assets are comprised of the following as of December 31, 1999
and 1998:

<TABLE>
<CAPTION>
1999 1998
-------- --------
(IN THOUSANDS)
<S> <C> <C>
Deferred Tax Assets:
Net operating loss carryforward........................... $ 10,395 $ 7,098
Oil, gas and other property basis differences............. 1,718 3,600
Other..................................................... 249 171
-------- --------
Total deferred tax assets......................... 12,362 10,869
Less valuation allowance.................................... (12,362) (10,869)
-------- --------
Net deferred tax assets........................... $ -- $ --
======== ========
</TABLE>

At December 31, 1999, for Federal income tax purposes, the Company had a
net operating loss ("NOL") carryforward of approximately $28,000,000, which
expires in varying amounts between 2001 and 2020.

NOTE 15. SEGMENT INFORMATION

The Company adopted SFAS No. 131, "Disclosures about Segments of an
Enterprise and Related Information" in 1998. SFAS No. 131 changes the way the
Company reports information about its operating segments. The Company's
reportable business segments have been identified based on the differences in
products provided. For all periods presented, the Company has one reportable
segment -- oil and gas exploration and production. Refer to Note 17 for
information on the Company's oil and gas exploration and production activities
for 1999, 1998 and 1997.

NOTE 16. RELATED PARTY TRANSACTIONS

The accounts receivable from related parties consists primarily of joint
interest billings to directors, officers, shareholders, employees and affiliated
entities for drilling and operating costs incurred on oil and gas properties in
which these related parties participate with Mallon Oil as working interest
owners. These amounts will generally be settled in the ordinary course of
business, without interest.

During the years ended December 31, 1999, 1998 and 1997, the Company paid
legal fees of $-0-, $-0-and $4,000, respectively, to a law firm of which a
director of the Company is a senior partner.

In July 1999, the Company entered into a financial consulting services
contract with Bear Ridge Capital LLC., which is wholly-owned by one of the
Company's directors. Under the contract, Bear Ridge Capital is paid a monthly
retainer and was issued warrants to purchase an aggregate of 40,000 shares of
the Company's common stock at a per share exercise price of $0.01 (see Note 8).
During 1999, the Company paid Bear Ridge Capital $110,000 in fees and expensed
$25,000 in stock compensation expense related to the warrants.

In 1997, the Company paid fees of $72,500 to two investment banking firms
in which one of the Company's current directors was a principal. In addition,
one of these investment banking firms earned commissions and other fees of
approximately $388,000 in connection with the Company's December 1997 public
stock sale. At the time such amounts were paid or earned, the individual was not
a director of the Company.

F-21
<PAGE> 69
MALLON RESOURCES CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

NOTE 17. SUPPLEMENTARY INFORMATION ON OIL AND GAS OPERATIONS

Certain historical costs and operating information relating to the
Company's oil and gas producing activities as of and for the years ended
December 31, 1999, 1998 and 1997 are as follows:

<TABLE>
<CAPTION>
1999 1998 1997
-------- -------- --------
(IN THOUSANDS)
<S> <C> <C> <C>
CAPITALIZED COSTS RELATING TO OIL AND GAS ACTIVITIES:
Oil and gas properties(2)(3)........................ $103,315 $ 93,624 $ 63,148
Natural gas processing plant........................ 8,341 8,275 2,760
Accumulated depreciation, depletion and
amortization..................................... (52,884) (48,297) (26,011)
-------- -------- --------
$ 58,772 $ 53,602 $ 39,897
======== ======== ========
COSTS INCURRED IN OIL AND GAS PRODUCING ACTIVITIES:
Property acquisition costs.......................... $ 123 $ 1,459 $ 1,847
Exploration costs................................... 2,080 2,091 59(1)
Development costs:
Gas plant processing............................. 80 5,497 2,760
Pipeline......................................... 1,646 3,970 --
Salt water disposal.............................. 326 1,527 --
Drilling......................................... 5,502 21,447 15,067
-------- -------- --------
$ 9,757 $ 35,991 $ 19,733
======== ======== ========
RESULTS OF OPERATIONS FROM OIL AND GAS PRODUCING
ACTIVITIES:
Oil and gas sales................................... $ 13,138 $ 13,069 $ 8,582
Lease operating expense............................. (5,107) (5,273) (3,037)
Depletion and depreciation.......................... (4,587) (5,443) (2,625)
Impairment of oil and gas properties................ -- (16,842) (24)
-------- -------- --------
Results of operations from oil and gas producing
activities....................................... $ 3,444 $(14,489) $ 2,896
======== ======== ========
</TABLE>

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

(1) Offshore Belize -- all other items relate to U.S. operations.

(2) At December 31, 1998, the net book value of the Company's oil and gas
properties exceeded the net present value of the underlying reserves by
$16,842,000. Accordingly, the Company wrote-down its oil and gas properties
at December 31, 1998. At December 31, 1999 and 1997, the net present value
of the underlying reserves exceeded the net book value of the Company's oil
and gas properties.

(3) Includes $1,285,000 of unevaluated property cost not being amortized at
December 31, 1999, of which $111,000, $661,000 and $265,000 were incurred in
1999, 1998 and 1997, respectively. The Company anticipates that
substantially all unevaluated costs will be classified as evaluated costs
within 5 years.

Estimated Quantities of Proved Oil and Gas Reserves (unaudited):

Set forth below is a summary of the changes in the net quantities of the
Company's proved crude oil and natural gas reserves estimated by independent
consulting petroleum engineering firms for the years ended

F-22
<PAGE> 70
MALLON RESOURCES CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

December 31, 1999, 1998 and 1997. All of the Company's reserves are located in
the continental United States.

<TABLE>
<CAPTION>
OIL GAS
(MBBLS) (MMCF)
------- -------
<S> <C> <C>
PROVED RESERVES
Reserves, December 31, 1996................................. 1,707 24,285
Acquisitions of reserves in place......................... -- 3,968
Extensions, discoveries and additions..................... 340 29,858
Production................................................ (196) (2,350)
Revisions................................................. (470) (5,889)
------ -------
Reserves, December 31, 1997................................. 1,381 49,872
Acquisitions of reserves in place......................... 17 1,119
Extensions, discoveries and additions..................... 7 43,510
Production................................................ (230) (5,852)
Revisions................................................. 89 (4,488)
------ -------
Reserves, December 31, 1998................................. 1,264 84,161
Extensions, discoveries and additions..................... 482 47,020
Production................................................ (172) (5,600)
Revisions................................................. 322 (33,056)
------ -------
Reserves, December 31, 1999................................. 1,896 92,525
====== =======
PROVED DEVELOPED RESERVES
December 31, 1997........................................... 1,110 24,709
====== =======
December 31, 1998........................................... 945 65,786
====== =======
December 31, 1999........................................... 1,204 38,539
====== =======
</TABLE>

Standardized Measure of Discounted Future Net Cash Flows and Changes Therein
Relating to Proved Oil and Gas Reserves (unaudited):

The following summary sets forth the Company's unaudited future net cash
flows relating to proved oil and gas reserves, based on the standardized measure
prescribed in SFAS No. 69, for the years ended December 31, 1999, 1998 and 1997:

<TABLE>
<CAPTION>
1999 1998 1997
-------- -------- --------
(IN THOUSANDS)
<S> <C> <C> <C>
Future cash in-flows................................... $240,007 $133,311 $119,335
Future production costs................................ (80,667) (47,850) (31,041)
Future development costs............................... (31,059) (13,627) (8,967)
Future income taxes.................................... (16,514) -- (11,140)
-------- -------- --------
Future net cash flows.................................. 111,767 71,834 68,187
Discount at 10%........................................ (48,719) (28,495) (27,022)
-------- -------- --------
Standardized measure of discounted future net cash
flows, end of year................................... $ 63,048 $ 43,339 $ 41,165
======== ======== ========
</TABLE>

Future net cash flows were computed using yearend prices and yearend
statutory income tax rates (adjusted for permanent differences, operating loss
carryforwards and tax credits) that relate to existing proved oil and gas
reserves in which the Company has an interest. The Company's oil and gas hedging
agreements

F-23
<PAGE> 71
MALLON RESOURCES CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

at December 31, 1999 described in Note 12, do not have a material effect on the
determination of future oil and gas sales.

The following are the principal sources of changes in the standardized
measure of discounted future net cash flows for the years ended December 31,
1999, 1998 and 1997:

<TABLE>
<CAPTION>
1999 1998 1997
-------- ------- -------
(IN THOUSANDS)
<S> <C> <C> <C>
Standardized measure, beginning of year................... $ 43,339 $41,165 $36,011
Net revisions to previous quantity estimates and other.... (10,881) (3,159) 2,022
Extensions, discoveries, additions, and changes in timing
of production, net of related costs..................... 30,107 21,189 27,642
Purchase of reserves in place............................. -- 617 1,720
Changes in estimated future development costs............. (14,053) (4,202) (2,938)
Previously estimated development costs incurred during the
period.................................................. 2,294 4,663 2,145
Sales of oil and gas produced, net of production costs.... (8,031) (5,545) (5,545)
Net change in prices and production costs................. 25,374 (22,643) (23,496)
Accretion of discount..................................... 4,215 4,529 341
Net change in income taxes................................ (9,316) 6,725 3,263
-------- ------- -------
Standardized measure, end of year......................... $ 63,048 $43,339 $41,165
======== ======= =======
</TABLE>

There are numerous uncertainties inherent in estimating quantities of
proved oil and gas reserves and in projecting the future rates of production,
particularly as to natural gas, and timing of development expenditures. Such
estimates may not be realized due to curtailment, shut-in conditions and other
factors which cannot be accurately determined. The above information represents
estimates only and should not be construed as the current market value of the
Company's oil and gas reserves or the costs that would be incurred to obtain
equivalent reserves.

F-24
<PAGE> 72

MALLON RESOURCES CORPORATION

CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS)

<TABLE>
<CAPTION>
JUNE 30, DECEMBER 31,
2000 1999
----------- ------------
(UNAUDITED)
<S> <C> <C>
ASSETS

Current assets:
Cash and cash equivalents................................. 1$,610.... $ 1,230
Accounts receivable:
Oil and gas sales....................................... 1,673.... 1,315
Joint interest participants, net of allowance of $43 and
$43, respectively...................................... 341...... 559
Related parties......................................... -- 53
Other................................................... 3........ 153
Inventories............................................... 219 200
Other..................................................... 167...... 83
-------- --------
Total current assets............................... 4,013 3,593
-------- --------
Property and equipment:
Oil and gas properties, full cost method.................. 112,262 103,315
Natural gas processing plant.............................. 8,407 8,341
Other property and equipment.............................. 1,104 1,084
-------- --------
121,773.. 112,740
Less accumulated depreciation, depletion and
amortization............................................ (55,608) (53,428)
-------- --------
66,165 59,312
-------- --------
Notes receivable............................................ 14 84
Debt issuance costs......................................... 1,652 1,885
Other, net.................................................. 276 552
-------- --------
Total Assets................................................ $ 72,120 $ 65,426
======== ========

LIABILITIES AND SHAREHOLDERS' EQUITY

Current liabilities:
Trade accounts payable.................................... $ 4,588 $ 4,883
Undistributed revenue..................................... 915 934
Accrued taxes and expenses................................ 48 55
Current portion of long-term debt......................... 427 399
Convertible note payable - related party.................. 552 --
-------- --------
Total current liabilities.......................... 6,530 6,271
-------- --------
Long-term debt, net of unamortized discount of $2,814 and
$3,146, respectively...................................... 44,785 34,874
-------- --------
Total liabilities........................................... 51,315 41,145
-------- --------
Commitments and contingencies (Note 6)
Series B Mandatorily Redeemable Convertible Preferred Stock,
$0.01 par value, 500,000 shares authorized, 80,000 and
135,200 shares issued and outstanding, respectively,
liquidation preference and mandatory redemption of $800
and $1,352, respectively.................................. 794 1,341
Mandatorily Redeemable Common Stock, $0.01 par value,
420,000 shares authorized, issued and outstanding,
mandatory redemption of $5,250............................ 3,649 3,450
Shareholders' equity:
Common Stock, $0.01 par value, 25,000,000 shares
authorized; 7,458,976 and 7,413,300 shares issued and
outstanding, respectively............................... 75 74
Additional paid-in capital................................ 77,805 77,013
Accumulated deficit....................................... (58,644) (54,914)
Notes receivable from related party shareholders.......... (2,776) (2,683)
Accounts receivable from shareholders..................... (98) --
-------- --------
Total shareholders' equity......................... 16,362 19,490
-------- --------
Total Liabilities and Shareholders' Equity.................. $ 72,120 $ 65,426
======== ========
</TABLE>

The accompanying notes are an integral part of these consolidated financial
statements.

F-25
<PAGE> 73

MALLON RESOURCES CORPORATION

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

<TABLE>
<CAPTION>
FOR THE SIX MONTHS
ENDED JUNE 30,
-------------------
2000 1999
-------- --------
<S> <C> <C>
Revenues:
Oil and gas sales......................................... $ 7,100 $ 5,933
Interest and other........................................ 133 45
------- -------
7,233 5,978
------- -------
Costs and expenses:
Oil and gas production.................................... 3,206 2,520
Depreciation, depletion and amortization.................. 2,719 2,357
General and administrative, net........................... 2,046 1,282
Interest and other........................................ 2,789 1,162
------- -------
10,760 7,321
------- -------
Net loss.................................................... (3,527) (1,343)
Dividends and accretion on preferred stock.................. (50) (60)
Accretion of mandatorily redeemable common stock............ (199) --
------- -------
Net loss attributable to common shareholders................ $(3,776) $(1,403)
======= =======
Basic loss per share:
Net loss attributable to common shareholders.............. $ (0.48) $ (0.20)
======= =======
Basic weighted average common shares outstanding............ 7,854 7,024
======= =======
</TABLE>

The accompanying notes are an integral part of these consolidated financial
statements.

F-26
<PAGE> 74

MALLON RESOURCES CORPORATION

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

<TABLE>
<CAPTION>
FOR THE SIX MONTHS
ENDED JUNE 30,
-------------------
2000 1999
-------- --------
<S> <C> <C>
Cash flows from operating activities:
Net loss.................................................. $(3,527) $(1,343)
Adjustments to reconcile net loss to net cash provided by
(used in) operating activities:
Depreciation, depletion and amortization............... 2,719 2,357
Accrued interest expense added to long-term debt....... 2,021 --
Accrued interest income added to notes receivable from
related party shareholders............................ (93) --
Amortization of discount on long-term debt............. 332 --
Stock compensation expense............................. 413 55
Changes in operating assets and liabilities:
(Increase) decrease in:
Accounts receivable............................... 283 117
Inventory and other assets........................ (108) (170)
Increase (decrease) in:
Trade accounts payable and undistributed
revenue.......................................... (314) (2,071)
Accrued taxes and expenses........................ (6) 160
Deferred revenue.................................. -- (455)
------- -------
Net cash provided by (used in) operating activities......... 1,720 (1,350)
------- -------
Cash flows from investing activities:
Additions to property and equipment....................... (9,022) (3,866)
Decrease in notes receivable.............................. 70 6
------- -------
Net cash used in investing activities....................... (8,952) (3,860)
------- -------
Cash flows from financing activities:
Proceeds from long-term debt.............................. 7,780 5,280
Payments of long-term debt................................ (195) (654)
Proceeds from stock option and warrants exercises......... 68 55
Payment of preferred dividends............................ (45) (54)
Other..................................................... 4 --
------- -------
Net cash provided by financing activities................... 7,612 4,627
------- -------
Net increase (decrease) in cash and cash equivalents........ 380 (583)
Cash and cash equivalents, beginning of period.............. 1,230 1,733
------- -------
Cash and cash equivalents, end of period.................... $ 1,610 $ 1,150
======= =======
Supplemental cash flow information:
Cash paid for interest.................................... $ 400 $ 1,086
======= =======
Non-cash transactions:
Issuance of common stock in exchange for oil and gas
properties purchased from officers and directors...... $ 119 $ --
======= =======
Issuance of common stock in exchange for accounts
receivable from shareholders.......................... $ 98 $ --
======= =======
</TABLE>

The accompanying notes are an integral part of these consolidated financial
statements.

F-27
<PAGE> 75

MALLON RESOURCES CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE SIX MONTHS ENDED JUNE 30, 2000 AND 1999
(UNAUDITED)

NOTE 1. GENERAL

Mallon Resources Corporation (the "Company") engages in oil and gas
exploration and production through its wholly-owned subsidiary, Mallon Oil
Company ("Mallon Oil"), whose oil and gas operations are conducted primarily in
the State of New Mexico. The Company operates its business and reports its
operations as one business segment. All significant inter-company balances and
transactions have been eliminated from the consolidated financial statements.

These unaudited consolidated financial statements have been prepared in
accordance with generally accepted accounting principles for interim financial
information and with the instructions to Form 10-Q and Article 10 of Regulation
S-X. Accordingly, they do not include all of the information and footnotes
required by generally accepted accounting principles for complete financial
statements. In the opinion of management, such interim statements reflect all
adjustments (consisting of normal recurring adjustments) necessary to present
fairly the financial position and the results of operations and cash flows for
the interim periods presented. The results of operations for these interim
periods are not necessarily indicative of the results to be expected for the
full year. These interim statements should be read in conjunction with the
consolidated financial statements and notes thereto included in the Company's
1999 Form 10-K.

Certain prior year amounts in the consolidated financial statements have
been reclassified to conform to the presentation used in 2000.

NOTE 2. LONG-TERM DEBT

Long-term debt consists of the following:

<TABLE>
<CAPTION>
JUNE 30, DECEMBER 31,
2000 1999
-------- ------------
<S> <C> <C>
Note payable to Aquila Energy Capital Corporation, due
2003...................................................... $42,692 $32,890
Less unamortized discount (effective rate of 13.7%)......... (2,814) (3,146)
------- -------
39,878 29,744
Lease obligation to Universal Compression, Inc. ............ 5,203 5,390
8.5% unsecured note payable to Bank One, Colorado, N.A., due
2002...................................................... 131 139
------- -------
45,212 35,273
Less current portion........................................ (427) (399)
------- -------
Total............................................. $44,785 $34,874
======= =======
</TABLE>

The borrowing base is subject to redetermination annually on or before
April 30. Aquila delayed its April 2000 redetermination until certain wells
drilled by the Company during the first four months of 2000 were completed and
their reserves evaluated. The Company had delayed its completion of the wells
pending receipt of approval from the Jicarilla Apache Tribe to commingle gas
from different zones. The approval was received in April 2000. In July 2000,
Aquila agreed to increase the amount available under the agreement from the
initial amount of $45.7 million to approximately $52.4 million. In connection
with the increase in the borrowing base, Mallon agreed to issue to Aquila an
additional 70,000 shares of common stock. Mallon

F-28
<PAGE> 76
MALLON RESOURCES CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

had previously issued to Aquila 420,000 shares of common stock in September 1999
in connection with the establishment of the credit facility. Aquila has the
one-time right to require Mallon to purchase all 490,000 shares from Aquila at
$12.50 per share during the 30-day period beginning September 9, 2003.

Principal payments on the four-year loan are based on the Company's cash
flow from operations, as defined, less advances for the Company's development
program. As of June 30, 2000, the advances exceeded cash flow from operations
and the Company had not made any principal payments.

During the six months ended June 30, 2000, the Company repaid $187,000 of
lease obligation to Universal Compression and $8,000 of unsecured note payable
to Bank One.

NOTE 3. EARNINGS (LOSS) PER SHARE

Under the provisions of Statement of Financial Accounting Standards
("SFAS") No. 128, basic earnings per share is computed by dividing income
available to common shareholders by the weighted average number of common shares
outstanding for the period. Diluted earnings per share reflects the potential
dilution that could occur if the Company's outstanding stock options and
warrants were exercised (calculated using the treasury stock method) or if the
Company's Series B Mandatorily Redeemable Convertible Preferred Stock were
converted to common stock.

The consolidated statements of operations for the six months ended June 30,
2000 and 1999 reflect only basic earnings per share because the Company was in a
loss position for all periods presented and all common stock equivalents are
anti-dilutive.

NOTE 4. RECENT PRONOUNCEMENTS

In March 2000, the FASB issued Interpretation No. 44, "Accounting for
Certain Transactions involving Stock Compensation." This Interpretation
clarifies (a) the definition of employee for purposes of applying APB Opinion
No. 25, (b) the criteria for determining whether a plan qualifies as a
noncompensatory plan, (c) the accounting consequence of various modifications to
the terms of a previously fixed stock option or award, and (d) the accounting
for an exchange of stock compensation awards in a business combination. This
Interpretation is effective July 1, 2000, but certain conclusions in this
Interpretation cover specific events that occur after either December 15, 1998,
or January 12, 2000. To the extent that this Interpretation covers events
occurring during the period after December 15, 1998, or January 12, 2000, but
before the effective date of July 1, 2000, the effects of applying this
Interpretation are recognized on a prospective basis from July 1, 2000. The
Company believes the adoption of this Interpretation will not have a material
impact on the Company's financial position and results of operations.

F-29
<PAGE> 77
MALLON RESOURCES CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

NOTE 5. MANDATORILY REDEEMABLE CONVERTIBLE PREFERRED STOCK

In April 2000, the Company redeemed 55,200 shares of its Series B
Mandatorily Redeemable Convertible Preferred Stock at the mandatory redemption
price of $10 per share by issuing a convertible promissory note for $552,000 to
the Series B holder, a company in which one of Mallon's directors is also a
director. Interest on the note accrues at 11.3% and is payable quarterly
beginning on June 30, 2000. The note and all unpaid accrued interest is payable
in full on April 15, 2001. The holder of the note may at any time cause any part
of the unpaid principal and accrued interest due to be converted into shares of
the Company's common stock using the same conversion price applicable to the
remaining Series B Preferred Stock shares, currently $10.28. After this
transaction, 80,000 shares of Series B Preferred Stock remain outstanding, all
of which the Company is required to redeem in April 2001.

NOTE 6. COMMITMENTS AND CONTINGENCIES

In April 1999, Mallon Oil filed a civil action to collect approximately
$265,000 of unpaid joint-interest billings from Wadi Petroleum, Inc. relating to
certain oil and gas properties operated by the Company. In April 2000, the
Company settled the matter for a payment to the Company of $150,000 and the
assignment to the Company of certain oil and gas properties.

NOTE 7. OIL AND GAS PROPERTIES

In April 2000, the Government of Costa Rica awarded the Company a
concession to explore for oil and natural gas on approximately 2.3 million acres
in the northeast quadrant of Costa Rica. The concession acreage is contained in
six large contiguous onshore acreage blocks. The Company has completed an
environmental assessment of its proposed operations, and expects approval by the
end of August 2000. The Company expects to sign final contracts thereafter. The
work program will require the expenditure of $8.8 million (including the
drilling of six wells) over a three-year period, with a possible extension of
three more years.

In June 2000, effective January 1, 2000, the Company purchased additional
working interests in certain wells from two of the Company's officers and one of
its directors in exchange for forgiveness of $56,000 of joint interest
participants accounts receivable, 14,800 shares of common stock valued at
$119,000 and $3,000 in cash.

F-30
<PAGE> 78

[MALLON RESOURCES LOGO]