-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, Wd6T6r+VhTiyGpK99TTC8o34p4Vqt+7hscIraLvKRnp6LomGMGb1tB3ymtM+BzPW ci8mAkJIh6o1epNWiRD3MQ== 0000821699-01-500003.txt : 20010410 0000821699-01-500003.hdr.sgml : 20010410 ACCESSION NUMBER: 0000821699-01-500003 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 2 CONFORMED PERIOD OF REPORT: 20001231 FILED AS OF DATE: 20010404 FILER: COMPANY DATA: COMPANY CONFORMED NAME: SOUTHWEST ROYALTIES INC CENTRAL INDEX KEY: 0000821699 STANDARD INDUSTRIAL CLASSIFICATION: CRUDE PETROLEUM & NATURAL GAS [1311] IRS NUMBER: 751917432 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: SEC FILE NUMBER: 000-23701 FILM NUMBER: 1595190 BUSINESS ADDRESS: STREET 1: 407 N BIG SPRING STREET SUITE 300 CITY: MIDLAND STATE: TX ZIP: 79701 BUSINESS PHONE: 9156869927 MAIL ADDRESS: STREET 1: 407 N BIG SPRING STREET SUITE 300 CITY: MIDLAND STATE: TX ZIP: 79701 10-K 1 a10kfinal.txt 90 SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 20549 FORM 10-K (Mark One) X Annual report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the Fiscal year ended December 31, 2000 or ? Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the transition period from __________ to _______________ Commission file number: 000-23701 SOUTHWEST ROYALTIES, INC. SOUTHWEST ROYALTIES (Exact Name of Registrant as HOLDINGS, INC. Specified in Its Charter) (Exact Name of Registrant as Specified in Its Charter) Delaware Delaware (State or Other Jurisdiction of (State or Other Jurisdiction of Incorporation or Organization) Incorporation or Organization) 75-1917432 75-2724264 (I.R.S. Employer Identification (I.R.S. Employer Identification Number) Number) 407 North Big Spring, Suite 300 Midland, Texas 79701 (Address of Principal Executive (Zip Code) Offices) Registrants' Telephone Number, Including Area Code: (915) 686-9927 Securities to be registered pursuant to Section 12(b) of the Act: None Securities to be registered pursuant to Section 12(g) of the Act: 10.5% Senior Notes due 2004 (Title of Class) Indicate by check whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No Indicate by check mark if disclosure of delinquent files pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. X As of March 30, 2001, Southwest Royalties, Inc. had outstanding 100 shares of common stock, $.10 par value, which is its only class of stock. As of March 30, 2001, Southwest Royalties Holdings, Inc. had outstanding 946,488 and 129,046 shares of common and redeemable common stock, respectively. The common stock of Southwest Royalties Holdings, Inc. is not traded on any exchange and, therefore, its aggregate market value and the value of shares held by nonaffiliates cannot be determined. All of the outstanding shares of Southwest Royalties, Inc. are held by Southwest Royalties Holdings, Inc. Documents Incorporated by Reference: None TABLE OF CONTENTS Page Number PART I Item 1. Business 3 Item 2. Properties 23 Item 3. Legal Proceedings 31 Item 4. Submission of Matters to a Vote of Security Holders 31 PART II Item 5. Market for Registrant's Common Equity and Related Stockholder Matters 32 Item 6. Selected Financial and Operating Data 33 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations 36 Item 7A. Quantitative and Qualitative Disclosures About Market Risk46 Item 8. Financial Statements and Supplementary Data 49 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 85 PART III Item 10. Directors and Executive Officers of the Registrant 85 Item 11. Executive Compensation 87 Item 12. Security Ownership of Certain Beneficial Owners and Management 88 Item 13. Certain Relationships and Related Transactions 89 PART IV Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K 90 Parts I and II of this Report contain ''forward-looking statements'' within the meaning of Section 27A of the Securities Act of 1933, as amended (the "Securities Act") and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"). All statements other than statements of historical facts included in this Report, including, without limitation, statements in "Item 1. Business" and under "Item 2. Properties" and "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations" regarding proved reserves, estimated future net reserves, present values, planned capital expenditures (including the amount and nature thereof), increases in oil and gas production, the number of wells anticipated to be drilled and the Company's financial position, business strategy and other plans and objectives for future operations, are forward-looking statements. Although the Company believes that the expectations reflected in such forward-looking statements are reasonable, there can be no assurance that the results or developments anticipated by the Company will be realized or, even if substantially realized, that they will have the expected consequences to or effects on its business or operations. There are numerous risks and uncertainties that can affect the outcome and timing of such events, including many factors beyond the control of the Company. All subsequent written and oral forward looking statements attributable to the Company or persons acting on its behalf are expressly qualified in their entirety by such factors. The Company assumes no obligation to update any such forward-looking statements. PART I Certain oil and gas terms used in this report are defined under "Item 1. Business - Glossary of Oil and Gas Terms." ITEM 1. BUSINESS. The Company Southwest Royalties Holdings, Inc. ("SRH"), a Delaware corporation, was formed in 1997 to serve as a holding company for Southwest Royalties, Inc. ("Southwest"), Midland Red Oak Realty, Inc. ("Red Oak") and an equity investment in Basic Energy Services, Inc., ("Basic") (formerly known as Sierra Well Services, Inc.). SRH is an independent oil and gas company engaged in the acquisition, development and production of oil and gas properties, primarily in the Permian Basin of West Texas and southeastern New Mexico, through its wholly-owned subsidiary, Southwest. Since 1983, Southwest has grown primarily through selective acquisitions of producing oil and gas properties, both directly and through the oil and gas partnerships it manages. SRH also owns and manages real estate properties through its subsidiary, Red Oak. References in this report to the "Company" are to SRH and its consolidated subsidiaries, including Southwest and Red Oak. The principal operating subsidiary of SRH is Southwest, a Delaware corporation that was formed in 1983 to acquire and develop oil and gas properties. Southwest initially financed the acquisition of oil and gas reserves and its exploration and development efforts through public and private limited partnership offerings. Southwest is a general partner of these limited partnerships, owns interests in these partnerships and receives management fees and operating cost reimbursements from these partnerships. As of December 31, 2000, Southwest had total estimated net proved reserves of 25.8 MMBbls of oil and 70.4 Bcf of natural gas, aggregating 37.5 MMBoe, with a PV-10 Value of $473.5 million. Southwest's primary operations are in the Permian Basin of West Texas and southeastern New Mexico. As of December 31, 2000, Southwest has only one subsidiary, Blue Heel Company ("Blue Heel"). Effective November 1999, Threading Products International, LLC ("TPI"), a former subsidiary of Southwest, was liquidated. Effective August 16, 2000, Midland Southwest Software ("MSS"), a former subsidiary of Southwest, was merged into Southwest. Blue Heel holds a nominal interest in certain oil and gas properties owned by Southwest. Red Oak, a Delaware corporation, was formed in 1992 to own and manage commercial real estate properties, including shopping centers and office buildings, in secondary real estate markets in the southwestern United States. As of December 31, 2000, Red Oak owned and managed 20 commercial real estate properties. SRH owns approximately 81% of the common stock of Red Oak on a diluted basis. As of December 31, 2000 Red Oak has four wholly-owned subsidiaries, MRO Management, Inc. ("MRO Management"), MRO Commercial, Inc. ("MRO Commercial"), MRO N Cross, Inc. ("Northcross"), and MRO Southwest, Inc. ("MRO Southwest"). MRO Commercial, Northcross and MRO Southwest each hold titles to certain real estate properties and are the borrowers under the credit agreements related to such properties. These credit agreements are non-recourse to Red Oak. MRO Management performs real estate management services for Red Oak, MRO Commercial, Northcross, MRO Southwest and for third party clients. In December 1999, MRO Madera, Inc. ("Madera"), a former subsidiary of Red Oak, was dissolved after all remaining tracts of land were sold. In June 1999, the net assets and liabilities of MRO Properties, Inc. ("MROP") and MRO La Placita, Inc. ("La Placita"), former subsidiaries of Red Oak, were merged into Red Oak. Basic, a Delaware corporation, was formed in 1992 to provide certain well services for oil and gas companies. Basic provides a broad range of well services to oil and gas companies, including workover rig services, liquids handling and other services. As of December 31, 2000, the Company directly owns approximately 6.65% of the common stock of Basic and indirectly owns an additional 2.48% interest through Southwest, which is the general partner and 15% interest holder in each of two partnerships that own approximately 16.24% of the common stock of Basic. As of July 1, 1997, Basic was deconsolidated from SRH. Through December 31, 2000, both the direct and the indirect investments in Basic are accounted for using the equity method. As of January 1, 2001, the direct investment will be accounted for at cost. On December 21, 2000, Basic entered into a refinancing and restructuring of its debt and equity. Upon the signing of the documents, the Company's percentage of direct and indirect ownership in Basic was diluted to 9.13%. A new equity investor, in exchange for 1,441,730 shares of Basic's common stock, purchased and retired $24.5 million of Basic's debt from its previous lender. The equity investor received a 76% ownership. Additionally, $10.5 million of the debt held by the previous lender was refinanced with a new lender. The Company had previously written down its investment in Basic to zero. Based on the restructuring of Basic's debt and equity and the subsequent dilution of the Company's ownership, the investment in Basic is no longer considered a material investment. The Company's principal executive offices are located at 407 North Big Spring, Suite 300, Midland, Texas 79701. The Company's telephone number is (915) 686-9927. Operating Strategy Funding for the Company's business activities has historically been provided by operating cash flows, bank borrowings and debt issuance, reserve-based financing and sales of equity. Any future capital expenditures or acquisitions will most likely require additional equity or financing and will be dependent upon financing arrangements available at the time. Management is constantly monitoring the Company's cash position and its ability to meet its financial obligations as they become due, and in this effort, is exploring various strategies for addressing its current and future liquidity needs. During 2000, 1999 and 1998, for instance, Southwest sold $566,000, $5.6 million and $5.7 million, respectively, of oil and gas properties in an ongoing effort to decrease its production costs and/or improve its cash position. The Company also negotiated a $50 million Revolving Loan Facility with BankOne Texas, N.A. the proceeds of which were used to purchase in December 1999 and January 2000, approximately $76.3 million of the 10.5% Senior Note due 2004. In August 2000, the Company refinanced the Revolving Loan Facility with a new lender and extended the maturity date out until August 2003. As of December 31, 2000, SRH's consolidated cash balance was $21.8 million, of which $16.4 million was available to Southwest and $5.4 million was available to Red Oak. The Company is tentatively budgeting $21.0 million in capital expenditures in its oil and gas business for 2001. Of the $21.0 million capital expenditures budgeted for 2001, $16.0 million is for development projects. The final budget will depend on financial strategies that are currently being developed including hedging strategies, divestitures and company structure. The budget will also be affected by the volatility of the oil and gas commodity prices. Further revisions may be necessary during the year in response to market conditions and any debt and/or equity restructurings, which can be negotiated by the Company. The Company is currently limited to $13.0 million in capital expenditures in its oil and gas business based on current loan covenants and will therefore need to request waivers from its lender for the expanded capital expenditure budget. Although the Company cannot be certain, based on the strong commodity pricing market, the Company expects the lender to waive the restriction. The Company is tentatively budgeting $4.0 million in capital improvement expenditures in its real estate business for 2001. Funding for the 2001 capital expenditures will come from draws on existing Notes, which are collateralized by the real estate on which the capital improvements are to be made. The Company concentrates its oil and gas activities in the Permian Basin of West Texas and southeastern New Mexico, with properties in this region representing over 95% of the Company's PV-10 Value at December 31, 2000. The Company believes that its long-life oil and gas properties and large inventory of development projects in the Permian Basin, coupled with region-specific geological, engineering and production experience, provide it with focused operations. Company-operated properties comprised approximately 68% of its PV-10 Value at December 31, 2000, allowing substantial control over the incurrence and timing of capital and operating expenditures. The Company hopes to continue the expansion of its real estate business, primarily in the southwestern United States. However, the expansion will depend to a large extent on Red Oak's ability to refinance approximately $58.5 million of principal on two credit facilities that expire in 2001. Depending on the debt market, Red Oak may have to sell equity to help reduce its highly leveraged capital structure. Due to the floating interest rate facilities and the rise in interest rates in 2000, Red Oak experienced difficulties in meeting all debt service obligations as they became due. Red Oak's financial difficulties stem largely from the increase in interest rates and the time needed to convert non-cash producing assets into cash flow. The recent drop in interest rates coupled with Red Oak's active management practices will lead to consolidation benefits, cost savings, more efficient utilization and improved cash flow, thereby lessening its financial difficulties. Southwest General. Since inception, the Company has focused on increasing its reserves and average daily production of oil and gas through acquisitions of producing properties and development drilling and production enhancement activities. Private Placement. On October 14, 1997, Southwest completed a $200 million private placement of 10.5% Senior Notes due 2004, Series A ("Series A Notes") pursuant to Rule 144A of the Securities Act (the "Private Placement"). Thereupon, the Series A Notes were offered and sold by the underwriters to only qualified institutional buyers. The net proceeds from the Private Placement were approximately $190 million. Proceeds from the Offering were used to among other things, provide approximately $72 million for an oil and gas acquisition and approximately $27 million for working capital. The Series A Notes were issued pursuant to an indenture, dated October 14, 1997 (the "Indenture"), by and among Southwest, as Issuer, SRH, as the Parent Guarantor, and State Street Bank and Trust Company, N.A., as Trustee (the "Trustee"). Exchange Offer. On March 11, 1998, Southwest concluded a registered offering to exchange the Series A Notes for 10.5% Series B Senior Notes due 2004, which had been registered under the Securities Act ("Notes"). The form and terms of the Notes are identical in all material respects to the form and terms of the Series A Notes. The Notes evidence the same debt as the Series A Notes and were issued under and are entitled to the benefits of the Indenture governing the Series A Notes. An integral part of Southwest's 1997 business strategy in conjunction with the Series A Notes issuance, involved the successful investment of the approximately $27 million of additional working capital into both the development and exploitation of its existing oil and gas properties and the possible acquisition of additional producing oil and gas properties. It was imperative to increase production volumes to meet the ongoing cash flow needs and requirements of the Company. Southwest had made substantial capital expenditures of $16.7 million and $32.1 million for 1996 and 1995 respectively and had budgeted additional capital spending of approximately $45 million for the remainder of 1997 and 1998. Management believed that the successful investment of the additional working capital would have increased production levels thereby supplying additional cash flow to the Company to meet requirements and continue to fund additional capital expenditure projects. The harsh decline in commodity pricing experienced by Southwest throughout 1998 and the first half of 1999, had a double impact on Southwest's cash flow by severely reducing proceeds associated with current production levels and reducing Southwest's investment in undeveloped reserves. The inability to replace the existing, depleting reserve base ultimately and systematically created lower revenues and margins. As net revenues fell due to declining price and production, an increasingly larger portion of Southwest's cash flow was necessary to meet debt interest expense. As prices remained depressed, the existing cash balance was depleted in an effort to meet current debt interest requirements. During the later part of 1999 and throughout 2000, commodity prices have made a come back. The improvements in the commodity price environment have enhanced Southwest's financial flexibility, as compared to what existed at the end of 1998 and 1999. Based on current commodity prices, Southwest is building its cash reserves and has reimplemented its drilling program. Southwest seeks to increase its oil and gas reserves, production and cash flow by concentrating on drilling low-risk developmental wells and by conducting additional development activities such as recompletions. Southwest is also actively searching for attractive oil and gas property acquisitions. Management realizes that Southwest is highly leveraged and intends to monitor closely the business environment and to continue its efforts to reduce debt and create financial flexibility. Southwest anticipates that it will continue to evaluate the sale of non-core assets, the disposition of which would increase capital resources available for other activities and create organizational and operational efficiencies. While Southwest generally does not dispose of assets solely for the purpose of reducing debt, such dispositions can have the result of furthering Southwest's objective of financial flexibility through reduced debt levels. Southwest regularly pursues and evaluates recapitalization strategies and acquisition opportunities (including opportunities to engage in mergers, consolidations or other business combinations) and at any given time may be in various stages of evaluating such opportunities. Drilling Activities. The Company has historically complemented its oil and gas reserves, production and cash flow by concentrating on drilling low-risk development wells and by conducting additional development activities such as recompletions. During 2000, the Company invested approximately $8.8 million on developmental activity as compared to $3.2 million in 1999. Exploratory Activities. The Company increased its spending for exploratory activities to $476,000 in 2000 from $76,000 in 1999. Exploratory drilling involves greater risks of dry holes or failure to find commercial quantities of hydrocarbons than development drilling or enhanced recovery activities. See "Item 1. - Operating Hazards and Risks." Red Oak Red Oak was formed by the Company in 1992 to acquire and manage neighborhood and community shopping centers, other retail and commercial properties and office buildings. These properties are primarily leased, on a long-term basis, to major retail companies, local specialty retailers and professional and business tenants throughout secondary urban markets in the southwestern United States. As of December 31, 2000, Red Oak owned and managed fifteen shopping centers, five office buildings and raw land held for future development. Red Oak's primary objective has historically been to acquire, own and manage a portfolio of commercial properties that provides opportunity to increase net operating income and results in significant capital appreciation. Consistent with this strategy, Red Oak focused its activities primarily in secondary markets in the southwestern United States, including San Antonio, Austin, Abilene, Midland, Odessa, Victoria and San Angelo, Texas; Tucson, Arizona; and Tulsa and Oklahoma City, Oklahoma. Red Oak's business plan focuses on the identification and acquisition of under-managed, and therefore undervalued, real estate. Red Oak's acquisition criterion identifies properties that have potential for value appreciation because of qualities such as irreplaceable location and unused pad sites as well as leasing opportunity based on previous unfocused management. Upon acquiring these properties, Red Oak must reposition and revitalize the majority of its properties to increase cash flow and market value. This process is very capital intensive. Red Oak generally obtains financing for both the acquisition and repositioning of the property. The revitalization and repositioning plan may take from eighteen to sixty months, depending on many factors. During the repositioning period, the property normally will not produce positive cash flow. Based on this operating strategy, Red Oak does not expect to generate much, if any, cash flow from operations in the near future and is dependent on its ability to create equity in its properties through its management practices to be able to obtain additional financing for operations until the time that the properties can cash flow on their own, or their market value is such that they can be sold at a profit. Red Oak experienced financial difficulties and generated losses for the years ended December 31, 2000, 1999 and 1998. The capital structure of Red Oak is highly leveraged with $58.5 million and $15.1 million of principal and cash interest payments, respectively, due in 2001. Management is currently in the process of renegotiating the terms of Red Oak's various obligations with its lenders and/or seeking new lenders or equity investors. Additionally, management is disposing of certain assets in order to meet its obligations. Employees As of December 31, 2000, Southwest employed 92 people and Red Oak employed 158. The Company's future success will depend partially on its ability to attract, retain and motivate qualified personnel. The Company is not a party to any collective bargaining agreements and has not experienced any strikes or work stoppages. The Company considers its relations with its employees to be satisfactory. SRH has no compensated employees. Competition The oil and natural gas industry is highly competitive. The Company's oil and gas business competes for the acquisition of oil and natural gas properties, primarily on the basis of the price to be paid for such properties, with numerous entities including major oil companies, other independent oil and natural gas concerns and individual producers and operators. Many of these competitors are large, well-established companies and have financial and other resources substantially greater than those of the Company. The Company's ability to acquire additional oil and gas properties and to discover reserves in the future will depend upon its ability to restructure debt facilities and/or procure non-recourse funding as well as its ability to evaluate and select suitable properties and to consummate transactions in a highly competitive environment. The Company's real estate business also competes for the acquisition of desirable commercial real estate properties, primarily on the basis of price. Operating Hazards and Risks The oil and natural gas business involves a variety of operating risks, including the risk of fire, explosions, blow outs, pipe failure, abnormally pressured formations and environmental hazards such as oil spills, gas leaks, ruptures or discharges of toxic gases. Any of these occurrences could result in substantial losses to the Company due to injury or loss of life, severe damage to or destruction of property, natural resources and equipment, environmental damage, clean-up responsibilities, regulatory investigation and penalties and suspension of operations. Drilling activities are subject to many risks, including the risk that no commercially productive reservoirs will be encountered. There can be no assurance that new wells drilled by the Company will be productive or that the Company will recover all or any portion of its investment. Drilling for oil and gas may involve unprofitable efforts, not only from dry wells, but from wells that are productive but do not produce sufficient net revenues to return a profit after drilling, operating or other costs. The cost of drilling, completing and operating wells is often uncertain. The Company's drilling operations may be curtailed, delayed or canceled as a result of numerous factors, many of which are beyond the Company's control, including title problems, weather conditions, mechanical problems, compliance with governmental requirements and shortages and delays in the delivery of equipment and services. The Company's future drilling activities may not be successful and, if unsuccessful, such failure may have a material adverse effect on the Company's future results of operations and financial condition. Although the Company maintains insurance coverage considered to be customary in each industry in which it participates, it is not fully insured against certain risks, either because insurance is not available or because of the high premium costs. The Company's real estate business carries business interruption insurance. The Company does maintain physical damage, employer's liability, comprehensive commercial general liability and workers' compensation insurance. There can be no assurance that any insurance obtained by the Company will be adequate to cover any losses or liabilities, or that such insurance will continue to be available or available on terms that are acceptable to the Company. Regulation General. Various aspects of the Company's oil and natural gas operations are subject to extensive and continually changing regulation, as legislation affecting the oil and natural gas industry is under constant review for amendment or expansion. Numerous departments and agencies, both federal and state, are authorized by statute to issue, and have issued, rules and regulations binding upon the oil and natural gas industry and its individual members. The Federal Energy Regulatory Commission ("FERC") regulates the transportation and sale for resale of natural gas in interstate commerce pursuant to the Natural Gas Act of 1938 ("NGA") and the Natural Gas Policy Act of 1978 ("NGPA"). In the past, the Federal government has regulated the prices at which oil and natural gas could be sold. While sales by producers of natural gas and all sales of crude oil, condensate and natural gas liquids can currently be made at uncontrolled market prices, Congress could reenact price controls in the future. Deregulation of wellhead sales in the natural gas industry began with the enactment of the NGPA in 1978. In 1989, Congress enacted the Natural Gas Wellhead Decontrol Act (the "Decontrol Act"). The Decontrol Act removed all remaining NGA and NGPA price and nonprice controls affecting wellhead sales of natural gas effective January 1, 1993. Regulation of Sales and Transportation of Natural Gas. The Company's sales of natural gas are affected by the availability, terms and cost of transportation. The price and terms for access to pipeline transportation are subject to extensive regulation. In recent years, the FERC has undertaken various initiatives to increase competition within the natural gas industry. As a result of initiatives like FERC Order No. 636, issued in April 1992, the interstate natural gas transportation and marketing system has been substantially restructured to remove various barriers and practices that historically limited non-pipeline natural gas sellers, including producers, from effectively competing with interstate pipelines for sales to local distribution companies and large industrial and commercial customers. The most significant provisions of Order No. 636 require that interstate pipelines provide firm and interruptible transportation service on an open access basis that is equal for all natural gas supplies. In many instances, the results of Order No. 636 and related initiatives have been to substantially reduce or eliminate the interstate pipelines' traditional role as wholesalers of natural gas in favor of providing only storage and transportation services. While the United States Court of Appeals have historically upheld most of Order No. 636, certain related FERC orders, including the individual pipeline restructuring proceedings, are still subject to judicial review and may be reversed or remanded in whole or in part. While the outcome of these proceedings cannot be predicted with certainty, the Company does not believe that it will be affected materially differently than its competitors. The FERC also announced several important transportation-related policy statements and proposed rule changes, including a statement of policy and a request for comments concerning alternatives to its traditional cost-of-service rate making methodology to establish the rates interstate pipelines may charge for their services. A number of pipelines have obtained FERC authorization to charge negotiated rates as one such alternative. In February 1997, the FERC announced a broad inquiry into issues facing the natural gas industry to assist the FERC in establishing regulatory goals and priorities in the post-Order No. 636 environment. Similarly, the Texas Railroad Commission has been reviewing changes to its regulations governing transportation and gathering services provided by intrastate pipelines and gatherers. While the changes being considered by these federal and state regulators would affect the Company only indirectly, they are intended to further enhance competition in natural gas markets. The Company cannot predict what further action the FERC or state regulators will take on these matters, however, the Company does not believe that it will be affected by any action taken materially differently than other natural gas producers with which it competes. Additional proposals and proceedings that might affect the natural gas industry are pending before Congress, the FERC, state commissions and the courts. The natural gas industry historically has been very heavily regulated; therefore, there is no assurance that the less stringent regulatory approach recently pursued by the FERC and Congress will continue. Oil Price Controls and Transportation Rates. Sales of crude oil, condensate and gas liquids by the Company are not currently regulated and are made at market prices. The price the Company receives from the sale of these products may be affected by the cost of transporting the products to market. Environmental. Extensive federal, state and local laws regulating the discharge of materials into the environment or otherwise relating to the protection of the environment affect Southwest's oil and natural gas operations. Numerous governmental departments issue rules and regulations to implement and enforce such laws, which are often difficult and costly to comply with and which carry substantial civil and even criminal penalties for failure to comply. Some laws, rules and regulations relating to protection of the environment may, in certain circumstances, impose strict liability for environmental contamination, rendering a person liable for environmental damages and cleanup costs without regard to negligence or fault on the part of such person. Other laws, rules and regulations may restrict the rate of oil and natural gas production below the rate that would otherwise exist or even prohibit exploration and production activities in sensitive areas. In addition, state laws often require various forms of remedial action to prevent pollution, such as closure of inactive pits and plugging of abandoned wells. The regulatory burden on the oil and natural gas industry increases the Company's cost of doing business and consequently affects the Company's profitability. The Company believes that it is in substantial compliance with current applicable environmental laws and regulations and that continued compliance with existing requirements will not have a material adverse impact on the Company's operations. However, environmental laws and regulations have been subject to frequent changes over the years, and the imposition of more stringent requirements could have a material adverse effect upon the capital expenditures, earnings or competitive position of the Company. In addition, Red Oak's real estate management activities are subject to federal, state and local laws, rules and regulations pertaining to protection of the environment which may, in certain circumstances, impose strict liability for environmental contamination, thus rendering Red Oak liable for environmental damages and clean up costs without regard to negligence or fault on the part of Red Oak. Asbestos-containing materials may be present at Red Oak's real estate holdings, which may dictate costly remediation to abate asbestos or which may increase the cost of renovations to property when they become necessary. Further, activities on adjacent properties, such as dry cleaning, gasoline retailing, and automobile maintenance, may result in subsurface soil and groundwater contamination that could impair Red Oak's use or sale of real estate holdings or cause Red Oak to incur costs to remediate any contamination caused by activities of lessors or adjacent properties. The Comprehensive Environmental Response, Compensation and Liability Act ("CERCLA") imposes liability, without regard to fault on certain classes of persons that are considered to be responsible for the release of a "hazardous substance" into the environment. These persons include the current or former owner or operator of the disposal site or sites where the release occurred and companies that disposed or arranged for the disposal of hazardous substances. Under CERCLA such persons may be subject to joint and several liability for the costs of investigating and cleaning up hazardous substances that have been released into the environment, for damages to natural resources and for the costs of certain health studies. In addition, companies that incur liability frequently also confront third party claims because it is not uncommon for neighboring landowners and other third parties to file claims for personal injury and property damage allegedly caused by hazardous substances or other pollutants released into the environment from a polluted site. The Federal Solid Waste Disposal Act, as amended by the Resource Conservation and Recovery Act of 1976 ("RCRA"), regulates the generation, transportation, storage, treatment and disposal of hazardous wastes and can require cleanup of hazardous waste disposal sites. RCRA currently excludes drilling fluids, produced waters and other wastes associated with the exploration, development or production of oil and natural gas from regulation as "hazardous waste." Disposal of such non-hazardous oil and natural gas exploration, development and production wastes usually are regulated by state law. Other wastes handled at exploration and production sites or used in the course of providing well services may not fall within this exclusion. Moreover, stricter standards for waste handling and disposal may be imposed on the oil and natural gas industry in the future. From time to time legislation is proposed in Congress that would revoke or alter the current exclusion of exploration, development and production wastes from the RCRA definition of "hazardous wastes" thereby potentially subjecting such wastes to more stringent handling, disposal and cleanup requirements. If such legislation were enacted it could have a significant impact on the operating costs of Southwest, as well as the oil and natural gas industry in general. The impact of future revisions to environmental laws and regulations cannot be predicted. The Company's operations are also subject to the Clean Air Act ("CAA") and comparable state and local requirements. Amendments to the CAA were adopted in 1990 and contain provisions that may result in the gradual imposition of certain pollution control requirements with respect to air emissions from operations of Southwest. Southwest may be required to incur certain capital expenditures in the next several years for air pollution control equipment in connection with obtaining and maintaining operating permits and approvals for air emissions. However, Southwest believes its operations will not be materially adversely affected by any such requirements, and the requirements are not expected to be any more burdensome to Southwest than to other similarly situated companies involved in oil and natural gas exploration and production activities or well servicing activities. Southwest maintains insurance against "sudden and accidental" occurrences, which may cover some, but not all, of the risks described above. Most significantly, the insurance maintained by Southwest will not cover the risks described above which occur over a sustained period of time. Further, there can be no assurance that such insurance will continue to be available to cover all such costs or that such insurance will be available at premium levels that justify its purchase. The occurrence of a significant event not fully insured or indemnified against could have a material adverse effect on Southwest's financial condition and operations. Regulation of Oil and Natural Gas Exploration and Production. Exploration and production operations of the Company are subject to various types of regulation at the federal, state and local levels. Such regulations include requiring permits and drilling bonds for the drilling of wells, regulating the location of wells, the method of drilling and casing wells, and the surface use and restoration of properties upon which wells are drilled. Many states also have statutes or regulations addressing conservation matters, including provisions for the utilization or pooling of oil and natural gas properties, the establishment of maximum rates of production from oil and natural gas wells and the regulation of spacing, plugging and abandonment of such wells. Some state statutes limit the rate at which oil and natural gas can be produced from Southwest's properties. See "Risk Factors-Compliance with Governmental Regulations." Risks Associated with Business Activities Adverse Financial Condition. The Company has experienced a period of adverse financial condition due mainly to cash flow shortfalls at Red Oak. The Company's auditors have added an explanatory paragraph to their report which states their concerns about the Company's ability to continue as a going concern. Their concern stems mainly from $58.5 million of principal maturing in 2001 and Red Oaks ability to refinance its debt. The Company had net income for the twelve months ended December 31, 2000 of $10.1 million compared to a net loss of $5.4 million during the twelve months ended December 31, 1999. Included in the net income of $10.1 million was an extraordinary gain of approximately $12.7 million from early extinguishment of debt. Although the Company experienced net income at the consolidated level Red Oak had a net loss of approximately $12.9 million and had negative cash flow from operations of approximately $2.3 million in 2000. The Company had a stockholders' deficit of $103.1 million as of December 31, 2000. Such deficit could impair the Company's ability to raise additional equity capital in the future. For further information about financial condition, please read "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations." Substantial Leverage. Because of the Company's substantial level of indebtedness, a significant portion of the Company's cash flow is dedicated to the payment of interest. The Company cannot ensure that it will be able to make the future payments required by its indebtedness. As of December 31, 2000, the Company's total indebtedness was $337.3 million, including $122.7 million attributable to our obligations under the Senior Notes, $50.0 million attributable to our obligations under the Revolving Loan Facility, $163.4 million attributable to Red Oak and $1.2 million attributable to other debt. Certain holders, who collectively own approximately 12% of SRH's common stock, have an option to cause SRH to redeem such holders' common stock at any time beginning December 31, 2001, five years from the date of issuance of such common stock, subject to the terms of a subscription agreement under which SRH sold the common stock (the "Subscription Agreement") and subject to any restrictions imposed by law. The Subscription Agreement provides that this redemption right terminates on the effective date of any registration statement under the Securities Act filed with the Commission relative to the offer and sale of any amount of SRH's common stock to the public. SRH is unable to predict the amount of money it would be required to pay if the redemption right is exercised. In addition, the Company is subject to an Indenture pursuant to its 10.5% Senior Notes due 2004 (the "Indenture") which may also restrict SRH's ability to make such payments. While SRH is prepared to explore ways to create a market for the Securities, it is unclear whether SRH will be able to publicly resale the Securities in order to terminate the redemption option. Payment Upon a Change of Control. Upon the occurrence of a "change of control", as defined in the Indenture, of the Company, each holder of the Notes may require Southwest to purchase all or a portion of such holder's Notes at 101% of the principal amount of the Notes, together with accrued and unpaid interest, if any, to the date of purchase. If a change of control were to occur, Southwest may not have the financial resources to repay all of the Notes and the other indebtedness that might become payable upon the occurrence of such change of control. Adequacy of Collateral; Risks of Foreclosure. SRH has pledged to the Trustee (under the Indenture), for the ratable benefit of the holders of the Notes, all of the Basic common stock and Red Oak common stock directly owned by SRH as security for the Parent Guarantee (collectively, the "Indenture Collateral"). Under the Loan and Security Agreement (the "Foothill Agreement") by and among Southwest, Foothill Capital Corporation as the agent (the "Agent") and certain financial institutions, Southwest has granted to the Agent for the benefit of the lender financial institutions continuing liens on substantially all of Southwest's assets, including its accounts receivable, equipment, inventory, negotiable collateral, oil and gas properties and real property (collectively, the "Foothill Collateral"). In the event of a default under the Indenture or the Foothill Agreement, there can be no assurance that the Trustee or the Agent would be able to foreclose on or dispose of any of the Indenture Collateral or the Foothill Collateral, as the case may be, without substantial delays and other risks or that the proceeds obtained therefrom would be sufficient to pay all amounts owed. Under the Indenture, SRH would be required to file a shelf registration statement and any of SRH's other subsidiaries whose stock is pledged to the Trustee would be required to grant registration rights with respect to such stock, in each case to allow the Trustee to be able to sell the pledged shares of their common stock publicly. Circumstances beyond the control of the Company, however, may delay the availability of a current prospectus. There is currently no public market for the shares of SRH common stock and there can be no assurance that there will be any public market for the common stock of any subsidiary of SRH. In addition, if Southwest becomes a debtor in a case under the United States Bankruptcy Code ("the Bankruptcy Code"), the automatic stay imposed by the Bankruptcy Code would prevent the Trustee or the Agent from selling or otherwise disposing of the Indenture Collateral or the Foothill Collateral, as the case may be, without bankruptcy court authorization. In that case, the foreclosure might be delayed indefinitely. Moreover, the bankruptcy of any entity related to Southwest might result in a similar delay if Southwest were "substantively consolidated" with the related entity. Possible Limitations on Enforceability of Subsidiary Guarantees. Southwest's obligations under the Notes and under the Foothill Agreement may under certain circumstances be guaranteed on a senior basis by certain subsidiaries of Southwest. Various fraudulent conveyance laws have been enacted for the protection of creditors and may be utilized by a reviewing court to subordinate or void a subsidiary guaranty. It is also possible that under certain circumstances a court could hold that the direct obligations of a subsidiary guarantor could be superior to the obligations under a subsidiary guaranty. To the extent that a court were to find that at the time a subsidiary guaranty was entered into either (1) the subsidiary guaranty was incurred with the intent to hinder, delay or defraud any present or future creditor or that the subsidiary guarantor contemplated insolvency with a design to favor one or more creditors to the exclusion in whole or in part of others or (2) the subsidiary guarantor did not receive fair consideration or reasonably equivalent value for issuing the subsidiary guaranty and, at the time it issued the guaranty, the subsidiary guarantor (i) was insolvent or rendered insolvent by reason of the issuance of the subsidiary guaranty, (ii) was engaged or about to engage in a business or transaction for which the remaining assets of the subsidiary guarantor constituted unreasonably small capital, or (iii) intended to incur, or believed that it would incur, debts beyond its ability to pay such debts as they matured, the court could void or subordinate the subsidiary in favor of the subsidiary guarantor's other creditors. Among other things, a legal challenge of a subsidiary guaranty issued on fraudulent conveyance grounds may focus on the benefits, if any, realized by the subsidiary guarantor. To the extent that proceeds from the Private Placement of the Notes or proceeds from the Foothill Loan were used to refinance the indebtedness of the Company, a court might find that a subsidiary guarantor did not benefit from incurrence of the indebtedness represented by the Notes or by the Foothill Loan, as the case may be. The measure of insolvency for purposes of determining whether a transfer is voidable as a fraudulent transfer varies depending upon the law of the jurisdiction that is being applied. Generally, however, a debtor would be considered insolvent if the sum of all its debts, including contingent liabilities, was greater than the value of all its assets at a fair valuation or if the present fair saleable value of the debtor's assets was less than the amount required to repay its probable liability on its debts, including contingent liabilities, as they become absolute and mature. To the extent that a subsidiary guaranty is voided as a fraudulent conveyance or found unenforceable for any other reason, holders of the Notes and lenders in the Foothill Loan would cease to have any claim in respect to the applicable subsidiary. In such event, the claims of the holders of the Notes and lenders in the Foothill Loan against such subsidiary would be subject to the prior payment of all liabilities and preferred stock claims of such subsidiary guarantor. There can be no assurance that, after providing for all prior claims and preferred stock interests, if any, there would be sufficient assets to satisfy the claims of the holders of the Notes and lenders in the Foothill Loan relating to any voided portion of such subsidiary guaranty. Voting Control. As of December 31, 2000, H. H. Wommack, III, Chairman of the Board, President and Chief Executive Officer of SRH and Southwest, owned 73.2% of the outstanding voting shares of common stock of SRH, which owns 100% of the common stock of Southwest and approximately 81% of the total common and preferred stock of Red Oak. Therefore, Mr. Wommack has the ability to elect all of the directors of SRH, Southwest and Red Oak and, directly and indirectly, influence all decisions made by SRH, Southwest and Red Oak. Dependence on Key Personnel. The Company depends to a large extent on the services of H. H. Wommack, III and certain other senior management personnel. The loss of the services of Mr. Wommack and other senior management personnel could have a material adverse effect on the Company's operations. The Company does not currently have an employment contract with any senior management or key personnel. The Company believes that its success is also dependent upon its ability to continue to employ and retain skilled technical personnel. The inability of the Company to employ or retain skilled technical personnel could have a material adverse effect on the Company's operations. Although the Company maintains key man life insurance on the life of Mr. Wommack in the amount of $15 million, the existence of such insurance does not mean that the death or disability of Mr. Wommack would not have a materially adverse effect upon the Company. The key man life insurance is pledged to Foothill Capital Corporation at December 31, 2000. Volatility of Oil and Gas Prices. Revenues from the Company's operations are highly dependent on the price of oil and gas. The markets for oil and gas are volatile and prices for oil and gas are subject to wide fluctuations in response to relatively minor changes in the supply of and demand for oil and gas and a variety of additional factors that are beyond the Company's control. These factors include the level of consumer demand, weather conditions, domestic and foreign governmental regulations, market uncertainty, the price and availability of alternative fuels, political conditions in the Middle East, foreign supply of oil and gas, price of foreign imports and overall economic conditions. It is impossible for the Company to predict future oil and gas prices with any certainty. In order to reduce the Company's exposure to price risks in the sale of its oil and gas, the Company enters into hedging arrangements from time to time. The hedging arrangements, however, only generally apply to a portion of the Company's production and provide only limited price protection against fluctuations in the oil and gas markets. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources" and "Hedging Activities" and "Business." Southwest uses the full cost method of accounting for its investment in oil and gas properties. Under the full cost method of accounting, all costs of acquisition, exploration and development of oil and gas reserves are capitalized into a "full cost pool" as incurred, and properties in the pool are depleted and charged to operations using the gross revenues method based on the ratio of current gross revenues to total proved future gross revenues, computed based on current prices. Significant downward revisions of quantity estimates or declines in oil and gas prices that are not offset by other factors could result in a writedown for impairment of oil and gas properties. Once incurred, a writedown of oil and gas properties is not reversible at a later date, even if oil or natural gas prices increase. Replacement of Reserves. The Company may not be able to replace its existing reserves as they are depleted. In general, the volume of production from oil and gas properties declines as reserves are depleted. Unless the Company acquires additional properties containing proved reserves or conducts successful development and exploration activities on existing properties, or both, proved reserves will decline as reserves are depleted and, as a result, cash flow will correspondingly decline. The Company's future oil and gas production is, therefore, highly dependent upon its success in finding or acquiring additional reserves. Exploring for, developing or acquiring new reserves requires substantial amounts of capital. Because cash flow from operations has been reduced and external sources of capital have become limited or unavailable, the Company's ability to make the capital investments necessary to maintain or expand its reserves has been impaired. In addition, the Company cannot ensure that future development, acquisition and exploration activities will result in additional proved reserves or that the Company will be able to drill productive wells at acceptable costs. Uncertainty of Reserve Information and Future Net Revenue Estimates. There are numerous uncertainties inherent in estimating oil and natural gas reserves and their estimated values, including many factors beyond the control of Southwest. The reserve data set forth herein represent only estimates. Reservoir engineering is a subjective process of estimating underground accumulations of oil and natural gas that cannot be measured in an exact manner. Estimates of economically recoverable oil and natural gas reserves and of future net cash flows necessarily depend upon a number of variable factors and assumptions, such as historical production from the area compared with production from other producing areas, the assumed effects of regulations by governmental agencies and assumptions concerning future oil and natural gas prices, future operating costs, severance and excise taxes, development costs and workover and remedial costs, all of which may in fact vary considerably from actual results. For these reasons, estimates of the economically recoverable quantities of oil and natural gas attributable to any particular group of properties, classifications of such reserves based on risk recovery and estimates of the future net cash flows expected therefrom prepared by different engineers or by the same engineers at different times may vary substantially and such reserve estimates may be subject to downward or upward adjustment based upon such factors. Actual production, revenues and expenditures with respect to Southwest's reserves will likely vary from estimates, and such variances may be material. See "Item 2. Properties-Oil and Gas Reserves." The present values of estimated future net cash flows referred to herein should not be construed as the current market value of the estimated oil and natural gas reserves attributable to Southwest's properties. In accordance with applicable requirements of the Commission, the estimated discounted future net cash flows from proved reserves are generally based on prices and costs as of the date of the estimate, whereas actual future prices and costs may be materially higher or lower. Actual future net cash flows also will be affected by factors such as the amount and timing of actual production, supply and demand for oil and natural gas, curtailments or increases in consumption by gas purchasers and changes in governmental regulations or taxation. The timing of actual future net cash flows from proved reserves, and their actual present value, will be affected by the timing of both the production and the incurrence of expenses in connection with development and production of oil and natural gas properties. In addition, the calculation of the present value of the future net revenues using a 10% discount, as required by the Commission, is not necessarily the most appropriate discount factor based on interest rates in effect from time to time and risks associated with Southwest's reserves or the oil and natural gas industry in general. Drilling Risks. Drilling involves numerous risks, including the risk that no commercially productive oil or natural gas reservoirs will be encountered. The cost of drilling, completing and operating wells is often uncertain, and drilling operations may be curtailed, delayed or canceled as a result of a variety of factors, including unexpected drilling conditions, pressure or irregularities in formations, equipment failures or accidents, adverse weather conditions, title problems and shortages or delays in the delivery of equipment. Southwest's future drilling activities may not be successful and, if unsuccessful, such failure will have an adverse effect on Southwest's future results of operations and financial condition. Marketability of Production. The marketability of Southwest's oil and natural gas production depends upon the availability and capacity of oil and gas gathering systems, pipelines and processing facilities, and the unavailability or lack of capacity thereof could result in the shut-in of producing wells or the delay or discontinuance of development plans for properties. In addition, federal and state regulation of oil and natural gas production and transportation, general economic conditions and changes in supply and demand could adversely affect Southwest's ability to produce and market its oil and natural gas on a profitable basis. Operating Risks of Oil and Natural Gas Operations. The oil and natural gas business involves a variety of operating risks, including the risk of fire, explosions, blowouts, pipe failure, casing collapse, abnormally pressured formations and hazards such as oil spills, natural gas leaks, ruptures or discharges of toxic gases. The occurrence of any of these operating risks could result in substantial losses to Southwest due to injury or loss of life, severe damage to or destruction of property and equipment, pollution or other environmental damage, including damage to natural resources, clean-up responsibilities, penalties and suspension of operations. In accordance with customary industry practice, Southwest maintains insurance against some, but not all, of the risks described above. There can be no assurance that any insurance obtained by Southwest will be adequate to cover any losses or liabilities. Southwest cannot predict the continued availability of insurance or the availability of insurance at premium levels that justify its purchase. Compliance with Governmental Regulations. The Company's oil and natural gas and well service operations are subject to various federal, state and local governmental laws and regulations that may be changed from time to time in response to economic or political conditions. Matters subject to regulation include discharge permits for drilling operations, drilling and abandonment bonds or other financial responsibility requirements, reports concerning operations, the spacing of wells, utilization and pooling of properties and taxation. From time to time, regulatory agencies have imposed price controls and limitations on production by restricting the rate of flow of oil and natural gas wells below actual production capacity to conserve supplies of oil and natural gas. In addition, the production, handling, storage, transportation and disposal of oil and natural gas, by-products thereof and other substances and materials produced or used in connection with oil and natural gas operations are subject to regulation under federal, state and local laws and regulations primarily relating to protection of human health and the environment. These laws and regulations may impose increasingly strict requirements for water and air pollution control and solid waste management and can result in the imposition of civil and even criminal penalties. The Company's commercial real estate properties are subject to various federal, state and local regulatory requirements, such as laws with respect to access by disabled persons and state and local fire and life safety requirements. Failure to comply with these requirements could result in the imposition of fines by governmental authorities or awards of damages to private litigants. The Company believes that the properties are currently in compliance in all material respects with all such regulatory requirements. However, there can be no assurance that these requirements will not be changed or that new requirements will not be imposed which would require significant unanticipated expenditures by the Company's real estate business and could have an adverse effect on expected distributions by the Company's real estate business. Substantial Competition. The Company experiences intense competition in its markets. Such markets are highly competitive and no one competitor is dominant. Southwest competes with major and independent oil and natural gas companies for the acquisition of desirable oil and natural gas properties, as well as for the equipment and labor required to develop and operate such properties. Southwest also competes with major and independent oil and natural gas companies in the marketing and sale of oil and natural gas to marketers and end-users. Red Oak competes with other companies for the acquisition of desirable real estate properties principally on the basis of price. Although the Company believes that it has certain advantages over these competitors, many of these competitors have greater financial and other resources than the Company. See "Item 1. Business-Competition." Environmental Risks. The Company is subject to a variety of federal, state and local governmental regulations related to the storage, use, discharge and disposal of toxic, volatile or otherwise hazardous materials. The Company does not currently anticipate any material adverse effect on its business, financial condition or results of operations as a result of the Company's required compliance with U.S. federal, state, provincial, local or foreign environmental laws or regulations or remediation costs. However, some risk of environmental liability and other costs is inherent in the nature of the Company's business. Moreover, the Company anticipates that such laws and regulations will become increasingly stringent in the future, which could lead to material costs for environmental compliance and remediation by the Company. See "Item 1. Business-Regulation." Any failure by the Company to obtain required permits for, control the use of, or adequately restrict the discharge of, hazardous substances under present or future regulations could subject the Company to substantial liability or could cause its operations to be suspended. Such liability or suspension of operations could have a material adverse effect on the Company's business, financial condition and results of operations. Red Oak Operations. Real estate property investments are subject to varying degrees of risk. The economic performance and values of real estate can be affected by many factors, including changes in the national, regional and local economic climates, local conditions such as an oversupply of space or a reduction in demand for real estate in the area, the attractiveness of the properties to tenants, competition from other available space, the ability of the owner to provide adequate maintenance and insurance and increased operating costs. In recent years, there has been a proliferation of new retailers and a growing consumer preference for value-oriented shopping alternatives that have, among other factors, heightened competitive pressures. In certain areas of the country, there may also be an oversupply of retail space. As a consequence, many companies in all sectors of the retailing industry have encountered significant financial difficulties. A substantial portion of Red Oak's income is derived from rental revenues from retailers in neighborhood and community shopping centers. Red Oak's income would be adversely affected if a significant number of Red Oak's tenants were unable to meet their obligations to Red Oak or if Red Oak were unable to lease a significant amount of space in its properties on economically favorable lease terms. Accordingly, no assurance can be given that Red Oak's financial results will not be adversely affected by these developments in the retail industry. Removal as General Partner. The limited partners have the ability to remove Southwest as the general partner of approximately 32 limited partnerships and such removal would decrease Southwest's cash flow and proved reserves. Southwest is the general partner of 32 limited partnerships. Most of the limited partnership agreements provide that a majority in interest of the limited partners may remove Southwest as the general partner and elect a replacement general partner. However, under three of the limited partnership agreements Southwest may only be removed with Southwest's consent. As the general partner, Southwest receives management and administrative fees from the partnerships, totaling an aggregate of approximately $3.3 million and has an ownership interest in each partnership. Southwest's portion of partnership properties contribute 5.5% of its proved reserves and 7.2% of PV-10 value. Therefore, Southwest removal as the general partner of some or all of the limited partnerships would decrease its cash flow and proved reserves. However, any losses in cash flow would be offset to some degree by decreasing administrative and operating expense. During 2000, the Company did not have any significant customers. The Company does not believe the loss of any purchaser would have a material adverse effect on its operations, revenues or cash flow. Glossary of Oil and Gas Terms The following are abbreviates and definitions of terms commonly used in the oil and gas industry that are used in this Report. All volumes of natural gas referred to herein are stated at the legal pressure base to the state or area where the reserves exit and at 60 degrees Fahrenheit and in most instances are rounded to the nearest major multiple. Bbl. One stock tank barrel, or 42 U.S. gallons liquid volume. Bcf. Billion cubic feet. Boe. Barrel of oil equivalent, determined using the ratio of one Bbl of crude oil, condensate or natural gas liquids to six Mcf of natural gas. Boepd. Barrels of oil per day. Completion. The installation of permanent equipment for the production of oil and natural gas, or in the case of a dry hole, the reporting of abandonment to the appropriate agency. Development well. A well drilled within the proved area of an oil or natural gas reservoir to the depth of a stratigraphic horizon known to be productive. Dry hole or well. A well found to be incapable of producing hydrocarbons in sufficient quantities such that proceeds from the sale of such production exceed production expenses and taxes. Exploratory well. A well drilled to find and produce oil or natural gas reserves not classified as proved, to find a new reservoir in a field previously found to be productive of oil or natural gas in another reservoir or to extend a known reservoir. Field. An area consisting of a single reservoir or multiple reservoirs all grouped on or related to the same individual geological structural feature and/or stratigraphic condition. Gross acres or gross wells. The total acres or wells, as the case may be, in which a working interest is owned. Horizontal drilling. A drilling technique that permits the operator to contact and intersect a larger portion of the producing horizon than conventional vertical drilling techniques and can result in both increased production rates and greater ultimate recoveries of hydrocarbons. MBbls. One thousand barrels. MBoe. One thousand barrels of oil equivalent, determined using the ratio of one Bbl of crude oil, condensate or natural gas liquids to six Mcf of natural gas. Mcf. One thousand cubic feet. Mcfd. One thousand cubic feet per day. Mcfe. One thousand cubic feet equivalent, determined using the ratio of six Mcf of natural gas to one Bbl of crude oil, condensate or natural gas liquids. MMBbls. One million barrels of crude oil or other liquid hydrocarbons. MMBoe. One million barrels of oil equivalent, determined using the ratio of one Bbl of crude oil, condensate or natural gas liquids to six Mcf of natural gas. MMcf. One million cubic feet. Net acres or net wells. The sum of the fractional working interests owned in gross acres or gross wells, as the case may be. Oil. Crude oil, condensate and natural gas liquids. Present value and PV-10 Value. When used with respect to oil and natural gas reserves, the estimated future net revenue to be generated from the production of proved reserves, determined in all material respects in accordance with the rules and regulations of the Securities and Exchange Commission (generally using prices and costs in effect as of the date indicated) without giving effect to non-property related expenses such as general and administrative expenses, debt service and future income tax expenses or to depreciation, depletion and amortization, discounted using an annual discount rate of 10%. Productive well. A well that is found to be capable of producing hydrocarbons in sufficient quantities such that proceeds from the sale of such production exceed production expenses and taxes. Proved developed producing reserves. Proved developed reserves that are expected to be recovered from completion intervals currently open in existing wells and capable of production. Proved developed reserves. Proved reserves that are expected to be recovered from existing wellbores, whether or not currently producing, without drilling additional wells. Production of such reserves may require a recompletion. Proved reserves. The estimated quantities of crude oil, natural gas, and natural gas liquids that geological and engineering data demonstrate with reasonable certainty to be recoverable in future years from known reservoirs under existing economic and operating conditions. Proved undeveloped location. A site on which a development well can be drilled consistent with spacing rules for purposes of recovering proved undeveloped reserves. Proved undeveloped reserves. Proved reserves that are expected to be recovered from new wells on undrilled acreage. Recompletion. The completion for production of an existing wellbore in another formation from that in which the well has been previously completed. Reserve life. A ratio determined by dividing the existing reserves by production from such reserves for the prior twelve month period. Reservoir. A porous and permeable underground formation containing a natural accumulation of producible oil and/or natural gas that is confined by impermeable rock or water barriers and is individual and separate from other reserves. Royalty interest. An interest in an oil and natural gas property entitling the owner to a share of oil or natural gas production free of costs of production. Undeveloped acreage. Lease acreage on which wells have not been drilled or completed to a point that would permit the production of commercial quantities of oil and natural gas regardless of whether such acreage contains proved reserves. Wellbore. The hole drilled by the bit. Working interest. The operating interest that gives the owner the right to drill, produce and conduct operating activities on the property and a share of production. Workover. Operations on a producing well to restore or increase production. ITEM 2. PROPERTIES. Facilities The principal offices of SRH, Southwest and Red Oak are located in Midland, Texas. SRH, Southwest, and Red Oak believe that their leased and owned properties, none of which individually is material to any of the companies, are adequate for current needs. Title to Properties The Company believes it has satisfactory title to all of its properties in accordance with standards generally accepted in the oil and gas and real estate industries. As is customary in the oil and natural gas industry, Southwest makes only a cursory review of title to farmout acreage and to undeveloped oil and natural gas leases upon execution of any contracts. Prior to the commencement of drilling operations, a thorough title examination is conducted and curative work is performed with respect to significant defects. To the extent title opinions or other investigations reflect title defects, Southwest, rather than the seller of the undeveloped property, is typically responsible to cure any such title defects at its expense. If Southwest were unable to remedy or cure any title defect of a nature such that it would not be prudent to commence drilling operations on the property, Southwest could suffer a loss of its entire investment in the property. Southwest has obtained title opinions on substantially all of its producing properties and believes that it has satisfactory title to such properties in accordance with standards generally accepted in the oil and natural gas industry. Prior to completing an acquisition of producing oil and natural gas leases, Southwest obtains title opinions on a majority of all leases. Southwest's oil and natural gas properties are subject to customary royalty interests, liens for current taxes and other burdens that Southwest believes do not materially interfere with the use of or affect the value of such properties. Oil and Gas Properties Southwest's Principal Oil and Gas Properties The Company's oil and gas properties are primarily located in the Permian Basin of West Texas and southeastern New Mexico. Over 95% of the Company's PV-10 Value is concentrated in this region. The region is characterized by numerous known producing horizons, providing significant opportunities to increase reserves, production and ultimate recoveries through additional development, horizontal drilling, recompletions, enhanced recovery methods, and the use of 3-D seismic, reprocessed 2-D seismic data and other advanced technologies. As of December 31, 2000, the Company operated properties comprising approximately 68% of its PV-10 Value. The following table provides information for the Company's ten largest fields which contribute 62% of its reserves and 55% of its PV-10 Value as of December 31, 2000. As of December 31, 2000 -------------------------------------- Net Proved PV-10 % of Total Reserves Value PV-10 Field (Mboe) (in thousands) Value ----- ---------------------- -------- Halley 2,772 $52,633 11.12% Foster 4,219 42,608 9.00% Hutto 1,063 25,842 5.46% Huntley 2,851 24,112 5.09% Flying M 3,226 22,360 4.72% Huntley East 2,412 20,315 4.29% Amacker Tippett 878 19,168 4.05% Jo-Mill 2,317 17,637 3.73% Rhoda Walker 1,106 17,395 3.67% Ackerly 2,315 16,960 3.58% ------ ------- ----- Total Top Ten Fields 23,159 $259,030 54.71% Halley Field. The Halley Field is located in Winkler County, Texas and consists of two leases totaling 7,608 gross acres, of which 3,190 gross acres have been developed. Southwest acquired working interests ranging from 43% to 70% in this field in 1995 and currently operates 110 active producing wells and 32 water injection wells. The field was discovered in 1937 and produces from multiple zones ranging from 2,400 to 3,000 feet in depth. Development plans, which have commenced, include the drilling of several proved undeveloped locations and numerous workovers. Foster Field. The Foster Field is located in Ector County, Texas. The field was discovered in 1936 and produces from the Grayburg and Queen formations in the Gist Unit. Southwest owns working interests ranging from 59.5% to 100% and operates 60 producing and 31 injection wells. Numerous workover and development drilling opportunities exist. Hutto Field. The Hutto Field is located in Howard County, Texas. The field was discovered in 1997 and produces from the Wolfcamp formation. Southwest owns working interests ranging from 15% to 62% in 16 producing gas wells. Development plans include drilling an additional 16 development gas wells. Huntley Field. The Huntley Field is located in Garza County, Texas. The field was discovered in 1953 and produces from the San Andres and Glorieta reservoirs. Southwest owns an 87% working interest and operates 34 producing and 21 injection wells. Flying M Field. The Flying M Field is located in northern Lea County, New Mexico and produces from the San Andres oil reservoir. The field was discovered in 1964 and was unitized in 1967 when water injection commenced. In 1997, Southwest acquired working interests ranging from 83% to 100% in 6,160 gross acres of the field area, of which 2,240 gross acres are undeveloped. Southwest operates all 46 producing wells and nine active water injection wells, including wells that are not contained within the unitized portion of the field. Development plans for this field include the drilling of ten 40-acre proved undeveloped locations and the conversion of ten wells to water injection. Further development of the field, including the reduction to 20-acre spacing from the current 40-acre spacing, is presently under evaluation. Huntley East Field. The Huntley East Field is located in Garza County, Texas. The field was discovered in 1956 and produces from a low-relief anticline which covers approximately 1,400 surface acres. Southwest has a 100% working interest in the Huntley East San Andres Unit, which comprises substantially all of the field, and a 100% working interest in the Harold L. Davies lease, and operates 38 producing and 21 injection wells. Amacker Tippett Area. The Amacker Tippett area is located in Upton County, Texas. The area is a multi-pay area with wells producing from the Bend, Wolfcamp, Devonian and Fusselman formations. Southwest owns working interests ranging from 8% to 69% in the area. Development drilling and workovers are planned for the area. Jo-Mill Field. The Jo-Mill Field is located in Borden County, Texas. The field was discovered in 1954, unitized in 1969, and produces from the Upper Spraberry, Lower Spraberry and Dean Sand reservoirs. Southwest owns a 6% working interest in the Jo-Mill Unit. Texaco, Inc. operates 172 producing and 73 injection wells. Rhoda Walker Field. The Rhoda Walker Field is located in Ward County, Texas and produces from 18 different reservoirs ranging in depth from 4,700 to 7,000 feet. Southwest acquired its working interests in this field, ranging from 1% to 34%, in 1990. Southwest operates 37 producing wells and five water disposal wells and also owns non-operated interests in 46 wells. The field was discovered in 1971 and contains significant proved developed locations and infill drilling. Ackerly (Dean) Field. The Ackerly (Dean) Field is located in Dawson County, Texas and produces from the Dean Sand oil reservoir. The field was discovered in 1954 with the drilling and completion of the Pan American Graves "A" No. 1 well. Southwest owns a 60% working interest in the East Ackerly Dean Unit-Phase II, along with interests in two additional leases. Henry Petroleum operates 70 producing and 30 injection wells. Oil and Gas Reserves. The following table summarizes the estimates of Southwest's historical net proved reserves and the related present values of such reserves at the dates shown. The reserve and present value data for the Company's existing properties as of December 31, 2000, 1999 and 1998 have been prepared by Ryder Scott Petroleum Engineers. As of December 31, ----------------------------- 2000 1999 1998 ---- ---- ---- Proved Reserves: Oil and Condensate (MBbls) 25,797 24,828 20,944 Natural Gas (MMcf) 70,375 65,079 58,273 Total (MBoe) 37,526 35,675 30,656 Proved Developed Reserves: Oil and Condensate (MBbls) 18,161 16,618 12,006 Natural Gas (MMcf) 46,592 43,023 37,481 Total (MBoe) 25,926 23,789 18,253 PV-10 Value (in thousands)(1) $ 473,457$ 228,748$ 71,900 Discounted Future Cash Flows (2) Future cash inflows $ 1,342,066 $727,615 $ 315,709 Future production and development costs (415,022) (284,354) (181,627) --------- ------- ------- Future net cash flows before income taxes 927,044 443,261 134,082 Future income tax expense (274,566)(103,067) - --------- ------- ------- Future net cash flows, net of tax 652,478 340,194 134,082 10% annual discount for estimated timing of cash flows (319,246)(164,634) (62,182) --------- ------- ------- Standardized measure of discounted future net cash flows, net of tax $ 333,232$ 175,560$ 71,900 ========= ======= ====== (1) The present value of future net revenues attributable to Southwest's reserves was prepared using prices in effect at the end of the respective periods presented, discounted at 10% per annum on a pre-tax basis. (2) Discounted future cash flows, including taxes, are not intended to represent estimates of the fair value of oil and gas properties. Estimates of fair value should also consider probable reserves, anticipated future oil and gas prices, interest rate, changes in development and production costs and production costs and risks associated with future production. Because of these considerations, any estimate of fair value is necessarily subjective and imprecise. In accordance with applicable requirements, estimates of Southwest's proved reserves and future net revenues are made using oil and natural gas sales prices estimated to be in effect as of the date of such reserve estimates and are held constant throughout the life of the properties (except to the extent a contract specifically provides for escalation.) The average prices used in the reserve report were $25.62/Bbl of oil and $9.68/Mcf of natural gas, $23.90/Bbl of oil and $2.06/Mcf of natural gas and $10.25/Bbl of oil and $1.73/Mcf of natural gas as of December 31, 2000, 1999 and 1998, respectively. Estimated quantities of proved reserves and future net revenues therefrom are affected by oil and natural gas prices, which have fluctuated widely in recent years. There are numerous uncertainties inherent in estimating oil and natural gas reserves and their values, including many factors beyond the control of the producer. Reservoir engineering is a subjective process of estimating underground accumulations of oil and natural gas that cannot be measured in an exact manner. The accuracy of any reserve estimate is a function of the quality of available data and of engineering and geological interpretation and judgment. As a result, estimates of different engineers, including those used by Southwest, may vary. In addition, estimates of reserves are subject to revision based upon actual production, results of future development and exploration activities, prevailing oil and natural gas prices, operating costs and other factors, which revisions may be material. Accordingly, reserve estimates are often different from the quantities of oil and natural gas that are ultimately recovered and are highly dependent upon the accuracy of the assumptions upon which they are based. In general, the volume of production from oil and natural gas properties decline as reserves are depleted. Except to the extent Southwest acquires properties containing proved reserves or conducts successful exploration and development activities, or both, the proved reserves of Southwest will decline as reserves are produced. Southwest's future oil and natural gas production is highly dependent upon its level of success in finding or acquiring additional reserves. Exploring for, developing or acquiring new reserves requires substantial amounts of capital. Net Production, Unit Prices and Costs. The following table presents certain information with respect to oil and gas production, prices and costs attributable to all oil and gas property interests owned by Southwest for the years ended December 31, 2000, 1999 and 1998: As of December 31, ----------------------------- 2000 1999 1998 ---- ---- ---- Production Volumes: Oil and condensate (MBbls) 1,236 1,306 1,689 Natural gas (MMcf) 4,784 4,627 5,556 Total (MBoe) 2,033 2,077 2,615 Average Daily Production: Oil and condensate (Bbls) 3,376 3,578 4,628 Natural Gas (Mcf) 13,070 12,677 15,222 Total (Boe) 5,555 5,691 7,165 Average Realized Prices: Oil and condensate (per Bbl) $ 28.56 $ 16.23 $ 12.73 Natural gas (per Mcf) 3.89 2.19 1.85 Per Boe 26.51 15.09 12.16 Expenses (per Boe): Lease operating (including production taxes)$ 7.45 $ 5.22 $ 7.03 Oil and gas depletion 2.46 2.36 5.97 General and administrative, net 1.25 .78 1.04 Producing Wells. The following table sets forth the number of productive wells in which Southwest owned an interest as of December 31, 2000: Gross Net Wells Wells ------ ------ Oil 6,611 546 Natural Gas 685 73 ----- --- Total 7,296 619 Productive wells consist of producing wells and wells capable of production, including gas wells awaiting pipeline connections and oil wells awaiting connection to production facilities. Wells that are completed in more than one producing horizon are counted as one well. A gross well is a well in which an interest is owned. A net well is the fractional working interest in a gross well. The number of net wells is the sum of the fractional interest owned in gross wells. Acreage. The following table sets forth Southwest's developed and undeveloped gross and net leasehold acreage as of December 31, 2000: Gross Net ------ ------ Developed 87,682 25,441 Undeveloped 303,582 102,870 ------- ------- Total 391,264 128,311 Undeveloped acreage includes leased acres on which wells have not been drilled or completed to a point that would permit the production of commercial quantities of oil and gas, regardless of whether or not such acreage contains proved reserves. A gross acre is an acre in which an interest is owned. A net acre is the fractional working interest in a gross acre. The number of net acres is the sum of the fractional interests owned in gross acres. Drilling Activities. The table below sets forth the drilling activity of Southwest on its properties for the periods ending December 31, 2000, 1999 and 1998. Year Ended December 31, ----------------------------------- 2000 1999 1998 -------------------- ---------- Gross Net Gross Net GrossNet -------------------- ---------- Development wells: Productive 28.0 11.2 12 5.1 15 5.7 Non-productive 4.0 1.0 1 .9 1 .5 ---- ---- -- --- -- --- Total 32.0 12.2 13 6.0 16 6.2 Exploratory wells: Productive 3.0 .6 - - 7 2.5 Non-productive - - - - 1 1.0 ---- ---- -- --- -- --- Total 3.0 .6 - - 8 3.5 Oil and Natural Gas Marketing and Hedging. The revenues generated by Southwest's operations are highly dependent upon the prices of and demand for oil and natural gas. The price received by Southwest for its oil and natural gas production depends on numerous factors beyond Southwest's control. Historically the markets for oil and natural gas have been volatile and are likely to continue to be volatile in the future. Prices for oil and natural gas are subject to wide fluctuation in response to relatively minor changes in the supply and demand for oil and natural gas, market uncertainty and a variety of additional factors. These factors include the level of consumer product demand, weather conditions, domestic and foreign governmental regulations, the price and availability of alternative fuels, political conditions in the Middle East, the actions of OPEC, the foreign supply of oil and natural gas and overall economic conditions. It is impossible to predict future oil and natural gas price movements with any certainty. Southwest, from time to time, uses option contracts to mitigate the volatility of price changes on commodities Southwest produces and sells as well as to lock in prices to protect the economics related to certain capital projects. On December 30, 1999, Southwest entered into a basket revenue protection agreement, which provides the Company with an oil and gas revenue floor. The contract was for the period January 1, 2000 through December 31, 2000. The agreement was to be calculated on a calendar year quarter as disclosed in the following table based on NYMEX Natural Gas and NYMEX Crude Oil: Notional Volumes Strike Prices ------------------------- ----------------------------- Crude Natural Crude Natural Minimum Oil (bbl) Gas (MMBtu) Oil Gas Boe Revenue ---------- ----------- ----- ------- ---- -------- Quarter 1 269,254 976,676 $ 21.12 $ 1.91 $ 28.76 $7,552,096 Quarter 2 263,058 910,325 $ 18.80 $ 1.92 $ 26.56 $6,714,359 Quarter 3 257,206 857,728 $ 18.00 $ 1.97 $ 25.88 $6,319,432 Quarter 4 251,914 813,400 $ 18.00 $ 2.20 $ 26.80 $6,323,932 Payments shall be made no later than five business days, after each quarterly floating price is determinable by NYMEX. The cost of the floor was approximately $638,000 and is amortized monthly as a reduction of oil and gas revenues. The cost of the floor was fully amortized at the conclusion of the December 31, 2000 contract period. On September 6, 2000, Southwest entered into a floor option, which provides the Company with a crude oil price floor. The contract is for the period January 1, 2001 through December 31, 2001. The option is for a notional amount of 1,100 Bbls of oil a day at a floor price of $25, based on NYMEX Light Sweet Crude. The agreement is to be calculated on a monthly basis with payments to be made no later than five business days after calculating period. The cost of the floor was approximately $466,000. On October 11, 2000, Southwest entered into a floor option, which provides the Company with a crude oil price floor. The contract is for the period January 1, 2001 through December 31, 2001. The option is for a notional amount of 500 bbls of oil a day at a floor price of $27, based on NYMEX Light Sweet Crude. The agreement is to be calculated on a monthly basis with payments to be made no later than five business days after calculating period. The cost of the floor was approximately $224,000. On November 20, 2000, Southwest entered into a floor option, which provides the Company with a crude oil price floor. The contract is for the period June 1, 2001 through May 31, 2002. The option is for a notional amount of 1,000 Bbls of oil a day at a floor price of $22, based on NYMEX Light Sweet Crude. The agreement is to be calculated on a monthly basis with payments to be made no later than five business days after calculating period. The cost of the floor was approximately $310,000. On December 1, 2000, Southwest entered into a floor option, which provides the Company with a natural gas price floor. The contract is for the period June 1, 2001 through May 31, 2002. The option is for a notional amount of 3,325 MMBtu of natural gas a day at a floor price of $3.00, based on NYMEX Henry Hub. The agreement is to be calculated on a monthly basis with payments to be made no later than five business days after calculating period. The cost of the floor was approximately $140,000. On December 8, 2000, Southwest entered into a floor option, which provides the Company with a natural gas price floor. The contract is for the period April 1, 2001 through March 31, 2002. The option is for a notional amount of 1,700 MMBtu of natural gas a day at a floor price of $4.50, based on NYMEX Henry Hub. The agreement is to be calculated on a monthly basis with payments to be made no later than five business days after calculating period. The cost of the floor was approximately $416,000. On February 14, 2001, Southwest entered into a floor option, which provides the Company with a natural gas price floor. The contract is for the period April 1, 2001 through March 31, 2002. The option is for a notional amount of 3,000 MMBtu of natural gas a day at a floor price of $4.25, based on NYMEX Henry Hub. The agreement is to be calculated on a monthly basis with payments to be made no later than five business days after calculating period. The cost of the floor was approximately $296,000. On February 14, 2001, Southwest entered into a floor option, which provides the Company with a natural gas price floor. The contract is for the period March 1, 2001 through August 31, 2001. The option is for a notional amount of 5,000 MMBtu of natural gas a day at a floor price of $4.50, based on NYMEX Henry Hub. The agreement is to be calculated on a monthly basis with payments to be made no later than five business days after calculating period. The cost of the floor was approximately $156,000. Red Oak Properties As of December 31, 2000, Red Oak owned and managed fifteen shopping centers, five office buildings and raw land held for future development. Red Oak's holdings are located primarily in secondary markets in the southwestern United States. Red Oak's existing property portfolio is shown in the table below. Gross Leasable Area Shopping Centers Location (Square Feet) ----------------- --------------- --------------- Plaza Oaks Midland, TX 94,779 Southwest Plaza San Angelo, TX 198,983 Town & Country Odessa, TX 120,855 State Bank Plaza Tulsa, OK 35,748 The Plaza Tulsa, OK 116,889 Madera Village Tucson, AZ 96,702 Bear Canyon Tucson, AZ 70,941 Bears Path Tucson, AZ 40,728 Plaza Palomino Tucson, AZ 98,634 River Oaks Abilene, TX 140,899 San Miguel Square Midland, TX 77,582 Colonnade at Polo Park Midland, TX 105,749 Crossroads San Antonio, TX 710,724 Northcross Mall Austin, TX 298,762 Victoria Mall Victoria, TX 632,466 Office Building ---------------- Independence Plaza Midland, TX 148,417 50 Penn Place Oklahoma City, OK 311,363 La Placita Village Tucson, AZ 216,446 Reunion Center Tulsa, OK 89,265 Century Plaza Midland, TX 95,443 Land Acres ---------------- -------- Red Oak (residential) Midland, TX 398.3 Lewisville (residential) Lewisville, TX 95.3 ITEM 3. LEGAL PROCEEDINGS. From time to time, the Company is party to litigation or other legal proceedings that each company considers to be a part of the ordinary course of its business. The Company is not involved in any legal proceedings nor is it party to any pending or threatened claims that could reasonably be expected to have a materially adverse effect on its financial condition, cash flow or results of operations. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. None. PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. Holders Southwest has one class of common equity securities outstanding, its Common Stock, par value $.10 per share. On December 31, 2000, all 100 outstanding shares of Southwest's Common Stock were held by SRH. SRH has one class of common equity securities, its Common Stock, par value $.10 per share. On December 31, 2000, 946,488 and 129,046 shares of SRH's Common Stock and Redeemable Common Stock, respectively were held by 382 holders of record. SRH's and Southwest's Common Stock are collectively referred to hereafter as the "Common Stock." Market There is currently no public market for the Common Stock and the Company does not anticipate that any such market will develop. The Common Stock has not been registered under the Securities Act. The stockholders have no rights to require registration of the Common Stock under the Securities Act or other applicable securities laws. The Common Stock may not be sold, transferred or otherwise disposed of except in a transaction that is either registered or exempt from registration under the Securities Act and all applicable state securities laws. In addition, the Common Stock is subject to transfer restrictions contained in SRH's and Southwest's By-Laws. Both SRH's and Southwest's By-Laws prohibit the transfer of its Common Stock except to a spouse, family member or affiliate of a stockholder. Any other transfer by a stockholder requires the prior written consent of the Company. In addition, SRH and H.H. Wommack, III have the option to purchase the shares in the event of a third party offer to purchase any of the Common Stock. Dividends Southwest and SRH have never paid cash dividends on the Common Stock and do not anticipate paying cash dividends in the foreseeable future. The Company intends to retain any future earnings to finance the expansion and continuing development of the Company's business. The future payment of dividends, if any, on the common Stock is within the discretion of the Company's Board of Directors and will depend upon the Company's earnings, capital requirements, and financial position, future loan covenants, general economic conditions and other relevant factors. There is no assurance that the Company will pay any dividends. There are several restrictions on the Company's ability to pay dividends, including (i) the provisions of the Delaware Corporation Laws, (ii) certain restrictive provisions in the Indenture executed in connection with Southwest's 10.5% Senior Notes due 2004 (the "Indenture"), and (iii) a restrictive covenant in the Company's Revolving Loan Facility Agreement dated August 17, 2000 with Foothill Capital Corporation, as Agent (the "Revolving Loan Facility"). Under the Indenture, the Company must meet several financial tests before it can pay cash dividends. These requirements work together to effectively prohibit the payment of cash dividends. In addition, the Revolving Loan Facility expressly prohibits the payment of cash dividends on Southwest's common stock. Recent Sales of Unregistered Securities None ITEM 6. SELECTED FINANCIAL DATA. The following tables set forth selected historical financial information of the Company for the periods shown. The following information should be read in conjunction with "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations," and the Company's Financial Statements and Notes thereto included in "Item 8. Financial Statements and Supplementary Data." Year Ended December 31, 2000 1999 1998 1997 (a) 1996 ------- --------- ------- ------- ------- (in thousands, except per share data) Consolidated Income Statement Data: Operating revenues: Oil and gas $ 54,263 $ 31,425 $ 32,467 $ 38,500 $ 33,787 Well service - - - 7,789 8,013 Real estate 31,113 31,301 25,650 9,338 4,487 Other 371 1,206 1,392 1,227 614 ------ ------ ------ ------ ------ 1887: Total operating revenue 85,747 63,932 59,509 56,854 46,901 ------ ------ ------ ------ ------ Operating expenses: Oil and gas 15,153 10,833 18,395 18,500 14,846 Well service - - - 5,600 6,145 Real estate 19,258 18,374 13,242 4,138 1,887 General and administrative 4,490 3,109 4,450 5,745 5,436 Depreciation, depletion and amortization 10,441 9,987 19,240 15,034 8,430 Impairment of oil and gas properties - - 64,000 - - Other 848 798 1,235 1,342 554 ------- ------ ------ ------ ------ Total operating expenses 50,190 43,101 120,562 50,359 37,298 ------- ------ ------ ------ ------ Operating income (loss) 35,557 20,831 (61,053) 6,495 9,603 ------- ------ ------ ------ ------ Other income (expense): Interest expense (42,964) (41,910) (36,490) (18,894) (10,016) Interest income 1,157 954 1,478 1,002 441 Other 2,641 952 370 145 561 ------- ------ ------ ------ ------ (39,166) (40,004) (34,642) (17,747) (9,014) ------- ------ ------ ------ ------ Year Ended December 31, 2000 1999 1998 1997 (a) 1996 ------- --------- ------- ------- ------- (in thousands, except per share data) Income (loss) before income taxes, minority interest, equity loss and extraordinary item (3,609) (19,173) (95,695) (11,252) 589 Income tax benefit (provision) - - 2,348 2,641 (365) Minority interest in subsidiaries, net of tax 1,109 1,820 913 430 181 Equity in loss of subsidiary and partnerships, net of tax - (931) (3,620) (203) - Extraordinary item, net of tax 12,622 12,875 - (3,109) - ------- ------ ------ ------ ------ Net income (loss) $ 10,122 $ (5,409) $(96,054) $(11,493) $ 405 ======= ====== ====== ====== ====== Income (loss) per common share 1931: before extraordinary item $(2.33) $(17.00) $(89.28) $ (7.78) $0.42 1933: Consolidated Balance Sheet Data: 1934: Cash and cash equivalents $ 17,217 $ 16,983 $ 13,801 $ 27,365 $ 8,284 1935: Net property and equipment 214,565 206,146 213,493 237,675 100,176 Total assets 263,801 262,167 257,550 305,443 130,284 Long-term debt, including current portion 337,265 347,083 335,084 283,642 93,805 Consolidated Cash Flow Statement Data: Net cash provided by (used in) operating activities 17,413 (10,772) (5,976) 6,034 10,280 Net cash used in investing activities (18,282) (1,124) (56,283) (173,902) (33,225) Net cash provided by financing activities 1,103 15,078 48,695 186,949 27,865 (a) Basic was deconsolidated on July 1, 1997. Earnings for the six months ended June 30, 1997 are included in the Company's consolidated statement of operations. Subsequent to June 30, 1997, any earnings (loss) associated with Basic are reflected in equity in loss of subsidiary. Selected Operating Data The following table sets forth selected information with respect to the Company's operating data for the periods shown. Year Ended December 31, 2000 1999 1998 1997 1996 ------- -------- ------- ------- ------- Production volumes: Oil and condensate (Mbbls) 1,236 1,306 1,689 1,308 1,001 Natural gas (MMcf) 4,784 4,627 5,556 5,639 5,403 Total (MBoe) 2,033 2,077 2,615 2,248 1,901 Average daily production: Oil and condensate (Bbls) 3,376 3,578 4,628 3,584 2,735 Natural gas (Mcf) 13,070 12,677 15,222 15,449 14,762 Total (Boe) 5,555 5,691 7,165 6,159 5,194 Average realized prices (a): Oil and gas condensate (per Bbl) $ 28.56 $ 16.23 $ 12.73 $ 19.12 $ 20.44 Natural gas (per Mcf) 3.89 2.19 1.85 2.24 2.22 Per Boe 26.51 15.09 12.16 16.75 17.07 Expenses (per Boe): Lease operating(including production taxes) $ 7.45 $ 5.22 $ 7.03 $ 8.23 $ 7.81 Oil and gas depletion 2.46 2.36 5.97 5.52 3.38 Oil and gas general and administrative, net (b) 1.25 .78 1.04 1.63 1.28 (a) Reflects the actual realized prices received by the Company, including the results of the Company's hedging activities. See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations." (b) Certain related party management fees received from oil and gas partnerships have been reclassified as a reduction of general and administrative expenses for all periods presented. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. General Southwest Royalties Holdings, Inc., a Delaware corporation, was formed in 1997 to serve as a holding company for Southwest Royalties, Inc., Midland Red Oak Realty, Inc. and an equity investment in Basic Energy Services, Inc. SRH is an independent oil and gas company engaged in the acquisition, development and production of oil and gas properties, primarily in the Permian Basin of West Texas and southeastern New Mexico, through its wholly-owned subsidiary, Southwest. Since 1983, Southwest has grown primarily through selective acquisitions of producing oil and gas properties, both directly and through the oil and gas partnerships it manages. SRH also owns and manages real estate properties through its subsidiary, Red Oak. SRH has grown over the last several years primarily through acquisitions in each of its businesses. On October 14, 1997, Southwest completed a $200 million private placement of 10.5% Senior Notes due 2004, to among other things, provide approximately $72 million for acquisitions and approximately $27 million of working capital. An integral part of the Southwest business strategy in conjunction with the 10.5% Senior Note issuance, involved the successful investment of the additional working capital into both the development and exploitation of its existing oil and gas properties and the acquisition of additional producing oil and gas properties. It was imperative to increase production volumes to meet the necessary ongoing cash flow needs and requirements of Southwest. The successful investment of the additional working capital would dramatically increase production levels thereby supplying additional cash flow to Southwest to meet requirements and continue to fund additional capital expenditure projects. The harsh decline in commodity pricing experienced by Southwest throughout 1998 and the first half of 1999, had a double impact on Southwest's cash flow by severely reducing proceeds associated with current production levels and reducing Southwest's investment into undeveloped reserves. The inability to replace the existing, depleting reserve base ultimately and systematically created lower revenues and margins. As net revenues fell due to these circumstances of declining price and production, an increasingly larger portion of Southwest's cash flow was necessary to meet debt interest expense. During the later part of 1999 and throughout 2000, commodity prices have made a come back. The improvements in the commodity price environment have enhanced Southwest's financial flexibility, as compared to what existed at the end of 1998 and 1999. Based on current commodity prices, Southwest is building its cash reserves and has reimplemented its drilling program. Southwest seeks to increase its oil and gas reserves, production and cash flow by concentrating on drilling low-risk developmental wells and by conducting additional development activities such as recompletions. Southwest is also actively searching for attractive oil and gas property acquisitions. Management realizes that Southwest is highly leveraged and intends to closely monitor the business environment and to continue its efforts to reduce debt and create financial flexibility. Southwest anticipates that it will continue to evaluate the sale of non-core assets, the disposition of which would increase capital resources available for other activities and create organizational and operational efficiencies. While Southwest generally does not dispose of assets solely for the purpose of reducing debt, such dispositions can have the result of furthering Southwest's objective of financial flexibility through reduced debt levels. Southwest uses the full cost method of accounting for its investment in oil and gas properties. Under the full cost method of accounting, all costs of acquisition, exploration and development of oil and gas reserves are capitalized into a "full cost pool" as incurred, and properties in the pool are depleted and charged to operations using the gross revenues method based on the ratio of current gross revenues to total proved future gross revenues, computed based on current prices. Significant downward revisions of quantity estimates or declines in oil and gas prices that are not offset by other factors could result in a writedown for impairment of oil and gas properties. Once incurred, a writedown of oil and gas properties is not reversible at a later date, even if oil or natural gas prices increase. As of December 31, 2000 and 1999 oil price had increased significantly over prices received during 1998, thus no write down of capitalized costs of oil and gas properties was deemed necessary for the years ended December 31, 2000 and 1999. Red Oak. Red Oak acquires and manages neighborhood and community shopping centers, other retail and commercial properties and office buildings. These properties are primarily leased, on a long-term basis, to major retail companies, local specialty retailers and professional and business tenants throughout secondary urban markets. As of December 31, 2000, Red Oak owned and managed fifteen shopping centers, five office buildings and raw land held for future development. Red Oak's revenue, profitability and cash flows are substantially dependent upon the ability of Red Oak to lease its properties on economically favorable lease terms. Red Oak's business plan focuses on the identification and acquisition of under-managed, and therefore undervalued, real estate. Red Oak's acquisition criterion identifies properties that have potential for value appreciation because of qualities such as irreplaceable location and unused pad sites as well as leasing opportunity based on previous unfocused management. Upon acquiring these properties, Red Oak must reposition and revitalize the majority of its properties to increase cash flow and market value. This process is very capital intensive. Red Oak generally obtains financing for both the acquisition and repositioning of the property. The revitalization and repositioning plan may take from eighteen to sixty months, depending on many factors. During the repositioning period, the property normally will not produce positive cash flow. Based on this operating strategy, Red Oak does not expect to generate much, if any, cash flow from operations in the near future and is dependent on its ability to create equity in its properties through its management practices to be able to obtain additional financing for operations until the time that the properties can cash flow on their own, or their market value is such that they can be sold at a profit. Red Oak experienced financial difficulties and generated losses for the years ended December 31, 2000, 1999 and 1998. The capital structure of Red Oak is highly leveraged with $58.5 million and $15.1 million of principal and cash interest payments, respectively, due in 2001. Management is currently in the process of renegotiating the terms of Red Oak's various obligations with its lenders and/or seeking new lenders or equity investors. Additionally, management would consider disposing of certain assets in order to meet its obligations. Basic. Effective July 1, 1997 Basic was deconsolidated from SRH's financial statements and SRH has subsequently, through December 31, 2000, accounted for its ownership in Basic as an equity investment consistent with the equity method of accounting under GAAP. As such, comparisons of Basic's revenue and expenses for the years ended December 31, 2000, 1999 and 1998 are not relevant, and therefore, no discussion of such results of operations are provided herein. On December 21, 2000, Basic completed a refinancing and restructuring of its debt and equity. (See Note 7 of Notes to Consolidated Financial Statements included in "Item 8. Financial Statements and Supplementary Data"). After giving effect to the refinancing and restructuring of Basic's debt and equity, the Company's direct and indirect ownership percentage in Basic was diluted to approximately 9.13% from 38.84% and is no longer deemed to be a material investment. SRH, Red Oak and Southwest regularly pursue and evaluate recapitalization strategies and acquisition opportunities (including opportunities to engage in mergers, consolidations or other business combinations) and at any given time may be in various stages of evaluating such opportunities. Results of Operations Year Ended December 31, 2000 Compared to Year Ended December 31, 1999 The following table summarizes production volumes and average sales prices for SRH's oil and gas operations, including the effect on revenues, for the periods indicated: Year Ended 2000 Compared December 31, to 1999 ----------------- --------------------- % Revenue Increase Increase 2000 1999 (Decrease)(Decrease) ------ ------ --------- --------- (in thousands) Production volumes: Oil and condensate (MBbls) 1,236 1,306 (5%) $(1,999) Natural gas (MMcf) 4,784 4,627 3% 611 Average sales prices: Oil and condensate (per Bbl) $ 28.56 $ 16.23 75% $ 16,103 Natural gas (per Mcf) 3.89 2.19 77% 7,866 Revenues. Revenues for SRH increased 34% to $85.7 million in 2000 from $63.9 million in 1999. Oil and gas revenue increased 73% to $54.3 million in 2000 from $31.4 million in 1999. The increase in oil and gas revenue is due to increases in oil and gas prices. Increases in oil and gas prices resulted in increased oil and gas revenues of approximately $24.0 million. Net decreases in production offset the increase in prices by approximately $1.4 million. Increased oil and gas partnership distributions added approximately $279,000 to increased oil and gas revenues. Oil and gas production decreased 2% or approximately 136 BOEPD, to 5,555 BOEPD in 2000 from approximately 5,691 BOEPD in 1999. In an ongoing effort to increase the Company's cash position and/or reduce the number of high operating expense properties in its oil and gas portfolio, management has sold oil and gas properties for approximately $566,000 in 2000 and $5.6 million in 1999. The production decline resulting from oil and gas property sales was approximately 138 BOEPD. Real estate revenues decreased 1% to $31.1 million in 2000 from $31.3 million in 1999. Operating Expenses. Operating expenses, before general and administrative expense, depreciation, depletion and amortization, increased 18% to $35.3 million in 2000 from $30.0 million in 1999. Oil and gas operating expense increased approximately 40% to $15.2 million in 2000 from $10.8 million in 1999. The increase is due primarily to increased production taxes, associated with the 73% increase in oil and gas revenue as discussed above, and increased workover expense and repairs associated with bringing wells back on line, which were deemed uneconomical due to depressed oil and gas prices experienced during 1998 and a portion of 1999. The average operating expense increased 43% to $7.45 per BOE in 2000 from $5.22 per BOE in 1999. Real estate operating expense increased approximately 5% to $19.3 million in 2000 from $18.4 million in 1999. The increase in real estate operating expenses is due primarily to increases in utilities expense, hazard insurance, property taxes and repairs and maintenance associated with the properties Red Oak owns, as well as increased salaries, health insurance and other administrative expenses associated with the property management staff. General and Administrative ("G&A") Expense. G&A expense for the Company increased 44% to $4.5 million in 2000 from $3.1 million in 1999. Oil and gas G&A expense increased 57% to $2.6 million in 2000 from $1.6 million in 1999, and averaged $1.25/Boe in 2000, a 60% increase compared to $.78/Boe in 1999. The increase in oil and gas G&A is due primarily to increased personnel and insurance costs as well as increased legal and professional fees associated with evaluating business strategies and opportunities. Real estate G&A expense decreased 9% to $1.5 million in 2000 from $1.6 million in 1999. The decrease in real estate G&A relates primarily to consulting fees incurred in 1999. Depreciation, Depletion and Amortization ("DD&A") Expense. DD&A expense for SRH increased 5% to $10.4 million in 2000 from $10.0 million in 1999. Oil and gas DD&A expense remained constant at $5.4 million in 2000 compared to $5.4 million in 1999 and on a Boe basis, increased 2% to $2.67/Boe in 2000 from $2.60/Boe in 1999. Real estate DD&A expense increased 8% to $4.8 million in 2000 from $4.5 million in 1999 due to the impact of capital improvements. Interest Expense. Interest expense for SRH increased 3% to $43.0 million in 2000 from $41.9 million in 1999. Oil and gas interest expense decreased 2% to $21.9 million in 2000 from $22.4 million in 1999. Real estate interest expense increased 7% to $21.1 million for 2000 compared to $19.7 million in 1999. The increase in real estate interest expense is due to additional debt used to finance capital improvements and operations. Equity in Loss of Subsidiary. Equity in Loss of Subsidiary for the year ended December 31, 1999 resulted in a charge of $931,000 of which, $744,000 was a non-cash charge for the impairment of the equity investment in Basic recognized in 1999. There was no charge during 2000 in relation to SRH's investment in Basic. The investment was written down to zero at December 31, 1999. This amount relates to SRH's 9.13% direct and indirect investment in Basic. Net Income (Loss). Due to the factors described above, net income for SRH increased 287% to $10.1 million in 2000 from a net loss of $5.4 million in 1999. Oil and gas net income was approximately $29.2 million in 2000 as compared to $7.3 million in 1999. Included in the oil and gas net income for 2000 and 1999 is an extraordinary gain associated with the repurchase of approximately 19% of the original issue, $200 million face 10.5% senior notes issued in October of 1997, in each of the two years of approximately $14.1 and $14.5 million, respectively. The extraordinary gain of $14.1 in 2000 was partially offset by an extraordinary loss of approximately $1.4 million associated with the refinancing of Southwest's $50.0 million Revolving Loan Facility in August 2000. Real estate net losses decreased 1% to $12.9 million in 2000 from $13.0 million in 1999. Included in the real estate net loss for 1999 is an extraordinary loss of $1.6 million associated with the write off of deferred debt costs related to a portion of Red Oak's debt which was refinanced in 1999. Results of Operations Year Ended December 31, 1999 Compared to Year Ended December 31, 1998 The following table summarizes production volumes and average sales prices for SRH's oil and gas operations, including the effect on revenues, for the periods indicated: Year Ended 1999 Compared December 31, to 1998 ----------------- --------------------- % Revenue Increase Increase 1999 1998 (Decrease)(Decrease) ------ ------ --------- --------- (in thousands) Production volumes: Oil and condensate (MBbls) 1,306 1,689 (23%) $(6,220) Natural gas (MMcf) 4,627 5,556 (17%) (2,034) Average sales prices: Oil and condensate (per Bbl) $ 16.23 $ 12.73 27% $ 5,912 Natural gas (per Mcf) 2.19 1.85 18% 1,889 Revenues. Revenues for SRH increased 7% to $63.9 million in 1999 from $ 59.5 million in 1998. Oil and gas revenue decreased 3% to $31.4 million in 1999 from $32.5 million in 1998. The decrease in oil and gas revenue is due primarily to decreases in oil and gas production which were offset by increases in oil and gas sales prices during 1999. Increases in oil and gas prices resulted in increased oil and gas revenues of approximately $7.8 million which were offset by decreased oil and gas production of $8.3 million and a decline of other oil and gas partnership distributions of approximately $584,000. Oil and gas production decreased 21% or approximately 1,500 BOEPD, to 5,700 BOEPD in 1999 from approximately 7,200 BOEPD in 1998. In an ongoing effort to increase the Company's cash position and reduce the number of high operating expense properties in its oil and gas portfolio, management has sold oil and gas properties for approximately $5.6 and $5.7 million in 1999 and 1998, respectively. The production decline resulting from oil and gas property sales was approximately 1,000 BOEPD, or approximately 14% of the total decline. The remainder of the production decline of approximately 7% is mostly results of natural decline. The average sales price per barrel of oil was $16.23 and the average sales price of natural gas was $2.19/Mcf in 1999, representing a 27% and 18% increase, respectively, compared to 1998 sales price levels. Real estate revenues increased 22% to $31.3 million in 1999 from $25.6 million in 1998. The increase in real estate revenues is due primarily to several acquisitions made late in the second quarter of 1998 and subsequent. Other operating revenues decreased 13% to $1.2 million in 1999 from $1.4 million in 1998. Operating Expenses. Operating expenses, before general and administrative expense, impairment of oil and gas properties, depreciation, depletion and amortization, decreased 9% to $30.0 million in 1999 from $32.9 million in 1998. Oil and gas operating expense decreased approximately 41% to $10.8 million in 1999 from $18.4 million in 1998. The decrease is due primarily to management's efforts to cut expenses through more efficient operations, and by selectively eliminating high operating expense properties from its oil and gas portfolio. Property sales accounted for approximately $4.0 million of the decline. The average operating expense decreased 26% to $5.22/Boe in 1999, from $7.03/Boe 1998. Real estate operating expense increased approximately 39% to $18.4 million in 1999 from $13.2 million in 1998. The increase in real estate operating expenses is due primarily to several acquisitions made late in the second quarter of 1998 and subsequent. Other operating expenses decreased 35% to $798,000 in 1999 from $1.2 million in 1998. General and Administrative ("G&A") Expense. G&A expense for the Company decreased 30% to $3.1 million in 1999 from $4.4 million in 1998. Oil and gas G&A expense decreased 40% to $1.6 million in 1999 from $2.7 million in 1998, and averaged $.76/Boe in 1999, a 27% decrease compared to $1.04/Boe in 1998. The oil and gas G&A decline is predominately due to the reduction in salary expense because of property sales and restructuring of duties. Real estate G&A expense decreased 12% to $1.6 million in 1999 from $1.8 million in 1998. The decrease in real estate G&A relates primarily to charges incurred during the later part of 1998 for travel and other professional services associated with a non consummated refinance. Depreciation, Depletion and Amortization ("DD&A") Expense. DD&A expense for SRH decreased 48% to $10.0 million in 1999 from $19.2 million in 1998. Oil and gas DD&A expense decreased 67% to $5.4 million in 1999 from 16.1 million in 1998 and on a Boe basis, decreased 58% to $2.60/Boe in 1999 from $6.16/Boe in 1998. The decrease in DD&A expense on an overall basis and/Boe is due primarily to the reduction in the carrying value of SRH's oil and gas properties because of the impairment of approximately $64.0 million, which was recorded during 1998. Real estate DD&A expense increased 53% to $4.5 million in 1999 from $2.9 million in 1998 due to the impact of acquisitions. Interest Expense. Interest expense for SRH increased 15% to $41.9 million in 1999 from $36.5 million in 1998. Oil and gas interest expense remained relatively constant at $22.4 million in 1999 as compared to $22.5 million in 1998. Real estate interest expense increased 41% to $19.7 million for 1999 from $14.0 million in 1998. The real estate interest expense increases were due to additional debt used to finance acquisitions and operations. Equity in Loss of Subsidiary. Equity in Loss of Subsidiary resulted in a charge of $931,000 of which, $744,000 was a non-cash charge for the impairment of the equity investment in Sierra recognized in 1999. This amount relates to SRH's 39% direct and indirect investment in Sierra. Net Income (Loss). Due to the factors described above, net loss for SRH decreased 94% to $5.4 million in 1999 from $96.1 in 1998. Oil and gas net income was approximately $7.3 million in 1999 as compared to a net loss of $88.4 million in 1998. Included in the oil and gas net income for 1999 is an extraordinary gain associated with the repurchase of approximately 19% of the original issue, $200 million face 10.5% senior notes issued in October of 1997, of approximately $14.5 million. Real estate net losses increased 122% to $13.0 million in 1999 from $5.9 million in 1998. Included in the real estate net loss for 1999 is an extraordinary loss of $1.6 million associated with the write off of deferred debt costs related to a portion of Red Oak's debt which was refinanced in 1999. Liquidity and Capital Resources Funding for the Company's business activities has historically been provided by operating cash flows, bank borrowings and debt issuance, reserve-based financing and sales of equity. Any future capital expenditures, other than those with previously arranged and set-aside lines of financing, will most likely require additional equity or financing and will be dependent upon financing arrangements available at the time. The significant decrease in oil and gas prices experienced during the last quarter of 1997 and extending through the first half of 1999, severely limited cash flow from operations, depleted working capital and rendered most other financing sources unavailable, or if available, on very unattractive terms to Southwest. With the upturn in commodity prices, Southwest's management believes that additional capital sources and financing opportunities may be available in the market. Because of higher commodity pricing, Southwest's operating cash flows have improved allowing for the investment of capital expenditures that would, if successful, increase company production and its reserve base. Management is constantly monitoring the Company's cash position and its ability to meet its financial obligations as they become due, and in this effort, is continually exploring various strategies for addressing its current and future liquidity needs. During 2000 and 1999, for instance, Southwest sold $566,000 and $5.6 million, respectively, of oil and gas properties in an ongoing effort to decrease its production costs and improve its cash position and also negotiated a $50 million Revolving Loan Facility, the proceeds of which were used to purchase in December 1999 and January 2000, approximately $76.3 million of the 10.5% Senior Notes due 2004. As of December 31, 2000, SRH's consolidated cash balance was $21.8 million, of which $16.4 million was available to Southwest and $5.4 million was available to Red Oak. SRH financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. The consolidated financial statements do not include any adjustments relating to the recoverability and classification of liabilities that might be necessary should SRH be unable to continue as a going concern. SRH has a highly leveraged capital structure with, approximately, $33.7 million of cash interest and $57.7 million of principal (net of a related party note of $817,000 between Southwest and Red Oak) due in 2001. The majority, $15.1 million of cash interest and $58.5 million of principal (which includes the $817,000 related party note between Southwest and Red Oak) due in 2001, pertains to Red Oak. Management is currently in the process of renegotiating the terms of SRH's various obligations with its debt holders and/or attempting to seek new lenders or equity investors. Additionally, management would consider disposing of certain assets in order to meet its obligations. There can be no assurance that SRH's debt restructuring efforts in connection with their real estate subsidiary will be successful or that the debt holders will agree to a course of action consistent with SRH's requirements in restructuring the obligations. Even if such agreement is reached, it may require approval of other creditors of SRH, none of which is assured. Furthermore, there can be no assurance that the sales of assets can be successfully accomplished on terms acceptable to SRH. SRH, Red Oak and Southwest regularly pursue and evaluate recapitalization strategies and acquisition opportunities (including opportunities to engage in mergers, consolidations or other business combinations) and at any given time may be in various stages of evaluating such opportunities. Net Cash Provided By (Used By) Operating Activities. SRH's operating activities provided cash flows of $17.4 million in 2000 and used cash flows of $10.4 million and $6.0 million in 1999 and 1998, respectively. SRH's ability to generate cash flow from operating activities has been substantially improved in 2000 do to the increase in the oil and gas commodity prices. Southwest generated $19.7 million of cash flow through operations in 2000. Red Oak used $2.3 million in its operating activities in 2000. Red Oak's ability to generate cash flow from operations is severely restricted due to its highly leveraged capital structure. Net Cash Used in Investing Activities. Cash flows used in SRH's investing activities were $18.3 million, $1.1 million and $56.3 million for 2000, 1999 and 1998, respectively. Oil and gas and commercial real estate acquisitions and development activities were the primary uses of funds in each year. The following table sets forth capital expenditures, including acquisitions, made by SRH during the periods indicated. Year Ended December 31, ----------------------------------- 2000 1999 1998 ----- ----- ----- (in thousands) Oil and gas properties Development $ 8,770 $ 3,195 $ 7,897 Exploration 476 76 834 Acquisitions 1,318 417 1,315 Oil and gas other 475 233 617 Real estate 9,389 6,723 53,412 Other - 305 433 ------ ------- ------- Total $ 20,428 $ 10,949 $ 64,508 ====== ======= ======= The Company is tentatively budgeting $21.0 million in capital expenditures in its oil and gas business for 2001 and expects the budget to be funded through current cash balances and cash provided from operations. Of the $21.0 million capital expenditures budgeted for 2001, $16.0 million is for development projects. The final budget will depend on financial strategies that are currently being developed including hedging strategies, divestitures and company structure. The budget will also be affected by the volatility of the oil and gas commodity prices. Further revisions may be necessary during the year in response to market conditions and any debt and/or equity restructurings, which can be negotiated by the Company. The Company is currently limited to $13.0 million in capital expenditures in its oil and gas business based on current loan covenants and will therefore need to request waivers from its lender for the expanded capital expenditure budget. Although the Company cannot be certain, based on the strong commodity pricing market, the company expects the lender to waive the restriction. The Company is tentatively budgeting $4.0 million in capital improvements expenditures in its real estate business for 2001. Funding for the 2001 capital expenditures will come from draws on existing Notes, which are collateralized by the real estate on which the capital improvements are to be made. Net Cash Provided by Financing Activities. Cash provided by SRH's financing activities was $1.1 million (including additional net borrowings of $1.3 million), $14.8 million (including additional net borrowings of $14.9 million) and $48.7 million (including additional net borrowings of $49.1 million) for 2000, 1999 and 1998, respectively. Southwest used $8.0 million in its financing activities in 2000 primarily to repurchase and retire a portion of its 10.5% Senior Notes and refinance its $50 million Revolving Loan Facility. Red Oak's financing activities provided $9.0 million in 2000 which was used primarily to fund capital improvements. For a complete listing of the Company's debt obligations see Note 7 of Notes to Consolidated Financial Statements included in "Item 8. Financial Statements and Supplementary Data". Hedging Activities. Southwest, from time to time, uses option contracts to mitigate the volatility of price changes on commodities Southwest produces and sells as well as to lock in prices to protect the economics related to certain capital projects. (See Note 13 of the Notes to Consolidated Financial Statements included in "Item 8. Financial Statements and Supplementary Data" for a discussion of Southwest's Commodity Hedging and Derivative Financial Instruments.) Other Issues Derivative Instruments and Hedging Activities. In June 1998, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No.133, "Accounting for Derivative Instruments and Hedging Activities." SFAS No. 133, as amended by SFAS No. 138, establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, (collectively referred to as derivatives) and for hedging activities. It requires an entity to recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. If certain conditions are met, a derivative may be specifically designated as (a) a hedge of the exposure to changes in the fair value of a recognized asset or liability or an unrecognized firm commitment, (b) a hedge of the exposure to changes in the fair value of the exposure to variable cash flows of a forecasted transaction, or (c) a hedge of the foreign currency exposure of a net investment in a foreign operation, an unrecognized firm commitment, an available-for-sale security, or a foreign currency denominated forecasted transaction. Special accounting for qualifying hedges allows a derivative's gains and losses to offset related results on the hedged item in the Company's statement of operations. The adoption of SFAS No. 133 on January 1, 2001 did not have a material impact on the Company's financial position or results of operations. The Company recorded a net transition adjustment gain of $1,030,000 in accumulated other comprehensive income on January 1, 2001. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The following quantitative and qualitative information is provided about financial instruments to which the Company is a party as of December 31, 2000, and from which the Company may incur future earnings gains or losses from changes in market interest rates or commodity prices. Quantitative Disclosures Interest rate sensitivity. The following table provides information about the Company's debt obligations which are sensitive to changes in interest rates. The table presents cash maturities by expected maturity dates together with the weighted average interest rates expected to be paid on the debt, given current contractual terms and market conditions. For fixed rate debt, the weighted average interest rate represents the contractual fixed rates that the Company is obligated to periodically pay on the debt; for variable rate debt, the average interest rate represents the average rates being paid on the debt at December 31, 2000. As of December 31, 2000 2001 2002 2003 2004 2005Thereafter Total Fair Value ---- ---- ---- ---- -------------- ----- - ---------- Total debt maturities $56,231 $ 104,197 $ 52,791 $ 122,785 $ 408 $ 853 $ 337,265 $ 318,854 Fixed rate debt $4,116 $ 390 $ 617 $ 122,759 $ 18 $ 853 $ 128,753 $ 110,342 Weighted average interest rate 10.48% 10.48% 10.48% 10.48% 8.04% 8.05% Variable rate debt $52,115 $ 103,807 $ 52,174 $ 26 $ 390 $ - - $ 208,512$208,512 Average interest rate 10.48% 10.48% 10.97% 10.50% 10.50% - - Commodity price sensitivity. See Notes 1 and 13 of Notes to Consolidated Financial Statements included in "Item 8. Financial Statements and Supplementary Data" for a description of the accounting procedures followed by SRH relative to hedge derivative financial instruments and for specific information regarding the terms of the Company's derivative financial instruments which are sensitive to changes in natural gas and crude oil commodity prices. Southwest, from time to time, uses option contracts to mitigate the volatility of price changes on commodities Southwest produces and sells as well as to lock in prices to protect the economics related to certain capital projects. On December 30, 1999, Southwest entered into a basket revenue protection agreement, which provides the Company with an oil and gas revenue floor. The contract was for the period January 1, 2000 through December 31, 2000. The agreement was to be calculated on a calendar year quarter as disclosed in the following table based on NYMEX Natural Gas and NYMEX Crude Oil: Notional Volumes Strike Prices ------------------------- ----------------------------- Crude Natural Crude Natural Minimum Oil (bbl) Gas (MMBtu) Oil Gas BOE Revenue ---------- ----------- ----- ------- ---- -------- Quarter 1 269,254 976,676 $ 21.12 $ 1.91 $ 28.76 $7,552,096 Quarter 2 263,058 910,325 $ 18.80 $ 1.92 $ 26.56 $6,714,359 Quarter 3 257,206 857,728 $ 18.00 $ 1.97 $ 25.88 $6,319,432 Quarter 4 251,914 813,400 $ 18.00 $ 2.20 $ 26.80 $6,323,932 Payments shall be made no later than five business days, after each quarterly floating price is determinable by NYMEX. The cost of the floor was approximately $638,000 and is amortized monthly as a reduction of oil and gas revenues. The cost of the floor was fully amortized at the conclusion of the December 31, 2000 contract period. On September 6, 2000, Southwest entered into a floor option, which provides the Company with a crude oil price floor. The contract is for the period January 1, 2001 through December 31, 2001. The option is for a notional amount of 1,100 Bbls of oil a day at a floor price of $25, based on NYMEX Light Sweet Crude. The agreement is to be calculated on a monthly basis with payments to be made no later than five business days after calculating period. The cost of the floor was approximately $466,000. On October 11, 2000, Southwest entered into a floor option, which provides the Company with a crude oil price floor. The contract is for the period January 1, 2001 through December 31, 2001. The option is for a notional amount of 500 bbls of oil a day at a floor price of $27, based on NYMEX Light Sweet Crude. The agreement is to be calculated on a monthly basis with payments to be made no later than five business days after calculating period. The cost of the floor was approximately $224,000. On November 20, 2000, Southwest entered into a floor option, which provides the Company with a crude oil price floor. The contract is for the period June 1, 2001 through May 31, 2002. The option is for a notional amount of 1,000 Bbls of oil a day at a floor price of $22, based on NYMEX Light Sweet Crude. The agreement is to be calculated on a monthly basis with payments to be made no later than five business days after calculating period. The cost of the floor was approximately $310,000. On December 1, 2000, Southwest entered into a floor option, which provides the Company with a natural gas price floor. The contract is for the period June 1, 2001 through May 31, 2002. The option is for a notional amount of 3,325 MMBtu of natural gas a day at a floor price of $3.00, based on NYMEX Henry Hub. The agreement is to be calculated on a monthly basis with payments to be made no later than five business days after calculating period. The cost of the floor was approximately $140,000. On December 8, 2000, Southwest entered into a floor option, which provides the Company with a natural gas price floor. The contract is for the period April 1, 2001 through March 31, 2002. The option is for a notional amount of 1,700 MMBtu of natural gas a day at a floor price of $4.50, based on NYMEX Henry Hub. The agreement is to be calculated on a monthly basis with payments to be made no later than five business days after calculating period. The cost of the floor was approximately $416,000. The total carrying value of the oil and gas floor options held by Southwest at December 31, 2000 is approximately $1,556,000. The fair market value of the oil and gas floor option at December 31, 2000 is approximately $2,586,000. On February 14, 2001, Southwest entered into a floor option, which provides the Company with a natural gas price floor. The contract is for the period April 1, 2001 through March 31, 2002. The option is for a notional amount of 3,000 MMBtu of natural gas a day at a floor price of $4.25, based on NYMEX Henry Hub. The agreement is to be calculated on a monthly basis with payments to be made no later than five business days after calculating period. The cost of the floor was approximately $296,000. On February 14, 2001, Southwest entered into a floor option, which provides the Company with a natural gas price floor. The contract is for the period March 1, 2001 through August 31, 2001. The option is for a notional amount of 5,000 MMBtu of natural gas a day at a floor price of $4.50, based on NYMEX Henry Hub. The agreement is to be calculated on a monthly basis with payments to be made no later than five business days after calculating period. The cost of the floor was approximately $156,000. Qualitative Disclosures Non-derivative financial instruments. The Company is a borrower under fixed rate and variable rate debt instruments that give rise to interest rate risk. The Company's objective in borrowing under fixed or variable rate debt is to satisfy capital requirements while minimizing the Company's costs of capital. To realize its objectives, the Company borrows under fixed and variable rate debt instruments, based on the availability of capital and market conditions. See Note 7 of Notes to Consolidated Financial Statement included in "Item 8. Financial Statements and Supplementary Data" for a discussion relative to the Company's debt instruments. Derivative financial instruments. Revenues from the Company's operations are highly dependent on the price of oil and gas. The markets for oil and natural gas are volatile and prices for oil and gas are subject to wide fluctuations in response to relatively minor changes in the supply of and demand for oil and gas and a variety of additional factors that are beyond SRH's control. These factors include the level of consumer demand, weather conditions, domestic and foreign governmental regulations, market uncertainty, the price and availability of alternative fuels, political conditions in the Middle East, foreign imports and overall economic conditions. It is impossible for SRH to predict future oil and gas prices with any certainty. In order to reduce the Company's exposure to oil and gas price risks, from time to time the Company enters into commodity price derivative contracts to hedge commodity price risks. As of December 31, 2000, the Company's primary risk exposures associated with financial instruments to which it is a party include natural gas and crude oil price volatility and interest rate volatility. The Company's primary risk exposures associated with financial instruments have not changed significantly since December 31, 2000. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. Index to Consolidated Financial Statements Page ----- Consolidated Financial Statements of Southwest Royalties Holdings, Inc. and Subsidiaries Independent Auditors' Report 50 Consolidated Balance Sheets as of December 31, 2000 and 1999 51 Consolidated Statements of Operations for the Years Ended December 31, 2000, 1999 and 1998 53 Consolidated Statements of Stockholders' Equity for the Years Ended December 31, 2000, 1999 and 1998 55 Consolidated Statements of Cash Flows for the Years Ended December 31, 2000, 1999 and 1998 56 Notes to Consolidated Financial Statements 58 INDEPENDENT AUDITORS' REPORT The Board of Directors and Stockholders Southwest Royalties Holdings, Inc.: We have audited the accompanying consolidated balance sheets of Southwest Royalties Holdings, Inc. and subsidiaries as of December 31, 2000 and 1999, and the related consolidated statements of operations, stockholders' equity and cash flows for each of the years in the three-year period ended December 31, 2000. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Southwest Royalties Holdings, Inc. and subsidiaries as of December 31, 2000 and 1999, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2000, in conformity with accounting principles generally accepted in the United States of America. The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 2 to the consolidated financial statements, the Company is experiencing difficulty in generating sufficient cash flow to meet its obligations and sustain its operations which raises substantial doubt about its ability to continue as a going concern. Management's plans in regard to these matters are also described in Note 2. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty. KPMG LLP Midland, Texas March 28, 2001 SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (in thousands) December 31, ------------------------ ASSETS 2000 1999 - ---------------------------------------------------------- ----- ----- Current assets Cash and cash equivalents $ 17,217 $ 16,983 Restricted cash 4,558 10,003 Accounts receivable, net of allowance of $559 and $440, respectively 10,302 7,134 Receivables from related parties 1,941 836 Other current assets 3,166 1,179 ------- ------- Total current assets 37,184 36,135 ------- ------- Oil and gas properties, using the full cost method of accounting Proved 203,776 193,319 Unproved 1,600 2,059 ------- ------- 205,376 195,378 Less accumulated depletion, depreciation and amortization 131,734 126,742 ------- ------- Oil and gas properties, net 73,642 68,636 ------- ------- Rental property, net 133,385 128,685 ------- ------- Rental property - construction in progress 2,926 3,984 ------- ------- Other property and equipment, net 4,612 4,841 ------- ------- Other assets Real estate investments 3,024 3,644 Deferred debt costs, net of accumulated amortization of $5,698 and $3,450, respectively 7,043 13,816 Noncompete covenants, net of accumulated amortization of $877 and $563, respectively 727 1,041 Other, net 1,258 1,385 ------- ------- Total other assets 12,052 19,886 ------- ------- Total assets $263,801 $262,167 ======= ======= (continued) The accompanying notes are an integral part of these consolidated financial statements. SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS - (continued) (in thousands, except per share data) December 31, LIABILITIES, MINORITY INTEREST, REDEEMABLE ------------------------ COMMON STOCK AND STOCKHOLDERS' EQUITY 2000 1999 - ---------------------------------------------------------- ----- ----- Current liabilities Current maturities of long-term debt $ 56,231 $ 40,277 Accounts payable 7,045 6,011 Accounts payable to related parties 1,543 867 Accrued expenses 6,477 5,896 Accrued interest payable 4,612 4,774 ------- ------- Total current liabilities 75,908 57,825 ------- ------- Long-term debt 281,034 306,806 ------- ------- Other long-term liabilities 1,645 1,220 ------- ------- Minority interest - 8 ------- ------- Redeemable common stock of subsidiary - 1,228 ------- ------- Redeemable common stock - 129,046 shares issued 8,290 8,290 ------- ------- Stockholders' equity Preferred stock - $1 par value; 5,000,000 shares authorized; none issued - - Common stock - $.10 par value; 5,000,000 shares authorized; 1,161,037 issued at December 31, 2000 and 1999 116 116 Additional paid-in capital 2,196 2,196 Accumulated deficit (100,662) (110,784) Note receivable from an officer and stockholder (1,616) (1,648) Less: treasury stock - at cost; 214,549 shares at December 31, 2000 and 214,215 shares at December 31, 1999 (3,110) (3,090) ------- ------- Total stockholders' deficit (103,076) (113,210) ------- ------- Total liabilities, minority interest, redeemable common stock and stockholders' equity $263,801 $262,167 ======= ======= The accompanying notes are an integral part of these consolidated financial statements. SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands, except per share data) For the years ended December 31, ---------------------------------- 2000 1999 1998 ----- ----- ----- Operating revenues Oil and gas $ 54,263 $ 31,425 $ 32,467 Real estate 31,113 31,301 25,650 Other 371 1,206 1,392 --------- --------- --------- Total operating revenues 85,747 63,932 59,509 --------- --------- --------- Operating expenses Oil and gas production 15,153 10,833 18,395 Real estate 19,258 18,374 13,242 General and administrative, net of related party management and administrative fees of $3,254, $3,515 and $3,789, respectively 4,490 3,109 4,450 Depreciation, depletion and amortization 10,441 9,987 19,240 Impairment of oil and gas properties - - 64,000 Other 848 798 1,235 --------- --------- --------- Total operating expenses 50,190 43,101 120,562 --------- --------- --------- Operating income (loss) 35,557 20,831 (61,053) --------- --------- --------- Other income (expense) Interest and dividend income 1,157 954 1,478 Interest expense (42,964) (41,910) (36,490) Other 2,641 952 370 --------- --------- --------- (39,166) (40,004) (34,642) --------- --------- --------- (continued) SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS - (continued) (in thousands, except per share data) For the years ended December 31, ---------------------------------- 2000 1999 1998 ----- ----- ----- Loss before income taxes, minority interest, equity loss and extraordinary item (3,609) (19,173) (95,695) Income tax benefit - - 2,348 --------- --------- --------- Loss before minority interest, equity loss and extraordinary item (3,609) (19,173) (93,347) Minority interest in subsidiaries, net of tax 1,109 1,820 913 Equity loss in subsidiary and partnerships, net of tax - (931) (3,620) --------- --------- --------- Loss before extraordinary item (2,500) (18,284) (96,054) Extraordinary gain from early extinguishment of debt, net of tax 12,622 12,875 - - --------- --------- --------- Net income (loss) $ 10,122 $ (5,409) $(96,054) ========= ========= ========= Income (Loss) per common share Loss per common share before extraordinary item $ (2.33) $ (17.00) $ (89.28) Extraordinary gain from early extinguishment of debt, net of tax 11.74 11.97 - - --------- --------- --------- Income (Loss) per common share $ 9.41 $ (5.03) $ (89.28) ========= ========= ========= Weighted average shares outstanding 1,075,534 1,075,868 1,075,868 ========= ========= ========= The accompanying notes are an integral part of these consolidated financial statements SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY For the years ended December 31, 2000, 1999 and 1998 (in thousands, except share data) Note Common StockAdditional ReceivableTreasury Stock --------------Paid-InAccumulated from --------------- Shares AmountCapital DeficitStockholderShares Amount ------- ------------- --------------------------------- - - Balance - January 1, 19981,161,037 $116 $2,196 $(9,321) $(1,707)214,215 $(3,090) Payments received on note receivable - - - - 28 - - Net loss - - - (96,054) - - - --------- ---- ----- ------- ------ ------- ------ Balance - December 31, 19981,161,037 116 2,196 (105,375) (1,679) 214,215 (3,090) Payments received on note receivable - - - - 31 - - Net loss - - - (5,409) - - - --------- ---- ----- ------- ------ ------- ------ Balance - December 31, 19991,161,037 116 2,196 (110,784) (1,648) 214,215 (3,090) Other - - - - - 334 (20) Payments received on note receivable - - - - 32 - - Net income - - - 10,122 - - - --------- ---- ----- ------- ------ ------- ------ Balance - December 31, 20001,161,037 $ 116 $ 2,196 $ (100,662) $ (1,616) 214,549 $ (3,110) ========= ==== ===== ======= ====== ======= ====== The accompanying notes are an integral part of these consolidated financial statements. SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) For the years ended December 31, ---------------------------------- 2000 1999 1998 ----- ----- ----- Cash flows from operating activities Net income (loss) $ 10,122 $ (5,409) $(96,054) Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: Depreciation, depletion and amortization 10,441 9,987 19,240 Impairment of oil and gas properties - - 64,000 Noncash interest expense 9,272 6,344 2,963 Extraordinary gain from early extinguishment of debt (12,622) (12,875) - (Gain) loss on sale of assets (1,607) (167) (275) Equity in loss of subsidiary and partnerships - 187 3,620 Noncash hedge amortization 638 - - Impairment of equity investment - 744 - Other noncash items 51 329 3 Amortization of lease commissions 189 525 184 Bad debt expense 346 438 501 Deferred income taxes - - (2,348) Minority interest in loss of subsidiary (1,109) (1,820) (913) Changes in operating assets and liabilities- Accounts receivable (4,646) (1,704) 3,709 Other current assets (1,038) 60 (226) Deferred lease costs (4) (398) (773) Accounts payable and accrued expenses 1,825 (512) 166 Accrued interest payable (162) (853) 227 Change in restricted cash 5,717 (5,284) - ------- ------- ------- Net cash provided by (used in) operating activities 17,413 (10,408) (5,976) ------- ------- ------- Cash flows from investing activities Proceeds from sale of oil and gas properties 566 5,575 5,706 Purchase of oil and gas properties (10,564) (3,688) (10,046) Purchase of other property, equipment and rental property (10,922) (3,277) (54,462) Purchase of other assets (1,780) (733) (712) Purchase of noncompete covenants - - (1,604) Change in construction in progress 1,058 (3,984) - Proceeds from sale of other assets 60 515 1,317 Proceeds from sale of other property, equipment and rental property 2,487 3,446 50 (continued) SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS - (continued) (in thousands) For the years ended December 31, ---------------------------------- 2000 1999 1998 ----- ----- ----- Purchase of real estate investments - - (333) Proceeds from sale of real estate investment 1,053 660 765 Change in restricted cash (272) 331 3,014 Other 32 31 22 ------- ------- ------- Net cash used in investing activities (18,282) (1,124) (56,283) ------- ------- ------- Cash flows from financing activities Proceeds from borrowings 79,152 144,740 54,589 Payments on debt (77,882) (120,388) (3,877) Decrease in other long-term liabilities (75) (52) (12) Deferred debt costs (1,465) (8,546) (1,576) Refund of debt issue costs 1,500 - - Prepayment penalty on early extinguishment of debt - (887) - Dividends paid to minority interest owners (119) (121) (120) Purchase of minority interest in subsidiary (8) - (309) Purchase of treasury stock by subsidiary - (32) - - ------- ------- ------- Net cash provided by financing activities 1,103 14,714 48,695 ------- ------- ------- Net increase (decrease) in unrestricted cash and cash equivalents 234 3,182 (13,564) Unrestricted cash and cash equivalents - beginning of period 16,983 13,801 27,365 ------- ------- ------- Unrestricted cash and cash equivalents - end of period $ 17,217 $ 16,983 $13,801 ======= ======= ======= Non-cash investing and financing activities Deferred debt cost incurred $ 1,000 $ - $ - Increase in other long-term liabilities associated with deferred debt costs $ 500 $ - $ - - Increase in accrued expenses associated with deferred debt costs $ 500 $ - $ - Supplemental disclosures of cash flow information Interest paid $ 33,855 $ 36,419 $31,695 The accompanying notes are and integral part of these consolidated financial statements. SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Organization and Summary of Significant Accounting Policies Business Southwest Royalties Holdings, Inc. ("SRH"), a Delaware corporation was formed in June 1997 to serve as a holding company for Southwest Royalties Inc. ("Southwest"), Midland Red Oak Realty, Inc. ("Red Oak") (collectively, the "Company") and an equity investment in Basic Energy Service, Inc. ("Basic") (formerly Sierra Well Services, Inc.). Each shareholder of Southwest was issued one share in SRH for each share of Southwest stock held. Prior to the formation of SRH, Red Oak and Basic were subsidiaries of Southwest. Southwest paid a dividend of the shares it owned in Red Oak and Basic to SRH. After the formation of SRH, Southwest and Red Oak became subsidiaries of SRH and, as of July 1, 1997, Basic was deconsolidated. Southwest is principally involved in the business of oil and gas development and production, as well as organizing and serving as managing general partner for various public and private limited partnerships engaged in oil and gas development and production. Southwest is also the general partner of Southwest Partners II and III, which own common stock in Basic. Southwest sells its oil and gas production to a variety of purchasers, with the prices it receives being dependent upon the oil and gas commodity prices. Red Oak is principally involved in real estate investment and development. Principles of Consolidation The consolidated financial statements include the accounts of SRH and its subsidiaries. As of December 31, 2000, the Company owned 100% of Southwest and 81% of Red Oak. As of December 31, 2000, Southwest has only one subsidiary, Blue Heel Company ("Blue Heel"). Effective November 1999, Threading Products International, LLC ("TPI"), a former subsidiary of Southwest, was liquidated. Effective August 2000, Midland Southwest Software ("MSS"), a former subsidiary of Southwest, was merged into Southwest. Blue Heel holds a nominal interest in certain oil and gas properties owned by Southwest. As of December 31, 2000 Red Oak has four wholly-owned subsidiaries, MRO Management, Inc. ("MRO Management"), MRO Commercial, Inc. ("MRO Commercial"), MRO N Cross, Inc. ("Northcross"), and MRO Southwest, Inc. ("MRO Southwest"). MRO Commercial, Northcross and MRO Southwest each hold titles to certain real estate properties and are the borrowers under the credit agreements related to such properties. These credit agreements are non-recourse to Red Oak. MRO Management performs real estate management services for Red Oak, MRO Commercial, Northcross, MRO Southwest and for third party clients. In December 1999, MRO Madera, Inc. ("Madera"), a former subsidiary of Red Oak, was dissolved after all remaining tracts of land were sold. In June 1999, the net assets and liabilities of MRO Properties, Inc. ("MROP") and MRO La Placita, Inc. ("La Placita"), former subsidiaries of Red Oak, were merged into Red Oak. The consolidated financial statements include the Company's proportionate share of the assets, liabilities, income and expenses of the oil and gas limited partnerships for which Southwest serves as managing general partner. Southwest accounts for its investments in Southwest Partners II and III using the equity method, as they exercise significant influence over the operations of these partnerships. All significant intercompany transactions have been eliminated. SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued) Estimates and Uncertainties Preparation of the accompanying consolidated financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Cash and Cash Equivalents The Company considers all highly liquid debt instruments purchased with a maturity of three months or less to be cash equivalents. In addition, the Company maintains its excess cash in several interest bearing accounts in various financial institutions. Restricted Cash Restricted cash represents amounts required to be reserved in separate accounts by financial lenders. The interest sinking fund is cash set aside to pay interest on the 10.5% Senior Notes. Effective August 17, 2000, with the refinancing of the Revolving Loan Facility, the interest sinking fund is no longer required to be maintained. Restricted cash accounts have been established for the following purposes (In thousands): 2000 1999 ---- ---- Cash bonds - Red Oak $ - $ 35 Certificate of Deposits - Red Oak 118 112 Tenant security deposits - Red Oak 536 512 Capital expenditures account - Red Oak 824 552 Tax and insurance reserve - Red Oak 2,034 2,465 Lockbox - Red Oak 160 439 Customer service reserve - Red Oak 12 10 Interest reserves - Red Oak 115 - Escrow fund - Southwest 759 627 Interest sinking - Southwest - 5,251 ----- ------ $ 4,558 $10,003 ===== ====== Real Estate Revenue Recognition The Company leases offices and retail shopping centers under noncancelable operating leases. The Company reports base rental revenue for financial statement purposes straight-line over the terms of the respective leases. Accrued straight-line rents represent the amount that straight-line rental revenue exceeds rents collected in accordance with the lease agreements. Management, considering current information and events regarding the tenants' ability to fulfill their lease obligations, considers accrued straight-line rents to be impaired if it is probable that the Company will be unable to collect all rents due according to the contractual lease terms. If accrued straight-line rents associated with a tenant are considered to be impaired, the amount of the impairment is measured based on the present value of expected future cash flows. Impairment losses, if any, are recorded through a loss on the write-off of assets. Cash receipts on impaired accrued straight-line rents are applied to reduce the remaining outstanding balance and as rental revenue, thereafter. SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued) Some leases provide for percentage rents based on the tenant's revenue. Percentage rents are accrued monthly based on prior experience or current tenant financial information. Some leases require tenants to reimburse the Company for certain expenses of operating the property. Tenant reimbursements are accrued and billed to the tenants monthly based on prior experience or certain identifiable costs. Concentrations of Credit Risk The Company is subject to credit risk through oil and gas trade receivables and real estate lease receivables. Although a substantial portion of its customers' ability to pay is dependent upon conditions in the oil and gas industry as well as general economic conditions, credit risk is reduced due to a large customer base. Commodity Hedging and Derivative Financial Instruments The Company has only limited involvement with derivative financial instruments and generally does not use them for trading purposes. They are used to manage commodity price risks. The Company is exposed to credit losses in the event of nonperformance by the counter-parties to its commodity hedges. The Company anticipates, however, that such counter- parties will be able to fully satisfy their obligations under the contracts. The Company does not obtain collateral or other security to support financial instruments subject to credit risk but monitors the credit standing of the counter-parties. Through December 31, 2000, premiums paid for commodity option contracts which qualify as hedges under Statement of Accounting Standards ("SFAS") No. 80 "Accounting for Futures Contracts", are amortized to oil and gas sales over the term of the agreements. Unamortized premiums are included in other assets in the consolidated balance sheet. Amounts receivable or payable under the commodity option contracts are accrued as an increase or decrease in oil and gas sales for the applicable periods. Effective January 1, 2001, any derivative financial instruments will be accounted for in accordance with SFAS 133 as amended by SFAS 138. In June 1998, the Financial Accounting Standards Board ("FASB") issued SFAS No.133, "Accounting for Derivative Instruments and Hedging Activities." SFAS No. 133, as amended by SFAS No. 138, establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, (collectively referred to as derivatives) and for hedging activities. It requires an entity to recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. If certain conditions are met, a derivative may be specifically designated as (a) a hedge of the exposure to changes in the fair value of a recognized asset or liability or an unrecognized firm commitment, (b) a hedge of the exposure to changes in the fair value of the exposure to variable cash flows of a forecasted transaction, or (c) a hedge of the foreign currency exposure of a net investment in a foreign operation, an unrecognized firm commitment, an available-for-sale security, or a foreign currency denominated forecasted transaction. Special accounting for qualifying hedges allows a derivative's gains and losses to offset related results on the hedged item in the Company's statement of operations. The adoption of SFAS No. 133 on January 1, 2001 did not have a material impact on the Company's financial position or results of operations. The Company recorded a net transition adjustment gain of $1,030,000 in accumulated other comprehensive income on January 1, 2001. SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued) Oil and Gas Properties All of the Company's oil and gas properties are located in the United States and are accounted for at cost under the full cost method. Under this method, all productive and nonproductive costs incurred in connection with the acquisition, exploration and development of oil and gas reserves are capitalized. No gain or loss is recognized on the sale of oil and gas properties unless nonrecognition would significantly alter the relationship between capitalized costs and remaining proved reserves for the affected amortization base. When gain or loss is not recognized, the amortization base is reduced by the amount of sales proceeds. Net capitalized costs of oil and gas properties, including the estimated future costs to develop proved reserves, are amortized using the units of revenue method, whereby the provision is computed on the basis of current gross revenues from production in relation to future gross revenues, based on current prices, from estimated production of proved oil and gas reserves. Should the net capitalized costs net of related deferred income taxes exceed the estimated present value of oil and gas reserves discounted at 10% and adjusted for related income taxes, such excess costs would be charged to expense in the Consolidated Statements of Operations. It is reasonably possible that the estimates of anticipated future gross revenues, the remaining estimated economic life of the product, or both could change significantly in the near term due to the fluctuation of oil and gas prices or production. Depletion estimates would also be affected by such changes. Management and service fees received for contractual arrangements, if any, are treated as reimbursement of costs, offsetting the costs incurred to provide those services, with any excess of fees over costs credited to the full cost pool and recognized through lower cost amortization only as production occurs. Property and Equipment Rental property and other property and equipment is stated at cost. Repairs and maintenance are charged to expense as incurred, with additions and improvements being capitalized. Upon sale or other retirement of depreciable property, the cost and accumulated depreciation are removed from the related accounts and any gain or loss is reflected in the Consolidated Statements of Operations. Depreciation is provided on the straight-line method based on the estimated useful lives of the depreciable assets as follows: Building and improvements 20 to 30 years Rental property and improvements 5 to 30 years Leasehold improvements 2 to 10 years Machinery and equipment 3 to 15 years Furniture and fixtures 3 to 5 years Equipment under capital lease 3 to 5 years SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued) Rental Property - Construction in Progress All costs associated with construction in progress are capitalized and subject to depreciation when each project is completed. Interest is capitalized for construction in progress. The capitalized interest is recorded as part of the asset to which it relates and is amortized over the assets useful life. In 2000 and 1999, no interest costs were capitalized. Impairment of Long-Lived Assets and Long-Lived Assets to Be Disposed Of In accordance with the provisions of SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of, the Company reviews its long-lived assets, excluding oil and gas properties accounted for using the full cost method of accounting, and certain identifiable intangibles for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. In this circumstance, the Company recognizes an impairment loss for the amount by which the carrying amount of the asset exceeds the estimated fair value of the asset. Deferred Debt Costs The Company capitalizes certain costs incurred in connection with issuing debt. These costs are being amortized to interest expense on the straight-line method over the term of the related debt. Gas Balancing The Company utilizes the sales method of accounting for over or under deliveries of natural gas. Under this method, the Company recognizes sales revenue on all natural gas sold. As of December 31, 2000, 1999 and 1998, the Company was underproduced by approximately 557 MMcf, 587 MMcf and 620 MMcf, respectively. Income Taxes Deferred tax assets and liabilities are recognized for the estimated future tax effects attributable to differences between the financial statement carrying amount of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rate is recognized in income in the period that includes the enactment date. Deferred tax assets are reduced, if necessary, by a valuation allowance for the amount of tax benefits that may not be realized. SRH and its eligible subsidiaries file a consolidated U.S. federal income tax return. Basic (through June 30, 1997) and Red Oak are consolidated for financial reporting purposes, but beginning January 1, 1996, were not eligible to be included in the consolidated U.S. federal income tax return. Separate provisions for income taxes have been determined for these entities. Reclassifications Certain reclassifications have been made to the 1999 and 1998 amounts to conform to the 2000 presentation. SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued) Income (loss) per share Basic net income (loss) per share is computed by dividing income available to common stockholders by the weighted average number of common shares outstanding for the period. The computation of diluted net income (loss) per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that would then share in the earnings of the entity. For 2000, 1999 and 1998, the computation of diluted net income (loss) per share was antidilutive; therefore, the amounts reported for basic and diluted net income (loss) per share were the same. Noncompete covenants Noncompete covenants are carried at cost less accumulated amortization. The covenants are being amortized over their contractual lives, generally three to five years. 2. Liquidity The accompanying consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. The consolidated financial statements do not include any adjustments relating to the recoverability and classification of liabilities that might be necessary should the Company be unable to continue as a going concern. SRH has a highly leveraged capital structure with, approximately, $33.7 million of cash interest and $57.7 million of principal (net of a related party note of $817,000 between Southwest and Red Oak) due in 2001. The majority, $15.1 million of cash interest and $58.5 million of principal (which includes the $817,000 related party note between Southwest and Red Oak) due in 2001, pertains to Red Oak. Management is currently in the process of renegotiating the terms of SRH's various obligations with its debt holders and/or attempting to seek new lenders or equity investors. Additionally, management would consider disposing of certain assets in order to meet its obligations. There can be no assurance that SRH's debt restructuring efforts in connection with their real estate subsidiary will be successful or that the debt holders will agree to a course of action consistent with SRH's requirements in restructuring the obligations. Even if such agreement is reached, it may require approval of other creditors of SRH, none of which is assured. Furthermore, there can be no assurance that the sales of assets can be successfully accomplished on terms acceptable to SRH. SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued) 3. Subsidiaries, Acquisitions and Dispositions During 1994, Red Oak sold 62,384 shares of redeemable common stock for approximately $1,560,000 million through a private placement offering. During 1995, Red Oak sold an additional 39,616 shares of redeemable common stock for approximately $990,000 and 34,611 shares of its Series A cumulative convertible preferred stock, for approximately $1,731,000. The redeemable common stock is redeemable at the stockholder's option at a price equal to the purchase price plus a 6% annual return computed on a cumulative, but not compounded basis. Redemptions are to be paid out of future earnings of Red Oak. If there are no future earnings, redemptions will be paid out of additional paid-in capital. The redemption rights expired on 58,384 of the redeemable common shares on December 1, 1999. The remaining shares' redemption rights expired in 2000. In June 1998, Red Oak acquired a retail shopping center in Texas for $13.5 million. The acquisition was financed by the variable note payable due July 2001 described in Note 7. The operations of the retail shopping center from the date of acquisition through December 31, 1998 have been included in the Consolidated Statement of Operations for the year ended December 31, 1998. In December 1998, Red Oak acquired a retail shopping center in Texas for $21.0 million. The acquisition was financed by the variable note payable due December 2001 described in Note 7. The operations of the retail shopping center from the date of acquisition through December 31, 1998 have been included in the Consolidated Statement of Operations for the year ended December 31, 1998. 4. Equity Investment in Affiliate and Partnerships As of December 31, 2000, the investment in affiliate held by the Company consists of a 6.65% direct ownership interest in Basic as well as an additional 2.48% indirect interest the Company obtained through limited partnerships, Southwest Partners II and Southwest Partners III, for which Southwest serves as the managing general partner. The investment had been accounted for using the equity method. Based on the December 21, 2000 transaction discussed below, the Company will be accounting for their direct investment in Basic using the cost method. The Company, no longer holds a direct or indirect 20% or more interest in Basic and exerts no significant influence over Basic's operations. On December 21, 2000, Basic entered into a refinancing and restructuring of its debt and equity. Upon the signing of the documents, the Companys percentage of direct and indirect ownership was diluted from 38.84% to 9.13%. A new equity investor, in exchange for 1,441,730 shares of Basic's common stock purchased and retired $24.5 million of Basic's debt from their previous lender. The equity investor received a 76% ownership. Additionally, $10.5 million of the debt held by the previous lender was refinanced with a new lender. The remaining debt held by the previous lender of approximately $21.7 million was cancelled. The Company had previously written down their investment in Basic to zero. The equity method had been suspended until such time as Basic began to show profit and the previous losses had been recouped. Based on the restructuring of Basic's debt and the subsequent dilution of the Company's direct and indirect ownership, the investment in Basic is no longer considered a material investment. SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued) 5. Property and Equipment Property and equipment, including rental property and other, consists of the following (in thousands): Years Ended December 31, ------------------------ 2000 1999 ----- ----- Land $ 2,352 $ 2,352 Building and improvements 1,054 1,051 Machinery and equipment 3,127 2,907 Furniture and fixtures 1,555 1,536 Equipment under capital lease 159 147 Rental property 146,544 137,433 ------- ------- 154,791 145,426 Less accumulated depreciation 16,794 11,900 ------- ------- $137,997 $133,526 ======= ======= 6. Future Lease Receivables Red Oak leases offices and retail shopping centers under noncancelable operating leases that expire at various dates through 2035. The following is a summary of minimum future rentals (base rent only, excludes percentage rents and tenant reimbursements) under noncancelable operating leases as of December 31, 2000 (in thousands): 2001 $ 18,675 2002 15,357 2003 12,171 2004 9,170 2005 6,799 Thereafter 26,520 ------ $ 88,692 ====== SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued) 7. Long-term Debt Long-term debt consists of the following (in thousands): December 31, ------------------- 2000 1999 ----- ----- 10.5% Senior Notes, interest payable semi-annually due October 15, 2004, net of discount of $945 and $1,487, respectively $122,740 $160,598 Revolving Loan Facility with variable rate interest, due December 2000. Collateralized by oil and gas properties - 35,000 Revolving Loan Facility with variable rate interest, due August 2003. Collateralized by oil and gas properties 50,000 - Variable Rate Notes Payables: Variable notes due July 2001, accrued interest due and payable monthly at 7.1% at December 31, 2000 and 1999, with additional 1% payable in cash or additional notes beginning July 1, 1998. Net of discount of $278 and $944, respectively 17,802 15,883 Variable notes due December 2001, accrued interest due and payable monthly at 7.1% at December 31, 2000 and 1999, with additional 1.5% payable in cash or additional notes beginning January 1, 1999. Net of discount of $1,222 and $2,556, respectively 33,373 25,298 Variable notes due July 2002, interest at 8.5% at December 31, 2000 and 1999, accrued interest due and payable monthly beginning July 1, 1999. Net of discount of $2,491 and $4,229, respectively 103,690 101,835 Other 9,660 8,469 ------- ------- 337,265 347,083 Less current maturities, net of discount of $1,500 56,231 40,277 ------- ------- $281,034 $306,806 ======= ======= 10.5% Senior Notes In October 1997, the Company issued $200 million aggregate principal amount of 10.5% Senior Notes due October 15, 2004 (the "Notes"). The Notes were sold at a discount and interest is payable April 15 and October 15 of each year, commencing April 15, 1998. The Notes are general unsecured senior obligations of the Company and rank equally in right of payment with all other senior indebtedness of the Company and senior in right of payment of all existing future subordinated indebtedness of the issuer. Net proceeds from the issuance of the Notes were used primarily to repay existing debt of approximately $84 million, purchase oil and gas properties for approximately $72 million, purchase additional stock in Red Oak for approximately $10 million, invest $1.7 million in an affiliate, with the remaining balance used for working capital. SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued) The Indenture imposes certain limitations on the ability of the Company and its restricted subsidiaries to, among other things, incur additional indebtedness or issue disqualified capital stock, make payments in respect to capital stock, enter into transactions with affiliates, incur liens, sell assets, change the nature of its business, merge or consolidate with any other person and sell, lease, transfer or otherwise dispose of substantially all of its properties or assets. The indenture requires the issuer to repurchase notes under certain circumstances with the excess cash of certain asset sales. The limitations are subject to a number of important qualifications and exceptions. The issuer must report to the Trustee on compliance with such limitations on a quarterly basis. Revolving Loan Facility In December 1999, Southwest entered into a Revolving Loan Facility with Bank One Texas, N.A., which provided a borrowing base of $50 million with a maturity date of December 29, 2000. Funds from the Revolving Loan Facility could be used for working capital and other general corporate purposes, including the repurchase of a portion of Southwest's outstanding 10.5% Senior Notes due 2004. Advances on the Revolving Loan Facility bore interest at the option of Southwest, based on the prime rate of Bank One Texas, N.A. (8.5% at December 31, 1999) plus one fourth of one percent (.25%), when the borrowing base usage is equal to or greater than 80% or zero percent (0%) when the borrowing base usage is less than 80% or, a Eurodollar rate (substantially equal to the London InterBank Offered Rate ("LIBOR")) plus 1.25% up to 2.0% based on the borrowing base usage percentage. The Revolving Loan Facility was secured by no less than 85% of Southwest's oil and gas properties. As of December 31, 1999, the company had drawn $35.0 million. The remaining $15.0 million was drawn in January 2000. The Revolving Loan Facility imposed certain limitations on the ability of Southwest to, among other things, incur additional indebtedness or issue disqualified capital stock, make payments in respect to capital stock, enter into transactions with affiliates, incur liens, sell assets, change the nature of its business, merge or consolidate with any other person and sell, lease, transfer or otherwise dispose of substantially all of its properties or assets. The Revolving Loan Facility required Southwest to establish a sinking fund account with an initial deposit of $3.5 million. Southwest transfered monthly one-twelfth of the annual interest payments on the 10.5% Senior Notes beginning December 31, 1999 into this sinking fund account for the purpose of making interest payments on the 10.5% Senior Notes. Southwest successfully completed a refinancing of their Revolving Loan Facility in the amount of $50.0 million on August 17, 2000 with a new lender. The Amended and Restated Loan and Security Agreement allows for a prime rate of interest (9.50% at December 31, 2000) plus one and one-half percent (1.5%). The new lender continues to impose the above noted limitations, however, the sinking fund requirement was eliminated. Southwest was able to extend the due date from December 29, 2000 to August 17, 2003. Southwest, in recording the refinancing of the Revolving Loan Facility, recorded an extraordinary loss from early extinquishment of debt in the amount of approximately $1.4 million. SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued) Variable Rate Notes Payable In June 1998, MRO N Cross, Inc., a wholly owned subsidiary of Red Oak negotiated two notes payable in the amount of $13.5 million, net of a $2 million discount, and $2.5 million. The $13.5 million note was used for the acquisition of rental property in the amount of $12.9 million with the remaining $600,000 to be used for capital improvements to the rental property purchased. The $2.5 million note is reserved for capital improvements to the rental property purchased of which $2.4 million has been utilized as of December 31, 2000. The notes are collateralized by the property purchased. In December 1998, MRO Commercial, Inc., a wholly owned subsidiary of Red Oak negotiated two notes payable in the amount of $21.7 million, net of a $4 million discount, and $9.7 million. The $21.7 million note was used for the acquisition of a retail shopping center and the funding of various escrow balances. The $9.7 million note is for capital improvements to the rental property purchased of which $8.4 million has been utilized as of December 31, 2000. The notes are collateralized by the property purchased. In June 1999, MRO Southwest, Inc., a wholly owned subsidiary of Red Oak negotiated two notes payable in the amount of $97.5 million and $8.0 million, net of discounts of $5.3 million. Borrowings for both notes accrue interest in arrears at a rate per annum equal to the greater of 8.6% or LIBOR plus 360 basis points. The interest rate includes a servicing fee of .10%. Approximately $91.4 million of the $97.5 million note was used to retire existing debt on properties contributed to MRO Southwest by Red Oak, $1.5 million was deposited into various restricted cash accounts and the remaining proceeds were used for general corporate purposes. The $8.0 million note is for capital improvements to rental property and $5.6 million has been utilized as of December 31, 2000. The notes are collateralized by the properties owned by MRO Southwest. The real estate notes impose certain restrictive covenants including restrictions on the incurrence of additional indebtedness, dissolution, termination or liquidation of all or substantially all of the assets, changes in the legal structure of the assets, making any loans or advances to any third party and commingling its assets with the assets of any of its affiliates or of any other person or entity. Extinguishment of Debt In June 1999, MRO Southwest repaid certain notes payable with proceeds from the aforementioned Variable Note Payable issued in June of 1999. Prepayment penalties and the remaining unamortized deferred debt costs associated with these notes resulted in an extraordinary charge of, approximately, $1.6 million or $(1.49) per share. Since there is no recorded income tax benefits on continuing operations there is no income tax benefits recorded on the extraordinary loss. In December of 1999, Southwest purchased approximately 19%, or approximately $37.9 million original face amount, of its 10.5% Senior Notes with the proceeds from the aforementioned Revolving Loan Facility. Southwest paid approximately $22.0 million, including all fees, to purchase the 10.5% Senior Notes and wrote off approximately $980,000 of deferred loan issue costs and approximately $349,000 of the original issue discount to recognize a $14.5 million extraordinary gain on the purchase of the Notes. Southwest has not recorded any income tax benefit on continuing operations and therefore there is no income tax effect related to the extraordinary gain. The extraordinary gain per share is approximately $13.48. SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued) In January of 2000, Southwest purchased approximately 19%, or approximately $38.4 million original face amount, of its 10.5% Senior Notes with the proceeds from the aforementioned Revolving Loan Facility. Southwest paid approximately $23.0 million, including all fees, to purchase the 10.5% Senior Notes and wrote off approximately $980,000 of deferred loan issue costs and approximately $349,000 of the original issue discount to recognize a $14.1 million extraordinary gain on the purchase of the Notes. The tax benefit of $6.0 million recognized in 2000 results from the reversal of a portion of the Company's deferred tax asset valuation allowance. In accordance with Statement of Financial Accounting Standards ("SFAS") No. 109, none of this amount is allocated to the extraordinary gain. The extraordinary gain per share is approximately $13.01. On August 17, 2000, Southwest refinanced their Revolving Loan Facility and recorded an extraordinary loss from early extinguishment of debt in the amount of approximately $1.4 million. There is no income tax benefit recognized on the extraordinary loss. The extraordinary loss per share is approximately $(1.27). Aggregate maturities of all long-term debt as of December 31, 2000 are as follows (in thousands): 2001 $ 57,731 2002 106,688 2003 52,791 2004 123,731 2005 408 Thereafter 853 ------- 342,202 Less unamortized discount 4,937 ------- $337,265 ======= 8. Income Taxes Income tax provision (benefit) and amounts separately allocated were as follows (in thousands): December 31, ---------------------------- 2000 1999 1998 ----- ----- ----- Loss before minority interest, equity loss and extraordinary item $ - $ - $(2,348) Equity loss in subsidiary - - - Extraordinary gain from early extinguishment - - - ------ ------ ----- $ - $ - $(2,348) ====== ====== ===== SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued) The U.S. Federal tax provision (benefit) attributable to loss before income taxes, minority interest and extraordinary item consists of the following (in thousands): December 31, ---------------------------- 2000 1999 1998 ----- ----- ----- Current $ - $ - $ - Benefit of net operating loss carryforward (1,907) (11,307) (14,165) Deferred 5,713 9,266 (20,237) Change in valuation allowance (3,806) 2,041 32,054 ------ ------ ----- $ - $ - $(2,348) ====== ====== ===== Reconciliation's between the amount determined by applying the U.S. federal statutory rate to loss before income taxes, minority interest and extraordinary item with the income tax provision (benefit) is as follows (in thousands): December 31, ---------------------------- 2000 1999 1998 ----- ----- ----- Computed "expected" tax expense using the U.S. federal statutory rate $(1,227) $(6,488) $(34,510) Effect of extraordinary item 4,442 4,944 - Meals and entertainment 43 16 16 Change in valuation allowance (3,806) 2,041 32,054 Other 548 (513) 92 ------ ------ ----- Provision (benefit) for income taxes $ - $ - $(2,348) ====== ====== ===== SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued) The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities were as follows (in thousands): December 31, ------------------- 2000 1999 Deferred tax assets: ----- ----- Net operating loss carry forwards $ 28,761 $ 28,226 Alternative minimum tax credit carryforwards 170 170 Receivables - 278 Oil and gas properties, principally due to differences in the tax and book basis and depletion methods and the deduction of intangible drilling costs for tax purposes - 2,356 Equity investment in subsidiary - 1,081 Other long term assets 4,211 2,192 Other long term liabilities 262 286 Covenant not to complete - 64 Other 512 243 ------ ------- Total gross deferred tax assets 33,916 34,896 ------ ------- Less valuation allowance (30,921) (34,727) ------ ------- Total gross deferred tax assets 2,995 169 ------ ------- Deferred tax liabilities: Oil and gas properties (1,740) - Other property and equipment (1,096) (158) Receivables (84) - Accounts payable and accrued expenses (63) (11) Other (12) - ------ ------- Total gross deferred tax liabilities (2,995) (169) ------ ------- Net deferred tax asset (liability) $ - $ - ====== ======= A valuation allowance is provided when it is more likely than not that some portion of the deferred tax assets will not be realized. Based on expectations for the future, management has determined that taxable income of the Company will likely not be sufficient to fully utilize available carryforwards prior to their ultimate expiration. As such, the Company has recorded a valuation allowance of $30,921,000 to reflect the realizability of its net deferred tax assets. The amount of the valuation allowance could be reduced if estimates of future taxable income during the carryforward period are increased. As of December 31, 2000, Southwest had net operating loss carryforwards for U.S. federal income tax purposes of approximately $54,804,000, which are available to offset future regular taxable income, if any. The net operating loss carryforwards expire in various periods through 2017. Southwest has alternative minimum tax credit carryforwards totaling $170,000 to offset regular income tax, which have no scheduled expiration date. SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued) Red Oak files an independent return exclusive of the Company and has net operating loss carryforwards of $28,175,000 expiring in various periods through 2017. 9. Profit Sharing Plan On January 1, 1991, the Company adopted an employee profit sharing plan that is intended to provide participating employees with additional income upon retirement. Employees may contribute between 1% and 15% of their base salary up to a maximum of $10,500 for 2000 and $10,000 for the years ended December 31, 1999 and 1998. For the years ended December 31, 2000, 1999 and 1998, the Company matched 20% of the employees' contributions. For the year ended December 31, 2001, the Company will match 20% of the employees' contributions. For subsequent years, the Company will make contributions to the plan on a discretionary basis. Employee contributions are fully vested at all times. Employer contributions are fully vested upon retirement or after five years of service. For the years ended December 31, 2000, 1999 and 1998, the Company contributed approximately $82,000, $72,000 and $61,000, respectively, to the plan. 10. Redeemable Common Stock In August 1996, the Company issued 129,046 shares of redeemable common stock through a private placement offering for $68 per share. The stock is redeemable at the stockholder's option at any time beginning five years from the issuance of the stock (December 31, 2001) at a purchase price determined as follows: (i) The Company shall review no less than five and no more than ten publicly traded oil and gas companies each with a market capitalization between $50 million and $150 million ("Public Company"). The Company shall determine the ratio of each Public Company's market capitalization to EBITDA for the most recent fiscal year. The Company shall then average such multiples and take this averaged multiple and apply it to the Company's EBITDA for the most recent fiscal year, to estimate a value for the Company's common stock. (ii) The Company will determine the multiple of the market capitalization of each Public Company relating to the present value of such Public Company's oil and gas reserves. Present value will be determined by discounting the expected net cash flow from the oil and gas reserves by 10%. The Company will then take the average multiple based on this methodology and apply it to the present value of the Company's oil and gas reserves discounted by 10% to determine a value for the expected net cash flow from the Company's common stock. The Company will then take the average of (i) and (ii) to determine the value of the Company's common stock. The redemption right terminates on the effective date of any registration statement filed with the Securities and Exchange Commission relative to the offer and sale of the Company's common stock to the public. SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued) 11. Stockholders' Equity During 1994, the Company issued a 6% note to a stockholder. The note requires semi-monthly payments of $5,500 and is collateralized by the Company's common stock held by the stockholder. 12. Commitments and Contingencies The partnership agreements relating to certain limited partnerships for which Southwest serves as managing general partner provide for Southwest to offer to repurchase such limited partner units. Under the terms of three of the partnership agreements, Southwest is obligated to repurchase a maximum of $100,000 annually of the units of limited partnerships' interests originally outstanding. Under the terms of nine other partnership agreements, Southwest's obligation to repurchase units in any one year is limited to 10% of the capital contributed by all of the respective limited partners. The repurchase price is based on the discounted future revenues from oil and gas reserves of the respective partnership and the value of other partnership assets. Such amounts required for repurchase in connection with the acceptance by a portion of the limited partners is approximately $4,052,000 at December 31, 2000. The total amount of limited partner unit repurchases for the years ended December 31, 2000 and 1999 was approximately $722,000 and $71,000, respectively. The Company is subject to extensive federal, state and local environmental laws and regulations. These laws, which are constantly changing, regulate the discharge of materials into the environment and may require the Company to remove or mitigate the environmental effects of the disposal or release of petroleum or chemical substances at various sites. Environmental expenditures are expensed or capitalized depending on their future economic benefit. Expenditures that relate to an existing condition caused by past operations and that have no future economic benefits are expensed. Liabilities for expenditures of a noncapital nature are expensed when environmental assessment and/or remediation is probable and the costs can be reasonably estimated. Management recognizes a financial exposure that may require future expenditures presently existing for oil and gas properties and other operations. Other long-term liabilities as of December 31, 2000, include $663,000 for estimated future remedial actions and cleanup costs. As of December 31, 2000, the Company has not been fined, cited or notified of any environmental violations which would have a material adverse effect upon capital expenditures, earnings or the competitive position in the oil and gas industry. However, management does recognize that by the very nature of its business, significant costs could be incurred to bring the Company into total compliance. The amount of such future expenditures is not readily determinable due to several factors, including the unknown magnitude of possible contaminations, the unknown timing and extent of the corrective actions which may be required, the determination of the Company's liability in proportion to other responsible parties and the extent to which such expenditures are recoverable from insurance or indemnifications from prior owners of the Company's properties. It is reasonably possible this estimate could change materially in the near term. Southwest has issued severance agreements to several members of its management team. These severance agreements provide for six months to one year annual salary as severance, upon termination due to change in control (as defined by the agreement). Southwest's contingent liability under the severance agreements at December 31, 2000 is approximately $634,000. SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued) In the normal course of its business, the Company is subject to pending or threatened legal actions; in the opinion of management, any such matters will be resolved without material effect on the Company's operations, cash flow or financial position. 13. Commodity Hedging and Derivative Financial Instruments The Company, from time to time, uses option contracts to mitigate the volatility of price changes on commodities the Company produces and sells as well as to lock in prices to protect the economics related to certain capital projects. On December 30, 1999, Southwest entered into a basket revenue protection agreement, which provides the Company with an oil and gas revenue floor. The contract was for the period January 1, 2000 through December 31, 2000. The agreement was to be calculated on a calendar year quarter as disclosed in the following table based on NYMEX Natural Gas and NYMEX Crude Oil: Notional Volumes Strike Prices ------------------------- ----------------------------- Crude Natural Crude Natural Minimum Oil (bbl) Gas (MMBtu) Oil Gas BOE Revenue ---------- ----------- ----- ------- ---- -------- Quarter 1 269,254 976,676 $ 21.12 $ 1.91 $ 28.76 $7,552,096 Quarter 2 263,058 910,325 $ 18.80 $ 1.92 $ 26.56 $6,714,359 Quarter 3 257,206 857,728 $ 18.00 $ 1.97 $ 25.88 $6,319,432 Quarter 4 251,914 813,400 $ 18.00 $ 2.20 $ 26.80 $6,323,932 Payments shall be made no later than five business days, after each quarterly floating price is determinable by NYMEX. The cost of the floor was approximately $638,000 and is amortized monthly as a reduction of oil and gas revenues. The cost of the floor was fully amortized at the conclusion of the December 31, 2000 contract period. On September 6, 2000, Southwest entered into a floor option, which provides the Company with a crude oil price floor. The contract is for the period January 1, 2001 through December 31, 2001. The option is for a notional amount of 1,100 Bbls of oil a day at a floor price of $25, based on NYMEX Light Sweet Crude. The agreement is to be calculated on a monthly basis with payments to be made no later than five business days after calculating period. The cost of the floor was approximately $466,000. On October 11, 2000, Southwest entered into a floor option, which provides the Company with a crude oil price floor. The contract is for the period January 1, 2001 through December 31, 2001. The option is for a notional amount of 500 bbls of oil a day at a floor price of $27, based on NYMEX Light Sweet Crude. The agreement is to be calculated on a monthly basis with payments to be made no later than five business days after calculating period. The cost of the floor was approximately $224,000. On November 20, 2000, Southwest entered into a floor option, which provides the Company with a crude oil price floor. The contract is for the period June 1, 2001 through May 31, 2002. The option is for a notional amount of 1,000 Bbls of oil a day at a floor price of $22, based on NYMEX Light Sweet Crude. The agreement is to be calculated on a monthly basis with payments to be made no later than five business days after calculating period. The cost of the floor was approximately $310,000. SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued) On December 1, 2000, Southwest entered into a floor option, which provides the Company with a natural gas price floor. The contract is for the period June 1, 2001 through May 31, 2002. The option is for a notional amount of 3,325 MMBtu of natural gas a day at a floor price of $3.00, based on NYMEX Henry Hub. The agreement is to be calculated on a monthly basis with payments to be made no later than five business days after calculating period. The cost of the floor was approximately $140,000. On December 8, 2000, Southwest entered into a floor option, which provides the Company with a natural gas price floor. The contract is for the period April 1, 2001 through March 31, 2002. The option is for a notional amount of 1,700 MMBtu of natural gas a day at a floor price of $4.50, based on NYMEX Henry Hub. The agreement is to be calculated on a monthly basis with payments to be made no later than five business days after calculating period. The cost of the floor was approximately $416,000. On February 14, 2001, Southwest entered into a floor option, which provides the Company with a natural gas price floor. The contract is for the period April 1, 2001 through March 31, 2002. The option is for a notional amount of 3,000 MMBtu of natural gas a day at a floor price of $4.25, based on NYMEX Henry Hub. The agreement is to be calculated on a monthly basis with payments to be made no later than five business days after calculating period. The cost of the floor was approximately $296,000. On February 14, 2001, Southwest entered into a floor option, which provides the Company with a natural gas price floor. The contract is for the period March 1, 2001 through August 31, 2001. The option is for a notional amount of 5,000 MMBtu of natural gas a day at a floor price of $4.50, based on NYMEX Henry Hub. The agreement is to be calculated on a monthly basis with payments to be made no later than five business days after calculating period. The cost of the floor was approximately $156,000. 14. Related Party Transactions Southwest is the managing general partner for several public and private oil and gas limited partnerships, with an officer of Southwest also serving as a general partner for certain of the limited partnerships. As is usual in the oil and gas industry, the operator is paid an amount for administrative overhead attributable to operating such properties and management fees attributable to serving as managing general partner. As provided for in the partnership agreements, such amounts paid by the partnerships to Southwest approximated $3,254,000, $3,515,000 and $3,789,000 for the years ended December 31, 2000, 1999 and 1998, respectively. Included in these amounts, an affiliate of Southwest paid management fees of approximately $0, $136,000 and $147,000, for the years ended December 31, 2000, 1999 and 1998. In addition, Southwest and certain officers and employees may have an interest in some of the partnership properties. An affiliate of the company performs various oilfield services for limited partnerships managed by Southwest. Such services aggregated $309,000, $365,000 and $115,000 for the years ended December 31, 2000, 1999 and 1998. The same affiliate performed services for Southwest that aggregated approximately $290,000, $313,000 and $131,000, for the years ended December 31, 2000, 1999 and 1998. In August 2000, Southwest made a prepayment to the affiliate in the amount of $975,000 for oil and gas services to the provided in the future. On August 11, 2000, Southwest invested $100,000 in a web-based company through a Private Placement Offering. Southwest holds 200,000 shares of Series A Preferred Stock. The President of the web-based company is the brother of H.H. Wommack, III, President of Southwest. SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued) A Director of Red Oak is a partner in a law firm that provides legal services to Red Oak and Southwest. Red Oak and Southwest paid fees to this law firm for legal services performed of approximately $79,252 and $82,604 in 2000 and 1999, respectively. 15. Disclosures About Fair Value of Financial Instruments The carrying amount of cash and cash equivalents, accounts receivable, accounts payable and accrued expenses, other current assets and other current liabilities approximates fair value because of the short maturity of these instruments. The fair value of the Company's 10.5% Senior Notes is estimated based on the quoted market price for the notes. 2000 1999 ----- ----- Carrying Fair Carrying Fair Amount Value Amount Value ------- ------ ------- ------ 10.5% Senior notes, net discount of $945 and 1,487, respectively $122,740 $104,329 $ 160,598 $ 89,935 The fair value of all other long-term debt approximates the carrying amount as of December 31, 2000 and 1999, based on the borrowing rates currently estimated to be available to the Company for loans with similar terms. The total carrying value of the oil and gas floor options held by Southwest at December 31, 2000 is approximately $1,556,000. The fair market value of the oil and gas floor options at December 31, 2000 is approximately $2,586,000. 16. Lines of Business The Company operates in two major segments: Oil and Gas Activities (oil and gas acquisition, development, exploration and production, as well as organizing and serving as managing general partner for various public and private limited partnerships engaged in oil and gas development and production) and Real Estate Investment and Management (owns and manages retail shopping centers and office buildings). Other items include eliminations, manufacturing, computer service and the holding Company. Effective August 2000, Midland Southwest Software ("MSS") a 100% wholly owned software subsidiary was merged into Southwest. Effective November 1999, Threading Products International ("TPI"), a wholly owned manufacturing subsidiary was liquidated. 2000 1999 1998 ----- ----- ----- (in thousands) Operating Revenue Oil and gas $54,306 $ 31,998 $32,599 Real estate 31,113 31,301 25,650 Other and eliminations 328 633 1,260 ------ ------ ------ $85,747 $ 63,932 $59,509 ====== ====== ====== SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued) 2000 1999 1998 ----- ----- ----- (in thousands) Operating profit (loss) Oil and gas $31,169 $ 14,146 $(68,633) Real estate 5,524 6,812 7,605 Other and eliminations (1,136) (127) (25) ------ ------ ------ $35,557 $ 20,831 $(61,053) ====== ====== ====== Interest Expense Oil and gas $21,945 $ 22,381 $22,536 Real estate 21,060 19,664 13,969 Other and eliminations (41) (135) (15) ------ ------- ------- $42,964 $ 41,910 $36,490 ====== ======= ======= Depreciation, depletion and amortization Oil and gas $ 5,434 $ 5,392 $16,118 Real estate 4,844 4,485 2,935 Other and eliminations 163 110 187 ------- ------- ------- $10,441 $ 9,987 $19,240 ======= ======= ======= Identifiable assets Oil and gas $119,357 $ 115,520 $ 111,876 Real estate 151,231 150,269 148,340 Other and eliminations (6,787) (3,622) (2,666) ------- ------- ------- $263,801 $ 262,167 $ 257,550 ======= ======= ======= Capital expenditures Oil and gas properties $10,564 $ 3,688 $10,046 Oil and gas, other 475 233 617 Real estate 9,389 6,723 53,412 Other - 305 433 ------- ------- ------- $20,428 $ 10,949 $64,508 ======= ======= ======= SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued) 17. Condensed Issuer Financial Data Summarized consolidated financial information for Southwest is as follows (in thousands): December 31, --------------------------------- 2000 1999 1998 ----- ----- ----- Consolidated Balance Sheet Data: Current assets $30,059 $ 28,276 $20,486 Net property and equipment 78,254 73,477 81,373 Other assets, net 11,044 10,814 8,417 ------- ------- ------- $119,357 $ 112,567 $ 110,276 ======= ======= ======= Current liabilities $12,645 $ 46,597 $12,299 Long-term debt 173,771 161,553 199,058 Other long-term liabilities 1,249 841 1,361 Minority interest - 8 7 Stockholders deficit (68,308) (96,432) (102,449) ------- ------- ------- $119,357 $ 112,567 $ 110,276 ======= ======= ======= Consolidated Cash Flow Data: Net cash provided by (used in) operating activities $19,718 $(8,412) $(5,309) Net cash provided by (used in) investing activities (11,691) 3,022 (5,803) Net cash provided by (used in) financing activities (7,960) 8,543 (770) ------- ------- ------- Net increase (decrease) in unrestricted cash and cash equivalents $ 67 $ 3,153 $(11,882) ======= ======= ======= SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued) Consolidating Statements of Operations Data (in thousands): SRH SouthwestRed Oak ElimConsolidat ed ------------------------------------ - - For the year ended December 31, 2000: Operating revenues $ - $54,640 $ 31,113 $ (6) $ 85,747 Depreciation, depletion and amortization - 5,597 4,844 - 10,441 Operating income (loss) (36) 30,069 5,524 - 35,557 Interest expense - 21,945 21,060 (41) 42,964 Income (loss) before taxes, minority interest and extraordinary item (20) 9,422 (12,947) (64) (3,609) Net income (loss) (20) 28,112 (12,947) (5,023) 10,122 For the year ended December 31, 1999: Operating revenues $ - $32,637 $ 31,301 $ (6) $ 63,932 Depreciation, depletion and amortization - 5,502 4,485 - 9,987 Operating income (loss) (55) 14,074 6,812 - 20,831 Interest expense - 22,382 19,664 (136) 41,910 Loss before taxes, minority interest, equity loss and extraordinary item (39) (7,623) (11,419) (92) (19,173) Net income (loss) (39) 5,986 (13,017) 1,661 (5,409) For the year ended December 31, 1998: Operating revenues $ - $33,879 $ 25,650 $ (20) $ 59,509 Depreciation, depletion and amortization - 16,305 2,935 - 19,240 Impairment of properties - 64,000 - - 64,000 Operating income (loss) (44) (68,614) 7,605 - (61,053) Interest expense - 22,544 13,969 (23) 36,490 Loss before taxes, minority interest, equity loss and extraordinary item (28) (89,769) (5,806) (92) (95,695) Net loss (2,645) (88,425) (5,858) 874 (96,054) 18. Subsequent Events On February 14, 2001, Southwest entered into a floor option, which provides the Company with a natural gas price floor. The contract is for the period April 1, 2001 through March 31, 2002. The option is for a notional amount of 3,000 MMBtu of natural gas a day at a floor price of $4.25, based on NYMEX Henry Hub. The agreement is to be calculated on a monthly basis with payments to be made no later than five business days after calculating period. The cost of the floor was approximately $296,000. On February 14, 2001, Southwest entered into a floor option, which provides the Company with a natural gas price floor. The contract is for the period March 1, 2001 through August 31, 2001. The option is for a notional amount of 5,000 MMBtu of natural gas a day at a floor price of $4.50, based on NYMEX Henry Hub. The agreement is to be calculated on a monthly basis with payments to be made no later than five business days after calculating period. The cost of the floor was approximately $156,000. In 1998, Southwest acquired a working interest of approximately 41.66% in 2,400 acres in Howard County, Texas. In January 2001, Southwest acquired an additional 25% working interest in the original acreage and also acquired a 100% working interest in 480 additional acres for approximately $5.4 million. As part of the purchase Southwest assumed operations of the properties. SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued) In February 2001, Red Oak purchased a real estate management company for $1,100,000, consisting of $300,000 cash and a note of $800,000 payable over five years. The results of operations of the acquired company will be consolidated as of the date of the purchase. 19. Supplemental Financial Data - Oil and Gas Producing Activities (unaudited): The following information is presented in accordance with Statement of Financial Accounting Standards No. 69, "Disclosure about Oil and Gas Producing Activities," (SFAS No. 69), except as noted. Costs incurred in connection with oil and gas producing activities are as follows (in thousands): Years ended December 31, -------------------------------- 2000 1999 1998 ----- ----- ----- Acquisition of properties $ 1,318 $ 417 $ 1,315 Exploration costs 476 76 834 Development costs 8,770 3,195 7,897 ------ ------ ------- Total costs incurred $ 10,564 $ 3,688 $ 10,046 ====== ====== ======= Results of operations for oil and gas producing activities are as follows (in thousands): Years ended December 31, -------------------------------- 2000 1999 1998 ----- ----- ----- Revenues $ 54,263 $ 31,425 $ 32,467 ------ ------- ------ Production costs 15,153 10,833 18,395 Depletion 4,992 4,901 15,601 Impairment of oil and gas properties - - 64,000 ------ ------- ------ 34,118 15,691 (65,529) Income tax provision 11,600 5,335 - ------- ------- ------ Results of operations from oil and gas producing activities (excluding corporate overhead) $ 22,518 $ 10,356 $ (65,529) ======= ======= ====== SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued) Reserve Quantity Information The estimates of the Company's proved oil and gas reserves, which are located in the United States, are based on evaluations reviewed by independent petroleum engineers. Reserves were estimated in accordance with guidelines established by the U.S. Securities and Exchange Commission and the Financial Accounting Standards Board, which require that reserve estimates be prepared under existing economic and operating conditions with no provision for price and cost escalations except by contractual arrangements. The reserve estimates at December 31, 2000 assume an average oil price of $25.62/Bbl (reflecting adjustments for oil quality and gathering and transportation costs) and an average gas price of $9.68/Mcf (reflecting adjustments for BTU content, gathering and transportation costs and gas processing and shrinkage). Oil and gas reserve quantity estimates are subject to numerous uncertainties inherent in the estimation of quantities of proved reserves and the projection of future rates of production and the timing of development expenditures. The accuracy of such estimates is a function of the quality of available data, engineering and geological interpretation and judgement. Results of subsequent drilling, testing and production may cause either upward or downward revision of previous estimates. Further, the volumes considered to be commercially recoverable fluctuate with the changes in prices and operating costs. The Company emphasizes that reserve estimates are inherently imprecise and that estimates of new discoveries are more imprecise than those of currently producing oil and gas properties. Accordingly, these estimates are expected to change, as additional information becomes available in the future. Oil and Natural Barrels of Condensate Gas Oil Equivalent (MBbls) (MMcf) (Mboe) ------ ------ ------- Total Proved Reserves: Balance, January 1, 1998 29,666 64,725 40,453 Extensions and discoveries 27 1,526 282 Purchase of minerals-in-place 288 895 437 Sales of minerals-in-place (1,024) (6,132) (2,046) Revisions of previous estimates (6,324) 2,815 (5,855) Production (1,689) (5,556) (2,615) ------ ------ ------ Balance, December 31, 1998 20,944 58,273 30,656 Purchase of minerals-in-place 261 1,329 483 Sales of minerals-in-place (1,704) (2,751) (2,163) Revisions of previous estimates 6,633 12,855 8,776 Production (1,306) (4,627) (2,077) ------ ------ ------ Balance, December 31, 1999 24,828 65,079 35,675 Purchase of minerals-in-place 82 580 179 Sales of minerals-in-place (8) (18) (11) Revisions of previous estimates 2,131 9,518 3,717 Production (1,236) (4,784) (2,033) ------ ------ ------ Balance, December 31, 2000 25,797 70,375 37,527 ====== ====== ====== SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued) Oil and Natural Barrels of Condensate Gas Oil Equivalent (MBbls) (MMcf) (Mboe) ------ ------ ------- Total proved developed reserves January 1, 1998 18,472 46,585 26,236 December 31, 1998 12,006 37,481 18,253 December 31, 1999 16,618 43,023 23,789 December 31, 2000 18,161 46,592 25,926 Standardized Measure of Discounted Future Net Cash Flows The standardized measure of discounted future net cash flows is computed by applying year-end prices of oil and gas (with consideration of price changes only to the extent provided by contractual arrangements) to the estimated future production of proved oil and gas reserves less estimated future expenditures (based on year-end costs) to be incurred in developing and producing the proved reserves, discounted using a rate of 10% per year to reflect the estimated timing of the future cash flows. Future income taxes are calculated by comparing discounted future cash flows to the tax basis of oil and gas properties plus available carryforwards and credits and applying the current tax rates to the difference. Discounted future cash flow estimates like those shown below are not intended to represent estimates of the fair value of oil and gas properties. Estimates of fair value should also consider probable reserves, anticipated future oil and gas prices, interest rates, changes in development and production costs and risks associated with future production. Because of these and other considerations, any estimate of fair value is necessarily subjective and imprecise. December 31, --------------------------------------- 2000 1999 1998 ----- ----- ----- (in thousands) Future cash inflows $1,342,066 $727,615 $ 315,709 Future production and development costs (415,022) (284,354) (181,627) --------- -------- -------- Future net cash flows before income taxes 927,044 443,261 134,082 Future income tax expense (274,566) (103,067) - --------- -------- -------- Future net cash flows 652,478 340,194 134,082 10% annual discount for estimated timing of cash flows (319,246) (164,634) (62,182) --------- -------- -------- Standardized measure of discounted future net cash flows $ 333,232 $175,560 $ 71,900 ========= ======== ======== SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued) The principal sources of change in the standardized measure of discounted future net cash flows are as follows: December 31, --------------------------------------- 2000 1999 1998 ----- ----- ----- (in thousands) Sales of oil and gas produced, net of production costs $(39,110) $(20,592) $(14,072) Net change in sales prices net of production costs 218,763 116,644 (76,234) Extensions and discoveries, net of future production and development costs - - 1,195 Revisions to estimated future development costs (5,903) (4,059) 3,103 Purchases of minerals-in-place 2,129 1,866 1,334 Revisions of previous quantity estimates 49,574 60,317 (18,054) Accretion of discount 22,875 7,190 17,230 Net change in income taxes (87,037) (53,188) 32,483 Sales of minerals-in-place (62) (5,685) (5,899) Changes in production rates, timing and other (3,557) 1,167 (9,007) ------- ------- ------- 157,672 103,660 (67,921) Discounted future net cash flows - Beginning of period 175,560 71,900 139,821 ------- ------- ------- End of period $ 333,232 $175,560 $ 71,900 ======= ======= ======= SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued) Selected Quarterly Financial Results (Unaudited) Quarter ---------------------------------------------- First Second Third Fourth ------ ------- ------ ------ 2000: Net sales $ 11,107 $ 11,938 $ 14,314 $ 13,129 Gross profit 7,492 8,371 10,428 9,266 Net income (loss) before extraordinary item (2,207) (1,095) 205 597 Net income (loss) per share before extraordinary item $ (2.05) $ (1.02) $ .19 $ .55 Net income (loss) $ 11,789 $ (1,095) $(1,169) $ 597 1999: Net sales $ 7,293 $ 7,488 $ 8,967 $ 10,179 Gross profit 3,762 4,273 6,479 6,317 Net income (loss) before extraordinary item (7,350) (6,116) (3,310) (1,508) Net income (loss) per share before extraordinary item $ (6.83) $ (5.69) $ (3.08) $ (1.40) Net income (loss) $ (7,350) $ (7,709) $(3,315) $ 12,965 In June 1999, MRO Southwest repaid certain notes payable with proceeds from a Variable Note Payable issued in June of 1999. Prepayment penalties and the remaining unamortized deferred debt costs associated with these notes resulted in an extraordinary charge of, approximately, $1,598,000 or $(1.49) per share. In December of 1999, Southwest purchased approximately 19%, or approximately $37.9 million original face amount, of its 10.5% Senior Notes with the proceeds from the Revolving Loan Facility. Southwest paid approximately $22.0 million, including all fees, to purchase the 10.5% Senior Notes and wrote off approximately $980,000 of deferred loan issue costs and approximately $349,000 of the original issue discount to recognize a $14.5 million extraordinary gain on the purchase of the Notes. The extraordinary gain per share is approximately $13.48. In January of 2000, Southwest purchased approximately 19%, or approximately $38.4 million original face amount, of its 10.5% Senior Notes with the proceeds from the Revolving Loan Facility. Southwest paid approximately $23.0 million, including all fees, to purchase the 10.5% Senior Notes and wrote off approximately $980,000 of deferred loan issue costs and approximately $349,000 of the original issue discount to recognize a $14.1 million extraordinary gain on the purchase of the Notes. The extraordinary gain per share is approximately $13.01. On August 17, 2000, Southwest refinanced their Revolving Loan Facility and recorded an extraordinary loss from early extinguishment of debt in the amount of approximately $1.4 million. The extraordinary loss per share is approximately $(1.27). ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. The directors and executive officers of SRH and Southwest are as follows: Name Age Position ----- ---- --------- H. H. Wommack, III 45 Chairman, President, Chief Executive Officer and Director H. Allen Corey 44 Secretary and Director Bill E. Coggin 46 Vice President and Chief Financial Officer J. Steven Person 42 Vice President, Marketing Paul L. Morris 59 Director Set forth below is a description of the backgrounds of the directors and executive officers of SRH and Southwest. H. H. Wommack, III has served as Chairman of the Board, President, Chief Executive Officer and a director of SRH since it was formed in July 1997 and of Southwest since its founding in 1983. Mr. Wommack has served as a director of Red Oak since 1992. Prior to the formation of Southwest, Mr. Wommack was a self-employed independent oil and gas producer engaged in the purchase and sale of royalty and working interests in oil and gas leases and the drilling of wells. H. Allen Corey has served as Secretary and a director of SRH since it was formed in July 1997 and of Southwest since its founding in 1983. Mr. Corey has served as a director and Assistant Secretary of Red Oak since 1992. Since January 1997, Mr. Corey has been president of Trolley Barn Brewery, Inc., a brew pub restaurant chain based in the southeastern United States and of counsel to the law firm of Baker, Donelson, Bearman & Caldwell, P.C. From 1986 to 1997, Mr. Corey was a partner at the law firm of Miller & Martin in Chattanooga, Tennessee. Bill E. Coggin has served as Vice President and Chief Financial Officer of SRH since it was formed in July 1997. Mr. Coggin has served as Vice President and Chief Financial Officer of Southwest since 1985. Mr. Coggin has served as a director of Red Oak since 1995. Previously, Mr. Coggin was controller for an oil and gas drilling company and an independent oil and gas operator. J. Steven Person has served as Vice President, Marketing of SRH since it was formed in July 1997. Mr. Person has served as Vice President, Marketing for Southwest since 1989 and as Vice President, Marketing of Red Oak since 1996. Prior to joining Southwest, Mr. Person was involved in the syndication of mortgage-based securities. Paul L. Morris has served as a director of SRH since August 1998 and Southwest since September 1998. Mr. Morris is President and CEO of Wagner & Brown, Ltd., one of the largest independently owned oil and gas companies in the United States. Prior to his position with Wagner & Brown, Mr. Morris served as President of Banner Energy and in various managerial positions with the Columbia Gas System, Inc. Other key employees of Southwest and Red Oak include: Southwest. Jon P. Tate, age 43, has served as Vice President, Land and Assistant Secretary of Southwest since 1989. From 1981 to 1989, Mr. Tate was employed by C.F. Lawrence & Associates, Inc., an independent oil and gas company, as land manager. Mr. Tate is a member of the Permian Basin Landman's Association and American Association of Petroleum Landmen. R. Douglas Keathley, age 45, has served as Vice President, Operations of Southwest since 1992. Before joining Southwest, Mr. Keathley worked as a senior drilling engineer for ARCO Oil and Gas Company and in similar capacities for Reading & Bates Petroleum Co. and Tenneco Oil Co. Red Oak. W. Neil McClung, age 50, has served as President and a director of Red Oak since 1994. Prior to his involvement with Red Oak, Mr. McClung was senior vice president of Heitman Properties, Ltd. from 1989 through 1993 where he was responsible for marketing, budget development and leasing for three million square feet of high-rise office building and industrial center space in several metropolitan and secondary markets. Mr. McClung has also served as a property and leasing manager for Heitman in Midland, Texas. J. Wesley Tune, age 41, has served as Vice President and Secretary of Red Oak since 1994. Mr. Tune was employed by Heitman Properties, Ltd. as property and leasing manager from 1992 until 1994 in Midland, Texas. Prior to his involvement with Heitman, Mr. Tune was a property manager for Mike Lewis & Associates in Midland, Texas, from 1990 to 1992, and manager and controller for Mission Country Club from 1988 to 1990. There is no family relationship between any of the directors and executive officers of SRH or Southwest. No director of either SRH or Southwest currently serves as a director of any other public company. Item 11. Executive Compensation. The following table sets forth certain information for fiscal years 2000 and 1999 with respect to the compensation paid to Mr. Wommack, the Chairman and President, and the four other most highly compensated executive officers of Southwest and/or Red Oak. Mr. Wommack determines the compensation of Southwest's and/or Red Oak's executive officers. No compensation has been paid to the executive officers of SRH for their services to SRH. All Other Name and Principal Position Year Salary Bonus(2)Compensati on(1) - -------------------------------------------------------------------- ----- - --------------- H. H. Wommack, III, President and Treasurer (3) 2000 $ 681,250 $ 411,253 $90,729 1999 671,750 182,303 51,934 1998 667,026 130,006 27,345 ---- ------- ------- - ------- Bill E. Coggin, Vice President and Chief 2000 226,250 152,690 5,090 Financial Officer of Southwest 1999 175,000 67,667 4,750 1998 188,219 30,387 7,180 ---- ------- ------- - ------- J. Steven Person, Vice President, Marketing 2000 162,500 103,568 6,030 for Southwest and Red Oak 1999 141,083 58,476 6,550 1998 163,589 14,540 8,036 ---- ------- ------- - ------- W. Neil McClung, President and Director 2000 126,250 20,000 9,063 Of Red Oak 1999 126,500 25,000 6,812 1998 120,781 - 5,276 ---- ------- ------- - ------- R. Douglas Keathley, Vice President, 2000 114,000 16,540 5,721 Operations of Southwest 1999 106,800 7,257 5,511 1998 106,800 2,764 7,316 ---- ------- ------- - ------- Carried Profit Interest in Insurance Sharing/401(k)Oil and Gas Name Year Premiums ContributionProperties(3) - ------ ---- ----------------------------------- H. H. Wommack, III 2000 $ 4,550 $2,100 $ 84,079 1999 4,550 2,000 45,384 1998 6,599 2,000 18,746 ---- ----- ----- ------- Bill E. Coggin 2000 2,990 2,100 - 1999 2,750 2,000 - 1998 5,180 2,000 - ---- ----- ----- ------- J. Steven Person 2000 4,549 1,481 - 1999 4,550 2,000 - 1998 6,244 1,612 - ---- ----- ----- ------- W. Neil McClung 2000 7,383 1,680 - 1999 5,132 1,680 - 1998 3,596 1,680 - ---- ----- ----- ------- R. Douglas Keathley 2000 4,520 1,201 - 1999 4,550 961 - 1998 6,355 961 - ---- ----- ----- ------- (1) Reflects (i) Southwest's and/or Red Oak's contributions to the Southwest Royalties, Inc. and/or Red Oak's Employee Profit Sharing and 401(k) Plans and premium payments made by Southwest and/or Red Oak for health, disability and life insurance policies for the referenced individuals and (ii) net cash received from carried interests in Oil and Gas Properties. (2) Amount includes club dues and automobiles furnished by Southwest and/or Red Oak. (3) Mr. Wommack has acted as a general partner of twenty-one income funds, two combination income/drilling funds and one drilling fund sponsored by Southwest since 1983, holding a 1% interest in these partnerships. In 2000 there were two non-employee directors who received $5,000 each for their services as directors of Southwest. In 1999 there were two non- employee directors who received $4,000 each for their services as directors of Southwest. Item 12. Security Ownership of Certain Beneficial Owners and Management. The following table sets forth information with respect to the beneficial ownership of the common stock, excluding treasury shares, of SRH by each person who is known by the Company to own beneficially 5% or more of the common stock of SRH, by each director, and by all officers and directors of SRH as a group. Southwest is a wholly-owned subsidiary of SRH. As of March 30, 2001, Southwest Royalties Holdings, Inc. had outstanding 946,488 and 129,046 shares of common and redeemable common stock, respectively. Number of Name and Address of Shares Percentage Beneficial Owner Owned of Class - --------------------- --------- ---------- H. Allen Corey 48,968 4.6% c/o Southwest Royalties Holdings, Inc. Southwest Royalties Building 407 N. Big Spring Midland, TX 79701-4326 George H. Jewell 61,855 5.8% Baker & Botts, L.L.P. One Shell Plaza 910 Louisiana Houston, Texas 77002 H. H. Wommack, III 787,977 73.3% c/o Southwest Royalties Holdings, Inc. Southwest Royalties Building 407 N. Big Spring Midland, TX 79701-4326 Bill Coggin 11,480 1.07% c/o Southwest Royalties Holdings, Inc. Southwest Royalties Building 407 N. Big Spring Midland, TX 79701-4326 Number of Name and Address of Shares Percentage Beneficial Owner Owned of Class - --------------------- --------- ---------- Steve Person 500 .05% c/o Southwest Royalties Holdings, Inc. Southwest Royalties Building 407 N. Big Spring Midland, TX 79701-4326 Paul L. Morris - - c/o Southwest Royalties Holdings, Inc. Southwest Royalties Building 407 N. Big Spring Midland, TX 79701-4326 Directors and officers as a group (five persons)848,925 78.9% Item 13. Certain Relationships and Related Transactions. The descriptions set forth below do not purport to be complete and are qualified in their entirety by reference to the applicable agreements. On December 15, 1994, H. H. Wommack, III borrowed approximately $1.7 million on an unsecured basis from Southwest for the purpose of purchasing the Southwest common stock held by a certain stockholder. The note held by Southwest was amended on March 15, 1995 to include $35,225 of accrued but unpaid interest. The note carries a 6% interest rate and is being amortized over 30 years with payments of $5,500 semi-monthly. As of December 31, 2000, the outstanding balance of this loan was $1.6 million. Mr. Wommack serves as a general partner of substantially all of the oil and gas limited partnerships sponsored by Southwest since 1983, and he holds an interest in these partnerships of approximately 1%. PART IV Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a) Financial Statements The following financial statements of the Company are included in "Item 8. Financial Statements and Supplementary Data": Page ----- Independent Auditors' Report 50 Consolidated Balance Sheets as of December 31, 2000 and 1999 51 Consolidated Statements of Operations for the Years Ended December 31, 2000, 1999 and 1998 53 Consolidated Statements of Stockholders' Equity for the Years Ended December 31, 2000, 1999 and 1998 55 Consolidated Statements of Cash Flows for the Years Ended December 31, 2000, 1999 and 1998 56 Notes to Consolidated Financial Statements 58 All other statements and schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission have been omitted because they are not required under related instructions or are inapplicable, or the information is shown in the financial statements. (b) Reports on Form 8-K None Exhibits The following instruments and documents are included as Exhibits to this Report. Exhibits incorporated by reference are so indicated by parenthetical information. Exhibit Number Description - -------------- ------------- 3.1 Certificate of Incorporation for Southwest Royalties, Inc. dated as of August 18, 1983, as amended March 30, 1987 and November 20, 1989, incorporated by reference to Exhibit 3.1 to S- 4 Registration Statement No. 333-41915 filed December 10, 1997. 3.2 Certificate of Incorporation for Southwest Royalties Holdings, Inc. dated as of July 1, 1997, incorporated by reference to Exhibit 3.2 to S-4 Registration Statement No. 333- 41915 filed December 10, 1997. 3.3 By-Laws of Southwest Royalties, Inc. dated as of August 12, 1996 as amended, incorporated by reference to Exhibit 3.3 to S-4 Registration Statement No. 333-41915 filed December 10, 1997. 3.4 By-Laws of Southwest Royalties Holdings, Inc. adopted as of July 1, 1997, incorporated by reference to Exhibit 3.4 to S-4 Registration Statement No. 333-41915 filed December 10, 1997. 4.1 Indenture dated as of October 14, 1997 among Southwest Royalties, Inc., as Issuer, Southwest Royalties Holdings, Inc., as Guarantor, and State Street Bank and Trust Co., as Trustee, incorporated by reference to Exhibit 4.1 to S-4 Registration Statement No. 333-41915 filed December 10, 1997. 4.2 Registration Rights Agreement dated as of October 14, 1997 by and between Southwest Royalties, Inc., Southwest Royalties Holdings, Inc., Jefferies & Company, Inc., Banc One Capital Corporation and Paribas Corporation, incorporated by reference to Exhibit 4.2 to S-4 Registration Statement No. 333-41915 filed December 10, 1997. 4.3 Warrant issued by Southwest Royalties Holdings, Inc. to Joint Energy Development Investments Limited Partnership dated as of October 14, 1997, incorporated by reference to Exhibit 4.3 to S-4 Registration Statement No. 333-41915 filed December 10, 1997. 4.4 Registration Rights Agreement by Southwest Royalties Holdings, Inc. and Joint Energy Development Investments Limited Partnership dated as of October 14, 1997, incorporated by reference to Exhibit 4.4 to S-4 Registration Statement No. 333- 41915 filed December 10, 1997. 10.1 Purchase and Sale Agreement dated as of September 10, 1997 between Conoco, Inc. and Southwest Royalties, Inc., incorporated by reference to Exhibit 10.1 to S-4 Registration Statement No. 333-41915 filed December 10, 1997. 10.2 Securities Purchase Agreement dated October 14, 1997 between Southwest Royalties Holdings, Inc. and Joint Energy Development Investments Limited Partnership, incorporated by reference to Exhibit 10.2 to S-4 Registration Statement No. 333-41915 filed December 10, 1997. 10.3 Credit Agreement among Southwest Royalties, Inc., as borrower and Bank One, Texas, N.A. and the Institutions named herein as Banks, and Bank One, Texas as Administrative Agent dated December 29, 1999, incorporated by reference to Exhibit 4.0 to Form 8-K/A filed December 30, 1999. 10.4 Amended and Restated Loan and Security Agreement dated August 17, 2000 among Southwest Royalties, Inc., as borrower and Foothill Capital Corporation as Lender and Agent. 21 List of Subsidiaries, incorporated by reference to Exhibit 21 to Amendment No. 1 to S-4 Registration Statement No. 333-41915 filed January 30, 1997. SIGNATURES SOUTHWEST ROYALTIES, INC. Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereto duly authorized. SOUTHWEST ROYALTIES, INC. By: /s/ H. H. Wommack, III ---------------------------------------- H.H. Wommack, III, Chairman, President, and Chief Executive Officer Date: April 4, 2001 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. SIGNATURE TITLE DATE --------- ----- ----- /s/ H. H. Wommack, III ------------------------ Chairman/President/ April 4, 2001 H. H. Wommack, III Chief Executive Officer /s/ Bill E. Coggin -------------------------Vice President/Chief April 4, 2001 Bill E. Coggin Financial Officer /s/ H. Allen Corey ------------------------- H. Allen Corey Director/Secretary April 4, 2001 SIGNATURES SOUTHWEST ROYALTIES HOLDINGS, INC. Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereto duly authorized. SOUTHWEST ROYALTIES HOLDINGS, INC. By: /s/ H. H. Wommack, III ---------------------------------------- H.H. Wommack, III, Chairman, President, and Chief Executive Officer Date: April 4, 2001 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. SIGNATURE TITLE DATE --------- ----- ----- /s/ H. H. Wommack, III ------------------------ Chairman/President/ April 4, 2001 H. H. Wommack, III Chief Executive Officer /s/ Bill E. Coggin ------------------------ Vice President/Chief April 4, 2001 Bill E. Coggin Financial Officer /s/ H. Allen Corey ------------------------ H. Allen Corey Director/Secretary April 4, 2001 EX-10 2 finalloan.txt EXECUTION COPY 9142.100.121662.10 AMENDED AND RESTATED LOAN AND SECURITY AGREEMENT by and between SOUTHWEST ROYALTIES, INC., as Borrower, and THE FINANCIAL INSTITUTIONS NAMED HEREIN as the Lenders, and FOOTHILL CAPITAL CORPORATION as Agent Dated as of August 17, 2000 TABLE OF CONTENTS Page(s) 1. DEFINITIONS AND CONSTRUCTION 2 1.1 Definitions 2 1.2 Accounting Terms 27 1.3 Code 27 1.4 Construction 27 1.5 Schedules and Exhibits 28 2. LOAN AND TERMS OF PAYMENT 28 2.1 Revolving Advances 28 2.2 Intentionally Omitted 35 2.3 Intentionally Omitted 35 2.4 Payments 35 2.5 Overadvances 36 2.6 Interest, Rates, Payments, and Calculations 36 2.7 Collection of Accounts 38 2.8 Crediting Payments; Application of Collections 40 2.9 Designated Account 40 2.10 Maintenance of Loan Account; Statements of Obligations 40 2.11 Fees 41 2.12 Loan Under Prior Credit Agreement 42 3. CONDITIONS; TERM OF AGREEMENT 42 3.1 Conditions Precedent to the Initial Advance 42 3.2 Conditions Precedent to all Advances 48 3.3 Condition Subsequent 48 3.4 Term; Automatic Renewal 49 3.5 Effect of Termination 49 3.6 Early Termination by Borrower 49 3.7 Termination Upon Event of Default 50 4. CREATION OF SECURITY INTEREST 50 4.1 Grant of Security Interest 50 4.2 Negotiable Collateral 50 4.3 Collection of Accounts, General Intangibles, and Negotiable Collateral 50 4.4 Delivery of Additional Documentation Required 51 4.5 Power of Attorney 51 4.6 Right to Inspect 51 4.7 Control Agreements 52 5. REPRESENTATIONS AND WARRANTIES 52 5.1 No Encumbrances 52 5.2 Eligible Proved Developed Producing Reserves; Ownership of Oil and Gas Properties 52 5.3 Operations of Oil and Gas Properties 54 5.4 Equipment 54 5.5 Location of Inventory and Equipment 54 5.6 Oil and Gas Property Collateral Records and Inventory Records 55 5.7 Location of Chief Executive Office; FEIN 55 5.8 Due Organization and Qualification; Subsidiaries 55 5.9 Due Authorization; No Conflict 56 5.10 Claims, Disputes, and Litigation 57 5.11 No Material Adverse Change 58 5.12 No Fraudulent Transfer 58 5.13 Employee Benefits 58 5.14 Environmental Condition 58 5.15 Compliance with the Law 59 5.16 Bonds and Insurance 59 5.17 Hedging Agreement 60 5.18 Brokerage Fees 60 5.19 Permits and other Intellectual Property 60 5.20 [Intentionally Omitted 61 5.21 Locations; Leases 61 5.22 Absence of Certain Changes 61 5.23 Operating Costs 62 5.24 Imbalances 62 5.25 No Default 62 5.26 Leases 62 5.27 Marketing Agreements 63 5.28 Non-Consent Operations 63 5.29 Condition of Equipment 63 5.30 Wells 63 6. AFFIRMATIVE COVENANTS 63 6.1 Accounting System 64 6.2 Collateral Reporting 64 6.3 Financial Statements, Reports, Certificates 67 6.4 Tax Returns 68 6.5 Guarantor Reports 68 6.6 [Intentionally Omitted] 68 6.7 Title to Equipment 68 6.8 Maintenance of Oil and Gas Property Collateral and Equipment; Operation of Business 68 6.9 Taxes 70 6.10 Insurance 71 6.11 No Setoffs or Counterclaims 72 6.12 Location of Inventory and Equipment 73 6.13 Compliance with Laws 73 6.14 Employee Benefits 74 6.15 Leases 74 6.16 Broker Commissions 74 6.17. Oil and Gas Property Title Information 75 6.18 Additional Collateral 75 6.19 Hedging Agreements 76 6.20 Further Assurances 76 7. NEGATIVE COVENANTS 77 7.1 Indebtedness 77 7.2 Liens 78 7.3 Restrictions on Fundamental Changes 78 7.4 Disposal of Assets 78 7.5 Change Name 80 7.6 Guarantee 80 7.7 Nature of Business 80 7.8 Prepayments and Amendments 80 7.9 Change of Control 81 7.10 Consignments 81 7.11 Distributions; Repurchases of Capital Stock 81 7.12 Accounting Methods 81 7.13 Investments 81 7.14 Transactions with Affiliates 82 7.15 Suspension 82 7.16 Compensation 82 7.17 Use of Proceeds 83 7.18 Change in Location of Chief Executive Offices; Inventory and Equipment 83 7.19 No Prohibited Transactions Under ERISA 83 7.20 Financial Covenants 84 7.21 Capital Expenditures 85 7.22 Securities Accounts 85 7.23 Gas Imbalances, Take-or-Pay or Other Prepayments 86 7.24 Payments on Unsecured Notes 86 7.25 Non-Consent Operations 86 7.26 Waivers of Rights Relating to Oil and Gas Properties86 7.27 Contracts for Sale of Production 86 7.28 Exploration 87 8. EVENTS OF DEFAULT 87 9. THE LENDER GROUP'S RIGHTS AND REMEDIES 90 9.1 Rights and Remedies 90 9.2 Remedies Cumulative 92 10. TAXES AND EXPENSES 92 11. WAIVERS; INDEMNIFICATION 93 11.1 Demand; Protest; etc 93 11.2 The Lender Group's Liability for Collateral 93 11.3 Indemnification 93 12. NOTICES 93 13. CHOICE OF LAW AND VENUE; SERVICE OF PROCESS; JURY TRIAL WAIVER 94 14. DESTRUCTION OF BORROWER'S DOCUMENTS 96 15. ASSIGNMENTS AND PARTICIPATIONS; SUCCESSORS 96 15.1 Assignments and Participations 96 15.2 Successors 98 16. AMENDMENTS; WAIVERS 99 16.1 Amendments and Waivers 99 16.2 No Waivers; Cumulative Remedies 100 17. AGENT; THE LENDER GROUP 100 17.1 Appointment and Authorization of Agent 100 17.2 Delegation of Duties 101 17.3 Liability of Agent 101 17.4 Reliance by Agent 101 17.5 Notice of Default or Event of Default 102 17.6 Credit Decision 102 17.7 Costs and Expenses; Indemnification 102 17.8 Agent in Individual Capacity 103 17.9 Successor Agent 103 17.10 Withholding Tax 104 17.11 Collateral Matters 105 17.12Restrictions on Actions by Lenders; Sharing of Payments 106 17.13 Agency for Perfection 107 17.14 Payments by Agent to the Lenders 107 17.15 Concerning the Collateral and Related Loan Documents 107 17.16Field Audits and Examination Reports; Confidentiality; Disclaimers by Lenders; Other Reports and Information 108 17.17 Several Obligations; No Liability 109 18. GENERAL PROVISIONS 109 18.1 Effectiveness 109 18.2 Section Headings 109 18.3 Interpretation 109 18.4 Severability of Provisions 110 18.5 Amendments in Writing 110 18.6 Counterparts; Telefacsimile Execution 110 18.7 Revival and Reinstatement of Obligations 110 18.8 Integration 110 18.9 Amendment and Restatement; Release 111 18.10.Borrower's Waiver of Rights Under Texas Deceptive Tra de Practices Act. 111 SCHEDULES AND EXHIBITS Schedule C-1 Commitments Schedule P-1 Permitted Liens Schedule 5.1(a) Certain Owned Oil and Gas Properties Schedule 5.1(b) Working Interest/Net Revenue Interest/Operator Schedule 5.1(c) Material Contract Rights & Obligations Schedule 5.1(d) Real Property Collateral Schedule 5.2(b) Imbalances in Gas Production or "Take or Pay" Payments Schedule 5.8 Capital Stock/Subsidiaries Schedule 5.10 Litigation Schedule 5.13 ERISA Benefit Plans Schedule 5.16 Insurance Schedule 5.17 Hedging Agreements Schedule 5.19 Permits and Other Intellectual Property Schedule 5.21 Certain Additional Locations of Collateral Schedule 5.22 Certain Other Changes Schedule 5.23 Certain Operating Costs Schedule 5.27 Certain Marketing Agreements Schedule 5.30 Certain Information Concerning Certain Wells Schedule 6.12 Location of Inventory and Equipment Schedule 7.1 Permitted Other Indebtedness Schedule 7.13 Certain Affiliate Limited Partnerships Schedule 7.16 Certain Severance Arrangements Exhibit A-1 Form of Agreement and Acceptance Exhibit B-1 Mortgages, Opinions, Certificates and Certain Other Required Items and Information Exhibit C-1 Form of Compliance Certificate Exhibit P-1 Forms of Prior Lenders Assignment Agreements Exhibit T-1 Form of Transfer Order Letters Exhibit 6.2 Form of Borrowing Base Certificate AMENDED AND RESTATED LOAN AND SECURITY AGREEMENT THIS AMENDED AND RESTATED LOAN AND SECURITY AGREEMENT (this "Agreement"), is entered into as of August 17, 2000, among the financial institutions listed on the signature pages hereof (such financial institutions, together with their respective successors and assigns, are referred to hereinafter each individually as a "Lender" and collectively as the "Lenders"), FOOTHILL CAPITAL CORPORATION, a California corporation, as agent for the Lenders ("Agent"), with a place of business located at 2450 Colorado Avenue, Suite 3000 West, Santa Monica, California 90404, and SOUTHWEST ROYALTIES, INC., a Delaware corporation ("Borrower"), with its chief executive office located at 407 North Big Spring Street, Suite 300, Midland, Texas 79701. RECITALS A. Borrower, certain lenders (the "Prior Lenders"), and Bank One, Texas, N.A., as Agent (the "Prior Agent"), are parties to that certain Credit Agreement, dated as of December 29, 1999 (such credit agreement, as amended, the "Prior Credit Agreement"). B. Borrower has requested that (i) the Lenders assume the obligations of the Prior Lenders under the Prior Credit Agreement, (ii) Agent assume the agency responsibilities of the Prior Agent under the Prior Credit Agreement, and (iii) Agent and the Lenders amend and restate the Prior Credit Agreement and make credit available to Borrower on the terms and conditions stated herein. It is Borrower's intention that for purposes of the Unsecured Notes Indenture (as defined below), (i) this Agreement and the other Loan Documents (as defined below) renew, refinance, replace and succeed, but not constitute an extinguishment or a novation of, the Prior Credit Agreement, and (ii) that the Obligations (as defined below) secured pursuant to this Agreement and the other Loan Documents renew, continue and refinance, but not constitute an extinguishment of or a novation of, the Indebtedness existing on the date hereof under the Prior Credit Agreement, and therefore, solely as among Borrower and the other parties to the Unsecured Notes Indenture, the intent of Borrower is that the Obligations incurred and secured pursuant to this Agreement and the other Loan Documents shall constitute "Permitted Indebtedness" (as defined in the Unsecured Notes Indenture) and that the Liens securing the same shall constitute "Permitted Liens" (as such term is defined in the Unsecured Notes Indenture) for purposes of the Unsecured Notes Indenture. C. Contemporaneously with the above transactions, Agent is entering into the Prior Lender Assignment Agreements (as defined below) wherein the assignment of the rights of the Prior Lenders to the Agent, on behalf of the Lenders, is intended to be for the ratable benefit of the Lenders. D. Agent and the Lenders, subject to the terms and conditions stated herein, are willing to amend and restate the Prior Credit Agreement and to make such credit facilities available. NOW, THEREFORE, for good and valuable consideration, the receipt and sufficiency of which are acknowledged, the parties hereto agree as follows: 1. DEFINITIONS AND CONSTRUCTION. 1.1 Definitions. As used in this Agreement, the following terms shall have the following definitions: "Account Debtor" means any Person who is or who may become obligated under, with respect to, or on account of, an Account. "Accounts" means all currently existing and hereafter arising accounts, contract rights, and all other forms of obligations owing to Borrower or any of its Subsidiaries arising out of the sale or lease of goods, Hydrocarbons or Oil and Gas Properties or the rendition of services by Borrower or any of its Subsidiaries, irrespective of whether earned by performance, and any and all credit insurance, guaranties, or security therefor. "Advances" has the meaning set forth in Section 2.1(a). "Affiliate" means, as applied to any Person, any other Person who directly or indirectly controls, is controlled by, is under common control with or is a director or officer of such Person. For purposes of this definition, "control" means the possession, directly or indirectly, of the power to vote 5% or more of the securities having ordinary voting power for the election of directors or the direct or indirect power to direct the management and policies of a Person. "Agent" means Foothill, solely in its capacity as agent for the Lenders, and shall include any successor agent. "Agent Account" means an account at a bank designated by Agent from time to time as the account into which Borrower shall make all payments to Agent for the benefit of the Lender Group, and into which the Lender Group shall make all payments to Agent, under this Agreement and the other Loan Documents. Initially, unless and until Agent notifies Borrower and the Lender Group to the contrary, the Agent Account shall be that certain deposit account bearing account number 323-266193 and maintained by Agent with The Chase Manhattan Bank, N.A., 4 New York Plaza, 15th Floor, New York, New York 10004, ABA #021- 000-021. "Agent Advances" has the meaning set forth in Section 2.1(g). "Agent's Liens" has the meaning set forth in Section 4.1. "Agent-Related Persons" means Agent and any successor agent, together with their respective Affiliates, and the officers, directors, employees, counsel, agents, and attorneys-in-fact of such Persons and their Affiliates. "Agreement" has the meaning set forth in the preamble hereto. "Assignee" has the meaning set forth in Section 15.1. "Assignment and Acceptance" has the meaning set forth in Section 15.1 and shall be in the form of Exhibit A-1 attached hereto. "Authorized Person" means any officer or other employee of Borrower. "Availability" means the amount that Borrower is entitled to borrow as Advances under Section 2.1, such amount being the difference derived when (a) the sum of the principal amount of Advances (including Agent Advances and Foothill Loans) then outstanding (including any amounts that the Lender Group may have paid for the account of Borrower pursuant to any of the Loan Documents and that have not been reimbursed by Borrower) is subtracted from (b) the least of (i) the Maximum Revolving Amount, or (ii) the Borrowing Base less the aggregate amount of the Reserves Against Availability, or (iii) the Unsecured Note Indebtedness Limitation. If the Revolving Facility Usage is equal to or greater than the least of the Borrowing Base, the Maximum Revolving Amount or the Unsecured Note Indebtedness Limitation, then the Availability is zero (-0-). "Average Unused Portion of Maximum Revolving Amount" means, as of any date of determination, (a) the Maximum Revolving Amount, less (b) the average Daily Balance of Advances that were outstanding during the immediately preceding month. "Bankruptcy Code" means the United States Bankruptcy Code (11 U.S.C. 101 et seq.), as amended, and any successor statute. "Benefit Plan" means a "defined benefit plan" (as defined in Section 3(35) of ERISA) for which Borrower, any Subsidiary of Borrower, or any ERISA Affiliate has been an "employer" (as defined in Section 3(5) of ERISA) within the past six years. "Blue Heel" means Blue Heel Company, a Delaware corporation. "Books" means all of Borrower's and its Subsidiaries' books and records including: ledgers; records indicating, summarizing, or evidencing Borrower's and its Subsidiaries' properties or assets (including the Collateral) or liabilities, including but not limited to well logs and seismographic reports; all information relating to Borrower's and its Subsidiaries' business operations or financial condition; and all computer programs, disk or tape files, printouts, runs, or other computer prepared information. "Borrower" has the meaning set forth in the preamble to this Agreement. "Borrowing" means a borrowing hereunder consisting of Advances made on the same day by the Lenders to Borrower, or by Foothill in the case of a Foothill Loan, or by Agent in the case of an Agent Advance. "Borrowing Base" has the meaning set forth in Section 2.1(a). "Borrowing Base Entities" means Borrower and Blue Heel. "Borrowing Request" has the meaning set forth in Section 2.1(c). "Business Day" means any day that is not a Saturday, Sunday, or other day on which national banks are authorized or required to close. "Change of Control" shall be deemed to have occurred at such time as: (a) a "person" or "group" (within the meaning of Sections 13(d) and 14(d)(2) of the Securities Exchange Act of 1934) becomes the "beneficial owner" (as defined in Rule 13d-3 under the Securities Exchange Act of 1934), directly or indirectly, of more than 10% of the total voting power of all classes of Stock then outstanding of Parent entitled to vote in the election of directors, or (b) (i) prior to the consummation of an Initial Public Offering by Borrower, a "person" or "group" (within the meaning of Sections 13(d) and 14(d)(2) of the Securities Exchange Act of 1934) other than Parent becomes a "beneficial owner" (as defined in Rule 13d-3 under the Securities Exchange Act of 1934), directly or indirectly, of more than 30% of the voting power of all class of Stock then outstanding of Borrower entitled to vote in the election of directors, or (ii) after the consummation of an Initial Public Offering by Borrower: (A) H. H. Wommack, III ceases to own, directly or indirectly, at least 30% of the total voting power of all classes of Stock then outstanding of Borrower entitled to vote on the election of directors; or (B) a "person" or "group" (within the meaning of Sections 13(d) and 14(d)(2) of the Securities Exchange Act of 1934) other than H. H. Wommack, III is or becomes a "beneficial owner" (as defined in Rule 13d-3 under the Securities Exchange Act of 1934), directly or indirectly, of either (I) a greater percentage of the total voting power of all classes of Stock then outstanding of Borrower entitled to vote on the election of directors than the percentage thereof then owned by H. H. Wommack, III, or (II) more than 15% of the voting power of all class of Stock then outstanding of Borrower entitled to vote in the election of directors, or (c) a "person" or "group" (within the meaning of Sections 13(d) and 14(d)(2) of the Securities Exchange Act of 1934), other than Borrower becomes a "beneficial owner" (as defined in Rule 13d-3 under the Securities Exchange Act of 1934), directly or indirectly, of any voting power of any partnership interest or equity interest then outstanding of Blue Heel or any Subsidiary of Borrower. "Closing Date" means the date of the first to occur of the making of the initial Advance or the issuance of the initial Letter of Credit. "Code" means the California Uniform Commercial Code. "Collateral" means all of Borrower's right, title, and interest (together with all of each Subsidiary of Borrower's right, title and interest) in and to each of the following: (a) the Accounts, (b) the Books, (c) the Equipment, (d) the General Intangibles, (e) the Inventory, (f) the Investment Property, (g) the Negotiable Collateral, (h) the Oil and Gas Properties, (i) the Real Property, (j) any money, or other assets of Borrower that now or hereafter come into the possession, custody, or control of any member of the Lender Group, and (k) the proceeds and products, whether tangible or intangible, of any of the foregoing, including proceeds of insurance covering any or all of the Collateral, and any and all Accounts, the Books, Equipment, General Intangibles, Inventory, Investment Property, Negotiable Collateral, Real Property, Oil and Gas Properties, money, deposit accounts, or other tangible or intangible property resulting from the sale, exchange, collection, or other disposition of any of the foregoing, or any portion thereof or interest therein, and the proceeds thereof. "Collateral Access Agreement" means a landlord waiver or consent, mortgagee waiver or consent, bailee letter, or a similar acknowledgement agreement of any warehouseman, processor, lessor, consignee, or other Person in possession of, having a Lien upon, or having rights or interests in the Equipment, Inventory, or Oil and Gas Properties, in each case, in form and substance satisfactory to Agent. "Collections" means all cash, checks, notes, instruments, and other items of payment (including, insurance proceeds, proceeds of cash sales, rental proceeds, and tax refunds). "Commitment" means, at any time with respect to each Lender, its Commitment, and, with respect to all Lenders, their Commitments, in each case as such Dollar amounts are set forth beside such Lender's name under the heading "Commitment" on Schedule C-1 attached hereto or on the signature page of the Assignment and Acceptance pursuant to which such Lender became a Lender hereunder in accordance with the provisions of Section 15.1. "Compliance Certificate" means a certificate substantially in the form of Exhibit C-1 and delivered by the chief accounting officer of Borrower to Agent. "Consolidated Net Income" shall mean with respect to Borrower and its Subsidiaries, for any period, the aggregate of the net income (or loss) of Borrower and its Subsidiaries after allowances for taxes for such period, determined on a consolidated basis in accordance with GAAP; provided that there shall be excluded from such net income (to the extent otherwise included therein) the following: (i) the net income of any Person in which Borrower or any of its Subsidiaries has an interest (which interest does not cause the net income of such other Person to be consolidated with the net income of Borrower and its Subsidiaries in accordance with GAAP), except to the extent of the amount of dividends or distributions actually paid in such period by such other Person to Borrower or to any of its Subsidiaries, as the case may be; (ii) the net income (but not loss) of any of Borrower's Subsidiaries to the extent that the declaration or payment of dividends or similar distributions or transfers or loans by that Subsidiary is not at the time permitted by operation of the terms of its charter or any agreement, instrument or Legal Requirement applicable to such Subsidiary, or is otherwise restricted or prohibited in each case determined in accordance with GAAP; (iii) the net income (or loss) of any Person acquired in a pooling-of-interests transaction for any period prior to the date of such transaction; (iv) any extraordinary gains, including gains attributable to Property sales not in the ordinary course of business; (v) the cumulative effect of a change in accounting principles and any gains or losses attributable to writeups or writedowns of assets; and (vi) any writedowns of non-current assets, provided however, that any ceiling limitation writedowns under SEC guidelines shall be treated as capitalized costs, as if such writedowns had not occurred. "Control Agreement" means a control agreement, in form and substance reasonably satisfactory to Agent, between Borrower, Agent, and the applicable securities intermediary with respect to the applicable Securities Account and related Investment Property. "Daily Balance" means the amount of an Obligation owed at the end of a given day. "Default" means an event, condition, or default that, with the giving of notice, the passage of time, or both, would be an Event of Default. "Defaulting Lender" means any Lender that fails to make any Advance that it is required to make hereunder on any Funding Date and that has not cured such failure by making such Advance within one (1) Business Day after written demand upon it by Agent to do so. "Defaulting Lenders Rate" means the Reference Rate for the first three (3) days from and after the date the relevant payment is due and, thereafter, at the interest rate then applicable to Advances. "Defensible Title" means as to the Mineral Interests, such title held by Borrower that (i) is free from reasonable doubt to the end that a prudent purchaser engaged in the business of the ownership, development and operation of producing oil and gas properties, with knowledge of all of the facts and their legal bearing, would be willing to accept and pay full value therefor; (ii) is deducible of record from the records of the applicable parish or county, or, in the case of federal leases, from the records of the applicable office of the Bureau of Lands Management or Minerals Management Service, or, in the case of state leases, from the applicable records of the applicable state land office; (iii) entitle Borrower to receive not less than the "Net Revenue Interest" set forth in Schedule 5.1(b) with respect to each Mineral Interest owned by Borrower as of the date of this Agreement, and not less than the "Net Revenue Interest" set forth in the most recent Reserve Report with respect to each Mineral Interest acquired by Borrower after the date of this Agreement, in each case, without reduction, suspension or termination throughout the productive life of such Mineral Interest; (iv) obligates Borrower to bear costs and expenses relating to operations on and the maintenance and development of each Mineral Interest in an amount not greater than the "Working Interest" set forth in Schedule 5.1(b) with respect to each Mineral Interest owned by Borrower as of the date of this Agreement, and not greater than the "Working Interest" set forth in the most recent Reserve Report with respect to each Mineral Interest acquired by Borrower after the date of this Agreement (except to the extent that Borrower is obligated under an Operating Agreement to assume a portion of a defaulting or non- consenting party's share of costs), in each case without increase for the respective productive life of such Mineral Interest; and (v) is free and clear of Liens and material encumbrances and defects, except for Permitted Liens. "Designated Account" means account number 1887235412 of Borrower maintained with Borrower's Designated Account Bank, or such other deposit account of Borrower (located within the United States) which has been designated, in writing and from time to time, by Borrower to Agent. "Designated Account Bank" means Bank One, Texas, N.A., whose office is located at 1717 Main Street, 4th Floor, Dallas, Texas 75265, and whose ABA number is 111000614. "Designated Affiliated Limited Partnerships" means those certain limited partnerships listed on Schedule 7.13 attached hereto of which, at the date of determination thereof, Borrower is the sole general partner or one of only two co-general partners (or, in the case of H.H. Wommack Income Fund 1983-1, L.P., the sole general partner of which is H.H. Wommack), as the case may be, as the same is set forth on such schedule. "Disbursement Letter" means an instructional letter executed and delivered by Borrower to Agent regarding the extensions of credit to be made on the Closing Date, the form and substance of which shall be satisfactory to Agent. "Dollars or $" means United States dollars. "Early Termination Premium" has the meaning set forth in Section 3.6. "EBITDA" shall mean, for any period, the sum, determined (without duplication) for Borrower and its Subsidiaries, of (i) Consolidated Net Income of Borrower and its Subsidiaries plus (ii) Interest Expense of Borrower and its Subsidiaries for such period to the extent deducted in the determination of Consolidated Net Income of Borrower and its Subsidiaries for such period plus (iii) depreciation, amortization and other similar non-cash items (with the exception of non-cash charges that require an accrual or reserve for cash charges for any future period and normally recurring accruals) to the extent deducted in the determination of Consolidated Net Income of Borrower and its Subsidiaries for such period plus (iv) all taxes accrued for such period on or measured by income to the extent deducted in the determination of Consolidated Net Income of Borrower and its Subsidiaries for such period. "Eligible Proved Developed Producing Reserves" means the value, as determined by Agent in its sole discretion, of Proved Developed Producing Reserves consisting of Mineral Interests of the Borrowing Base Entities that: (i) are subject to a duly executed and recorded Oil and Gas Property Mortgage that creates a first priority perfected lien in such Mineral Interest; (ii) either are identified on Schedule 5.1(a) or constitute Qualified Subsequent Oil and Gas Property; (iii) are included as Proved Developed Producing Reserves in the Reserve Report most recently delivered to Agent; (iv) strictly comply with each and all of the representations and warranties made by Borrower to Agent in the Loan Documents; and (v) are and at all times continue to be acceptable to Agent in all respects; provided, however, the standards of eligibility may be fixed and revised from time to time by Agent in Agent's credit judgment. In determining the amount to be so included, Eligible Proved Developed Producing Reserves shall be valued based upon the NYMEX Value of such Proved Developed Producing Reserves as of the date of determination of Eligible Proved Developed Producing Reserves, with such adjustments as Agent may deem appropriate in its sole discretion. An item of Proved Developed Producing Reserves shall not be included in Eligible Proved Developed Producing Reserves if: (a) it is not owned solely by a Borrowing Base Entity or a Borrowing Base Entity does not have either good, valid, and marketable title thereto or Defensible Title thereto acceptable to Agent, or the title information relating thereto is not satisfactory to Agent; (b) it is not subject to a valid and perfected first priority Lien and security interest in favor of Agent for the benefit of the Lender Group created by a duly recorded Oil and Gas Property Mortgage, except for Permitted Liens with respect to which Agent has established a Reserve Against Availability in the full amount (or such other amount as may be determined by Agent in its sole discretion) that any holders of the Permitted Liens could assert from time to time thereunder (whether upon the passage of time, the satisfaction of conditions, or otherwise); or (c) it is subject to a Lien in favor of any third Person or any order, judgment, writ or decree, which either restricts or purports to restrict Borrower or any of its Subsidiaries' ability to grant Liens to other Persons on or in respect of its respective assets or properties. "Eligible Transferee" means: (a) a commercial bank organized under the laws of the United States, or any state thereof, and having total assets in excess of $100,000,000; (b) a commercial bank organized under the laws of any other country which is a member of the Organization for Economic Cooperation and Development or a political subdivision of any such country, and having total assets in excess of $100,000,000; provided that such bank is acting through a branch or agency located in the United States; (c) a finance company, insurance company or other financial institution or fund that is engaged in making, purchasing or otherwise investing in commercial loans in the ordinary course of its business and having total assets in excess of $50,000,000; (d) any Affiliate (other than individuals) of, or any fund, money market account, investment account or other account managed by, a pre-existing Lender under this Agreement; (e) so long as no Event of Default has occurred and is continuing, any other Person approved by Agent and Borrower; and (f) during the continuation of an Event of Default, any other Person approved by Agent. "Environmental Laws" shall mean any and all Legal Requirements pertaining to health or the environment in effect in any and all jurisdictions in which the Borrower or any Subsidiary is conducting or at any time has conducted business, or where any Property of the Borrower or any Subsidiary is located, including without limitation, the Oil Pollution Act of 1990 ("OPA"), the Clean Air Act, as amended, the Comprehensive Environmental, Response, Compensation, and Liability Act of 1980 ("CERCLA"), as amended, the Federal Water Pollution Control Act, as amended, the Occupational Safety and Health Act of 1970, as amended, the Resource Conservation and Recovery Act of 1976 ("RCRA"), as amended, the Safe Drinking Water Act, as amended, the Toxic Substances Control Act, as amended, the Superfund Amendments and Reauthorization Act of 1986, as amended, the Hazardous Materials Transportation Act, as amended, and other environmental conservation or protection laws. The term "oil" shall have the meaning specified in OPA, the term "release" (or "threatened release") has the meaning specified in CERCLA, and the terms "solid waste" and "disposal" (or "disposed") have the meanings specified in RCRA; provided, however, that (i) in the event either OPA, CERCLA or RCRA is amended so as to broaden the meaning of any term defined thereby, such broader meaning shall apply subsequent to the effective date of such amendment, and (ii) to the extent the laws of the state in which any Property of the Borrower or any Subsidiary is located establish a meaning for "oil," "release," "solid waste" or "disposal" which is broader than that specified in either OPA, CERCLA or RCRA, such broader meaning shall apply as to Borrower or such Subsidiary, as the case may be, and the Property thereof located within that particular state. "Equipment" means all of Borrower's present and hereafter acquired machinery, machine tools, motors, equipment, furniture, furnishings, fixtures, drillsite equipment (including separators, dehydrators, meters, etc.), compressors, gathering lines, pipelines, vehicles (including motor vehicles and trailers), tools, parts, and other goods (other than consumer goods, farm products, or Inventory), wherever located, including, (a) any interest of Borrower in any of the foregoing, and (b) all attachments, accessories, accessions, replacements, substitutions, additions, and improvements to any of the foregoing. "ERISA" means the Employee Retirement Income Security Act of 1974, 29 U.S.C. 1000 et seq., amendments thereto, successor statutes, and regulations or guidance promulgated thereunder. "ERISA Affiliate" means (a) any corporation subject to ERISA whose employees are treated as employed by the same employer as the employees of Borrower under IRC Section 414(b), (b) any trade or business subject to ERISA whose employees are treated as employed by the same employer as the employees of Borrower under IRC Section 414(c), (c) solely for purposes of Section 302 of ERISA and Section 412 of the IRC, any organization subject to ERISA that is a member of an affiliated service group of which Borrower is a member under IRC Section 414(m), or (d) solely for purposes of Section 302 of ERISA and Section 412 of the IRC, any party subject to ERISA that is a party to an arrangement with Borrower and whose employees are aggregated with the employees of Borrower under IRC Section 414(o). "ERISA Event" means (a) a Reportable Event with respect to any Benefit Plan or Multiemployer Plan, (b) the withdrawal of Borrower or any of its Subsidiaries or ERISA Affiliates from a Benefit Plan during a plan year in which it was a "substantial employer" (as defined in Section 4001(a)(2) of ERISA), (c) the providing of notice of intent to terminate a Benefit Plan in a distress termination (as described in Section 4041(c) of ERISA), (d) the institution by the PBGC of proceedings to terminate a Benefit Plan or Multiemployer Plan, (e) any event or condition (i) that provides a basis under Section 4042(a)(1), (2), or (3) of ERISA for the termination of, or the appointment by the PBGC of a trustee to administer, any Benefit Plan or Multiemployer Plan, or (ii) that may result in termination of a Multiemployer Plan pursuant to Section 4041A of ERISA, (f) the partial or complete withdrawal within the meaning of Sections 4203 and 4205 of ERISA, of Borrower, any of its Subsidiaries or ERISA Affiliates from a Multiemployer Plan, or (g) providing any security to any Plan under Section 401(a)(29) of the IRC by Borrower or its Subsidiaries or any of their ERISA Affiliates. "Event of Default" has the meaning set forth in Section 8. "Exchange Act" means the Securities Exchange Act of 1934, as amended, and any successor statute thereto. "FEIN" means Federal Employer Identification Number. "Foothill" means Foothill Capital Corporation, a California corporation. "Foothill Loans" has the meaning set forth in Section 2.1(f). "Funding Date" means the date on which a Borrowing occurs. "GAAP" means generally accepted accounting principles as in effect from time to time in the United States, consistently applied. "General Intangibles" means all of Borrower's present and future general intangibles and other personal property (including contract rights, rights arising under common law, statutes, or regulations, choses or things in action, goodwill, Permits, patents, trade names, trademarks, servicemarks, copyrights, blueprints, drawings, purchase orders, customer lists, monies due or recoverable from pension funds, route lists, rights to payment and other rights under any royalty or licensing agreements, infringement claims, computer programs, information contained on computer disks or tapes, literature, reports, catalogs, deposit accounts, insurance premium rebates, tax refunds, and tax refund claims), other than goods, Accounts, and Negotiable Collateral. "Governing Documents" means, with respect to any Person, the certificate or articles of incorporation, by-laws, or other organizational or governing documents of such Person. "Governmental Authority" means any nation or government, any state, province, or other political subdivision thereof, any central bank (or similar monetary or regulatory authority) thereof, any entity exercising executive, legislative, judicial, regulatory or administrative functions of or pertaining to government, and any corporation or other entity owned or controlled, through Stock or capital ownership or otherwise, by any of the foregoing. "Guaranty Agreements" means, collectively, any and all of the guaranty agreements with respect to the Obligations which are, or are to be, executed by a Guarantor in favor of Agent for the benefit of the Lender Group, as required from time to time by Agent, in form and substance satisfactory to Agent, in each case as the same may be amended, modified, restated, supplemented, increased, renewed, extended, substituted for or replaced from time to time. "Guarantor" means Blue Heel, each other Subsidiary of Borrower not a signatory to this Agreement, Parent, and each other Person who may hereafter guarantee payment or performance of the whole or any part of the Obligations. "Hazardous Materials" means (a) substances that are defined or listed in, or otherwise classified pursuant to, any applicable laws or regulations as "hazardous substances," "hazardous materials," "hazardous wastes," "toxic substances," or any other formulation intended to define, list, or classify substances by reason of deleterious properties such as ignitability, corrosivity, reactivity, carcinogenicity, reproductive toxicity, or "EP toxicity", (b) oil, petroleum, or petroleum derived substances, natural gas, natural gas liquids, synthetic gas, drilling fluids, produced waters, and other wastes associated with the exploration, development, or production of crude oil, natural gas, or geothermal resources, (c) any flammable substances or explosives or any radioactive materials, and (d) asbestos in any form or electrical equipment that contains any oil or dielectric fluid containing levels of polychlorinated biphenyls in excess of 50 parts per million. "Hedging Agreements" shall mean (i) any interest rate or currency swap, rate cap, rate floor, rate collar, forward agreement or other exchange or rate protection agreements or any option with respect to any such transaction and (ii) any swap agreement, cap, floor, collar, exchange transaction, forward agreement or other exchange or protection agreement relating to Hydrocarbons or any option with respect to any such transaction. "Hedging Agreement Undertaking" shall mean any guaranty of payment, indemnity, participation and/or undertaking related to any Hedging Agreements. "Hydrocarbons" shall mean oil, natural gas, casinghead gas, drip gasoline, natural gasoline, condensate, distillate, liquid hydrocarbons, gaseous hydrocarbons and all constituents, elements or compounds thereof and products refined or separated therefrom. "Indebtedness" means: (a) all obligations of Borrower or any of its Subsidiaries for borrowed money, (b) all obligations of Borrower or any of its Subsidiaries evidenced by bonds, debentures, notes, or other similar instruments and all reimbursement or other obligations of Borrower or any of its Subsidiaries in respect of letters of credit, bankers acceptances, interest rate swaps, or other financial products, (c) all obligations of Borrower or any of its Subsidiaries under capital leases, (d) all obligations or liabilities of others secured by a Lien on any property or asset of Borrower or any of its Subsidiaries, irrespective of whether such obligation or liability is assumed, (e) all obligations of Borrower or any of its Subsidiaries for the deferred purchase price of assets (other than trade debt incurred in the ordinary course of a Borrower's and its Subsidiaries' business and repayable in accordance with customary trade practices), (f) any obligation of a Borrower or any of its Subsidiaries guaranteeing or intended to guarantee (whether directly or indirectly guaranteed, endorsed, co-made, discounted, or sold with recourse to a Borrower) any obligation of any other Person, (g) the net mark to market value of all obligations of Borrower or any of its Subsidiaries under any Hedging Agreements and any Hedging Agreement Undertaking, (h) all obligations of Borrower or any of its Subsidiaries to deliver goods or services including Hydrocarbons in consideration of advance payments, (i) the undischarged balance of any production payment, (j) the undischarged balance of any net profits interest or overriding royalty interest created by Borrower or any of its Subsidiaries or for the creation of which Borrower or any of its Subsidiaries directly or indirectly received payment. "Indemnified Liabilities" has the meaning set forth in Section 11.3. "Indemnified Person" has the meaning set forth in Section 11.3. "Initial Public Offering" means the first firm commitment, underwritten public offering of common Stock of Borrower to the general public under the federal Securities Act of 1933, completed by Borrower and resulting in gross proceeds (before underwriting discounts and commissions) to Borrower of at least $25,000,000. "Insolvency Proceeding" means any proceeding commenced by or against any Person under any provision of the Bankruptcy Code or under any other bankruptcy or insolvency law, assignments for the benefit of creditors, formal or informal moratoria, compositions, extensions generally with creditors, or proceedings seeking reorganization, arrangement, or other similar relief. "Intangible Assets" means, with respect to any Person, that portion of the book value of all of such Person's assets that would be treated as intangibles under GAAP. "Intellectual Property" has the meaning ascribed thereto in Section 5.19. "Interest Expense" shall mean, for any period, the sum (determined without duplication) of the aggregate amount of interest expense accruing during such period on Indebtedness of Borrower and its Subsidiaries, including the interest portion of payments under capitalized leases and any capitalized interest, but excluding amortization of debt discount and expense. "Inventory" means all present and future inventory in which Borrower or any of its Subsidiaries has any interest, including goods and extracted Hydrocarbons held for sale or lease or to be furnished under a contract of service and all of Borrower's present and future raw materials, work in process, finished goods, and packing and shipping materials, wherever located. "Investment" means, with respect to any Person, any investment by such Person in any other Person (including Affiliates) in the form of loans, guarantees, advances, or capital contributions (excluding (a) commission, travel, and similar advances to officers and employees of such Person made in the ordinary course of business, and (b) bona fide Accounts arising from the sale of goods or rendition of services in the ordinary course of business consistent with past practice), purchases or other acquisitions for consideration of Indebtedness or Stock, and any other items that are or would be classified as investments on a balance sheet prepared in accordance with GAAP. "Investment Property" means all of Borrower's present and hereafter acquired "investment property" as that term is defined in the Code, and any and all supporting obligations in respect thereof. "IRC" means the Internal Revenue Code of 1986, as amended, and the regulations thereunder. "Legal Requirements" means all applicable international, foreign, federal, state, and local laws, judgments, decrees, orders, statutes, ordinances, rules, regulations, or Permits, including, without limitation, all Environmental Laws. "Lender" and "Lenders" have the respective meanings set forth in the preamble to this Agreement, and shall include any other Person made a party to this Agreement in accordance with the provisions of Section 15.1 hereof. "Lender Group" means, individually and collectively, each of the individual Lenders and Agent. "Lender Group Expenses" means all: costs or expenses (including taxes, and insurance premiums) required to be paid by Borrower under any of the Loan Documents that are paid or incurred by the Lender Group; reasonable fees or charges paid or incurred by the Lender Group in connection with the Lender Group's transactions with Borrower, including, fees or charges for photocopying, notarization, couriers and messengers, telecommunication, public record searches (including tax lien, litigation, and UCC [or equivalent] searches and including searches with the patent and trademark office, the copyright office, or the department of motor vehicles), filing, recording, publication, appraisal (including periodic Oil and Gas Property Collateral appraisals and engineer reports), Reserve Reports and environmental audits; costs and expenses incurred by Agent in the disbursement of funds to Borrower (by wire transfer or otherwise); reasonable charges paid or incurred by Agent resulting from the dishonor of checks; costs and expenses paid or incurred by the Lender Group to correct any default or enforce any provision of the Loan Documents, or in gaining possession of, maintaining, handling, preserving, storing, shipping, selling, preparing for sale, or advertising to sell the Collateral, or any portion thereof, irrespective of whether a sale is consummated; reasonable costs and expenses paid or incurred by Agent in examining the Books; costs and expenses of third party claims or any other suit paid or incurred by the Lender Group in enforcing or defending the Loan Documents or in connection with the transactions contemplated by the Loan Documents or the Lender Group's relationship with Borrower (or any of its Subsidiaries party to one or more Loan Documents); and the Lender Group's reasonable attorneys fees and expenses incurred in advising, structuring, drafting, reviewing, administering, amending, terminating, enforcing (including attorneys fees and expenses incurred in connection with a "workout," a "restructuring," or an Insolvency Proceeding concerning Borrower), defending, or concerning the Loan Documents, irrespective of whether suit is brought. "Lender-Related Persons" means, with respect to any Lender, such Lender, together with such Lender's Affiliates, and the officers, directors, employees, counsel, agents, and attorneys-in-fact of such Lender and such Lender's Affiliates. "Letter of Credit Undertaking" means any letter of credit or guaranty of payment, indemnity, participation and/or undertaking relating to any letter of credit. "Lien" means any interest in Property securing an obligation owed to, or a claim by, any Person other than the owner of the Property, whether such interest shall be based on the common law, statute, or contract, whether such interest shall be recorded or perfected, and whether such interest shall be contingent upon the occurrence of some future event or events or the existence of some future circumstance or circumstances, including (a) the lien or security interest arising from a mortgage, deed of trust, encumbrance, pledge, hypothecation, assignment, deposit arrangement, security agreement, adverse claim or charge, conditional sale or trust receipt, or from a lease, consignment, or bailment for security purposes and also including reservations, exceptions, encroachments, easements, rights-of-way, covenants, conditions, restrictions, leases, and other title exceptions and encumbrances affecting Oil and Gas Property or Real Property and (b) production payments and the like payable out of Oil and Gas Property. For purposes of this Agreement, Borrower or any of its Subsidiaries shall be deemed to be the owner of any Property which it has acquired or holds subject to a conditional sale agreement, or leases under a financing lease or other arrangement pursuant to which title to the Property has been retained by or vested in some other Person in a transaction intended to create financing. "Loan Account" has the meaning set forth in Section 2.10. "Loan Documents" means this Agreement, the Disbursement Letter, the Letters of Credit, the Lockbox Agreements, the Oil and Gas Property Mortgages, the Real Property Mortgages, the Guaranty Agreements, the Security Agreements, the Prior Lender Assignment Agreements, any note or notes executed by Borrower and payable to the Lender Group, and any other agreement entered into, now or in the future, in connection with this Agreement. "Loan Party" means Borrower and each Guarantor. "Lockbox Account" shall mean a depositary account established pursuant to one of the Lockbox Agreements. "Lockbox Agreements" means Lockbox Operating Procedural Agreements and those certain Depository Account Agreements, in form and substance satisfactory to Agent, each of which is among Borrower, Agent, and one of the Lockbox Banks. "Lockbox Banks" means such banks as may be agreed to by Borrower and Foothill from time to time. "Lockboxes" has the meaning set forth in Section 2.7. "Material Adverse Change" means (a) a material adverse change in the business, prospects, operations, results of operations, assets, liabilities or condition (financial or otherwise) of Borrower, (b) a material adverse effect on the ability of Borrower to carry out its business as at the Closing Date or as proposed as of the Closing Date, (c) the material impairment of Borrower's ability to perform its obligations under the Loan Documents to which it is a party or of the Lender Group to enforce the Obligations or realize upon the Collateral, (d) any event or circumstance that is likely to have a material adverse effect on the value of the Collateral or the amount that the Lender Group would be likely to receive (after giving consideration to delays in payment and costs of enforcement) in the liquidation of the Collateral, or (e) a material impairment of the priority of the Agent's Liens with respect to the Collateral. "Material Contract" means, as to any Person, any supply, purchase, service, employment, tax, indemnity, farmout, gas marketing, gas imbalance, operating, unitization, communitization, partnership, joint venture or other agreement of such Person or any of its Subsidiaries or by which such Person or any of its Subsidiaries or any of their respective properties are otherwise bound, which is material to the business, operations or properties of such Person, as the same shall be amended, modified and supplemented and in effect from time to time. "Maximum Revolving Amount" means $50,000,000. "Mineral Interests" shall mean all right, title, interest and estates now owned or hereafter acquired in and to oil and gas leases, oil, gas and mineral leases, or other liquid or gaseous hydrocarbon leases, mineral fee interests, overriding royalty and royalty interests, net profit interests and production payment interests, including any reserved interests, reversionary interests, carried working interests, or residual interests of whatever nature. "Moody's" means Moody's Investors Service, Inc. and any successor thereto. "Mortgage Amendment Agreements" means the amendments to mortgages, deeds of trust and other mineral interest security agreements covering the mineral interests which secure the indebtedness, liabilities and other obligations under the Prior Credit Agreement, in form and substance satisfactory to Agent. "Multiemployer Plan" means a "multiemployer plan" (as defined in Section 4001(a)(3) of ERISA) to which Borrower, any of its Subsidiaries, or any ERISA Affiliate has contributed, or was obligated to contribute, within the past six years. "Negotiable Collateral" means all of a Person's present and future letters of credit, notes, drafts, instruments, Investment Property, documents, personal property leases (wherein such Person is the lessor), chattel paper, and the Books relating to any of the foregoing. "NYMEX Price" means, as of the date of the determination thereof, the average of the 24 succeeding monthly futures contract prices, commencing with the month during which the determination is to be made, for each of the appropriate crude oil or natural gas categories included in the most recent Reserve Report provided by Borrower to Agent pursuant to Section 6.2, as applicable, as quoted on the New York Merchantile Exchange ("NYMEX"), or, if the NYMEX no longer provides futures contract price quotes for 24 month periods, the longest period of quotes of less than 24 months shall be used, and, if the NYMEX no longer provides such futures contract quotes or has ceased to operate, the Agent shall designate another nationally recognized commodities exchange to replace the NYMEX. "NYMEX Value" means, at any date of determination thereof as to any Proved Reserves of the Borrowing Base Entities, the result of (a) the discounted present value of future net revenues (i.e., after deducting production and ad valorem taxes and less future capital costs and operating expenses) from Proved Reserves of the Borrowing Base Entities as of such date utilizing the NYMEX Price for the appropriate category of oil or gas as quoted in a nationally recognized publication for such pricing as selected as of such date by Agent and assuming that production costs thereafter remain constant, then discounted at a rate of 10% per year to obtain the present value; minus (b) to the extent not taken into account in subparagraph (a) above, the discounted present value (discounted at a rate of 10% per year) of the Borrowing Base Entities' future plugging and abandonment expenses; minus (c) to the extent not taken into account in subparagraph (a) above, minority interests and other interests of Persons other than a Borrowing Base Entity and any natural gas balancing liabilities of a Borrowing Base Entity. "Obligations" means all loans, Advances, debts, principal, interest (including any interest that, but for the provisions of the Bankruptcy Code, would have accrued), contingent reimbursement obligations under any Letter of Credit Undertakings or Hedging Agreement Undertakings, premiums (including Early Termination Premiums), liabilities (including all amounts charged to Borrower's Loan Account pursuant hereto), obligations, fees, charges, costs, or Lender Group Expenses (including any fees or expenses that, but for the provisions of the Bankruptcy Code, would have accrued), lease payments, guaranties, covenants, and duties owing by Borrower to the Lender Group of any kind and description (whether pursuant to or evidenced by the Loan Documents or pursuant to any other agreement between the Lender Group and Borrower, and irrespective of whether for the payment of money), whether direct or indirect, absolute or contingent, due or to become due, now existing or hereafter arising, and including any debt, liability, or obligation owing from Borrower to others that the Lender Group may have obtained by assignment or otherwise, any debt, liability, or obligation owing to Agent or any Lender arising from any Hedging Agreements under which Agent or any Lender is a counterparty or any Hedging Agreement Undertaking, and further including all interest not paid when due and all Lender Group Expenses that Borrower is required to pay or reimburse by the Loan Documents, by law, or otherwise. "Oil and Gas Properties" means all of the present and future right, title and interest (real, personal, mixed, contractual or otherwise) of Borrower and its Subsidiaries in, to and under or derived from the following: (a) All presently existing and hereafter arising Mineral Interests and surface interests; (b) All presently existing and hereafter arising unitization, communitization and pooling declarations, orders, and agreements (including all units formed by voluntary agreement and those formed under the rules, regulations, orders or other official acts of any governmental entity or tribal authority having appropriate jurisdiction); (c) All presently existing and arising oil sales contracts, casinghead gas sales contracts, gas sales contracts, processing contracts, gathering contracts, transportation contracts, easements, rights-of-way, servitudes, surface leases, subsurface leases, farm-out contracts, farm-in contracts, operating agreements, areas of mutual interest and other contracts, agreements and instruments; (d) All presently existing and hereafter arising personal property, improvements, fixtures, wells (whether producing, plugged and abandoned, shut-in, injection, disposal or water supply), tanks, boilers, buildings, machinery, vehicles, Equipment, gathering lines, pipelines, utility lines, power lines, telephone lines, water rights, roads, permits, licenses and other appurtenances, to the extent the same are situated upon and used or held for use by Borrower or any of its Subsidiaries in connection with the ownership, operation, maintenance or repair of the Mineral Interests and/or surface interests; and (e) All reservoir, reserve, seismic, geologic or geophysical information and data. "Oil and Gas Property Collateral" means the Oil and Gas Properties which are identified on Schedule 5.1(a) or Schedule 5.1(b), and any other Oil and Gas Properties now owned or hereafter acquired by Borrower or any of its Subsidiaries. "Oil and Gas Property Mortgages" means one or more mortgages, deeds of trust, or deeds to secure debt, executed by Borrower and each of its Subsidiaries in favor of Agent, the form and substance of which shall be satisfactory to Agent, that encumber the Oil and Gas Property Collateral and the related improvements thereto (including the Prior Lender Assignment Agreements). "Overadvance" has the meaning set forth in Section 2.5. "Parent" means Southwest Royalties Holdings, Inc., a Delaware corporation. "Participant" has the meaning set forth in Section 15.1(e). "PBGC" means the Pension Benefit Guaranty Corporation as defined in Title IV of ERISA, or any successor thereto. "Permits" of a Person shall mean all rights, franchises, permits, authorities, licenses, certificates of approval or authorizations, including licenses and other authorizations issuable by a Governmental Authority, which pursuant to applicable Legal Requirements are necessary to permit such Person lawfully to conduct and operate its business as currently conducted and to own and use its assets. "Permitted Investments" means (a) investments in marketable direct obligations issued or unconditionally guaranteed by the United States or issued by any agency thereof and backed by the full faith and credit of the United States, in each case maturing within 1 year from the date of acquisition thereof, (b) investments in marketable direct obligations issued by any state of the United States or any political subdivision of any such state or any public instrumentality thereof maturing within 1 year from the date of acquisition thereof and, at the time of acquisition, having the highest rating obtainable from either S&P or Moody's, (c) investments in commercial paper maturing no more than 1 year from the date of acquisition thereof and, at the time of acquisition, having a rating of A-1 or P-1, or better, from S&P or Moody's, (d) investments in certificates of deposit or bankers' acceptances maturing within 1 year from the date of acquisition thereof either (i) issued by any bank organized under the laws of the United States or any state thereof which bank has a rating of A or A2, or better, from S&P or Moody's, or (ii) certificates of deposit less than or equal to $100,000 in the aggregate issued by any other bank insured by the Federal Deposit Insurance Corporation, (e) investments in negotiable instruments for collection, and (f) reasonable advances made in connection with purchases of goods or services in the ordinary course of business. "Permitted Liens" means (a) Liens held by Agent for the benefit of the Lender Group, (b) Liens for unpaid taxes that either (i) are not yet due and payable or (ii) are the subject of Permitted Protests, (c) Liens set forth on Schedule P- 1, (d) the interests of lessors under operating leases and purchase money Liens of lessors under capital leases and purchase money Liens on motor vehicles arising after the Closing Date solely for the acquisition thereof to the extent that the acquisition or lease of the underlying asset is permitted under Section 7.21 and so long as the Lien only attaches to the asset purchased or acquired and only secures the purchase price of the asset, (e) Liens arising by operation of law in favor of warehousemen, landlords, carriers, mechanics, materialmen, laborers, or suppliers, or other like Liens arising by operation of law incidental to the exploration, development, operation and maintenance of Oil and Gas Properties, in each case incurred in the ordinary course of business of Borrower and not in connection with the borrowing of money, and which Liens either (i) are for sums not yet due and payable, or (ii) are the subject of Permitted Protests, (f) Liens arising from deposits made in connection with obtaining worker's compensation or other unemployment insurance, (g) Liens on deposits and escrowed funds made to secure performance of bids, tenders and leases (to the extent permitted under this Agreement) incurred in the ordinary course of business of Borrower and not in connection with the borrowing of money, (h) Liens of or resulting from any judgment or award that do not result in and reasonably could not be expected to result in a Material Adverse Change and as to which the time for the appeal or petition for rehearing of which has not yet expired, or in respect of which Borrower is in good faith prosecuting an appeal or proceeding for a review and in respect of which a stay of execution pending such appeal or proceeding for review has been secured, (i) Liens with respect to the Oil and Gas Property Collateral that are exceptions to the title opinions issued in connection with the Oil and Gas Property Mortgages, as accepted by Agent, (j) with respect to any Oil and Gas Property Collateral consisting of Mineral Interests acquired by Borrower or any of its Subsidiaries after the date of this Agreement, (I) minor easements, rights of way, servitudes, permits, surface leases and other rights in respect to the surface operations, pipelines, grazing, logging, canals, ditches, reservoirs or the like, conditions, covenants and other restrictions, and easements of streets, alleys, highways, pipelines, telephone lines, power lines, railways and other easements and rights of way on, over or in respect of the Borrower's assets or properties and other minor defects in title which (A) do not affect the Defensible Title of or restrict the full use or other benefits of ownership by Borrower or such Subsidiary, as the case may be, thereto to an extent unacceptable to Agent in its reasonable judgement and (B) do not affect the ability of Borrower or such Subsidiary, as the case may be, to receive a share of production or proceeds from, allocated to, or attributable to such Mineral Interests equal to the interest of Borrower or such Subsidiary, as the case may be, therein as represented herein or in the other Loan Documents, and (C) do not materially interfere with the ordinary conduct of the business of Borrower or such Subsidiary, as the case may be, and (D) do not interfere with or impair the value of Agent's Lien therein for the benefit of the Lender Group, and (E) are customarily waived by reasonable and prudent Mineral Interest owners, and (II) Liens reserved in leases or farmout agreements for rent or royalties and for compliance with the terms of the farmout agreements or leases in the case of leasehold estates, to the extent that any such Lien referred to in this clause does not materially impair the use of the Mineral Interest covered by such Lien for the purposes for which such Mineral Interest is held by the Borrower or any Subsidiary, does not materially interfere with or impair the value of such Mineral Interest subject thereto or Agent's Lien therein for the benefit of the Lender Group, is customarily waived by reasonable and prudent operators, and is consented to in writing by Agent, (k) farmout, carried working interests, joint operating, unitization, royalty, overriding royalty, sales and similar agreements relating to the exploration or development of, or production from, Oil and Gas Properties or the sale of the hydrocarbons after they are produced which are existing at the time of acquisition of such Oil and Gas Property, are usual and customary for the industry, and are disclosed to and approved by Agent in writing prior to any Proved Developed Producing Reserves attributable to such Oil and Gas Property being included in Eligible Proved Developed Producing Reserves. "Permitted Protest" means the right of Borrower to protest any Lien other than any such Lien that secures the Obligations, tax (other than payroll taxes or taxes that are the subject of a United States federal tax lien), or rental payment, provided that (a) a reserve with respect to such obligation is established on the books of Borrower in an amount that is satisfactory to Agent, (b) any such protest is instituted and diligently prosecuted by Borrower in good faith, and (c) Agent is satisfied that, while any such protest is pending, there will be no impairment of the enforceability, validity, or priority of any of the Agent's Liens in and to the Collateral. "Permitted SWP Merger" means the merger or consolidation after the Closing Date, but on or before March 31, 2001, of Southwest Partners, L.P., with and into Borrower (and no other entities involved) in a transaction in which Borrower is the sole surviving entity of the transaction; provided that (i) there has not occurred or then exist any Default or Event of Default, and no Default or Event of Default would is likely to occur or exist after giving effect thereto, (ii) the sole consideration in the transaction is the exchange of partnership interests in Southwest Partners, L.P., for shares of common Stock of Borrower, (iii) all documentation and compliance with Legal Requirements pertaining to the transaction has been provided to Agent and is satisfactory to Agent in its reasonable discretion, (iv) neither Borrower nor any of its Subsidiaries incurs any indebtedness, liabilities or other obligations in connection with or as a result of the transaction other than up to $500,000 of indebtedness for borrowed money owing to Western National Bank, Odessa, Texas, (v) neither Borrower nor any of its Subsidiaries incurs or suffers to exist any Liens in connection with or resulting from the transaction other than Liens (other than Permitted Liens) existing on the date of this Agreement in favor of Western National Bank, Odessa, Texas, which encumber only the Mineral Interests acquired by Borrower in the transaction to the extent of only up to $500,000 of the same indebtedness for borrowed money owing to Western National Bank, Odessa, Texas, as is described in the immediately preceding clause (iv), and Borrower shall have provided to Agent such searches of UCC filing offices, Title Opinions and such other evidence thereof as may be requested by Agent, and (vi) no Person receives any consideration in connection with or resulting from the transaction which would not otherwise be permitted to be paid to such Person at such time under this Agreement. "Person" means and includes natural persons, corporations, limited liability companies, limited partnerships, general partnerships, limited liability partnerships, joint ventures, trusts, land trusts, business trusts, or other organizations, irrespective of whether they are legal entities, and governments and agencies and political subdivisions thereof. "Personal Property Collateral" means all Collateral other than the Oil and Gas Property Collateral and other than the Real Property Collateral. "Plan" means any employee benefit plan, program, or arrangement maintained or contributed to by Borrower or with respect to which it may incur liability. "Prior Credit Agreement" has the meaning set forth in the recitals hereto. "Prior Lender Assignment Agreements" means the assignment agreements in the form and substance of Exhibit P-1 attached hereto. "Prior Lenders" has the meaning set forth in the recitals. "Property" means any interest in any kind of property or asset, whether real, personal or mixed, tangible or intangible. "Pro Rata Share" means: (a) with respect to a Lender's obligation to make an Advance and receive payments of principal, interest, fees, costs, and expenses with respect thereto, the percentage obtained by dividing (i) such Lender's Commitment by (ii) the aggregate Commitments of all Lenders, and (b) with respect to all other matters (including the indemnification obligations arising under Section 17.7), the percentage obtained by dividing (i) such Lender's Commitment, by (ii) the aggregate amount of Commitments of all Lenders; provided, however, that, in each case, in the event that all Commitments have been terminated, Pro Rata Share shall be determined according to the Commitments in effect immediately prior to such termination. "Proved Developed Non-Producing Reserves" means Proved Reserves of the Borrowing Base Entities, other than Proved Developed Producing Reserves and Proved Undeveloped Reserves, that can be expected to be recovered through existing wells with existing equipment and operating methods. "Proved Developed Producing Reserves" means Proved Reserves of Borrowing Base Entities, other than Proved Developed Non-Producing Reserves and Proved Undeveloped Reserves, that can be expected to be recovered from currently producing zones under the continuation of present operating methods. "Proved Reserves" means at any particular time, the estimated quantities of Hydrocarbons which geological and engineering data demonstrate with reasonable certainty to be recoverable in future years from known reservoirs attributable to Mineral Interests included or to be included in the Reserve Report under existing economic and operating conditions. "Proved Undeveloped Reserves" means Proved Reserves of the Borrowing Base Entities, other than Proved Developed Producing Reserves and Proved Developed Non-Producing 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. "Qualified Subsequent Oil and Gas Property" means, as at any date of determination thereof, Oil and Gas Properties acquired subsequent to the date of this Agreement with respect to which all of the representations specified in Section 5.2 are true and correct and Borrower has delivered to Agent the Oil and Gas Mortgages, opinions, certificates and other items and information described on Exhibit B-1. "Real Property" means any estates or interests in real property now owned or hereafter acquired by Borrower or any Subsidiary of Borrower, excluding Oil and Gas Properties. "Real Property Collateral" means the parcel or parcels of real property and the related improvements thereto identified on Schedule 5.1(d) and any Real Property hereafter acquired by Borrower. "Real Property Mortgages" means one or more mortgages, deeds of trust, or deeds to secure debt, executed by Borrower and each of its Subsidiaries in favor of Agent, or to the Prior Agent and assigned to Agent, the form and substance of which shall be satisfactory to Agent, that encumber the Real Property Collateral and the related improvements thereto. "Reference Rate" means the variable rate of interest, per annum, most recently announced by Wells Fargo Bank, National Association, or any successor thereto, as its "prime rate," irrespective of whether such announced rate is the best rate available from such financial institution. "Refinancing Letter" means a letter, in form and substance reasonably satisfactory to Agent, from Prior Lender respecting the amount necessary to purchase and refinance in full all of the obligations of Borrower owing to Prior Lenders and obtain an assignment to Agent of all of the Liens existing in favor of Prior Lenders in and to the properties or assets of Borrower. "Renewal Date" has the meaning set forth in Section 3.4. "Reportable Event" means any of the events described in Section 4043(c) of ERISA or the regulations thereunder other than a Reportable Event as to which the provision of 30 days notice to the PBGC is waived under applicable regulations. "Required Lenders" means, at any time, Lenders whose Pro Rata Shares aggregate 51% or more of the Commitments, or, if the Commitments have been terminated irrevocably, 51% of the Obligations then outstanding. "Reserve Report" means a report, in form and substance satisfactory to Agent, prepared by Borrower and audited by Ryder Scott Company, Pollard Gore & Harrison or another firm of independent petroleum engineers selected by Borrower and acceptable to Agent evaluating the oil and gas reserves attributable to the Mineral Interests of the Borrowing Base Entities (and no other Persons) which shall, among other things, (a) identify the wells covered thereby, (b) specify said third party's opinions with respect to the total volume of Proved Reserves (specifying with such opinions the terms of categories Proved Developed Producing Reserves, Proved Developed Non- Producing Reserves and Proved Undeveloped Reserves) which Borrower has the right to produce (or cause to be produced) for its own account, (c) set forth said firm's opinions with respect to the NYMEX Value of each of the categories of the Proved Reserves as specified in subclause (b) above, (d) set forth said firm's opinions with respect to the projected future rate of production of the Proved Reserves, (e) contain such other information as requested by Agent with respect to the projected rate of production, gross revenues, operating expenses, net income, taxes, capital expenditures and other capital costs, net revenues and present value of future net revenues attributable to such reserves and production therefrom, and (f) contain a statement of the price and escalation parameters, procedures and assumptions upon which such determinations were based. "Reserves Against Availability" means such reserves as Agent determines in Agent's sole discretion as being appropriate to reflect impediments to Agent's ability to realize upon the Collateral or impairments or reductions to the value of the Collateral. Without limiting the generality of the foregoing, Reserves Against Availability may include (but are not limited to) reserves based upon the following: (a) accounts payable which are 45 days or more past the original invoice date thereof; (b) past due or accrued taxes or other governmental charges, including ad valorem, personal property, production, severance and other taxes which may have priority over the Liens or security interests of Agent in the Collateral; (c) Liens in favor of third Persons (whether or not such Liens are Permitted Liens); (d) deposits which are due or scheduled to become due during the immediately following 180 day period under deposit or escrow arrangement concerning costs, expenses and liabilities relating to the plugging and abandonment of Oil and Gas Properties; (e) estimates of present and future costs, expenses, deposits and liabilities related to the plugging and abandonment of the Oil and Gas Properties net of the amount thereof which has been taken into account in the most recent Reserve Report or is fully secured by an escrow arrangement acceptable to Agent; (f) sums which any Borrowing Base Entity may be required to pay which are due or are scheduled to become due during such period as shall be determined by Agent with respect to rental, lease and other amounts payable under leases or the Oil and Gas Properties (except for commercial building leases with respect to which Borrower has delivered to Agent a Collateral Access Agreement); (g) without duplication of the foregoing, amounts owing by any Borrowing Base Entity to any Person to the extent secured by a Lien (whether or not such Lien is a Permitted Lien) on, or trust (constructive or otherwise) over, any of the Collateral (including proceeds thereof or collections from the sale of Hydrocarbons or Mineral Interests which may from time to time come into the possession of any of the Lender Group or its agents), which Lien or trust, in the determination of Agent (from the perspective of an asset-based lender), has a possibility of having a priority superior to the Agent's Liens (such as landlord liens, ad valorem taxes, production taxes, severance taxes, sales taxes, Collections attributable to Mineral Interests of Persons other than a Borrowing Base Entity) in and to such item of Collateral, proceeds or collection; and (h) to the extent not taken into account in the most recent Reserve Report submitted to Agent in the determination of the NYMEX Value of any Proved Reserves of the Borrowing Base Entities used in determining the Borrowing Base, sums which Agent determines are appropriate to account for minority interests and other interests of Persons other than a Borrowing Base Entity and any natural gas balancing liabilities of Borrower. "Retiree Health Plan" means an "employee welfare benefit plan" within the meaning of Section 3(1) of ERISA that provides benefits to individuals after termination of their employment, other than as required by Section 601 of ERISA. "Revolving Facility Usage" means, as of any date of determination, the aggregate amount of Advances outstanding. "SEC" means the United States Securities and Exchange Commission and any successor Federal agency having similar powers. "Securities Account" means a "securities account" as that term is defined in Section 8501 of the Code. "Security Agreements" means, collectively, any and all of the security agreement, pledges, mortgages, deeds of trust, assignments, stock pledge agreements, assignments of partnership interests, and such other agreements, documents and instruments, in form and substance satisfactory to Agent, which are, or are to be, executed by Borrower and/or any one or more of its Subsidiaries in favor of Agent and/or the Lenders as may be required from time to time by Agent to provide Agent for the benefit of the Lender Group with Liens upon all of the assets and properties of Borrower and its Subsidiaries as security for the payment and performance in full of the Obligations, in each case as the same may be amended, modified, restated, supplemented, increased, renewed, extended, substituted for or replaced from time to time, together with the Prior Lender Assignment Agreements and the security agreements, pledges, mortgages, deeds of trust, assignments, stock pledge agreements, assignments of partnership interests, and other agreements, documents and instruments covered thereby. "Settlement" has the meaning set forth in Section 2.1(h)(i). "Settlement Date" has the meaning set forth in Section 2.1(h)(i). "Solvent" means, with respect to any Person on a particular date, that on such date (a) at fair valuations, all of the properties and assets of such Person are greater than the sum of the debts, including contingent liabilities, of such Person, (b) the present fair salable value of the properties and assets of such Person is not less than the amount that will be required to pay the probable liability of such Person on its debts as they become absolute and matured, (c) such Person is able to realize upon its properties and assets and pay its debts and other liabilities, contingent obligations and other commitments as they mature in the normal course of business, (d) such Person does not intend to, and does not believe that it will, incur debts beyond such Person's ability to pay as such debts mature, and (e) such Person is not engaged in business or a transaction, and is not about to engage in business or a transaction, for which such Person's properties and assets would constitute unreasonably small capital after giving due consideration to the prevailing practices in the industry in which such Person is engaged. In computing the amount of contingent liabilities at any time, it is intended that such liabilities will be computed at the amount that, in light of all the facts and circumstances existing at such time, represents the amount that reasonably can be expected to become an actual or matured liability. "Standard & Poor's" means Standard & Poor's Ratings Services, a division of The McGraw-Hill Companies, Inc., and any successor thereto. "Stock" means all shares, options, warrants, interests, participations, or other equivalents (regardless of how designated) of or in a corporation or equivalent entity, whether voting or nonvoting, including common stock, preferred stock, or any other "equity security" (as such term is defined in Rule 3a11-1 of the General Rules and Regulations promulgated by the SEC under the Exchange Act). "Subsidiary" of a Person means a corporation, partnership, limited liability company, or other entity in which that Person directly or indirectly owns or controls the shares of Stock or other ownership interests having ordinary voting power to elect a majority of the board of directors (or appoint other comparable managers) of such corporation, partnership, limited liability company, or other entity; provided, however, that (i) Blue Heel shall at all times be considered a Subsidiary of Borrower for purposes of this Agreement, (ii) Basic Energy Services, Inc., a Delaware corporation, shall not be considered a Subsidiary of Borrower for purposes of this Agreement, and (iii) none of the Designated Affiliated Limited Partnerships shall be considered a Subsidiary of Borrower for purposes of this Agreement other than for purposes of the definitions of "Benefit Plan", "Environmental Laws" and "ERISA Event" contained herein and for purposes of Sections 2.7, 5.8, 5.13, 5.14, 5.15, 5.18, 5.22, 6.2(l), 6.2(m), 6.9, 6.13, 6.14, 7.7, 7.8, 7.19, 7.24, 7.28, 17.3, 17.6, and 17.8 of this Agreement. "Tangible Net Worth" means, as of any date of determination, the difference of (a) Borrower's total stockholder's equity, minus (b) the sum of: (i) all Intangible Assets of Borrower, (ii) all of Borrower's prepaid expenses, and (iii) all amounts due to Borrower from Affiliates. "Title Opinion" has the meaning set forth in Section 3.1(l). "Transfer Order Letters" means transfer order letters in the form of Exhibit T-1 attached hereto containing the information as provided for therein. "Unsecured Notes" means those certain 10 1/2% unsecured notes in the aggregate original principal amount of $200,000,000, dated as of October 15, 1997, and maturing on October 15, 2004, issued under the Unsecured Notes Indenture, as amended, modified, renewed or restated from time to time. "Unsecured Notes Indebtedness Limitation" means at any particular date the maximum amount of Obligations which may at such time be outstanding pursuant to this Agreement that constitute "Permitted Indebtedness" (as such term is defined in the Unsecured Notes Indenture) and not cause or result in a violation of the Unsecured Notes Indenture or cause or result in any holders of the Unsecured Notes (or any trustee or agent for the benefit thereof) having the right to demand repayment, repurchase, retirement or redemption thereof or any similar right with respect thereto, as determined by Agent in its sole discretion. "Unsecured Notes Indenture" means that certain Indenture, dated as of October 15, 1997, among Borrower, Parent and State Street Bank and Trust Company, as Trustee, pursuant to which the Unsecured Notes have been issued, as amended, modified, renewed or restated from time to time. "Voidable Transfer" has the meaning set forth in Section 18.7. "Working Interest" means that interest in an oil and gas mineral lease which gives the owner the right to explore for, develop, exploit, and/or produce the minerals and includes the obligation to pay the expense of such activities. 1.2 Accounting Terms. All accounting terms not specifically defined herein shall be construed in accordance with GAAP. When used herein, the term "financial statements" shall include the notes and schedules thereto. Whenever the term "Borrower" is used in respect of a financial covenant or a related definition, it shall be understood to mean Borrower on a consolidated basis unless the context clearly requires otherwise. 1.3 Code. Any terms used in this Agreement that are defined in the Code shall be construed and defined as set forth in the Code unless otherwise defined herein. 1.4 Construction. Unless the context of this Agreement or any other Loan Document clearly requires otherwise, references to the plural include the singular, references to the singular include the plural, the term "including" is not limiting, and the term "or" has, except where otherwise indicated, the inclusive meaning represented by the phrase "and/or." The words "hereof," "herein," "hereby," "hereunder," and similar terms in this Agreement or any other Loan Document refer to this Agreement or any other Loan Documents, as the case may be, as a whole and not to any particular provision of this Agreement or such other Loan Document, as the case may be. An Event of Default shall "continue" or be "continuing" until such Event of Default has been waived in writing by Agent. Section, subsection, clause, schedule, and exhibit references herein are to this Agreement unless otherwise specified. Any reference in this Agreement or in the Loan Documents to this Agreement or any of the Loan Documents shall include all alterations, amendments, changes, extensions, modifications, renewals, replacements, substitutions, joinders, and supplements, thereto and thereof, as applicable. 1.5 Schedules and Exhibits. All of the schedules and exhibits attached to this Agreement shall be deemed incorporated herein by reference. 2. LOAN AND TERMS OF PAYMENT 2.1 Revolving Advances. (a) Subject to the terms and conditions of this Agreement and during the term of this Agreement, each Lender (severally, not jointly or jointly and severally) agrees to make advances ("Advances") to Borrower in an amount at any one time outstanding not to exceed such Lender's Pro Rata Share of an amount equal to the least of (i) the Maximum Revolving Amount, or (ii) the Borrowing Base, or (iii) the Unsecured Note Indebtedness Limitation. For purposes of this Agreement, the "Borrowing Base," as of any date of determination (which, in the absence of the occurrence and continuation of an Event of Default, shall be determined no less frequently than monthly), shall mean the result of: (x) 45% of Borrower's Eligible Proved Developed Producing Reserves, minus (y) the sum of aggregate amount of reserves, if any, established by Agent under Section 2.1(b). In determining the Borrowing Base as of any date of determination, the Proved Developed Producing Reserves of any Mineral Interest shall be based upon the volumetric quantity and production forecasts and the related lease operating expenses of the Proved Developed Producing Reserves of such Mineral Interest estimated in the Reserve Report covering the same most recently delivered to Agent minus the amount of Proved Developed Producing Reserves of such Mineral Interest that has been projected to be produced since the date of such Reserve Report as set forth in the independent petroleum engineer's opinion with respect to the projected rate of such future production contained in such Reserve Report (subject to adjustment if the amount actually produced since such date exceeds the amount projected to be produced since such date). Unless otherwise required by Agent, the Borrowing Base shall be determined on the first day of each month. The Borrowing Base on the Closing Date shall be based upon the volumetric quantity and production forecasts of Proved Developed Producing Reserves as of June 30, 2000, multiplied by the NYMEX Price as of the day which is not more than 5 Business Days immediately preceding the Closing Date. The Lenders shall have no obligation to make additional Advances hereunder to the extent such additional Advances would cause the outstanding Revolving Facility Usage to exceed the least of (i) the Maximum Revolving Amount, or (ii) the Borrowing Base, or (iii) the Unsecured Note Indebtedness Limitation. Amounts borrowed pursuant to this Section 2.1 may be repaid and, subject to the terms and conditions of this Agreement, reborrowed at any time during the term of this Agreement. (b) Advance Rate Adjustments and Reserves; Proved Developed Producing Reserves Reappraisals. (i) Anything to the contrary in this Section notwithstanding, Agent shall have the right to establish reserves against the Borrowing Base in such amounts as Agent, in its credit judgment (from the perspective of an asset-based lender) shall deem necessary or appropriate, including reserves on account of (A) sums that Borrower is required to pay (such as taxes, assessments, insurance premiums, or, in the case of leased assets, rents or other amounts payable under such leases) and has failed to pay under any Section of this Agreement or any other Loan Document, (B) without duplication of the foregoing, amounts owing by such Borrower to any Person to the extent secured by a Lien on, or trust over, any of the Collateral, which Lien or trust, in the determination of Agent (from the perspective of an asset-based lender), could have a priority superior to the Agent's Liens (such as landlord liens, ad valorem taxes, or sales taxes where given priority under applicable law) in and to such item of Collateral, and (C) without duplication of the foregoing, Reserves Against Availability. (ii) Agent shall have the right to require, from time to time, Borrower to deliver updated Reserve Reports whereby the volumetric quantity and production forecasts and related lease operating expenses of Proved Developed Producing Reserves are redetermined from time to time by a qualified petroleum engineer approved by Agent after the Closing Date for the purpose of recalculating the NYMEX Value of the Proved Developed Producing Reserves located at the Oil and Gas Property Collateral. In the absence of the occurrence and continuation of an Event of Default, such redeterminations shall occur semi- annually on such dates of each year as shall be required by Agent, and such appraisals shall be delivered to Agent not later than 90 days after each such date. (c) Procedure for Borrowing. Each Borrowing shall be made upon Borrower's irrevocable request therefor (the "Borrowing Request") either delivered in writing or made by telephone to Agent (which notice must be received by Agent no later than 10:00 a.m. (California time) on the fifth (5th) Business Day preceding the requested Funding Date specifying (i) the amount of the Borrowing, and (ii) the requested Funding Date, which shall be a Business Day, and each such Borrowing Request shall be accompanied by a Reserve Report with respect to any Oil and Gas Properties which are to be acquired by Borrower. All Advances requested in any Borrowing Request must be in an amount not less than $1,000,000 and integral multiples of $500,000 in excess thereof, unless the amount available for further Revolving Advances under Section 2.1(a) is less than $1,000,000, in which event the Borrowing Request must be in an amount equal to the maximum amount then available for further Revolving Advances. There may be no more than one Advance made during any specific seven consecutive day period. (d) Agent's Election. Promptly after receipt of a request for a Borrowing pursuant to Section 2.1(c), Agent shall elect, in its discretion, (i) to have the terms of Section 2.1(e) apply to such requested Borrowing, or (ii) to request Foothill to make a Foothill Loan pursuant to the terms of Section 2.1(f) in the amount of the requested Borrowing; provided, however, that if Foothill declines in its sole discretion to make a Foothill Loan pursuant to Section 2.1(f), Agent shall elect to have the terms of Section 2.1(e) apply to such requested Borrowing. (e) Making of Advances. (i) In the event that Agent shall elect to have the terms of this Section 2.1(e) apply to a requested Borrowing as described in Section 2.1(d), then promptly after receipt of a request for a Borrowing pursuant to Section 2.1(c), Agent shall notify the Lenders, not later than 1:00 p.m. (California time) on the Business Day immediately preceding the Funding Date applicable thereto, by telecopy, telephone, or other similar form of transmission, of the requested Borrowing. Each Lender shall make the amount of such Lender's Pro Rata Share of the requested Borrowing available to Agent in immediately available funds, to such account of Agent as Agent may designate, not later than 10:00 a.m. (California time) on the Funding Date applicable thereto. After Agent's receipt of the proceeds of such Advances, upon satisfaction of the applicable conditions precedent set forth in Section 3 hereof, Agent shall make the proceeds of such Advances available to Borrower on the applicable Funding Date by transferring same day funds equal to the proceeds of such Advances received by Agent to Borrower's Designated Account; provided, however, that, subject to the provisions of Section 2.1(k), Agent shall not request any Lender to make, and no Lender shall have the obligation to make, any Advance if Agent shall have received written notice from any Lender, or otherwise has actual knowledge, that (1) one or more of the applicable conditions precedent set forth in Section 3 will not be satisfied on the requested Funding Date for the applicable Borrowing unless such condition has been waived by Agent, or (2) the requested Borrowing would exceed the Availability of the Borrower requesting the Advance on such Funding Date. (ii) Unless Agent receives notice from a Lender on or prior to the Closing Date or, with respect to any Borrowing after the Closing Date, at least one (1) Business Day prior to the date of such Borrowing, that such Lender will not make available as and when required hereunder to Agent for the account of Borrower the amount of that Lender's Pro Rata Share of the Borrowing, Agent may assume that each Lender has made or will make such amount available to Agent in immediately available funds on the Funding Date and Agent may (but shall not be so required), in reliance upon such assumption, make available to Borrower on such date a corresponding amount. If and to the extent any Lender shall not have made its full amount available to Agent in immediately available funds and Agent in such circumstances has made available to Borrower such amount, that Lender shall on the Business Day following such Funding Date make such amount available to Agent, together with interest at the Defaulting Lenders Rate for each day during such period. A notice submitted by Agent to any Lender with respect to amounts owing under this subsection shall be conclusive, absent manifest error. If such amount is so made available, such payment to Agent shall constitute such Lender's Advance on the date of Borrowing for all purposes of this Agreement. If such amount is not made available to Agent on the Business Day following the Funding Date, Agent will notify Borrower of such failure to fund and, upon demand by Agent, Borrower shall pay such amount to Agent for Agent's account, together with interest thereon for each day elapsed since the date of such Borrowing, at a rate per annum equal to the interest rate applicable at the time to the Advances composing such Borrowing. The failure of any Lender to make any Advance on any Funding Date shall not relieve any other Lender of any obligation hereunder to make an Advance on such Funding Date, but no Lender shall be responsible for the failure of any other Lender to make the Advance to be made by such other Lender on any Funding Date. (iii) Agent shall not be obligated to transfer to a Defaulting Lender any payments made by Borrower to Agent for the Defaulting Lender's benefit; nor shall a Defaulting Lender be entitled to the sharing of any payments hereunder. Amounts payable to a Defaulting Lender shall instead be paid to or retained by Agent. Agent may hold and, in its discretion, re- lend to Borrower the amount of all such payments received or retained by it for the account of such Defaulting Lender. Solely for the purposes of voting or consenting to matters with respect to the Loan Documents and determining Pro Rata Shares, such Defaulting Lender shall be deemed not to be a "Lender" and such Lender's Commitment shall be deemed to be zero (-0-). This section shall remain effective with respect to such Lender until (x) the Obligations under this Agreement shall have been declared or shall have become immediately due and payable or (y) the requisite non-Defaulting Lenders and Agent shall have waived such Lender's default in writing. The operation of this section shall not be construed to increase or otherwise affect the Commitment of any Lender, or relieve or excuse the performance by Borrower of its duties and obligations hereunder. (f) Making of Foothill Loans. (i) In the event Agent shall elect, with the consent of Foothill as a Lender, to have the terms of this Section 2.1(f) apply to a requested Borrowing as described in Section 2.1(d), Foothill as a Lender shall make an Advance in the amount of such Borrowing (any such Advance made solely by Foothill as a Lender pursuant to this Section 2.1(f) being referred to as a "Foothill Loan" and such Advances being referred to collectively as "Foothill Loans") available to Borrower on the Funding Date applicable thereto by transferring same day funds to Borrower's Designated Account. Each Foothill Loan is an Advance hereunder and shall be subject to all the terms and conditions applicable to other Advances, except that all payments thereon shall be payable to Foothill as a Lender solely for its own account (and for the account of the holder of any participation interest with respect to such Advance). Subject to the provisions of Section 2.1(k), Agent shall not request Foothill as a Lender to make, and Foothill as a Lender shall not make, any Foothill Loan if Agent shall have received written notice from any Lender, or otherwise has actual knowledge, that (i) one or more of the applicable conditions precedent set forth in Section 3 will not be satisfied on the requested Funding Date for the applicable Borrowing unless such condition has been waived, or (ii) the requested Borrowing would exceed the Availability of Borrower on such Funding Date. Foothill as a Lender shall not otherwise be required to determine whether the applicable conditions precedent set forth in Section 3 have been satisfied on the Funding Date applicable thereto prior to making, in its sole discretion, any Foothill Loan. (ii) The Foothill Loans shall be secured by the Collateral and shall constitute Advances and Obligations hereunder, and shall bear interest at the rate applicable from time to time to Advances pursuant to Section 2.6 hereof. (g) Agent Advances. (i) Subject to the limitations set forth in the proviso contained in this Section 2.1(g), Agent hereby is authorized by Borrower and the Lenders, from time to time in Agent's sole discretion, (1) after the occurrence and during the continuance of a Default or an Event of Default, or (2) at any time that any of the other applicable conditions precedent set forth in Section 3 have not been satisfied, to make Advances to Borrower on behalf of the Lenders that Agent, in its reasonable business judgment, deems necessary or desirable (A) to preserve or protect the Collateral, or any portion thereof, (B) to enhance the likelihood of repayment of the Obligations, or (C) to pay any other amount chargeable to Borrower pursuant to the terms of this Agreement, including Lender Group Expenses and the costs, fees, and expenses described in Section 10 (any of the Advances described in this Section 2.1(g) shall be referred to as "Agent Advances"). Each Agent Advance is an Advance hereunder and shall be subject to all the terms and conditions applicable to other Advances, except that all payments on such Agent Advance shall be payable to Agent solely for its own account (and for the account of the holder of any participation interest with respect to such Agent Advance). (ii) Agent Advances shall be repayable on demand and secured by the Collateral, shall constitute Advances and Obligations hereunder, and shall bear interest at the rate applicable from time to time to the Advances pursuant to Section 2.6 hereof. (h) Settlement. It is agreed that each Lender's funded portion of the Advances is intended by the Lenders to equal, at all times, such Lender's Pro Rata Share of the outstanding Advances. Such agreement notwithstanding, Agent, Foothill, and the other Lenders agree (which agreement shall not be for the benefit of or enforceable by Borrower) that in order to facilitate the administration of this Agreement and the other Loan Documents, settlement among them as to the Advances, the Foothill Loans, and the Agent Advances shall take place on a periodic basis in accordance with the following provisions: (i) Agent shall request settlement ("Settlement") with the Lenders on a weekly basis, or on a more frequent basis if so determined by Agent, (1) on behalf of Foothill, with respect to each outstanding Foothill Loan, (2) for itself, with respect to each Agent Advance, and (3) with respect to Collections received, as to each by notifying the Lenders by telecopy, telephone, or other similar form of transmission, of such requested Settlement, no later than 2:00 p.m. (California time) on the Business Day immediately prior to the date of such requested Settlement (the date of such requested Settlement being the "Settlement Date"). Such notice of a Settlement Date shall include a summary statement of the amount of outstanding Advances, Foothill Loans, and Agent Advances for the period since the prior Settlement Date, the amount of repayments received in such period, and the amounts allocated to each Lender of the interest, fees, and other charges for such period. Subject to the terms and conditions contained herein (including Section 2.1(e)(iii)): (y) if a Lender's balance of the Advances, Foothill Loans, and Agent Advances exceeds such Lender's Pro Rata Share of the Advances, Foothill Loans, and Agent Advances as of a Settlement Date, then Agent shall by no later than 12:00 p.m. (California time) on the Settlement Date transfer in immediately available funds to the account of such Lender as such Lender may designate, an amount such that each such Lender shall, upon receipt of such amount, have as of the Settlement Date, its Pro Rata Share of the Advances, Foothill Loans, and Agent Advances; and (z) if a Lender's balance of the Advances, Foothill Loans, and Agent Advances is less than such Lender's Pro Rata Share of the Advances, Foothill Loans, and Agent Advances as of a Settlement Date, such Lender shall no later than 12:00 p.m. (California time) on the Settlement Date transfer in immediately available funds to such account of Agent as Agent may designate, an amount such that each such Lender shall, upon transfer of such amount, have as of the Settlement Date, its Pro Rata Share of the Advances, Foothill Loans, and Agent Advances. Such amounts made available to Agent under clause (z) of the immediately preceding sentence shall be applied against the amounts of the applicable Foothill Loan or Agent Advance and, together with the portion of such Foothill Loan or Agent Advance representing Foothill's Pro Rata Share thereof, shall constitute Advances of such Lenders. If any such amount is not made available to Agent by any Lender on the Settlement Date applicable thereto to the extent required by the terms hereof, Agent shall be entitled to recover for its account such amount on demand from such Lender together with interest thereon at the Defaulting Lenders Rate. (ii) In determining whether a Lender's balance of the Advances, Foothill Loans, and Agent Advances is less than, equal to, or greater than such Lender's Pro Rata Share of the Advances, Foothill Loans, and Agent Advances as of a Settlement Date, Agent shall, as part of the relevant Settlement, apply to such balance the portion of payments actually received in good funds by Agent or Foothill with respect to principal, interest, fees payable by Borrower and allocable to the Lenders hereunder, and proceeds of Collateral. To the extent that a net amount is owed to any such Lender after such application, such net amount shall be distributed by Agent or Foothill to that Lender as part of such next Settlement. (iii) Between Settlement Dates, Agent, to the extent no Agent Advances or Foothill Loans are outstanding, may pay over to Foothill any payments received by Agent, that in accordance with the terms of this Agreement would be applied to the reduction of the Advances, for application to Foothill's Pro Rata Share of the Advances. If, as of any Settlement Date, Collections received since the then immediately preceding Settlement Date have been applied to Foothill's Pro Rata Share of the Advances other than to Foothill Loans or Agent Advances, as provided for in the previous sentence, Foothill shall pay to Agent for the accounts of the Lenders, and Agent shall pay to the Lenders, to be applied to the outstanding Advances of such Lenders, an amount such that each Lender shall, upon receipt of such amount, have, as of such Settlement Date, its Pro Rata Share of the Advances. During the period between Settlement Dates, Foothill with respect to Foothill Loans, Agent with respect to Agent Advances, and each Lender with respect to the Advances other than Foothill Loans and Agent Advances, shall be entitled to interest at the applicable rate or rates payable under this Agreement on the daily amount of funds employed by Foothill, Agent, or the Lenders, as applicable. (i) Notation. Agent shall record on its books the principal amount of the Advances owing to each Lender, including the Foothill Loans owing to Foothill, and Agent Advances owing to Agent, and the interests therein of each Lender, from time to time. In addition, each Lender is authorized, at such Lender's option, to note the date and amount of each payment or prepayment of principal of such Lender's Advances in its books and records, including computer records, such books and records constituting rebuttably presumptive evidence, absent manifest error, of the accuracy of the information contained therein. (j) Lenders' Failure to Perform. All Advances (other than Foothill Loans and Agent Advances) shall be made by the Lenders simultaneously and in accordance with their Pro Rata Shares. It is understood that (i) no Lender shall be responsible for any failure by any other Lender to perform its obligation to make any Advances hereunder, nor shall any Commitment of any Lender be increased or decreased as a result of any failure by any other Lender to perform its obligation to make any Advances hereunder, and (ii) no failure by any Lender to perform its obligation to make any Advances hereunder shall excuse any other Lender from its obligation to make any Advances hereunder. (k) Optional Overadvances. Any contrary provision of this Agreement notwithstanding, if the condition for borrowing under Section 3.2(d) cannot be fulfilled, the Lenders nonetheless hereby authorize Agent or Foothill, as applicable, and Agent or Foothill, as applicable, may, but is not obligated to, knowingly and intentionally continue to make Advances (including Foothill Loans) to Borrower such failure of condition notwithstanding, so long as, at any time (i) the outstanding Revolving Facility Usage does not exceed the Borrowing Base by more than five percent (5.0%) of the Borrowing Base, and (ii) the outstanding Revolving Facility Usage (except for and excluding amounts charged to the Loan Account for interest, fees, or Lender Group Expenses) does not exceed the Maximum Revolving Amount. The foregoing provisions are for the sole and exclusive benefit of Agent, Foothill, and the Lenders and are not intended to benefit Borrower in any way. The Advances and Foothill Loans, as applicable, that are made pursuant to this Section 2.1(k) shall be subject to the same terms and conditions as any other Advance or Foothill Loan, as applicable, except that the rate of interest applicable thereto shall be the rates set forth in Section 2.6(b) hereof without regard to the presence or absence of a Default or Event of Default; provided, that the Required Lenders may, at any time during the continuance of an Event of Default or if Borrower fails to satisfy any other material lending condition, revoke Agent's authorization contained in this Section 2.1(k) to make Overadvances (except for and excluding amounts charged to the Loan Account for interest, fees, or Lender Group Expenses), any such revocation to be in writing and to become effective upon Agent's receipt thereof. In the event Agent obtains actual knowledge that Revolving Facility Usage exceeds the amount permitted by the preceding paragraph, regardless of the amount of or reason for such excess, Agent shall notify Lenders as soon as practicable (and prior to making any, or any further, intentional Overadvances (except for and excluding amounts charged to the Loan Account for interest, fees, or Lender Group Expenses) unless Agent determines that prior notice would result in imminent harm to the Collateral or its value), and the Lenders thereupon shall, together with Agent, jointly determine the terms of arrangements that shall be implemented with Borrower intended to reduce, within a reasonable time, the outstanding principal amount of the Advances to Borrower to an amount permitted by the preceding paragraph. In the event any Lender disagrees over the terms of reduction and/or repayment of any Overadvance, the terms of reduction and/or repayment thereof shall be implemented according to the determination of the Required Lenders. Each Lender shall be obligated to settle with Agent as provided in Section 2.1(h) for the amount of such Lender's Pro Rata Share of any unintentional Overadvances by Agent reported to such Lender, any intentional Overadvances made as permitted under this Section 2.1(k), and any Overadvances resulting from the charging to the Loan Account of interest, fees, or Lender Group Expenses. (l) Effect of Bankruptcy. If a case is commenced by or against Borrower under the U.S. Bankruptcy Code, or other statute providing for debtor relief, then, unless otherwise agreed by all Lenders, the Lender Group shall not make additional loans or provide additional financial accommodations under the Loan Documents to Borrower as debtor or debtor-in-possession, or to any trustee for Borrower, nor consent to the use of cash collateral (provided that the Loan Account shall continue to be charged, to the fullest extent permitted by law, for accruing interest, fees, and Lender Group Expenses). 2.2 [Intentionally Omitted]. 2.3 [Intentionally Omitted]. 2.4 Payments. (a) Payments by Borrower. (i) All payments to be made by Borrower shall be made without set-off, recoupment, deduction, or counterclaim, except as otherwise required by law. Except as otherwise expressly provided herein, all payments by Borrower shall be made to Agent for the account of the Lenders at Agent's address set forth in Section 12, and shall be made in immediately available funds, no later than 11:00 a.m. (California time) on the date specified herein. Any payment received by Agent later than 11:00 a.m. (California time), at the option of Agent, shall be deemed to have been received on the following Business Day and any applicable interest or fee shall continue to accrue until such following Business Day. (ii) Whenever any payment is due on a day other than a Business Day, such payment shall be made on the following Business Day, and such extension of time shall in such case be included in the computation of interest or fees, as the case may be. (iii) Unless Agent receives notice from Borrower prior to the date on which any payment is due to the Lenders that Borrower will not make such payment in full as and when required, Agent may assume that Borrower has made such payment in full to Agent on such date in immediately available funds and Agent may (but shall not be so required), in reliance upon such assumption, distribute to each Lender on such due date an amount equal to the amount then due such Lender. If and to the extent Borrower has not made such payment in full to Agent, each Lender shall repay to Agent on demand such amount distributed to such Lender, together with interest thereon at the Reference Rate for each day from the date such amount is distributed to such Lender until the date repaid. (b) Apportionment, Application, and Reversal of Payments. Except as otherwise provided with respect to Defaulting Lenders and except as may otherwise be agreed among the Lenders, aggregate principal and interest payments shall be apportioned ratably among the Lenders (according to the unpaid principal balance of the Advances to which such payments relate held by each Lender) and payments of the fees (other than fees designated for Agent's sole and separate account) shall, as applicable, be apportioned ratably among the Lenders. All payments shall be remitted to Agent and all such payments not relating to principal or interest of specific Advances, or not constituting payment of specific fees, and all proceeds of Accounts or other Collateral received by Agent, shall be applied, first, to pay any fees, or expense reimbursements then due to Agent from Borrower; second, to pay any fees or expense reimbursements then due to the Lenders from Borrower; third, to pay interest due in respect of all Advances (including Foothill Loans and Agent Advances); fourth, to pay or prepay principal of Foothill Loans and Agent Advances; fifth, ratably to pay principal of the Advances (other than Foothill Loans and Agent Advances); and sixth, ratably to pay any other Obligations due to Agent or any Lender by Borrower. 2.5 Overadvances. If, at any time or for any reason, the amount of Obligations pursuant to Sections 2.1 is greater than either the Dollar or percentage limitations set forth in Sections 2.1 (an "Overadvance"), Borrower immediately shall pay to Agent, in cash, the amount of such excess, which amount shall be used by Agent to reduce the Obligations in accordance with the priority set forth in Section 2.4(b). 2.6 Interest, Rates, Payments, and Calculations. (a) Interest Rate. Except as provided in clause (c) and clause (d) below, all Obligations shall bear interest on the Daily Balance at a per annum rate equal to the sum of (i) one and one-half percent (1.5%), plus (ii) the Reference Rate. (b) [Intentionally omitted.] (c) Default Rate. Upon the occurrence and during the continuation of an Event of Default, all Obligations shall bear interest at a per annum rate equal to the sum of (i) five and one-half percent (5.5%), plus (ii) the Reference Rate. (d) Minimum Interest. In no event shall the rate of interest chargeable under Section 2.6(a) for any day be less than 9% per annum. To the extent that interest accrued hereunder at the rate set forth in such section would be less than the foregoing minimum daily rate, the interest rate chargeable hereunder for such day automatically shall be deemed increased to the minimum rate. (e) Payments. Interest payable hereunder shall be due and payable, in arrears, on the first day of each month during the term hereof. Borrower hereby authorizes Agent, at its option, without prior notice to Borrower, to charge such interest, all Lender Group Expenses (as and when incurred), the fees and charges provided for in Section 2.11 (as and when accrued or incurred), and all installments or other payments due under any Loan Document to Borrower's Loan Account, which amounts thereafter shall accrue interest at the rate then applicable to Advances hereunder. Any interest not paid when due shall be compounded and shall thereafter accrue interest at the rate then applicable to Advances hereunder. (f) Computation. The Reference Rate as of the date of this Agreement is 9.5% per annum. In the event the Reference Rate is changed from time to time hereafter, the rate of interest provided for in Section 2.6(a) and Section 2.6(c) automatically and immediately shall be increased or decreased by an amount equal to such change in the Reference Rate. All interest and fees chargeable under the Loan Documents shall be computed on the basis of a 360 day year for the actual number of days elapsed. (g) Intent to Limit Charges to Maximum Lawful Rate. It is the intention of the parties hereto that the Agent or each Lender shall conform strictly to usury laws applicable to it. Accordingly, if the transactions contemplated hereby or by any other Loan Document would be usurious as to the Agent or any Lender under laws applicable to it (including the laws of the United States of America and the State of California or any other jurisdiction whose laws may be mandatorily applicable to such Lender notwithstanding the other provisions of this Agreement), then, in that event, notwithstanding anything to the contrary in any of the Loan Documents or any agreement entered into in connection with or as security for the Indebtedness, it is agreed as follows: (i) the aggregate of all consideration which constitutes interest under law applicable to Agent or any Lender that is contracted for, taken, reserved, charged or received by Agent or such Lender under any of the Loan Documents or agreements or otherwise in connection with the Indebtedness shall under no circumstances exceed the maximum amount allowed by such applicable law, and any excess shall be canceled automatically and if theretofore paid shall be credited by the Agent or such Lender on the principal amount of the Indebtedness (or, to the extent that the principal amount of the Indebtedness shall have been or would thereby be paid in full, refunded by the Agent or such Lender, as applicable, to the Borrower); and (ii) in the event that the maturity of the Indebtedness is accelerated by reason of an election of the holder thereof resulting from any Event of Default under this Agreement or otherwise, or in the event of any required or permitted prepayment, then such consideration that constitutes interest under law applicable to Agent or any Lender may never include more than the maximum amount allowed by such applicable law, and excess interest, if any, provided for in this Agreement or otherwise shall be canceled automatically by Agent or such Lender, as applicable, as of the date of such acceleration or prepayment and, if theretofore paid, shall be credited by Agent or such Lender, as applicable, on the principal amount of the Indebtedness (or, to the extent that the principal amount of the Indebtedness shall have been or would thereby be paid in full, refunded by Agent or such Lender to the Borrower). All sums paid or agreed to be paid to Agent or any Lender for the use, forbearance or detention of sums due hereunder shall, to the extent permitted by law applicable to Agent or such Lender, be amortized, prorated, allocated and spread throughout the full term of the Obligations until payment in full so that the rate or amount of interest on account of any Obligations hereunder does not exceed the maximum amount allowed by such applicable law. If at any time and from time to time (i) the amount of interest payable to Agent or any Lender on any date shall be computed at the Highest Lawful Rate (as defined below) applicable to Agent or such Lender pursuant to this Section 2.6(g) and (ii) in respect of any subsequent interest computation period the amount of interest otherwise payable to Agent or such Lender would be less than the amount of interest payable to Agent or such Lender computed at the Highest Lawful Rate applicable to Agent or such Lender, then the amount of interest payable to Agent or such Lender in respect of such subsequent interest computation period shall continue to be computed at the Highest Lawful Rate applicable to Agent or such Lender until the total amount of interest payable to Agent or such Lender shall equal the total amount of interest which would have been payable to Agent or such Lender if the total amount of interest had been computed without giving effect to this Section 2.6(g). For purposes of this Section 2.6(g), the term "applicable law" shall mean that law in effect from time to time and applicable to the loan transaction between Borrower and the Lender Group that lawfully permits the charging and collection of the highest permissible, lawful non-usurious rate of interest on such loan transaction and this Agreement, including laws of the State of California and, to the extent controlling, laws of the United States of America. For purposes of this Section 2.6(g), "Highest Lawful Rate" means, with respect to Agent or any Lender, the maximum non-usurious interest rate, if any, that at any time or from time to time may be contracted for, taken, reserved, charged or received on the Obligations under the laws applicable to Agent or such Lender which are currently in effect or, to the extent allowed by law, under such applicable laws which may hereafter be in effect and which allow a higher maximum non- usurious interest rate than applicable laws now allow. 2.7 Collection of Accounts. (a) Borrower shall, as of the date of this Agreement establish and at all times thereafter maintain lockboxes (the "Lockboxes") at the Lockbox Banks and, immediately after the Closing Date (i) shall, and shall cause each of its Subsidiaries to, instruct all Account Debtors with respect to the Accounts, General Intangibles, and Negotiable Collateral of Borrower or such Subsidiary, as the case may be, to remit all Collections in respect thereof to such Lockboxes, and (ii) shall, and shall cause each of its Subsidiaries to, deposit all other Collections received by Borrower or such Subsidiary from any source immediately upon receipt into the Lockboxes, and (iii) shall request in writing and otherwise take such steps as are necessary to ensure that all Account Debtors forward payment directly to such Lockboxes. From time to time as requested by Agent, Borrower shall, and shall cause each of its Subsidiaries to, execute and deliver Transfer Orders to Agent, in form and substance satisfactory to Agent, with respect to all present and future rights to payment relating to or arising from the Oil and Gas Property Collateral. Borrower, each of Borrower's Subsidiaries, Agent, and the Lockbox Banks shall enter into the Lockbox Agreements, which among other things shall provide for the opening of a Lockbox Account for the deposit of Collections at a Lockbox Bank. Borrower agrees that all Collections and other amounts received by Borrower or any of its Subsidiaries from any Account Debtor or any other source (other than the Advances made under this Agreement) immediately upon receipt shall be deposited into a Lockbox Account. No Lockbox Agreement or arrangement contemplated thereby shall be modified by Borrower or any of its Subsidiaries without the prior written consent of Agent. Upon the terms and subject to the conditions set forth in the Lockbox Agreements, following Agent giving notice to the applicable Lockbox Bank to do so (which notice Agent agrees not to give to the applicable Lockbox Bank prior to the occurrence of a Triggering Event), all amounts received in each Lockbox Account shall be wired each Business Day into the Agent's Account; provided, however, that Agent reserves the right, in its sole discretion, to require that any amounts received in any Lockbox Account which may represent amounts attributable to trust funds (i.e., production taxes, severance taxes, or payroll taxes) or amounts attributable to Mineral Interests of third Persons be segregated by the Lockbox Bank and held in a separate account or otherwise as directed by Agent. From and after the occurrence of a Triggering Event, no Borrower shall, or shall cause or permit any Subsidiary thereof to, accumulate or maintain cash in disbursement or payroll accounts as of any date of determination in excess of checks outstanding against such accounts as of that date and amounts necessary to meet minimum balance requirements. As used in this Agreement, "Triggering Event" means: (A) the occurrence or continued existence of an Event of Default or (B) the occurrence or continued existence of the sum of (I) Availability of Borrower, plus Borrower's immediately available unrestricted cash on hand, minus an amount determined by Agent in its sole discretion that would be sufficient to maintain Borrower's and its Subsidiaries' accounts payable and other current liabilities within reasonable terms (as determined on a consolidated basis) is less than (II) $2,500,000 at any time. (b) Borrower shall not establish any bank accounts other than the Lockbox Accounts after the date of this Agreement except upon not less than 10 days prior written notice to Agent and the delivery to Agent of a tri-party blocked account agreement in form and substance acceptable to Agent among such bank, Agent and Borrower. Each such blocked account agreement shall provide, among other things, that (i) all Collections and proceeds thereof deposited in such accounts are held by such banks as agent or bailee-in-possession for Agent, (ii) the bank executing such agreement has no rights of setoff or recoupment or any other claim against such account, as the case may be, other than for payment of its service fee and other charges directly related to the administration of such account and for returned checks or other items of payment, and (iii) following Agent giving notice to such bank to do so (which notice Agent agrees not to give to such bank prior to the occurrence of a Triggering Event), such bank agrees to immediately forward all amounts received in the applicable account to the Agent's Account. (c) The Lockboxes, the Lockbox Accounts and the Designated Account shall be cash collateral accounts, with all cash, checks and similar items of payment in such accounts securing payment of the Obligations and all other Indebtedness, and in which each Loan Party shall have granted a Lien to Agent hereunder and pursuant to the other Loan Documents. (d) Borrower shall and shall cause its Subsidiaries, Affiliates, officers, employees, agents, directors or other Persons acting for or in concert with such Borrower (each a "Related Person") to (i) hold in trust for Agent all Collections received by Borrower or any such Related Person, and (ii) immediately upon receipt by Borrower or any Related Person of any Collections, deposit the same into a Lockbox Account of Borrower. Borrower and each Related Person thereof acknowledges and agrees that all Collections are the property of Agent for the benefit of the Lenders. Without limiting the foregoing, all proceeds of the sale or other disposition of any Collateral, shall be deposited directly into the applicable Lockbox Account. 2.8 Crediting Payments; Application of Collections. The receipt of any payment item by Agent (whether from transfers to Agent by the Lockbox Banks pursuant to the Lockbox Agreements or otherwise) shall not be considered a payment on account unless such payment item is a wire transfer of immediately available federal funds and is made to the Agent's Account or unless and until such payment item is honored when presented for payment; provided, however, that Agent reserves the right, in its sole discretion, to exclude from such provisional reduction and payment the amount of any such Collections that Agent determines may constitute trust funds (e.g., production taxes, severance taxes, or payroll taxes) or amounts attributable to Mineral Interests of third Persons. From and after the Closing Date, Agent shall be entitled to charge Borrower for 1 Business Day of `clearance' or `float' at the rate then applicable to the Obligations under Section 2.6(a) or Section 2.6(c), as the case may be, on all Collections that are received by Borrowers, the Lockbox Banks or Agent (regardless of whether forwarded by Borrower or the Lockbox Banks to Agent, whether provisionally applied to reduce the Obligations under Section 2.1, whether wire transferred or otherwise paid to the Agent Account, or otherwise). This across-the-board 1 Business Day clearance or float charge on all Collections is acknowledged by the parties to constitute an integral aspect of the pricing of the financing of Borrower, and shall apply irrespective of the characterization of whether receipts are owned by Borrower or Agent, and whether or not there are any outstanding monetary Obligations; the effect of such clearance or float charge being the equivalent of charging 1 Business Day of interest on such Collections. Should any Collection item not be honored when presented for payment, then Borrower shall be deemed not to have made such payment, and interest shall be recalculated accordingly. Anything to the contrary contained herein notwithstanding, any Collection item shall be deemed received by Agent only if it is received into the Agent Account on a Business Day on or before 11:00 a.m. California time. If any Collection item is received into the Agent Account on a non-Business Day or after 11:00 a.m. California time on a Business Day, it shall be deemed to have been received by Agent as of the opening of business on the immediately following Business Day. The parties acknowledge and agree that the economic benefit of the foregoing provisions of this Section 2.8 shall be for the exclusive benefit of Agent. 2.9 Designated Account. Agent, Foothill, and the Lenders are authorized to make the Advances, and the Letters of Credit under this Agreement based upon telephonic or other instructions received from anyone purporting to be an Authorized Person, or without instructions if pursuant to Section 2.6(e). Borrower agrees to establish and maintain the Designated Account with the Designated Account Bank for the purpose of receiving the proceeds of the Advances requested by Borrower and made by Agent, Foothill or the Lenders hereunder. Unless otherwise agreed by Agent and Borrower, any Advance requested by Borrower and made hereunder shall be made to the Designated Account. 2.10 Maintenance of Loan Account; Statements of Obligations. Agent shall maintain an account on its books in the name of Borrower (the "Loan Account") on which Borrower will be charged with all Advances made by Agent, Foothill, or the Lenders to Borrower or for Borrower's account, including, accrued interest, Lender Group Expenses, and any other payment Obligations of Borrower. In accordance with Section 2.8, the Loan Account will be credited with all payments received by Agent from Borrower or for Borrower's account, including all amounts received in the Agent Account from any Lockbox Bank. Agent shall render statements regarding the Loan Account to Borrower, including principal, interest, fees, and including an itemization of all charges and expenses constituting Lender Group Expenses owing, and such statements shall be conclusively presumed to be correct and accurate and constitute an account stated between Borrower and the Lender Group unless, within 30 days after receipt thereof by Borrower, Borrower shall deliver to Agent written objection thereto describing the error or errors contained in any such statements. 2.11 Fees. Borrower shall pay to Agent, for the ratable benefit of the Lender Group (except as otherwise indicated), the following fees: (a) Closing Fee. On the Closing Date, a closing fee of $1,500,000, which amount shall be fully earned and nonrefundable as of the Closing Date, and payment thereof shall be as follows: (i) $500,000 due on the Closing Date; (ii) $500,000 due on the earlier to occur of (A) the first anniversary of the Closing Date or (B) the date of the termination of this Agreement; and (iii) $500,000 due on the earlier to occur of (A) the second anniversary of the Closing Date or (B) the date of the termination of this Agreement. (b) Unused Line Fee. On the first day of each month during the term of this Agreement, an unused line fee in an amount equal to 0.50% per annum times the Average Unused Portion of the Maximum Revolving Amount during the immediately preceding month, payable in arrears. (c) [Intentionally Omitted] (d) Financial Examination, Documentation, and Appraisal Fees. For the sole and separate account of Agent: Agent's customary fee of $750 per day per examiner, plus Agent's out-of-pocket expenses for each financial analysis and examination (i.e., audits) of Borrower performed by personnel employed by Agent; Agent's customary appraisal fee of $1,500 per day per appraiser, plus Agent's out-of-pocket expenses for each appraisal of the Collateral performed by personnel employed by Agent; and, the actual charges paid or incurred by Agent if it elects to employ the services of one or more third Persons to perform such financial analyses and examinations (i.e., audits) of Borrower or to appraise the Collateral. (e) Loan Servicing Fee. For the sole and separate account of Agent, on the first day of each month during the term of this Agreement, a loan servicing fee in an amount equal to $5,000 per month, which amount shall be fully earned and nonrefundable, and be payable in arrears on the first day of each month. 2.12 Loan Under Prior Credit Agreement. On the Closing Date: (a) Borrower shall pay all accrued and unpaid commitment fees outstanding under the Prior Credit Agreement for the account of each Prior Lender under the Prior Credit Agreement; (b) each loan, advance or other extension of credit under the Prior Loan Agreement shall be deemed to be an Advance under this Agreement; and (c) the Prior Credit Agreement and the commitments thereunder shall be superceded by this Agreement and such commitments shall terminate. 3. CONDITIONS; TERM OF AGREEMENT. 3.1 Conditions Precedent to the Initial Advance. The obligation of the Lender Group (or any member thereof) to make the initial Advance is subject to the fulfillment, to the satisfaction of Agent and its counsel, of each of the following conditions on or before the Closing Date: (a) the Closing Date shall occur on or before August 19, 2000; (b) Agent shall have received all financing statements and fixture filings required by Agent, duly executed by Borrower, and Agent shall have received searches of all recording offices requested by Agent reflecting the filing of all such financing statements and fixture filings, together with searches of such other offices as Agent may require (including those of Borrower, and the Subsidiaries of Borrower), each such search dated a date within 15 days of the Closing Date; (c) Agent shall have received each of the following documents, in form and substance satisfactory to Agent, duly executed (and acknowledged, as the case may be) by all parties and formalities contemplated thereunder, and each such document shall be in full force and effect: i. the tri-party blocked account agreements; ii. the Disbursement Letter; iii. the Refinancing Letter, together with the Prior Lender Assignment Agreements, UCC assignment statements, UCC termination statements and other documentation evidencing the assignment and/or termination (as determined by Agent) by the Prior Lenders (and all other holders, if any, of the indebtedness, liabilities and other obligations under or relating to the Prior Credit Agreement) and each other holder of Liens against the properties or assets of Borrower or any of its Subsidiaries (other than Permitted Liens), of its Liens in and to the properties and assets of Borrower and its Subsidiaries; iv. the Oil and Gas Property Mortgages, dated as of the Closing Date, covering each of the Oil and Gas Properties; v. Guaranty Agreements, in form and substance acceptable to Agent, executed by each of Borrower's Subsidiaries; vi. Security Agreements, in form and substance acceptable to Agent, executed by Borrower and each of Borrower's Subsidiaries, with respect to all of the assets and properties of any and all of them; vii. the governmental permits, approvals and orders for such wells and such units as may be required by Agent pertaining to the Oil and Gas Properties described in the Oil and Gas Property Mortgages, which shall be in form and substance satisfactory to Agent; viii. the Transfer Order Letters for such purchasers of production from wells on the Oil and Gas Properties as may be required by Agent, which shall be in form and substance satisfactory to Agent; ix. assignments in form and substance acceptable to Agent of each Material Contract pertaining to the Oil and Gas Property Collateral which either (i) affects Borrower's or any of its Subsidiaries', as the case may be, title to the Oil and Gas Property Collateral or otherwise affects the value, use or operation of the Oil and Gas Property Collateral in any material respect or (ii) creates or evidences a material obligation or liability on the part of Borrower or any or its Subsidiaries, together with copies of each such Material Contract attached thereto; x. a solvency certificate with respect to Borrower and each of its Subsidiaries, in the form and substance acceptable to Agent, executed by an executive officer of Borrower; xi. the Mortgage Amendment Agreements, dated as of the Closing Date covering each of the mortgages, deeds of trust and other mineral interest security agreements assigned to Agent for the benefit of the Lenders pursuant to the Prior Lender Assignment Agreements; xii. all original Stock certificates and other instruments or certificates evidencing all the issued and outstanding shares of capital Stock or other equity interests, as the case may be, of Blue Heel owned by Borrower, together with Stock powers and other assignments and powers, as the case may be, duly executed in blank by Borrower; xiii. all original Stock certificates evidencing all the issued and outstanding shares of capital Stock of Borrower owned by Parent or any other Person, together with Stock powers duly executed in blank by Parent and all of the other holders of all of the legal and beneficial ownership thereof; xiv. the Real Property Mortgages, dated as of the Closing Date; and xv. such other documents as shall be required by Agent. (d) Agent shall have received a certificate from the Secretary of Borrower attesting to the resolutions of Borrower's Board of Directors authorizing its execution, delivery, and performance of this Agreement and the other Loan Documents to which Borrower is a party and authorizing specific officers of Borrower to execute the same; (e) Agent shall have received copies of Borrower's Governing Documents, as amended, modified, or supplemented by the Closing Date, certified by the Secretary of Borrower; (f) Agent shall have received a certificate of status with respect to Borrower, dated within 10 days of the Closing Date, such certificate to be issued by the appropriate officer of the jurisdiction of organization of Borrower, which certificate shall indicate that Borrower is in good standing in such jurisdiction; (g) Agent shall have received certificates of status with respect to Borrower, each dated within 15 days of the Closing Date, such certificates to be issued by the appropriate officer of the jurisdictions in which its failure to be duly qualified or licensed would constitute a Material Adverse Change, which certificates shall indicate that Borrower is in good standing in such jurisdictions; (h) Agent shall have received a certificate of insurance, which names Agent for the benefit of the Lender Group as loss payee and additional insured on all of Borrower's policies of insurance (other than worker's compensation insurance) as are required by Section 6.10, the form and substance of which shall be satisfactory to Agent and its counsel; (i) Agent shall have received such Collateral Access Agreements from lessors, warehousemen, bailees, and other third persons with respect to (i) Borrower's leased premises at which its chief executive offices, (ii) all locations at which Borrower's Books are located from time to time, and (iii) each other location of Borrower except the Oil and Gas Properties; (j) Agent shall have received copies of all contracts set forth on Schedule 5.1(c), and such contracts shall be in form and substance satisfactory to Agent; (k) Agent shall have received an opinion of Borrower's and Guarantor's counsel in form and substance satisfactory to Agent in its sole discretion, and opinions of Borrower's and Guarantors' counsel in such other states and jurisdictions as may be requested by Agent in form and substance satisfactory to Agent in its sole discretion; (l) Agent shall have received (i) appraisals of the Oil and Gas Properties in the form of Reserve Reports prepared by a third party petroleum engineering firm (including, but not limited to, appraisals, verifications and liquidation analyses of Borrower's Proved Reserves) covering the Borrowing Base Entities' Mineral Interests listed on Schedule 5.1(a) in each case satisfactory to Agent, (ii) confirmations for such of the Oil and Gas Properties as shall be required by Agent, in its sole discretion, issued to Agent for the benefit of the Lender Group, by abstractors satisfactory to Agent who record the Oil and Gas Property Mortgages, that there have been no intervening Liens, transfers or conveyances pertaining to such Oil and Gas Properties since the date of the updated title opinions described in subparagraph (A) below of this subparagraph (l), and (iii) title reports and/or opinions for such of the Oil and Gas Properties as shall be required by Agent, in its sole discretion, issued to Agent for the benefit of the Lender Group by a legal counsel to Borrower or such other person that is experienced in the examination of title to such Oil and Gas Properties and is satisfactory to Agent (each a "Title Opinion" and, collectively, the "Title Opinions"), to the extent of at least $94,000,000 of NYMEX Value in the aggregate as of the Closing Date, each of which Title Opinions (and other legal opinions supplemental thereto) shall be in form and substance satisfactory to Agent and shall: (A) as to the Oil and Gas Properties as shall be required by Agent, in its sole discretion, covered by a mortgage, deed of trust, or deed to secure debt executed by Borrower in favor of or for the benefit of the Prior Agent and/or a Prior Lender, be updated to a date within 15 days prior to the Closing Date to confirm the priority of the Lien created under such mortgage, deed of trust or deed to secure debt, as the case may be (together with a confirmation by an abstractor satisfactory to Agent who records the Prior Lender Assignment Agreements with respect to such Oil and Gas Properties that there has been no intervening Liens, transfers or conveyances pertaining to such Oil and Gas Properties since the date of the most recent Title Opinion covering the same), (B) opine as to such matters incident to such Oil and Gas Properties as Agent may reasonably request including the following with respect to the Mineral Interests in the particular Oil and Gas Property Collateral being reviewed: (I) Borrower or its Subsidiary, as the case may be, that is the grantor under the Oil and Gas Property Mortgage covering the Oil and Gas Properties has good and marketable title to such Oil and Gas Properties to the extent of the Mineral Interests as specified therein, free and clear of all Liens and defects except Permitted Liens. (II) Borrower or its Subsidiary, as the case may be, that is the grantor under the Oil and Gas Property Mortgage covering the Oil and Gas Properties is entitled to receive, after giving effect to all royalties, overriding royalties and other burdens payable out of production, a decimal share of all Hydrocarbons produced and sold from such Oil and Gas Properties, before and after payout, not less than set forth in the opinion. (III) The operating interest in such Oil and Gas Properties of Borrower or its Subsidiary, as the case may be, that is the grantor under the Oil and Gas Property Mortgage covering the Oil and Gas Properties, is not obligated to bear a decimal share of all costs and expenses from the operation thereof in excess of that set forth therein. (IV) The Liens created by the Oil and Gas Property Mortgage are valid and enforceable first priority mortgage Liens which are first in right and prior in time and superior to all other Liens against such Mineral Interests and other Oil and Gas Properties other than Permitted Liens. (m) The Mineral Interests in the Oil and Gas Property Collateral shall not be less than the Mineral Interests for such properties furnished by the Borrowing Base Entities to Agent in connection with Agent's credit evaluation in connection with this Agreement; (n) Borrower shall have delivered to Agent evidence satisfactory to Agent confirming that each of the producing wells that are included in the most recent Reserve Report delivered to Agent covering the Oil and Gas Properties listed on Schedule 5.1(b) is located on an Oil and Gas Property (i) covered by the Title Opinions to the extent required by Agent and (ii) described in the legal description contained in an Oil and Gas Property Mortgage which has been duly executed and delivered to Agent; (o) Borrower shall have delivered to Agent such existing environmental reports as Borrower currently has (whether prepared internally or by an outside party) with respect to the Oil and Gas Property Collateral, including, without limitation, spill prevention and control plans, and the matters contained therein shall be reasonably acceptable to Agent; (p) Agent shall have received satisfactory evidence that all tax returns required to be filed by Borrower have been timely filed and all taxes upon Borrower or its properties, assets, income, and franchises (including real property taxes and payroll taxes) have been paid prior to delinquency, except such taxes that are the subject of a Permitted Protest; (r) Agent shall have received satisfactory reference investigation reports of key officers and employees; (s) On the Closing Date, Borrower shall have not less than $10,000,000 of Availability and unrestricted immediately available cash on hand after making the payments described in Section 7.17(a)(i) and making the payment of the $500,000 due on the Closing Date pursuant to Section 2.11(a)(i) and after reserving as an additional deduction from Availability an amount determined by Agent in its sole discretion that would be sufficient to maintain Borrower's and its Subsidiaries' accounts payable and other current liabilities within reasonable terms (with Borrower providing to Agent such evidence of the aging of such accounts payable and other liabilities as is in form and substance acceptable to Agent); (t) Agent shall have reviewed Borrower's and each of its Subsidiaries' Hedging Agreements and other hedging arrangements (with respect to its present and future Hydrocarbon production and otherwise), and all of such Hedging Agreements and other hedging arrangements shall be acceptable to Agent; (u) Agent shall have received evidence satisfactory to Agent including, without limitation, a certificate executed by the chief financial officer of Borrower, to such effect, that no Material Adverse Change has occurred in the business, assets, operations, prospects or financial or other condition of Borrower or any of its Subsidiaries since March 31, 2000; (v) Agent and counsel to Agent shall have received and reviewed all documentation relating to the Unsecured Notes, including, without limitation, the Unsecured Notes Indenture, and all of such documentation, and the terms and provisions of such documentation, including, without limitation, the Unsecured Notes and the Unsecured Notes Indenture, shall be acceptable to Agent and its counsel; (w) Agent shall have received and reviewed the final appraisal report prepared as of June 26, 2000, by Pollard, Gore & Harrison or such other petroleum engineering consultant to Agent as may be selected by Agent, relating to the Reserve Report prepared as of such date, and such report shall contain such information as may be requested by Agent and shall be in form and substance satisfactory to Agent; (x) Agent shall have received commitments from Lenders other than Foothill Capital Corporation to acquire or purchase Commitments under this Agreement in the amount of $20,000,000, such Lenders to be acceptable to Agent and such commitments to be in form and substance satisfactory to Agent; (y) Agent shall have received evidence of the dissolution and liquidation of each of Threading Products International, LLC, a Delaware limited liability company, and SWV Aviation, LLC, a Texas limited liability company, in form and substance satisfactory to Agent; (z) Agent shall have received evidence of the merger of Midland Southwest Software, Inc., a Delaware corporation, and e-bacus Solutions, Inc., a Delaware corporation, with and into Borrower, with Borrower as the sole surviving entity, in form and substance satisfactory to Agent; (aa) [intentionally omitted]; (bb) Agent shall have received an "Absolute Assignment" of each key man life insurance policy listed on Schedule 5.16 attached hereto; and (cc) all other documents and legal matters in connection with the transactions contemplated by this Agreement shall have been delivered, executed, or recorded and shall be in form and substance satisfactory to Agent and its counsel. 3.2 Conditions Precedent to all Advances. The obligation of the Lender Group (or any member thereof) to make all Advances shall be subject to the following conditions precedent: (a) the representations and warranties contained in this Agreement and the other Loan Documents shall be true and correct in all respects on and as of the date of such extension of credit, as though made on and as of such date (except to the extent that such representations and warranties relate solely to an earlier date); (b) no Default or Event of Default shall have occurred and be continuing on the date of such extension of credit, nor shall either result from the making thereof; (c) no injunction, writ, restraining order, or other order of any nature prohibiting, directly or indirectly, the extending of such credit shall have been issued and remain in force by any governmental authority against any Borrower, Agent, the Lender Group, or any of their respective Affiliates; (d) the amount of the Revolving Facility Usage, after giving effect to the requested Advance, shall not exceed the Availability; and (e) no Material Adverse Change shall have occurred. The foregoing conditions precedent are not conditions to each Lender participating in or reimbursing Foothill or the Agent for such Lenders' Pro Rata Share of any Foothill Loan or Agent Advance as provided herein. 3.3 Condition Subsequent. As conditions subsequent to initial closing hereunder, Borrower shall perform or cause to be performed the following (the failure by Borrower to so perform or cause to be performed constituting an Event of Default): (a) within 45 days of the Closing Date, deliver to Agent the certified copies of the policies of insurance, together with the endorsements thereto, as are required by Section 6.10, the form and substance of which shall be satisfactory to Agent and its counsel; (b) within 60 days of the Closing Date, deliver to Agent an original of each "Absolute Assignment" of each key man life insurance policy listed on Schedule 5.16 which has been executed by the issuer of the respective policy and evidences that it has been recorded with such issuer and that such issuer has accepted such assignment; and (c) within seven (7) days immediately following the date of recordation of the Prior Lender Assignment Agreements and the Mortgage Amendment Agreements, Borrower shall cause to be issued to Agent for the benefit of the Lender Group updated Title Opinions and other legal opinions supplemental thereto in form and substance satisfactory to Agent which conform to the requirements described in subparagraph (B) of Section 3.1(l) covering such of the Oil and Gas Properties, the Prior Lender Assignment Agreements and the Mortgage Amendment Agreements as shall be required by Agent. 3.4 Term; Automatic Renewal. (a) This Agreement shall become effective upon the execution and delivery hereof by Borrower and the Lender Group and shall continue in full force and effect for a term ending on the date (the "Renewal Date") that is 3 years from the Closing Date and automatically shall be renewed for successive 1 year periods thereafter. (b) Either party may terminate this Agreement on the Renewal Date or on any 1 year anniversary of the Renewal Date by giving the other party at least 90 days prior written notice. The foregoing notwithstanding, the Lender Group shall have the right to terminate its obligations under this Agreement immediately and without notice upon the occurrence and during the continuation of an Event of Default. 3.5 Effect of Termination (a) On the date of termination of this Agreement, all Obligations immediately shall become due and payable without notice or demand. No termination of this Agreement, however, shall relieve or discharge Borrower of Borrower's duties, Obligations, or covenants hereunder or under the other Loan Documents, and Agent's continuing security interests in the Collateral, for the benefit of the Lender Group, shall remain in effect until all Obligations have been fully and finally discharged and the Lender Group's obligations to provide additional credit hereunder have been terminated. (b) If Borrower has sent a notice of termination pursuant to the provisions of Section 3.4, but fails to pay the Obligations in full on the date set forth in such notice, then the Lender Group may, but shall not be required to, renew this Agreement for an additional term of 1 years. 3.6 Early Termination by Borrower. The provisions of Section 3.4 that allow termination of this Agreement by Borrower only on the Renewal Date and certain anniversaries thereof notwithstanding, Borrower has the option, at any time upon 30 days prior written notice to Agent, to terminate this Agreement by paying to Agent, for the ratable benefit of the Lender Group, in cash, the Obligations in full, together with a premium (the "Early Termination Premium") equal to (a) if the termination occurs on or before the first anniversary of the Closing Date, an amount equal to 3% of the Maximum Revolving Amount, (ii) if the termination occurs after the first anniversary of the Closing Date but on or before the second anniversary of the Closing Date, an amount equal to 2% of the Maximum Revolving Amount, and (iii) if the termination occurs after the second anniversary of the Closing Date (other than on the Renewal Date or on the last day of any successive renewal period), an amount equal to 1% of the Maximum Revolving Amount. 3.7 Termination Upon Event of Default. If the Lender Group terminates this Agreement upon the occurrence of an Event of Default, in view of the impracticability and extreme difficulty of ascertaining actual damages and by mutual agreement of the parties as to a reasonable calculation of the Lender Group's lost profits as a result thereof, Borrower shall pay to Agent, for the ratable benefit of the Lender Group, upon the effective date of such termination, a premium in an amount equal to the Early Termination Premium. The Early Termination Premium shall be presumed to be the amount of damages sustained by the Lender Group as the result of the early termination and Borrower agrees that it is reasonable under the circumstances currently existing. The Early Termination Premium provided for in this Section 3.7 shall be deemed included in the Obligations. 4. CREATION OF SECURITY INTEREST. 4.1 Grant of Security Interest. Borrower hereby grants to Agent, for the benefit of the Lender Group, continuing Liens on all right, title, and interest of Borrower in and to all currently existing and hereafter acquired or arising Collateral in order to secure prompt repayment of any and all Obligations and in order to secure prompt performance by Borrower of each of its covenants and duties under the Loan Documents (the "Agent's Liens"). The Agent's Liens in and to the Collateral shall attach to all Collateral without further act on the part of the Lender Group or Borrower. Anything contained in this Agreement or any other Loan Document to the contrary notwithstanding, except for the sale of Inventory to buyers in the ordinary course of business and except as specifically permitted under Section 7.4, Borrower has no authority, express or implied, to dispose of any item or portion of the Collateral. Subject to Section 2.4(b), the secured claims of the Lender Group secured by the Collateral shall be of equal priority, and ratable according to the respective Obligations due each member of the Lender Group. 4.2 Negotiable Collateral. In the event that any Collateral, including proceeds, is evidenced by or consists of Negotiable Collateral, Borrower promptly shall, and shall cause each of its Subsidiaries to, endorse and deliver physical possession of such Negotiable Collateral to Agent. 4.3 Collection of Accounts, General Intangibles, and Negotiable Collateral. At any time, Agent or Agent's designee may (a) notify customers or Account Debtors that the Accounts, General Intangibles, or Negotiable Collateral have been assigned to Agent for the benefit of the Lender Group, or that Agent, for the benefit of the Lender Group, has a security interest therein and (b) collect the Accounts, General Intangibles, and Negotiable Collateral directly and charge the collection costs and expenses to the Loan Account. Borrower agrees that it will, and will cause each of its Subsidiaries to, hold in trust for the Lender Group, as the Lender Group's trustee, any Collections that it receives and immediately will deliver said Collections to Agent in their original form as received by Borrower or any of its Subsidiaries, as the case may be. 4.4 Delivery of Additional Documentation Required. At any time upon the request of Agent, Borrower shall, and shall cause each of its Subsidiaries to, execute and deliver to Agent all financing statements, collateral assignments, continuation financing statements, fixture filings, security agreements, pledges, assignments, mortgages, leasehold mortgages, deeds of trust, leasehold deeds of trust, endorsements of certificates of title, applications for title, affidavits, reports, notices, schedules of accounts, letters of authority, and all other documents that Agent reasonably may request, in form satisfactory to Agent, to perfect and continue perfected the Agent's Liens on the Collateral (whether now owned or hereafter arising or acquired) or to give notice of perfection of Agent's Liens on the Collateral, and in order to consummate fully all of the transactions contemplated hereby and under the other the Loan Documents. 4.5 Power of Attorney. Borrower hereby irrevocably makes, constitutes, and appoints Agent (and any of Agent's officers, employees, or agents designated by Agent) as Borrower's true and lawful attorney, with power to (a) if Borrower refuses to, or fails timely to execute and deliver any of the documents described in Section 4.4, sign the name of Borrower on any of the documents described in Section 4.4, (b) at any time that an Event of Default has occurred and is continuing, sign Borrower's name on any invoice or bill of lading relating to any Account, drafts against Account Debtors, schedules and assignments of Accounts, verifications of Accounts, and notices to Account Debtors, (c) send requests for verification of Accounts, (d) endorse Borrower's name on any Collection item that may come into the Lender Group's possession, (e) at any time that an Event of Default has occurred and is continuing, notify the post office authorities to change the address for delivery of Borrower's mail to an address designated by Agent, to receive and open all mail addressed to Borrower, and to retain all mail relating to the Collateral and forward all other mail to Borrower, (f) at any time that an Event of Default has occurred and is continuing, make, settle, and adjust all claims under Borrower's policies of insurance and make all determinations and decisions with respect to such policies of insurance, and (g) at any time that an Event of Default has occurred and is continuing, settle and adjust disputes and claims respecting the Accounts directly with Account Debtors, for amounts and upon terms that Agent determines to be reasonable, and Agent may cause to be executed and delivered any documents and releases that Agent determines to be necessary. The appointment of Agent as Borrower's attorney, and each and every one of Agent's rights and powers, being coupled with an interest, is irrevocable until all of the Obligations have been fully and finally repaid and performed and the Lender Groups' obligations to extend credit hereunder are terminated. 4.6 Right to Inspect. Agent (through any of its officers, employees, or agents) shall have the right, from time to time hereafter to inspect the Books and to check, test, audit and appraise the Collateral in order to verify Borrower's and its Subsidiaries' financial condition or the amount, quality, value, condition of, or any other matter relating to, the Collateral (including checks, tests and audits by a qualified engineer selected by Agent of Borrower's and each of its Subsidiaries' onshore and offshore (if any) wells, rigs, pipeline distribution systems and operations). 4.7 Control Agreements. Borrower agrees that it will not, and that it will cause each of its Subsidiaries not to, transfer assets out of any Securities Accounts other than as permitted under Section 7.22 and, if to another securities intermediary, unless each of Borrower, such Subsidiary, Agent, and the substitute securities intermediary have entered into a Control Agreement. No arrangement contemplated hereby or by any Control Agreement in respect of any Securities Accounts or other investment property shall be modified by Borrower or any of its Subsidiaries without the prior written consent of Agent. Upon the occurrence and during the continuance of a Default or Event of Default, Agent may notify any securities intermediary to liquidate or transfer the applicable Securities Account or any related investment property maintained or held thereby and remit the proceeds thereof to the Agent Account. 5. REPRESENTATIONS AND WARRANTIES. In order to induce the Lender Group to enter into this Agreement, Borrower makes the following representations and warranties to the Lender Group which shall be true, correct, and complete in all respects as of the date hereof, and shall be true, correct, and complete in all respects as of the Closing Date, and at and as of the date of the making of each Advance made thereafter, as though made on and as of the date of the making of such Advance (except to the extent that such representations and warranties relate solely to an earlier date) and such representations and warranties shall survive the execution and delivery of this Agreement: 5.1 No Encumbrances. The Borrowing Base Entities have good, valid and Defensible Title to the Collateral, free and clear of all Liens (except for Permitted Liens), including but not limited to: (a) Ownership of the Oil and Gas Properties as listed on Schedule 5.1(a); (b) The amount of the Working Interest and Net Revenue Interest of the Oil and Gas Properties, as set forth on Schedule 5.1(b); (c) All rights under the Material Contracts listed on Schedule 5.1(c); and (d) Ownership of the Real Property listed on Schedule 5.1(d). 5.2 Eligible Proved Developed Producing Reserves; Ownership of Oil and Gas Properties. (a) All Eligible Proved Developed Producing Reserves are Proved Developed Producing Reserves of which a Borrowing Base Entity has fee simple legal title to or valid leasehold interest in (in each case, either good, marketable and indefeasible, or Defensible Title, except for Permitted Liens), and of which a Borrowing Base Entity is the beneficial owner of, to the full extent of the quantity of interest specified in the most recent Reserve Report delivered to Agent by Borrower, and all of the information with respect thereto contained on Schedules 5.1(a), 5.1(b), 5.1(c), and 5.2(b) attached hereto (and with respect to all future Eligible Proved Developed Producing Reserves other than those listed on Schedule 5.1(a), the analogous supplemental schedules contemplated on Exhibit B-1 attached hereto and made a part hereof with respect thereto) is true and correct. All Mineral Interests of which the Eligible Proved Developed Producing Reserves are a part are in full force and effect and each of the Borrowing Base Entities is in compliance in all material respects with its obligations thereunder. All wells drilled and Hydrocarbons produced by a Borrowing Base Entity with respect to Eligible Proved Developed Producing Reserves were drilled and produced in compliance with all applicable regulations. To the best of Borrower's knowledge, all wells drilled and Hydrocarbons produced by any Person other than a Borrowing Base Entity with respect to such Eligible Proved Developed Producing Reserves were drilled and produced in compliance with all applicable regulations. To the best of Borrower's knowledge, Schedule 5.2(a) attached hereto sets forth all authorities for expenditures outstanding as of the date of this Agreement and as of the Closing Date. To the best of Borrower's knowledge, there are no outstanding authorities for expenditures with respect to any Eligible Proved Developed Producing Reserves which are not reflected in the most recent Reserve Report delivered by Borrower to Agent, except for those which first arise after the Closing Date and have been reported to Agent in writing as and when required under Section 6.2(b). Except as set forth in Section 5.2(a), there are no proposed, current or completed operations under any operating agreement, unit agreement, governmental order or otherwise associated with any Oil and Gas Properties with respect to which any Borrowing Base Entity has become or intends to become a non-consenting party other than those operations commencing after the Closing Date as to which Borrower shall have given to Agent prior written notice of such Borrowing Base Entity's intention to non-consent within the time periods specified in Section 7.25. All of such Eligible Proved Developed Producing Reserves are a part of the Oil and Gas Properties described in Schedule 5.1(a), are covered by the engineering reports which Borrower has delivered to and which have been relied upon by Agent in connection with this Agreement prior to their inclusion in Eligible Proved Developed Producing Reserves, are part of the Oil and Gas Property Collateral covered by the Oil and Gas Property Mortgages, and are covered by Title Opinions and other legal opinions supplemental thereto in form and substance satisfactory to Agent which conform to the requirements described in subparagraph (B) of Section 3.1(l), Section 6.17 and Section 6.18. Except as set forth on Schedule 5.23, all bills in excess of $2,500 (except for those which are less than 60 days past original invoice date (or those for which neither Borrower nor any of its Subsidiaries has received any invoice), are not past due and do not give rise to a Lien other than a Permitted Lien) and taxes have been paid with respect to all Eligible Proved Developed Producing Reserves, other than those which are the subject of a bona fide dispute which is being contested in good faith by Borrower by appropriate proceedings as to which a reserve is established on the books of Borrower in an amount that is satisfactory to Agent (and if a Lien secures the same or may secure the same, such Lien is subject to a Permitted Protest). (b) To the best of Borrower's knowledge, all of each Borrowing Base Entity's marketing arrangements with respect to its Proved Reserves are valid, enforceable and in full force and effect. There do not exist any cumulative imbalances in gas production or receipt of "take or pay" payments except as disclosed (as to both existence and extent) on Schedule 5.2(b) attached hereto. (c) Without limiting the foregoing, after giving full effect to the Permitted Liens, each Borrowing Base Entity owns the respective net revenue interests in production attributable to the Oil and Gas Properties covered by the Oil and Gas Property Mortgages as is reflected in the most recently delivered Reserve Report and the ownership of such Properties shall not in any material respect obligate any Borrowing Base Entity to bear the costs and expenses relating to the maintenance, development and operations of each such Property in an amount in excess of the working interest of each such Property set forth in the most recently delivered Reserve Report. All information contained in the most recently delivered Reserve Report is true and correct in all material respects as of the date thereof. (d) Without limiting the foregoing, after giving full effect to the Permitted Liens, Borrower owns the net revenue interests in production attributable to the Oil and Gas Properties covered by the Oil and Gas Property Mortgages as is reflected in the most recently delivered Reserve Report, and the ownership of such Properties shall not in any material respect obligate Borrower to bear the costs and expenses relating to the maintenance, development and operations of each such Property in an amount in excess of the working interest of each such Property set forth in the most recently delivered Reserve Report. All information contained in the most recently delivered Reserve Report is true and correct in all material respects as of the date thereof. (e) There has not been any Material Adverse Change in the Oil and Gas Properties since December 31, 1999. 5.3 Operations of Oil and Gas Properties. With respect to each Mineral Interest which is a working interest, Schedule 5.1(b) attached hereto sets forth (i) the Oil and Gas Property as to which each Borrowing Base Entity is the operator, (ii) the Oil and Gas Property as to which the operator is a Person other than a Borrowing Base Entity, and (iii) the Oil and Gas Property which currently has no operator. 5.4 Equipment. All of the Equipment is used or held for use in Borrower's business and is fit for such purposes, subject to (a) normal wear and tear and (b) dispositions permitted under Section 7.4. 5.5 Location of Inventory and Equipment. (a) The Inventory and Equipment are located on the Oil and Gas Property Collateral or otherwise are located in Texas, New Mexico or Oklahoma. From time to time upon the request of Agent, Borrower shall provide to Agent a list of the specific locations of the Inventory and Equipment and the names and addresses of any bailee, warehouseman or similar party with whom such Inventory or Equipment is stored (and upon the reasonable request of Agent, Borrower shall obtain and deliver to Agent a Collateral Access Agreement executed by each such bailee, warehouseman or similar party with respect to such Inventory and Equipment). (b) The primary accounting and business books, records and papers of Borrower (including those pertaining to the Collateral) are kept and maintained solely at Borrower's chief executive office set forth in the beginning of this Agreement. The name and address of Borrower's landlord for the premises of Borrower's chief executive office set forth in the beginning of this Agreement is Arthur S. Demoss Foundation, 777 South Flager Drive, West Tower, Suite 1600, West Palm Beach, Florida 33401, Attention: Lanny Nelson. 5.6 Oil and Gas Property Collateral Records and Inventory Records. Borrower keeps correct and accurate records itemizing and describing the kind, type, quality, and quantity of the Oil and Gas Property Collateral and the Inventory, and Borrower's cost therefor. 5.7 Location of Chief Executive Office; FEIN. The chief executive office of Borrower is located at the address indicated in the preamble to this Agreement and Borrower's FEIN is 75-1917432. The chief executive office of Parent is located at 407 North Big Spring Street, Suite 300, Midland, Texas 79701 and Parent's FEIN is 75-2724264. The chief executive office of Blue Heel is located at 407 North Big Spring Street, Suite 300, Midland, Texas 79701. Blue Heel's FEIN is 75-2740345. 5.8 Due Organization and Qualification; Subsidiaries. (a) Borrower is duly organized and existing and in good standing under the laws of the jurisdiction of its incorporation and qualified and licensed to do business in, and in good standing in, any state where the failure to be so licensed or qualified could be expected to constitute a Material Adverse Change. Each of Borrower's Subsidiaries is duly organized and existing and in good standing under the laws of the jurisdiction of its incorporation or organization and qualified and licensed to do business in, and in good standing in, any state where the failure to be so licensed or qualified could be expected to constitute a Material Adverse Change. (b) Set forth on Schedule 5.8 is a complete and accurate description of the authorized capital Stock of Borrower, by class, and, as of the Closing Date, a description of the number of shares of each such class that are issued and outstanding and the number of such shares that are held in Borrower's treasury. All such outstanding shares have been validly issued and, as of the Closing Date, are fully paid, nonassessable shares free of contractual preemptive rights. The issuance and sale of all such shares have been in compliance with all applicable federal and state securities laws. Other than as described on Schedule 5.8, there are no subscriptions, options, warrants, or calls relating to any shares of Borrower's capital Stock, including any right of conversion or exchange under any outstanding security or other instrument. Neither Borrower nor any of its Subsidiaries is subject to any obligation (contingent or otherwise) to repurchase or otherwise acquire or retire any shares of its capital Stock or any security convertible into or exchangeable for any of its capital Stock. (c) Set forth on Schedule 5.8 is a complete and accurate list of Borrower's direct and indirect Subsidiaries, showing: (i) the jurisdiction of their incorporation or organization; (ii) the number of shares of each class of common and preferred Stock authorized for each of such Subsidiaries; and (iii) the number and the percentage of the outstanding shares of each such class owned directly or indirectly by Borrower. All of the outstanding capital Stock of each such Subsidiary has been validly issued and is fully paid and non-assessable. Borrower has no direct or indirect interest in any partnerships (other than as set forth in Schedule 5.8). Borrower has no equity interest having a value in excess of $5,000 in any Person other than as set forth in Schedule 5.8. (d) Except as set forth on Schedule 5.8 no capital Stock (or any securities, instruments, warrants, options, purchase rights, conversion or exchange rights, calls, commitments or claims of any character convertible into or exercisable for capital Stock) of any direct or indirect Subsidiary of Borrower is subject to the issuance of any security, instrument, warrant, option, purchase right, conversion or exchange right, call, commitment or claim of any right, title, or interest therein or thereto. (e) On or before the Closing Date, (I) Borrower has caused to be dissolved and liquidated each of Threading Products International, LLC, a Delaware limited liability company, and SWV Aviation, LLC, a Texas limited liability company, in form and substance satisfactory to Agent, and (II) Borrower has caused the merger of Midland Southwest Software, Inc., a Delaware corporation, and e-bacus Solutions, Inc., a Delaware corporation, with and into Borrower, with Borrower as the sole surviving entity, in form and substance satisfactory to Agent; and all of the foregoing dissolutions, liquidations and mergers have been consummated in full on or before the Closing Date. 5.9 Due Authorization; No Conflict. (a) The execution, delivery, and performance by Borrower of this Agreement and the Loan Documents to which it is a party have been duly authorized by all necessary corporate action. (b) The execution, delivery, and performance by Borrower of this Agreement and the Loan Documents to which it is a party do not and will not (i) violate any provision of federal, state, or local law or regulation (including Regulations U and X of the Federal Reserve Board) applicable to Borrower, the Governing Documents of Borrower, or any order, judgment, or decree of any court or other Governmental Authority binding on Borrower, (ii) conflict with, result in a breach of, or constitute (with due notice or lapse of time or both) a default under any Material Contract or other material contractual obligation or material lease of Borrower, (iii) result in or require the creation or imposition of any Lien of any nature whatsoever upon any properties or assets of Borrower, other than Permitted Liens, or (iv) require any approval of stockholders or any approval or consent of any Person under any Material Contract or other material contractual obligation of Borrower. (c) Other than the taking of any action expressly required under this Agreement and the Loan Documents, the execution, delivery, and performance by Borrower of this Agreement and the Loan Documents to which Borrower is a party do not and will not require any registration with, consent, or approval of, or notice to, or other action with or by, any federal, state, foreign, or other Governmental Authority or other Person. (d) This Agreement and the Loan Documents to which Borrower is a party, and all other documents contemplated hereby and thereby, when executed and delivered by Borrower will be the legally valid and binding obligations of Borrower, enforceable against Borrower in accordance with their respective terms, except as enforcement may be limited by equitable principles or by bankruptcy, insolvency, reorganization, moratorium, or similar laws relating to or limiting creditors' rights generally. (e) The Agent's Liens granted by Borrower to Agent, for the benefit of the Lender Group, in and to its properties and assets pursuant to this Agreement and the other Loan Documents are validly created, perfected, and first priority Liens, subject only to Permitted Liens. (f) Neither the Borrower nor any of its Subsidiaries has violated, and neither the Borrower nor any Subsidiary will be in violation of, any provisions of the Natural Gas Act or the Natural Gas Policy Act of 1978 or any other Federal or State law or any of the regulations thereunder (including those of the respective Conservation Commissions and Land Offices of the various jurisdictions having authority over its Oil and Gas Properties) with respect to its Oil and Gas Properties which would create a Material Adverse Change, and the Borrower and each Subsidiary have or will have made all necessary rate filings, certificate applications, well category filings, interim collection filings and notices, and any other filings or certifications, and has or will have received all necessary regulatory authorizations (including without limitation necessary authorizations, if any, with respect to any processing arrangements conducted by it or others respecting its Oil and Gas Properties or production therefrom) required under said laws and regulations with respect to all of its Oil and Gas Properties or production therefrom so as not to create a Material Adverse Change. Said material rate filings, certificate applications, well category filings, interim collection filings and notices, and other filings and certifications contain no untrue statements of material facts nor do they omit any statements of material facts necessary in said filings. 5.10 Claims, Disputes, and Litigation. There are no actions or proceedings pending by or against Borrower before any court or administrative agency and Borrower does not have knowledge or belief of any pending or threatened litigation, governmental investigations, or claims, complaints, actions, or prosecutions involving Borrower or any guarantor of the Obligations, except for: (a) ongoing collection matters in which Borrower is the claimant, petitioner or plaintiff; (b) matters disclosed on Schedule 5.10; (c) matters existing on the date of this Agreement which do not involve an amount in controversy of more than $25,000 individually or $100,000 in the aggregate; and (d) matters arising after the date hereof that, if decided adversely to Borrower, reasonably could not be expected to result in a Material Adverse Change. 5.11 No Material Adverse Change. All financial statements relating to Borrower or any guarantor of the Obligations that have been delivered by Borrower to the Lender Group have been prepared in accordance with GAAP (except, in the case of unaudited financial statements, for the lack of footnotes and being subject to year-end audit adjustments) and fairly present Borrower's (or such guarantor's, as applicable) financial condition as of the date thereof and Borrower's results of operations for the period then ended. There has not been a Material Adverse Change with respect to Borrower (or such guarantor, as applicable) since the date of the latest financial statements submitted to the Lender Group on or before the Closing Date. 5.12 No Fraudulent Transfer. (a) Borrower and each of its Subsidiaries is Solvent. (b) No transfer of property is being made by Borrower and no obligation is being incurred by Borrower or any of its Subsidiaries in connection with the transactions contemplated by this Agreement or the other Loan Documents with the intent to hinder, delay, or defraud either present or future creditors of Borrower or any of its Subsidiaries. 5.13 Employee Benefits. None of Borrower, any of its Subsidiaries, or any of their ERISA Affiliates maintains or contributes to any Benefit Plan, other than those listed on Schedule 5.13. Borrower, each of its Subsidiaries and each ERISA Affiliate have satisfied the minimum funding standards of ERISA and the IRC with respect to each Benefit Plan to which it is obligated to contribute. No ERISA Event has occurred nor has any other event occurred that may result in an ERISA Event that reasonably could be expected to result in a Material Adverse Change. None of Borrower or its Subsidiaries, any ERISA Affiliate, or any fiduciary of any Plan is subject to any direct or indirect liability with respect to any Plan under any applicable law, treaty, rule, regulation, or agreement. None of Borrower or its Subsidiaries or any ERISA Affiliate is required to provide security to any Plan under Section 401(a)(29) of the IRC. 5.14 Environmental Condition. Borrower has disclosed in writing to Agent any currently known and pending environmental conditions or matters which could result in a Material Adverse Change. Other than as disclosed, to the knowledge of Borrower and its Subsidiaries: none of the Oil and Gas Properties or the Real Property has ever been used in the disposal of, or to produce, store, handle, treat, release or transport any Hazardous Materials in a manner which could result in a Material Adverse Change, or has ever been designated or identified in any manner pursuant to any Environmental Laws is a Hazardous Materials disposal site or as a candidate for closure. No Lien arising under any Environmental Laws has attached to any revenues or to any real or personal property owned or operated by Borrower or by any Subsidiary of Borrower. Neither Borrower nor any Subsidiary of Borrower has received a summons, citation, notice, or directive from the Environmental Protection Agency or any other federal or state governmental agency concerning any action or omission by Borrower or any Subsidiary of Borrower resulting in the releasing or disposing of Hazardous Materials into the environment and which could result in a Material Adverse Change. To the knowledge of Borrower and its Subsidiaries, no Hazardous Materials, solid waste, or oil and gas exploration and production wastes, have been disposed of or otherwise released on or to any Property of Borrower or any of its Subsidiaries except in compliance in all material respects with Environmental Laws and so as not to pose an imminent and substantial endangerment to public health or welfare or the environment. To the extent applicable, and to the knowledge of Borrower and its Subsidiaries, all Property of Borrower and each of its Subsidiaries currently satisfies in all material respects all design, operation, and equipment requirements imposed by the OPA or known to Borrower to be or scheduled as of the Closing Date to be imposed by OPA during the term of this Agreement, and Borrower does not have any reason to believe that such Property, to the extent subject to OPA, will not be able to maintain in all material respects compliance with the OPA requirements during the term of this Agreement. Neither Borrower nor any of its Subsidiaries has any known contingent liability in connection with any release or threatened release of any oil, Hazardous Materials or solid waste into the environment. To the knowledge of Borrower and its Subsidiaries, all Hazardous Materials, solid waste, and oil and gas exploration and production wastes, if any, generated at any and all Property of Borrower or any of its Subsidiaries have in the past been transported, treated and disposed of in accordance with Environmental Laws and so as not to pose an imminent and substantial endangerment to public health or welfare or the environment, and so as not to create a risk of Material Adverse Change to Borrower or any of its Subsidiaries. 5.15 Compliance with the Law. To their knowledge, neither Borrower nor any of its Subsidiaries has violated any requirement of a Governmental Authority or failed to obtain any license, permit, franchise or other governmental authorization necessary for the ownership of the Property or the conduct of its business, which violation or failure could be expected to result in (in the event such violation or failure were asserted by any Person through appropriate action) a Material Adverse Change. Except for such acts or failures to act as do not result in and could not be expected to result in a Material Adverse Change, the Oil and Gas Properties have been maintained, operated and developed in a good and workmanlike manner and in conformity with all applicable laws and all rules, regulations and orders of all duly constituted authorities having jurisdiction and in conformity with the provisions of all leases, subleases or other contracts comprising a part of the Mineral Interests and other contracts and agreements forming a part of the Oil and Gas Properties; specifically in this connection, (i) after the Closing Date, no Oil and Gas Properties are subject to having allowable production reduced below the full and regular allowable (including the maximum permissible tolerance) because of any overproduction (whether or not the same was permissible at the time) prior to the Closing Date and (ii) none of the wells comprising a part of the Oil and Gas Properties are deviated from the vertical more than the maximum permitted by applicable laws, regulations, rules and orders, and such wells are, in fact, bottomed under and are producing from the Oil and Gas Properties. Neither Borrower nor any of its Subsidiaries has entered into, and the Oil and Gas Properties are not subject to, any agreements, consent orders, administrative orders or similar obligations based on a violation or alleged violation of Legal Requirements that could be expected to result in a Material Adverse Change 5.16 Bonds and Insurance. Schedule 5.16 attached hereto contains an accurate and complete description of all performance bonds related to operations on or pertaining to the Oil and Gas Properties, and all material policies of insurance owned or held by Borrower and each Subsidiary. Except as set forth on Schedule 5.16, all such policies are in full force and effect, all premiums with respect thereto covering all periods up to and including the Closing Date have been paid, and no notice of cancellation or termination has been received with respect to any such policy. Such bonds and policies are sufficient for compliance with all requirements of law and of all agreements to which Borrower or any of its Subsidiaries is a party; are valid, outstanding and enforceable policies; provide adequate coverage in at least such amounts and against at least such risks (but including in any event public liability) as are required by Governmental Authorities and/or usually insured or bonded against in the same general area by companies engaged in the same or a similar business for the assets and operations of Borrower and each of its Subsidiaries; will remain in full force and effect through the respective dates set forth in Schedule 5.16 without the payment of additional premiums except as set forth on Schedule 5.16; and will not in any way be affected by, or terminate or lapse by reason of, the transactions contemplated by this agreement. Neither Borrower nor any of its Subsidiaries has been refused any bonds or insurance with respect to its assets or operations, nor has its coverage been limited below usual and customary bond or policy limits, by any bonding company or insurance carrier to which it has applied for any such bond or insurance or with which it has carried insurance during the last three years. 5.17 Hedging Agreement. Schedule 5.17 sets forth, as of the Closing Date, a true and complete list of all Hedging Agreements (including commodity price swap agreements, forward agreements or contracts of sale which provide for prepayment for deferred shipment or delivery of oil, gas or other commodities) of the Borrower and each of its Subsidiaries, the material terms thereof (including the type, term, effective date, termination date and notional amounts or volumes), the net mark to market value thereof, all credit support agreements relating thereto (including any margin required or supplied), and the counterparty to each such agreement. Borrower has delivered true and correct copies of each of the Hedging Agreements to Agent prior to the date of this Agreement. 5.18 Brokerage Fees. Except as set forth in Schedule 5.18, no brokerage commission or finders fees has or shall be incurred or payable in connection with or as a result of Borrower's obtaining financing from the Lender Group under this Agreement, and neither Borrower nor any of its Subsidiaries has utilized the services of any broker or finder in connection with Borrower's obtaining financing from the Lender Group under this Agreement. Borrower acknowledges that neither Agent nor any Lender is in any way liable for the payment of any brokerage commission or finders fees in connection with or as a result of Borrower's obtaining financing from the Lender Group under this Agreement. 5.19 Permits and other Intellectual Property. Except as set forth on Schedule 5.19, Borrower owns or possesses adequate licenses or other rights to use all Permits, patents, patent applications, trademarks, trademark applications, service marks, service mark applications, trade names, copyrights, trade secrets and know-how (collectively, the "Intellectual Property") that are necessary for the operation of its business as currently conducted. No claim is pending or threatened to the effect that Borrower infringes upon, or conflicts with, the asserted rights of any other Person under any Intellectual Property, and to the best of Borrower's knowledge there is no basis for any such claim (whether pending or threatened). To the best of Borrower's knowledge, no claim is pending or threatened to the effect that any such Intellectual Property owned or licensed by Borrower, or in which Borrower otherwise has the right to use is invalid or unenforceable by Borrower, and to the best of Borrower's knowledge there is no basis for any such claim (whether or not pending or threatened). 5.20 [Intentionally Omitted]. 5.21 Locations; Real Property Leases. (a) The primary accounting and business books, records and papers of Borrower and its Subsidiaries (including those pertaining to the Collateral) are kept and maintained solely at Borrower's chief executive office set forth in the beginning of this Agreement. In addition, the Oil and Gas Property Collateral is kept and maintained solely at those locations which are listed on Schedule 5.1(a) attached hereto and at Borrower's chief executive office set forth in the beginning of this Agreement. In addition, the Collateral consisting of Inventory and Equipment are kept and maintained solely at those locations which are listed on Schedule 5.1(a) attached hereto, those locations specified on Schedule 5.21 attached hereto and at Borrower's chief executive office set forth in the beginning of this Agreement, which schedules include the names and addresses of each of Borrower's landlords. Except (i) to accomplish sales of Inventory in the ordinary course of business, or (ii) to dispose of Collateral to the extent prescribed under Section 7.4, Borrower shall not remove any Collateral from said executive office or those locations listed on Schedule 5.1(a) or Schedule 5.21, as the case may be. (b) Except as Borrower shall have notified in writing prior thereto and Borrower shall have delivered to Agent a Collateral Access Agreement in form and substance satisfactory to Agent, no tangible personal property of Borrower or any of its Subsidiaries shall be in the care or custody of any third party or stored or entrusted with a bailee or other third party and none shall hereafter be placed under such care, custody, storage or entrustment. 5.22 Absence of Certain Changes. Except as set forth in Schedule 5.22, since December 31, 1999, there has not been without Agent's prior written consent: (a) A waiver of any right relating to the Oil and Gas Properties; (b) A sale, lease or other disposition of the Oil and Gas Properties; (c) A mortgage, pledge or grant of a lien or security interest in any of the Oil and Gas Properties; (d) A contract for the sale of products produced from the Oil and Gas Properties, except for (i) such contracts that have been supplied to and reviewed and approved by Agent, and (ii) such contracts which do not (I) require sales of minimum quantities by Borrower or any of its Subsidiaries, (II) involve any advance payments or other advances to or by Borrower or any of its Subsidiaries, (III) provide for a sale price of less than 70% of (A) for oil, the NYMEX EDQ calendar month price as reported by The New York Merchantile Exchange on NYMEX.com or in a comparable oil and gas industry publication of nationally recognized standing (or an equivalent price in the event that such NYMEX EDQ calendar month price is no longer reported) for the appropriate category of oil covered by such contract and (B) for gas, the spot price for the appropriate category of gas covered by such contract, and (IV) constitute Indebtedness or otherwise involve any material undertaking by Borrower or any of its Subsidiaries; (e) A contract between Borrower and any of its Subsidiaries; or (f) A contract or commitment to do any of the foregoing. 5.23 Operating Costs. Except as set forth in Schedule 5.23, all costs and expenses incurred in connection with the operation of the Properties have been fully paid and discharged by Borrower, except normal costs and expenses incurred in operating the Oil and Gas Properties within the previous 60 days or for which Borrower has not yet been billed. 5.24 Imbalances. Except as set forth on Schedule 5.2(b) or on the most recent Reserve Report delivered to Agent by Borrower pursuant to Section 6.2(h), or following the Closing Date as permitted pursuant to Section 7.23, no Borrowing Base Entity has taken or received any amount of gas, oil, liquid hydrocarbons (or products refined therefrom) so that any person or entity may thereafter be entitled to receive any portion of the interests of any Borrowing Base Entity to "balance" any previous disproportionate allocation. 5.25 No Default. Except as set forth on Schedule 5.1(c), no contracts exist which encumber the Oil and Gas Properties. The contracts associated with the Oil and Gas Properties are in full force and effect in accordance with their respective terms, and there exist no violations or defaults (and Borrower is not aware of any event or circumstance that with notice or lapse of time, or both, would constitute a violation or default) in the performance of any obligation thereunder that could be expected to result in a Material Adverse Change, or that is likely to have a material adverse effect on the value of any such Oil and Gas Properties or the amount that the Lender Group would be likely to receive (after giving consideration to delays in payment and costs of enforcement) in the liquidation of such Oil and Gas Property, or that could be expected to result in a material impairment of the priority of the Agent's Liens with respect to such Oil and Gas Property. 5.26 Leases. The oil and gas leases associated with the Oil and Gas Properties are in full force and effect in accordance with their respective terms, and there exist no violations or defaults in the performance of any obligation thereunder that could be expected to result in a Material Adverse Change, or that is likely to have a material adverse effect on the value of any such Oil and Gas Properties or the amount that the Lender Group would be likely to receive (after giving consideration to delays in payment and costs of enforcement) in the liquidation of such Oil and Gas Property, or that could be expected to result in a material impairment of the priority of the Agent's Liens with respect to such Oil and Gas Property. Additionally, Borrower is not aware of any event that with notice or lapse of time, or both, would constitute a material violation or default under any such oil and gas leases. 5.27 Marketing Agreements. Except as set forth in Schedule 5.27 and except to the extent permitted under Section 7.27, the Oil and Gas Properties (and the production therefrom) are not subject to any purchase agreement, sale agreement or similar marketing arrangement not cancelable on thirty (30) days notice, nor are any of the Properties subject to any agreements with any companies affiliated with Borrower that cannot be terminated immediately upon Closing without penalty, cost or liability to Borrower. 5.28 Non-Consent Operations. Since July 31, 2000, there have been no operations associated with the Oil and Gas Properties under an operating agreement, unit agreement or governmental order with respect to which any Borrowing Base Entity has become a non-consenting party, except for those described in Schedule 5.2(a) and except for those relating to periods after the Closing Date to the extent permitted under Section 7.25. 5.29 Condition of Equipment. All of the wells, facilities and equipment associated with the Oil and Gas Properties that are material to the operation thereof are: (a) structurally sound with no material defects known to Borrower, (b) in good operating condition, normal wear and tear excepted, and suitable for the purposes for which they are being utilized, and (c) have been and are maintained in accordance with prudent business standards. 5.30 Wells. Each oil or gas well located on the Oil and Gas Properties is: (a) except as otherwise disclosed on Schedule 5.1(b), if such oil or gas well is listed on a Reserve Report, capable of producing in paying quantities, (b) properly permitted, (c) to the best of Borrower's knowledge, in compliance with all applicable Laws, and (d) within the production tolerances allocated by the governmental entity or tribal authority having appropriate jurisdiction. All of the leaseholds in which there are located Mineral Interests of a Borrowing Base Entity are producing Hydrocarbons in commercial quantities except for those leaseholds which either (i) are listed on the most recent Reserve Report delivered to Agent as having Proved Developed Producing Revenues with a NYMEX Value at $10,000 or less or are not listed on the most recent Reserve Report delivered to Agent or are not listed on the most recent Reserve Report delivered to Agent as having Proved Developed Producing Revenues. Each of Borrowing Base Entity's producing wells listed on Schedule 5.1(b) as having a NYMEX Value of $100,000 or more is located on an Oil and Gas Property (i) covered by Title Opinions to the extent of at least $94,000,000 of NYMEX Value in the aggregate as of the Closing Date, and thereafter as are required pursuant to Section 6.17(a), and (ii) described in the legal description contained in an Oil and Gas Property Mortgage which has been duly executed and delivered to Agent, except as otherwise disclosed on Schedule 5.30 attached hereto. 6. AFFIRMATIVE COVENANTS. Borrower covenants and agrees that, so long as any credit hereunder shall be available and until full and final payment of the Obligations, Borrower shall, and shall cause each of its Subsidiaries to, do all of the following: 6.1 Accounting System. Maintain a standard and modern system of accounting that enables Borrower to produce financial statements in accordance with GAAP, and maintain records pertaining to the Collateral that contain information as from time to time may be requested by Agent. Borrower also shall keep a modern joint interest billing and remittance system with respect to each of the Oil and Gas Properties on which it is the operator and a modern reporting system that shows, among other things, the value, revenues and profits/losses of the Oil and Gas Properties, volume of production and value of sales of Hydrocarbon production, the location and condition of the Equipment and Borrower's positions and liability exposure under the Hedging Agreements. 6.2 Collateral Reporting. Provide Agent with the following documents at the following times in form satisfactory to Agent during the term of this Agreement: (a) By no later than the last day of each month, (i) a detailed update, for the previous month, of the Borrowing Base on the form of the Borrowing Base Certificate which is attached hereto as Exhibit 6.2 (or on such other form as Agent in its sole discretion may require), including a detailed calculation of the NYMEX Value of each of the Oil and Gas Properties included in the Eligible Proved Developed Producing Reserves (such update and calculation shall include Oil and Gas Properties converted to Eligible Proved Developed Producing Reserves during such previous month, if any, as approved by Agent and for which a Reserve Report described in Section 6.2(i) shall have been prepared by Pollard Gore & Harrison and received by Agent), and (ii) a detailed calculation of the Unsecured Notes Indebtedness Limitation; (b) By no later than forty-five (45) days after the end of each fiscal quarter of Borrower (or with such greater frequency as Agent may request from time to time), a detailed update, for the previous month, of the Borrowing Base on the form of the Borrowing Base Certificate which is attached hereto as Exhibit 6.2 (or on such other form as Agent in its sole discretion may require), including (i) a detailed calculation of the NYMEX Value of each of the Oil and Gas Properties (categorized by Proved Developed Producing Reserves, Proved Developed Non-Producing Reserves and Proved Undeveloped Reserves, Eligible Proved Developed Producing Reserves, and "other"), (ii) a reconciliation and explanation of the changes of categorization of any Oil and Gas Properties among Proved Developed Producing Reserves, Proved Developed Non-Producing Reserves and Proved Undeveloped Reserves, Eligible Proved Developed Producing Reserves, and "other", since the date of the immediately preceding Borrowing Base Certificate, (iii) an updated schedule, in substantially the form of Schedule 5.2(f) or such other form as may be requested by Agent, setting forth as to each Oil and Gas Property owned by any Borrowing Base Entity the name, location, lease description, operator and ownership percentage of costs and revenue associated with such property and also indicating any changes in such working interest or net revenue interest in the Oil and Gas Property Collateral since the previous report, (iv) a schedule of the aggregate amount of all authorities for expenditures for all Proved Reserves which are outstanding as of such date, and (v) list of all authorities for expenditures for any Proved Reserves requiring an expenditure in excess of $25,000 by any Borrowing Base Entity on a combined basis for any single operation since the date of the previous report; (c) By no later than the last day of each month, (i) Borrower's "Lease Cash Flow Report", in form and substance reasonably acceptable to Agent, which will include a detailed statement of sales and revenues derived from all products produced from the Oil and Gas Properties, for the previous month, including prices received, lease operating expenses and such other information as Agent may deem necessary or appropriate, in Agent's sole discretion, (ii) Borrower's "Monthly O&G Revenue Accrual Report", in form and substance reasonably acceptable to Agent, which will include the prior period adjustments to such revenues and prices, and any Material Adverse Change affecting the sales or marketing agreements or arrangements with the purchasers of such products and historical production data of the oil and gas reserves included in the Oil and Gas Property Collateral since the date of the most recent Reserve Report (except that with respect to the portion of such reserves which are being produced from Oil and Gas Properties on which neither Borrower nor any of its Affiliates is the operator, the information pertaining thereto described in this subclause (ii) shall be due by no later than the 15th day after the last day of such month, rather than being due on the last day of such month), and (iii) a receivables aging as to all customers of Borrower and its Subsidiaries; (d) By no later than the last day of each month, a written report to Agent, in form and substance acceptable to Agent, detailing and aging each Borrowing Base Entity's unpaid lease operating expenses and unpaid other liabilities, for the previous month, with respect to which a mineral lien, subcontractor's lien, mechanic's lien, materialmen's lien or other Lien against any of the Collateral may arise which may have a priority superior to Agent's Lien on such Collateral; (e) By no later than the last day of each month, notice of all claims, disputes, and litigation that have arisen since the date of the most recent statement to Agent pursuant to this Section 6.2(e) through the last day of the immediately preceding month; except (i) ongoing collection matters in which Borrower is the claimant or plaintiff; and (ii) matters that, if decided adversely to any Loan Party, do not result in and could not be expected to result in a Material Adverse Change; (f) By no later than the last day of each month, for the previous month, a written report, in form and substance acceptable to Agent, detailing the costs incurred and revenues received by each Borrowing Base Entity under its Hedging Agreements for oil and gas production; (g) By the last day of the month following each calendar quarter (i.e., the last day of April, July, October and January), a report: (i) listing the total amount actually paid by each Borrowing Base Entity during the preceding quarter for: (A) plugging and abandonment costs for previous or ongoing plugging and abandonment operations pertaining to the Oil and Gas Properties, and (B) general bond and supplemental bond payments pertaining to plugging and abandonment costs; and (ii) estimating the future payments for the items described in the immediately preceding subclause (i) for each of the succeeding two quarters if the estimated aggregate amount thereof is greater than $25,000 for such period; (h) Reserve Reports prepared by Borrower and audited by Ryder Scott Company or other qualified independent petroleum engineering consultant selected by Borrower and approved by Agent pertaining to the six-month period ending December 31st and June 30th of each year (with such Reserve Reports to be delivered as soon as available, but in any event not later than the 90th day following such six-month period). Each Reserve Report described in this subparagraph (h) shall be in form and substance satisfactory to Agent, and shall: (i) be accompanied by a certification of Borrower to the effect that nothing has occurred since the date of the last Reserve Report that could reasonably be expected to result in a Material Adverse Change, except that which has previously been disclosed to Agent in writing; (ii) be accompanied by a reconciliation showing any changes in the Oil and Gas Property Collateral since the date of the most recent of such Reserve Report in each Borrowing Base Entity's Working Interest or net revenue interest; and (iii) contain such other information as may be requested by Agent; (i) Promptly following the preparation thereof, Reserve Reports prepared by Borrower and audited by Pollard Gore & Harrison or other qualified independent petroleum engineering consultant selected by Borrower and approved by Agent pertaining to Oil and Gas Properties of a Borrowing Base Entity which were included in the then most recent Reserve Report described in Section 6.2(h) as reserves other than Proved Developed Producing Reserves and since the date thereof were converted to Proved Developed Producing Reserves of such Borrowing Base Entity. Each Reserve Report described in this subparagraph (i) shall be in form and substance satisfactory to Agent and shall contain such other information as may be requested by Agent; (j) Upon request by Agent from time to time, copies of each Borrowing Base Entity's lease files, well files and contract files (including production reports on each well, marketing contracts, and information regarding locations of and equipment located on each well); (k) Such other information, reports, statements, materials and data as to the wells operated by a Borrowing Base Entity or in which a Borrowing Base Entity otherwise has an interest and the accounting and billing procedures utilized by such Borrowing Base Entity in connection with such wells as shall be requested by Agent, including, without limitation, relevant computer programs, disks and tapes; (l) On a weekly basis, Collections reports specifying Borrower's and each other Loan Party's, and each of their respective Subsidiaries', Collections for the immediately preceding calendar week; and (m) Such other reports as to the Collateral or the business or financial condition of Borrower or its Subsidiaries as Agent may request from time to time. Each delivery of a Reserve Report or a Borrowing Base Certificate by Borrower to Agent shall constitute a representation and warranty by Borrower to Agent that, unless otherwise disclosed to Agent in writing on or prior to the date of such delivery, (I) Borrower (or its Subsidiary, as the case may be) owns the Oil and Gas Properties described in the Reserve Report free and clear of any Liens (except Permitted Liens), and (II) the Oil and Gas Properties described in such Reserve Report constitute at least ninety-five percent (95%) of the value of Borrower's Proved Developed Producing Reserves. 6.3 Financial Statements, Reports, Certificates. Deliver to Agent, with copies to each Lender: (a) as soon as available, but in any event within 45 days after the end of each month during each of Borrower's fiscal years, a company prepared balance sheet, income statement, and statement of cash flow covering Borrower's operations during such period; and (b) as soon as available, but in any event within 90 days after the end of each of Borrower's fiscal years, financial statements of Borrower for each such fiscal year, audited by independent certified public accountants reasonably acceptable to Agent and certified, without any qualifications, by such accountants to have been prepared in accordance with GAAP, together with a certificate of such accountants addressed to Agent stating that such accountants do not have knowledge of the existence of any Default or Event of Default. Such audited financial statements shall include a balance sheet, profit and loss statement, and statement of cash flow and, if prepared, such accountants' letter to management. If Borrower is a parent company of one or more Subsidiaries, or Affiliates, or is a Subsidiary or Affiliate of another company, then, in addition to the financial statements referred to above, Borrower agrees to deliver financial statements prepared on a consolidating basis acceptable to Agent so as to present Borrower and each such related entity separately, and on a consolidated basis. Together with the above, Borrower also shall deliver to Agent, with copies to each Lender, Borrower's Form 10-Q Quarterly Reports, Form 10-K Annual Reports, and Form 8-K Current Reports, and any other filings made by Borrower with the SEC, if any, as soon as the same are filed, or any other information that is provided by Borrower to its shareholders, and any other information reasonably requested by the Lender Group relating to the financial condition of Borrower. Each month, together with the financial statements provided pursuant to Section 6.3(a), Borrower shall deliver to Agent, with copies to each Lender, a certificate signed by its chief financial officer to the effect that: (i) all financial statements delivered or caused to be delivered to any one or more members of the Lender Group hereunder have been prepared in accordance with GAAP (except, in the case of unaudited financial statements, for the lack of footnotes and being subject to year- end audit adjustments) and fairly present the financial condition of Borrower, (ii) the representations and warranties of Borrower contained in this Agreement and the other Loan Documents are true and correct in all material respects on and as of the date of such certificate, as though made on and as of such date (except to the extent that such representations and warranties relate solely to an earlier date), (iii) for each month that also is the date on which a financial covenant in Section 7.20 is to be tested, a Compliance Certificate demonstrating in reasonable detail compliance at the end of such period with the applicable financial covenants contained in Section 7.20, and (iv) on the date of delivery of such certificate to Agent there does not exist any condition or event that constitutes a Default or Event of Default (or, in the case of clauses (i), (ii), or (iii), to the extent of any non-compliance, describing such non-compliance as to which he or she may have knowledge and what action Borrower has taken, is taking, or proposes to take with respect thereto). As soon as available and in any event within forty-five (45) days after the last day of each calendar quarter, a report, in form and substance satisfactory to the Agent, setting forth as of the last Business day of such calendar quarter, a true and complete list of all Hedging Agreements (including commodity price swap agreements, forward agreements or contracts of sale which provide for prepayment for deferred shipment or delivery of oil, gas or other commodities) of the Borrower and each Subsidiary, the material terms thereof (including the type, term, effective date, termination date and notional amounts or volumes), the net mark to market values therefor, any new credit support agreements relating thereto, any margin required or supplied under any credit support document, and the counterparty to each such agreement; provided, however, that if there have been no changes since the date of the immediately preceding such report delivered by Borrower to Agent, delivery by Borrower of a report which states "no changes since date of immediately preceding report" (or words of equivalent substance) shall be acceptable for purposes of this paragraph. Borrower shall have issued written instructions to its independent certified public accountants authorizing them to communicate with Agent and to release to Agent whatever financial information concerning Borrower that Agent may request. Borrower hereby irrevocably authorizes and directs all auditors, accountants, or other third parties to deliver to Agent, at Borrower's expense, copies of Borrower's financial statements, papers related thereto, and other accounting records of any nature in their possession, and to disclose to Agent any information they may have regarding Borrower's business affairs and financial conditions. 6.4 Tax Returns. Deliver to Agent copies of each of Borrower's future federal income tax returns, and any amendments thereto, within 30 days of the filing thereof with the Internal Revenue Service. 6.5 Guarantor Reports. Cause any Guarantor of any of the Obligations to deliver its annual financial statements at the time when Borrower provides its audited financial statements to Agent and copies of all federal income tax returns as soon as the same are available and in any event no later than 45 days after the same are required to be filed by law. 6.6 [Intentionally Omitted]. 6.7 Title to Equipment. Upon Agent's request, Borrower promptly shall deliver to Agent, properly endorsed, any and all evidences of ownership of, certificates of title, or applications for title to any items of Equipment. 6.8 Maintenance of Oil and Gas Property Collateral and Equipment; Operation of Business. (a) At its expense, do or cause to be done all things necessary to preserve and keep in good repair, working order and efficiency (except for normal wear and tear) all of its Oil and Gas Property Collateral and other material Properties including, without limitation, all equipment, machinery and facilities material thereto, and from time to time make all the necessary repairs, renewals and replacements so that at all times the state and condition of its Oil and Gas Property Collateral and other material Property will be fully preserved and maintained, allowing for depletion in the ordinary course of business, except (x) to the extent a portion of such Oil and Gas Property Collateral is no longer capable of producing Hydrocarbons in commercial quantities (in which case Borrower or the relevant Subsidiary of Borrower, as the case may be, shall fully comply with all of its obligations and Legal Requirements pertaining to plugging and abandoning its wells related to such portion), and (y) as long as no Default or Event of Default then exists and no Default or Event of Default would result therefrom, Borrower and its Subsidiaries shall be permitted to abandon Mineral Interests which have NYMEX Value as only Proved Undeveloped Reserves, probable reserves or possible reserves (but no NYMEX Value as Proved Developed Producing Reserves and no NYMEX Value as Proved Developed Non-Producing Reserves) of up to $500,000 in the aggregate during any fiscal year of Borrower. Borrower and its Subsidiaries shall be permitted to. Borrower shall, and shall cause each of its Subsidiaries to, promptly: (i) pay and discharge, or make reasonable and customary efforts to cause to be paid and discharged, all delay rentals, royalties, expenses and indebtedness accruing under the leases or other agreements affecting or pertaining to its Oil and Gas Property Collateral; (ii) perform or make reasonable and customary efforts to cause to be performed, in accordance with industry standards, all obligations required by each and all of the assignments, deeds, leases, sub-leases, contracts and agreements affecting its interests in its Oil and Gas Property Collateral and other material Properties necessary or desirable to maintain its interests therein in full force and effect, and all other material obligations required under such assignments, deeds, leases, subleases, contracts and agreements affecting its interests in its Oil and Gas Property Collateral and other material Properties; (iii) shall, and shall cause each of its Subsidiaries to, do all other things necessary to keep unimpaired, except for Permitted Liens, its rights with respect to each and all of the assignments, deeds, leases, sub-leases, contracts and agreements affecting its interests in its Oil and Gas Property Collateral and other material Property and prevent any forfeiture thereof or a default thereunder, except (A) to the extent a portion of such Oil and Gas Property Collateral is no longer capable of producing Hydrocarbons in economically reasonable amounts and (B) for dispositions permitted by Section 7.4 hereof. Borrower shall, and shall cause each of its Subsidiaries, to operate its Oil and Gas Property Collateral and other material Property or cause or make reasonable and customary efforts to cause such Oil and Gas Property Collateral and other material Properties to be operated in a reasonably prudent manner in accordance with the practices of the industry and in compliance in all material respects with all applicable contracts and agreements and in compliance in all material respects with all Legal Requirements. (b) At its expense, maintain all material Equipment in good operating condition and repair (ordinary wear and tear excepted), and make all necessary replacements thereto, so that the value and operating efficiency thereof shall at all times be maintained and preserved. Other than those items of Equipment that constitute fixtures attached to the lands covered by Mineral Interests subject to the Oil and Gas Mortgages, Borrower shall not permit any item of Equipment to become a fixture to real estate or an accession to other property, and such Equipment shall at all times remain personal property. (c) At its expense, (i) develop and cause the other Borrowing Base Entities to develop (to the extent reasonably necessary to maintain the lease) and maintain, and cause the other Borrowing Base Entities to maintain, the leases, wells, units and acreage to which the Oil and Gas Property Collateral pertains in a prudent and economical manner, (ii) act prudently (and to cause the other Borrowing Base Entities to act prudently) and in accordance with customary industry standards in managing or operating the Oil and Gas Property Collateral, (iii) pay and promptly discharge all rentals, delay rentals, royalties, overriding royalties, payments of production and other indebtedness or obligations accruing under the leases comprising the Oil and Gas Property Collateral, and perform (and cause the other Borrowing Base Entities to perform) every commercially reasonable act required to keep such leases in full force and effect, (iv) deliver all operating agreements, pooling or unitization agreements, sales or processing contracts, drilling and/or development agreements, pipeline transportation agreements and other material agreements which pertain to the Oil and Gas Property Collateral, (v) deliver production information on a monthly basis, (vi) deliver copies of all reports, forms and other documents and data submitted by Borrower or any of its Subsidiaries to the Federal Energy Regulatory Commission, the applicable state conservation agencies and any other applicable Governmental Authorities, (vii) not mortgage, pledge or otherwise encumber or sell (and not permit any other Borrowing Base Entity to mortgage, pledge or otherwise encumber or sell) the Oil and Gas Property Collateral except to the limited extent specifically permitted under this Agreement, (viii) not alter (or permit any other Borrowing Base Entity to alter) any Material Contract relating to the Oil and Gas Property Collateral except to the limited extent specifically permitted under this Agreement, (ix) pay on or before the due date thereof all of Borrower's and each of its Subsidiaries' lease operating expenses and other liabilities with respect to which a mineral lien, subcontractor's lien, mechanic's lien, materialmen's lien or other Lien against any of the Collateral may arise which may have a priority superior to Agent's Lien on such Collateral, and (x) perform all acts and execute such documents as Agent may reasonably require in order to maintain the existence, perfection and first priority of Agent's Lien on the Oil and Gas Property Collateral and the other Collateral. 6.9 Taxes. (a) Cause all assessments and taxes, whether real, personal, or otherwise, due or payable by, or imposed, levied, or assessed against Borrower (or any Subsidiary of Borrower) or any of its property or assets to be paid in full, before delinquency or before the expiration of any extension period, except to the extent that the validity of such assessment or tax (other than production taxes, severance taxes, payroll taxes or taxes that are the subject of a United States federal tax lien) shall be the subject of a Permitted Protest. (b) Make due and timely payment or deposit of all such federal, state, and local taxes, assessments, or contributions required of it (or any Subsidiary of Borrower) by law, and will execute and deliver to Agent, on demand, appropriate certificates attesting to the payment thereof or deposit with respect thereto. (c) Make timely payment or deposit of all tax payments and withholding taxes required of it and its Subsidiaries by applicable laws, including those laws concerning F.I.C.A., F.U.T.A., state disability, and local, state, and federal income taxes, and will, upon request, furnish Agent with proof satisfactory to Agent indicating that Borrower has made such payments or deposits. 6.10 Insurance. (a) At its expense, keep the Collateral insured against loss or damage by such hazards and risks as are ordinarily insured against by other owners in similar businesses and in such amounts as shall be reasonably required by Agent. Borrower shall also maintain such public liability and property damage insurance relating to Borrower's ownership and use of Collateral as is ordinarily maintained by other owners in similar businesses and in such amounts as shall be reasonably required by Agent. In addition to and not in limitation of the foregoing, Borrower shall at its expense maintain the insurance policies described in Schedule 5.16 in full force and effect. (b) [Intentionally Omitted.] (c) All such policies of insurance shall be in such form, with such companies, and in such amounts as may be reasonably satisfactory to Agent. All hazard insurance and such other insurance as Agent shall specify, shall contain a lender's loss payable endorsement (or equivalent endorsement) satisfactory to Agent, showing Agent as sole loss payee thereof, and shall contain a waiver of warranties. Every policy of insurance referred to in this Section 6.10 shall contain an agreement by the insurer that it will not cancel such policy except after 30 days prior written notice to Agent and that any loss payable thereunder shall be payable notwithstanding any act or negligence of Borrower or the Lender Group which might, absent such agreement, result in a forfeiture of all or a part of such insurance payment and notwithstanding (i) occupancy or use of the Collateral for purposes more hazardous than permitted by the terms of such policy, (ii) any foreclosure or other action or proceeding taken by the Lender Group pursuant to the Oil and Gas Mortgages or the Real Property Mortgages upon the happening of an Event of Default, or (iii) any change in title or ownership of the Collateral. Borrower shall deliver to Agent certified copies of such policies of insurance and evidence of the payment of all premiums therefor. (d) Original policies or certificates thereof satisfactory to Agent evidencing such insurance shall be delivered to Agent at least 30 days prior to the expiration of the existing or preceding policies. Borrower shall give Agent prompt notice of any loss covered by such insurance. Prior to the occurrence or existence of a Default or an Event of Default, Borrower shall have the right to adjust any loss which, individually and collectively, is less than $50,000. Agent shall have the exclusive right to adjust all losses payable under any such insurance policies in excess of $50,000, and during the existence of a Default or an Event of Default Agent shall have the right to adjust all losses payable under any such insurance policies, in each case without any liability to Borrower or any Subsidiary of Borrower whatsoever in respect of such adjustments. Borrower shall be permitted to discuss proposed adjustments of losses with its insurance carriers; provided, however, that (i) Borrower shall not have the authority to agree to or settle without Agent's prior written approval any loss which Agent has the exclusive right to adjust hereunder, and (ii) Agent reserves the right to adjust such losses independently of Borrower and any Subsidiary of Borrower at any time. Any monies received as payment for any loss under any insurance policy including the insurance policies mentioned above, shall be paid over to Agent to be applied at the option of the Required Lenders either to the prepayment of the Obligations without premium, in such order or manner as Agent may elect, or shall be disbursed to Borrower under stage payment terms satisfactory to Agent for application to the cost of repairs, replacements, or restorations. All repairs, replacements, or restorations shall be effected with reasonable promptness and shall be of a value at least equal to the value of the items or property destroyed prior to such damage or destruction. Upon the occurrence of an Event of Default, the Lender Group shall have the right to apply all prepaid premiums to the payment of the Obligations in such order or form as Agent shall determine. (e) Neither Borrower nor any Subsidiary of Borrower shall take out separate insurance concurrent in form or contributing in the event of loss with that required to be maintained under this Section 6.10, unless Agent is included thereon as named insured with the loss payable to Agent under a lender's loss payable endorsement (or its equivalent) satisfactory to Agent. Borrower immediately shall notify Agent whenever such separate insurance is taken out, specifying the insurer thereunder and full particulars as to the policies evidencing the same, and originals of such policies immediately shall be provided to Agent. (f) Borrower shall, and shall cause each of its Subsidiaries to, either (i) maintain its own, or (ii) use its best efforts to cause the operator of each Oil and Gas Property Collateral in which Borrower or any of its Subsidiaries owns a non-operating Working Interest to maintain for the benefit of all Working Interest owners, insurance of the types and in the coverage amounts and with reasonable deductibles as is usual and customary, including those specified in Section 6.10(b), to name the non-operating Working Interest owners, including Borrower and its Subsidiaries, as an additional insured on the liabilities, and to otherwise have the such insurance comply with the requirements specified in Section 6.10(c). Borrower shall, and shall cause each of its Subsidiaries to, use its best efforts to obtain from its operators certificates of insurance evidencing coverage of the Oil and Gas Property Collateral as set forth above as and when requested by Agent. (g) Borrower shall furnish Agent with an "Absolute Assignment" of each key man life insurance policy listed on Schedule 5.16 attached hereto, shall record each such "Absolute Assignment" with the issuer of the respective policy, and shall finish proof of such issuer's acceptance of such assignment. All proceeds payable under such key man life insurance policies shall be payable to Agent to be applied on account of the Obligations. 6.11 No Setoffs or Counterclaims Make payments hereunder and under the other Loan Documents by or on behalf of Borrower without setoff or counterclaim and free and clear of, and without deduction or withholding for or on account of, any federal, state, or local taxes. 6.12 Location of Inventory and Equipment Keep the Inventory and Equipment only at the locations identified in Schedule 5.21, the locations specified in the Oil and Gas Property Mortgages in Schedule 5.1(a) and in the States listed (or only in the counties listed, in cases in which counties in any State are listed) on Schedule 6.12 attached hereto; provided, however, that Borrower may amend Schedule 5.21 and Schedule 6.12 so long as such amendment occurs by written notice to Agent not more than 15 days after the date on which the Inventory or Equipment is moved to such new location, so long as such new location is within the continental United States, and so long as, at the time of such written notification, Borrower provides any financing statements or fixture filings necessary or advisable to perfect and continue perfected the Agent's Liens on such assets and also provides to Agent a Collateral Access Agreement. 6.13 Compliance with Laws. (a) Comply with the requirements of all applicable laws, rules, regulations, and orders of any Governmental Authority, including all Environmental Laws, the Fair Labor Standards Act and the Americans With Disabilities Act, other than laws, rules, regulations, and orders the non- compliance with which, individually or in the aggregate, would not result in and reasonably could not be expected to result in a Material Adverse Change. (b) Establish and implement such procedures as may be necessary to continuously determine and assure that any failure of the following would not result in and could not be expected to result in a Material Adverse Change: (i) all Property of the Borrower and its Subsidiaries and the operations conducted thereon and other activities of the Borrower and its Subsidiaries are in compliance with and do not violate the requirements of any Environmental Laws, (ii) no oil, Hazardous Materials or solid wastes are disposed of or otherwise released on or to any Property owned by any such party except in compliance with Environmental Laws, (iii) no Hazardous Materials will be released on or to any such Property in a quantity equal to or exceeding that quantity which requires reporting pursuant to Section 103 of CERCLA, and (iv) no oil, oil and gas exploration and production wastes, or Hazardous Materials is released on or to any such Property so as to pose an imminent and substantial endangerment to public health or welfare or the environment. (c) Promptly notify Agent in writing of any threatened action, investigation or inquiry by any Governmental Authority of which Borrower or any of its Subsidiaries has knowledge in connection with any Environmental Laws, excluding routine testing and minor corrective action. (d) Provide environmental audits and tests in accordance with American Society for Testing and Materials standards, as reasonably requested by Agent or as otherwise reasonably required to be obtained by Agent or by any Governmental Authority in connection with Borrower's existing and hereafter acquired Oil and Gas Properties or other material Properties. 6.14 Employee Benefits. (a) Cause to be delivered to Agent: (i) promptly, and in any event within 15 Business Days after Borrower or any of its Subsidiaries knows or has reason to know that an ERISA Event has occurred that has resulted in or reasonably could be expected to result in a Material Adverse Change, a written statement of the chief financial officer of Borrower describing such ERISA Event and any action that is being taking with respect thereto by Borrower, any such Subsidiary or ERISA Affiliate, and any action taken or threatened by the IRS, Department of Labor, or PBGC. Borrower or such Subsidiary, as applicable, shall be deemed to know all facts known by the administrator of any Benefit Plan of which it is the plan sponsor, (ii) promptly, and in any event within 5 Business Days after the filing thereof with the IRS, a copy of each funding waiver request filed with respect to any Benefit Plan and all communications received by Borrower, any of its Subsidiaries or, to the knowledge of Borrower, any ERISA Affiliate with respect to such request, and (iii) promptly, and in any event within 5 Business Days after receipt by Borrower, any of its Subsidiaries or, to the knowledge of Borrower, any ERISA Affiliate, of the PBGC's intention to terminate a Benefit Plan or to have a trustee appointed to administer a Benefit Plan, copies of each such notice. (b) Cause to be delivered to Agent, promptly, and in any event within 15 Business Days, after Agent's request therefor, each of the following: (i) a copy of each Plan (or, where any such plan is not in writing, complete description thereof) (and if applicable, related trust agreements or other funding instruments) and all amendments thereto; (ii) the most recent determination letter issued by the IRS with respect to each Benefit Plan, if any; (iii) for the three most recent plan years, annual reports on Form 5500 Series required to be filed with any governmental agency for each Benefit Plan, if any; (iv) all actuarial reports prepared for the last three plan years for each Benefit Plan; (v) a listing of all Multiemployer Plans, with the aggregate amount of the most recent annual contributions required to be made by Borrower or any ERISA Affiliate to each such plan and copies of the collective bargaining agreements requiring such contributions; (vi) any information that has been provided to Borrower or any ERISA Affiliate regarding withdrawal liability under any Multiemployer Plan; and (vii) the aggregate amount of the most recent annual payments made to former employees of Borrower or its Subsidiaries under any Retiree Health Plan. 6.15 Leases. Pay when due all rents and other amounts payable under any material leases to which Borrower or any Subsidiary of Borrower is a party or by which Borrower's or such Subsidiary's Oil and Gas Properties or other material properties and assets are bound, unless such payments are the subject of a Permitted Protest. To the extent that Borrower or any Subsidiary of Borrower fails timely to make payment of such rents and other amounts payable when due under its leases, Agent shall be entitled, in its discretion, to reserve an amount equal to such unpaid amounts against the Borrowing Base. 6.16 Broker Commissions. Pay any and all brokerage commission or finders fees incurred or payable in connection with or as a result of Borrower's obtaining financing from the Lender Group under this Agreement. 6.17. Oil and Gas Property Title Information. (a) Within 90 days following the delivery to Agent of each Reserve Report required by Section 2.1(b) or Section 6.2, Borrower will provide Agent with current Title Opinions covering such of the Oil and Gas Property Collateral which are acquired after the Closing Date, which become Proved Developed Producing Reserves after the Closing Date, or the value of the Proved Developed Producing Reserves portion of which increases materially after the date of the Closing as shall reasonably be required by Agent for which current Title Opinions have not previously been provided to Agent, and covering such other Oil and Gas Property Collateral as Agent may from time to time require so that at all times the value of Eligible Proved Developed Producing Reserves for which Title Opinions are or have been provided to Agent shall equal or exceed seventy-five percent (75%) of the NYMEX Value of all Oil and Gas Property Collateral as set forth in the most recently delivered Reserve Report of Proved Developed Producing Reserves. (b) Borrower shall cure all title defects or exceptions which are not Permitted Liens, or substitute acceptable Oil and Gas Property Collateral with no title defects or exceptions except for Permitted Liens covering Oil and Gas Property Collateral of an equivalent value, within 90 days after a request by Agent to cure such defects or exceptions. If the Borrower is unable to cure any title defect requested by Agent to be cured within the 90 day period, such failure to cure shall not be a Default or an Event of Default, but instead such Property shall remain excluded from the Borrowing Base as provided in Section 2.1 until such time as title is satisfactory to Agent. Upon the discovery of any title defect or exception which is not a Permitted Lien, Agent shall have the right to exercise the right to remedy such title defect or exception in its sole discretion from time to time (and any failure to so exercise this remedy at any time shall not be a waiver as to future exercise of the remedy by Agent). 6.18 Additional Collateral. (a) (i) Should Borrower or any of its Subsidiaries purchase, otherwise acquire or own any Oil and Gas Property having a NYMEX value of $50,000 or more that is not already included in the Oil and Gas Property Collateral and the subject of an Oil and Gas Property Mortgage in favor of Agent for the benefit of the Lender Group, Borrower will grant or cause to be granted to Agent as security for the Obligations a first- priority Lien (subject only to Permitted Liens) on all of Borrower's or such Subsidiary's, as the case may be, interest in such Oil and Gas Properties not already subject to a Lien of such an Oil and Gas Property Mortgage simultaneously with Borrower's or such Subsidiary's purchase, acquisition or ownership of such Oil and Gas Property which Lien will be created and perfected by and in accordance with the provisions of an Oil and Gas Property Mortgage and other security agreements and financing statements, or other security instruments, all in form and substance satisfactory to Agent in its sole discretion and in sufficient executed (and acknowledged where necessary or appropriate) counterparts for recording purposes; and (ii) should Borrower or any of its Subsidiaries purchase, otherwise acquire or own any Real Property that is not already included in the Real Property Collateral and the subject of a Real Property Mortgage in favor of Agent for the benefit of the Lender Group, Borrower will grant or cause to be granted to Agent as security for the Obligations a first-priority Lien (subject only to Permitted Liens) on all of Borrower's or such Subsidiary's, as the case may be, interest in such Real Property not already subject to a Lien of such a Real Property Mortgage simultaneously with Borrower's or such Subsidiary's purchase, acquisition or ownership of such Real Property which Lien will be created and perfected by and in accordance with the provisions of a Real Property Mortgage and other security agreements and financing statements, or other security instruments, all in form and substance satisfactory to Agent in its sole discretion and in sufficient executed (and acknowledged where necessary or appropriate) counterparts for recording purposes, (b) Concurrently with the granting of the Lien or other action referred to in Section 6.18(a) above as to Oil and Gas Property, Borrower will provide to Agent title information and a title opinion in form and substance satisfactory to Agent in its sole discretion with respect to Borrower's or such Subsidiary's, as the case may be, interests in such Oil and Gas Properties, and concurrently with the granting of the Lien or other action referred to in Section 6.18(a) above as to Real Property, Borrower will provide to Agent title information and a mortgagee title insurance commitment in form and substance satisfactory to Agent in its sole discretion with respect to Borrower's or such Subsidiary's, as the case may be, interests in such Real Property. (c) Borrower shall cause all of its present and future Subsidiaries that are 50% or more owned directly or indirectly by Borrower to execute a Guaranty Agreement and Security Agreements. 6.19 Hedging Agreements. The Borrowing Base Entities shall maintain in effect at all times on a continuous basis one or more Hedging Agreements satisfactory to the Agent with respect to its Hydrocarbon production with one or more investment grade counterparties, rated Aa3 or better by Moody's, A+ or better according to Standard & Poor's, or the equivalent by a rating agency acceptable to Agent or with a counterparty otherwise acceptable to Agent in its reasonable judgment, which Hedging Agreements taken together shall at all times cover, for the period ending not less than 6 months from the date of any determination of compliance with this Section 6.19, aggregate notional volumes of Hydrocarbons equal to not less than 50% and not more than 90% of the Borrowing Base Entities' forecasted Hydrocarbon production for such period from Oil and Gas Properties classified as Proved Developed Producing Reserves as of the date of the most recent Reserve Report. Borrower shall use such Hedging Agreements solely as a part of its normal business operations as a risk management strategy and/or hedge against changes resulting from market conditions related to Borrower's and its Subsidiaries' oil and gas operations and not as a means to speculate for investment purposes on trends and shifts in financial or commodities markets. Borrower shall notify Agent immediately upon becoming aware (in any event not later than the close of business on the same Business Day) that the production of Hydrocarbons by Borrower could reasonably be expected to be insufficient to meet its obligations under any Hedging Agreements. 6.20 Further Assurances. Cure promptly any defects in the creation or issuance of the Obligations or the execution or delivery of the Obligations and/or Loan Documents, including this Agreement. Borrower at its expense shall, and shall cause each or its Subsidiaries to promptly execute and deliver to Agent upon request all such other documents, agreements and instruments to comply with or accomplish the covenants and agreements of Borrower or any of its Subsidiaries in the Loan Documents, including this Agreement, or to further evidence and more fully describe the collateral intended as security for the Obligations, or to correct any omissions in the Loan Documents, or to state more fully the security obligations set out herein or in any of the Loan Documents, or to perfect, protect or preserve any Liens created pursuant to any of the Loan Documents, or to make any recordings, to file any notices or obtain any consents, all as may be reasonably necessary or appropriate in connection therewith. 7. NEGATIVE COVENANTS. Borrower covenants and agrees that, so long as any credit hereunder shall be available and until full and final payment of the Obligations, Borrower will not, and will not permit any of its Subsidiaries to, do any of the following without the Required Lenders' prior written consent: 7.1 Indebtedness. Create, incur, assume, permit, guarantee, or otherwise become or remain, directly or indirectly, liable with respect to any Indebtedness, except: (a) Indebtedness evidenced by this Agreement; (b) Indebtedness set forth on Schedule 7.1; (c) Indebtedness secured by Permitted Liens; (d) the Unsecured Notes; (e) accounts payable (for the deferred purchase price of Property or services) from time to time incurred in the ordinary course of business which, if greater than 90 days past the invoice or billing date, are subject to a bona fide dispute which is being contested in good faith by appropriate proceedings as to which a reserve is established on the books of Borrower in an amount that is satisfactory to Agent (and if a Lien secures the same or may secure the same, such Lien is subject to a Permitted Protest); (f) Indebtedness associated with bonds or surety obligations required by Legal Requirements in connection with the operation of Borrower's and its Subsidiaries' Oil and Gas Properties; (g) Indebtedness which does not exceed $2,000,000 in the aggregate outstanding at any time under Hedging Agreements (or to issuers of letters of credit for the account of Borrower which support Hedging Agreements) entered into by Borrower covering oil or gas entered into as a part of Borrower's normal business operations as a risk management strategy and/or hedge against changes resulting from market conditions related to Borrower's and its Subsidiaries' oil and gas operations (but not as a means to speculate for investment purposes on trends and shifts in financial or commodities markets) but only to the extent that the total volumes hedged for any 12 month period are not greater than 90% of the forecasted Hydrocarbon production of the Borrowing Base Entities for such period from Oil and Gas Properties classified as Proved Developed Producing Reserves as indicated in the most recent Reserve Report; and (h) refinancings, replacements, renewals, or extensions of Indebtedness permitted under clauses (b) and (c) of this Section 7.1 (and continuance or renewal of any Permitted Liens associated therewith) and under clause (d) of this Section 7.1, in each such case so long as: (i) the terms and conditions of such refinancings, replacements, renewals, or extensions do not materially impair the prospects of repayment of the Obligations by Borrower, (ii) the net cash proceeds of such refinancings, replacements, renewals, or extensions do not result in an increase in the aggregate principal amount of the Indebtedness so refinanced, renewed, or extended, (iii) such refinancings, replacements, renewals or extensions do not result in a shortening of the average weighted maturity of the Indebtedness so refinanced, renewed, or extended, and (iv) to the extent that Indebtedness that is refinanced, replaced, renewed or extended was subordinated in right of payment to the Obligations, then the subordination terms and conditions of the refinancing, replacement, renewal or extension, Indebtedness must be at least as favorable to the Lender Group as those applicable to the refinanced, replaced, renewed or extended Indebtedness. 7.2 Liens. Create, incur, assume, or permit to exist, directly or indirectly, any Lien on or with respect to any of its property or assets, of any kind, whether now owned or hereafter acquired, or any income or profits therefrom, except for Permitted Liens (including Liens that are replacements of Permitted Liens to the extent that the original Indebtedness is refinanced under Section 7.1(g) and so long as the replacement Liens only encumber those assets or property that secured the original Indebtedness). 7.3 Restrictions on Fundamental Changes. (a) Enter into any merger or consolidation (other than the Permitted SWP Merger), or any reorganization or recapitalization, or reclassify its capital Stock (except for solely an increase in the number of shares of common Stock of Borrower in connection with the Initial Public Offering). (b) Liquidate, wind up, or dissolve itself (or suffer any liquidation or dissolution). (c) Convey, sell, assign, lease, license, transfer, or otherwise dispose of, in one transaction or a series of transactions, all or any substantial part of its property or assets. 7.4 Disposal of Assets. Sell, lease, assign, farm- out, convey, transfer, or otherwise dispose of any of any Borrower's or any of its Subsidiaries' Properties or assets other than: (a) sales of Inventory to buyers in the ordinary course of such Borrower's business as currently conducted; (b) the sale or transfer of Equipment (other than in connection with the sale of an Oil and Gas Property, Equipment located on such Oil and Gas Property which is an essential component of the existing Hydrocarbon production, if any, of the wells on such Oil and Gas Property), having a fair saleable value of less than an aggregate amount of $100,000 during any fiscal year of Borrower and its Subsidiaries during the term of this Agreement that is no longer necessary for the business of Borrower or such Subsidiary or is replaced by Equipment of at least comparable value and use, provided that the proceeds of such sale or transfer are immediately paid to Agent for application to the Obligations by wire transfer of immediately available funds to the Agent Account; and (c) cash sales in the ordinary course of business of Proved Reserves, as long as: (i) no Default or Event of Default is existing or would result therefrom and no Overadvance would result therefrom, and (ii) Borrower at such time has at least an aggregate amount of $1.00 of Availability and unrestricted immediately available cash on hand reserving as an additional deduction from Availability an amount determined by Agent in its sole discretion that would be sufficient to maintain Borrower's and its Subsidiaries' accounts payable and other current liabilities within reasonable terms, and (iii) the proceeds of the sale of such Proved Reserves are immediately paid to Agent for application to the Obligations by wire transfer of immediately available funds to the Agent Account, and (iv) the sale price of such Proved Reserves is equal to or greater than fifty percent (50%) of the NYMEX Value of such Proved Reserves as of the date of the most recent applicable Reserve Report delivered to Agent by Borrower, provided that: (w) in the case of Proved Developed Producing Reserves, the aggregate NYMEX Value of such Proved Developed Reserves, as of the date of the most recent applicable Reserve Report delivered by Borrower to Agent, may not exceed $250,000 in the aggregate during any twelve calendar month period during the term of this Agreement, (x) in the case of Proved Reserves other than Proved Developed Producing Reserves, the aggregate NYMEX Value of such Proved Reserves, as of the date of the most recent applicable Reserve Report delivered by Borrower to Agent, may not exceed $500,000 in the aggregate during the term of this Agreement, (y) the Borrowing Base shall be adjusted by an amount equal to the value, if any, assigned to such Proved Reserves in the most recently determined Borrowing Base, and (z) at or prior to the closing date of any such sale of any such Proved Reserves, and as a condition of Borrower's authority to do so, Borrower shall deliver to Agent a certificate executed by the chief executive officer or chief financial officer of Borrower certifying (I) that no Default or Event of Default has occurred and is continuing, (II) to the valuation of the Proved Reserves involved utilizing the NYMEX Price for valuation purposes, (III) that the dispositions proposed will not violate the dollar limitation set forth in this Section 7.4, (IV) that the disposition will not result in an Overadvance, (V) the consideration and manner of the payment thereof to be received by Borrower for the disposition of the Proved Reserves involved, and (VI) that Borrower has the minimum Availability required for such sale. 7.5 Change Name. Change Borrower's or any of its Subsidiaries' name, FEIN, corporate structure (within the meaning of Section 9402(7) of the Code), or identity, or add any new fictitious name. 7.6 Guarantee. Guarantee or otherwise become in any way liable with respect to the obligations of any third Person except by endorsement of instruments or items of payment for deposit to the account of Borrower or which are transmitted or turned over to Agent. 7.7 Nature of Business. Make any material change in the principal nature of Borrower's or any of its Subsidiaries' business as an independent oil and gas exploration and production company, except that Borrower may continue to pursue development of its software and back office outsourcing efforts related to the oil and gas business provided that the aggregate expenditures for Borrower and its Subsidiaries thereon does not exceed $1,000,000 during any fiscal year. 7.8 Prepayments and Amendments. (a) Except in connection with a refinancing permitted by Section 7.1(h), prepay, redeem, retire, defease, purchase, or otherwise acquire any Indebtedness owing to any third Person (including, but not limited to, the Unsecured Notes), other than the Obligations in accordance with this Agreement (provided, however, that Borrower shall be permitted to repurchase or redeem additional amounts of the Unsecured Notes as long as a condition precedent thereto, (x) no Default or Event of Default then exists or reasonably could be expected to result therefrom, and (y) Borrower at such time, after giving effect thereto, has at least an aggregate amount of $10,000,000 of Availability and unrestricted immediately available cash on hand reserving as an additional deduction from Availability an amount determined by Agent in its sole discretion that would be sufficient to maintain Borrower's and its Subsidiaries' accounts payable within reasonable terms), or (b) Except in connection with a refinancing permitted by Section 7.1(h), directly or indirectly, amend, modify, alter, increase, or change any of the terms or conditions of any agreement, instrument, document, indenture (including, but not limited to, the Unsecured Notes Indenture) or other writing evidencing or concerning Indebtedness permitted under Sections 7.1(b), (c), (d) or (g). 7.9 Change of Control. Cause, permit, or suffer, directly or indirectly, any Change of Control. 7.10 Consignments. Consign any Inventory or sell any Inventory on bill and hold, sale or return, sale on approval, or other conditional terms of sale. 7.11 Distributions; Repurchases of Capital Stock. Make any distribution or declare or pay any dividends (in cash or other property, other than capital Stock) on, or purchase, acquire, redeem, or retire any of Borrower's capital Stock, of any class, whether now or hereafter outstanding. 7.12 Accounting Methods. Modify or change its method of accounting or enter into, modify, or terminate any agreement currently existing, or at any time hereafter entered into with any third party accounting firm or service bureau for the preparation or storage of Borrower's accounting records without said accounting firm or service bureau agreeing to provide Agent information regarding the Collateral or Borrower's financial condition. Borrower waives the right to assert a confidential relationship, if any, it may have with any accounting firm or service bureau in connection with any information requested by Agent pursuant to or in accordance with this Agreement, and agrees that Agent may contact directly any such accounting firm or service bureau in order to obtain such information. 7.13 Investments. Except for Permitted Investments, directly or indirectly, make or acquire any Investment, or incur any liabilities (including contingent obligations) for or in connection with any Investment; provided, however, that: (a) if no Default or Event of Default is existing or could be expected to result therefrom, and Borrower at such time, after giving effect thereto, has at least an aggregate amount of $1.00 of Availability and unrestricted immediately available cash on hand reserving as an additional deduction from Availability an amount determined by Agent in its sole discretion that would be sufficient to maintain Borrower's and its Subsidiaries' accounts payable within reasonable terms, then Borrower may purchase limited partnership interests in the Designated Affiliated Limited Partnerships for not more than fair value on an arm's length basis from the limited partners thereof which are not Affiliates of Borrower or any of its Subsidiaries for an aggregate amount which does not exceed $500,000 in the aggregate during any fiscal year of Borrower; provided further, however, that as a condition precedent to each such purchase of limited partner interests described in this subparagraph (a), Borrower shall have granted to Agent for the benefit of the Lender Group a first priority perfected Lien on and security interest in and to all of such limited partnership interests so purchased; and (b) if no Default or Event of Default is existing or could be expected to result therefrom, and Borrower at such time, after giving effect thereto, has at least an aggregate amount of $5,000,000 of Availability and unrestricted immediately available cash on hand reserving as an additional deduction from Availability an amount determined by Agent in its sole discretion that would be sufficient to maintain Borrower's and its Subsidiaries' accounts payable within reasonable terms, then Borrower may purchase limited partnership interests in the Designated Affiliated Limited Partnerships for not more than fair value on an arm's length basis from the limited partners thereof which are not Affiliates of Borrower or any of its Subsidiaries for an aggregate amount which does not exceed $4,000,000 in the aggregate during any fiscal year of Borrower; provided further, however, that as a condition precedent to each such purchase of limited partner interests described in this subparagraph (b), Borrower shall have granted to Agent for the benefit of the Lender Group a first priority perfected Lien on and security interest in and to all of such limited partnership interests so purchased; and (c) Borrower shall be permitted to make loans or advances to Parent in an aggregate amount that does not exceeding $2,500,000 outstanding at any time; and (d) Borrower shall be permitted to continue the $76,000 outstanding balance of accrued unpaid management fees owing to it on the date of this Agreement from Southwest Partners II, L.P., a Delaware limited partnership, and the $325,000 outstanding balance of accrued unpaid management fees owing to it on the date of this Agreement from Southwest Partners III, L.P., a Delaware limited partnership; and (e) Borrower shall be permitted to maintain balances of up to $100,000 in the aggregate outstanding at any time owing to it from Southwest Partners II, L.P., a Delaware limited partnership, and Southwest Partners III, L.P., a Delaware limited partnership. 7.14 Transactions with Affiliates. Directly or indirectly (a) enter into or permit to exist any material transaction with any Affiliate of Borrower except for transactions that are in the ordinary course of Borrower's business, upon fair and reasonable terms, that are fully disclosed to Agent, and that are no less favorable to Borrower than would be obtained in an arm's length transaction with a non- Affiliate or (b) make any payments to or otherwise transfer any assets or funds to any of Basic Well Services, Inc., a Delaware corporation, Midland Red Oak Realty, a Delaware corporation, Parent, or any limited partnership of which Borrower is the general partner except for (i) those purchases of limited partnership interests in the Designated Affiliated Limited Partnerships to the extent permitted under subclauses (a) and (b) of Section 7.13, and (ii) those loans or advances to Parent to the extent permitted under subclause (c) of Section 7.13. 7.15 Suspension. Suspend or go out of a substantial portion of its business. 7.16 Compensation. (a) Increase the annual fee or per-meeting fees paid to the members of its Board of Directors during any year by more than 15% over (i) that paid or accrued in the prior year, or (ii) for fiscal year 2000 of Borrower, the amounts thereof on the books of Borrower as of June 30, 2000 as provided to Agent in writing prior to the date of this Agreement; (b) Pay or accrue total cash compensation, during any year, to officers and senior management employees in an aggregate amount in excess of 125% of that (i) paid or accrued in the prior year or (ii) for fiscal year 2000 of Borrower, the budgeted salary and bonus on the books of Borrower as of June 30, 2000 as provided to Agent in writing prior to the date of this Agreement; or (c) Pay or accrue any severance amounts or retirement amounts except as described on Schedule 7.16 attached hereto. 7.17 Use of Proceeds. Use the proceeds of the Advances made hereunder for any purpose other than (a) on the Closing Date, (i) to fund the assignment to the Agent and the Lender Group in full of the outstanding principal, accrued interest, accrued fees and expenses owing to Prior Lenders, and (ii) to pay transactional fees, costs, and expenses incurred in connection with this Agreement, and (b) thereafter, consistent with the terms and conditions hereof, for its lawful and permitted corporate purposes. 7.18 Change in Location of Chief Executive Offices; Inventory and Equipment. Relocate its chief executive office to a new location without providing to Agent, within 15 days immediately following such relocation, written notification thereof and, at the time of such written notification, any financing statements or fixture filings necessary to perfect and continue perfected the Agent's Liens and also provides to Agent a Collateral Access Agreement with respect to such new location. The Inventory and Equipment shall not at any time now or hereafter be stored with a bailee, warehouseman, or similar party without Agent's prior written consent. Borrower will not, and will not permit its Subsidiaries to store, warehouse or bail the Inventory and Equipment of Borrower and its Subsidiaries at Real Property other than such Real Property listed on Schedule 5.1(d). 7.19 No Prohibited Transactions Under ERISA. Directly or indirectly: (a) engage, or permit any Subsidiary of Borrower to engage, in any prohibited transaction which is reasonably likely to result in a civil penalty or excise tax described in Sections 406 of ERISA or 4975 of the IRC for which a statutory or class exemption is not available or a private exemption has not been previously obtained from the Department of Labor; (b) permit to exist with respect to any Benefit Plan any accumulated funding deficiency (as defined in Sections 302 of ERISA and 412 of the IRC), whether or not waived; (c) fail, or permit any Subsidiary of Borrower to fail, to pay timely required contributions or annual installments due with respect to any waived funding deficiency to any Benefit Plan; (d) terminate, or permit any Subsidiary of Borrower to terminate, any Benefit Plan where such event would result in any liability of Borrower, any of its Subsidiaries or any ERISA Affiliate under Title IV of ERISA; (e) fail, or permit any Subsidiary of Borrower to fail, to make any required contribution or payment to any Multiemployer Plan; (f) fail, or permit any Subsidiary of Borrower to fail, to pay any required installment or any other payment required under Section 412 of the IRC on or before the due date for such installment or other payment; (g) amend, or permit any Subsidiary of Borrower to amend, a Plan resulting in an increase in current liability for the plan year such that either of Borrower, any Subsidiary of Borrower or any ERISA Affiliate is required to provide security to such Plan under Section 401(a)(29) of the IRC; or (h) withdraw, or permit any Subsidiary of Borrower to withdraw, from any Multiemployer Plan where such withdrawal is reasonably likely to result in any liability of any such entity under Title IV of ERISA; which, individually or in the aggregate, results in or reasonably would be expected to result in a claim against or liability of Borrower, any of its Subsidiaries or any ERISA Affiliate in excess of $50,000. 7.20 Financial Covenants. Fail to maintain: (a) Tangible Net Worth. As of the last day of each month set forth below, a consolidated Tangible Net Worth of Borrower and its Subsidiaries of at least the amount set forth below corresponding to such month: Month Amount Each month during the ($90,750,000) period commencing on the Closing Date and ending on November 30, 2001 December 2001 and each ($88,400,000); month thereafter provided, however, that with respect to each month ending on or after December 31, 2001, the applicable Amount pertaining thereto may be modified upon mutual written agreement between Borrower and Agent in accordance with the following procedure: (i) on or before the 30th day prior to the last day of each calendar year ending on or after December 31, 2001, Borrower shall deliver to Agent Borrower's financial projections for the next following calendar year, which financial projections shall be in form and substance acceptable to Agent, and (ii) Borrower and Agent shall negotiate in good faith regarding the proposed minimum Tangible Net Worth amounts to be the applicable Amounts for each month during such next following calendar year; and (b) Consolidated Interest Coverage Ratio. As of the last day of each month set forth below, Borrower's ratio of (i) consolidated EBITDA for the three-month period then ended, to (ii) consolidated Interest Expense for the three-month period then ended, of not less than the ratio set forth below corresponding to such period: Month Ratio Each month during the period 1.0:1.0 commencing on the Closing Date and ending on September 30, 2000 October 2000 and each month 1.6:1.0; ending thereafter provided, however, that with respect to each month ending on or after December 31, 2001, the applicable Ratio pertaining thereto may be modified upon mutual written agreement between Borrower and Agent in accordance with the following procedure: (i) on or before the 30th day prior to the last day of each calendar year ending on or after December 31, 2001, Borrower shall deliver to Agent Borrower's financial projections for the next following calendar year, which financial projections shall be in form and substance acceptable to Agent, and (ii) Borrower and Agent shall negotiate in good faith regarding the proposed minimum ratio to be the applicable Ratio for each month during such next following calendar year. 7.21 Capital Expenditures. Make capital expenditures in any fiscal year in excess of $13,000,000 in the aggregate. 7.22 Securities Accounts. Neither Borrower nor any Subsidiary of Borrower shall establish or maintain any Securities Account unless Borrower shall have notified Agent of the existence, location and other particulars thereof and Agent shall have received a Control Agreement, duly executed and in full force and effect, in respect of such Securities Account; provided, however, that no such Control Agreement shall be required prior to Agent requesting the same in writing from Borrower. Borrower agrees that neither it nor any of its Subsidiaries will transfer assets out of any Securities Accounts; provided, however, that, so long as no Event of Default has occurred and is continuing or would result therefrom, Borrower may use such assets to the extent permitted by this Agreement. 7.23 Gas Imbalances, Take-or-Pay or Other Prepayments. Borrower shall not, and shall not permit any of its Subsidiaries to, enter into any contracts or agreements which warrant production of Hydrocarbons (other than Hedging Agreements otherwise permitted hereunder) and will not hereafter allow or accept gas imbalances, take-or-pay or other prepayments with respect to its Oil and Gas Properties which would require such Person to deliver Hydrocarbons produced from such Oil and Gas at some future time without then or thereafter receiving full payment therefor to exceed, in the aggregate, five percent (5%) of the current aggregate monthly gas production for such monthly period from the Oil and Gas Properties. 7.24 Payments on Unsecured Notes Make any payment of interest, principal, premium or other amount on the Unsecured Notes, provided, however, that Borrower shall be permitted to make regularly scheduled payments of interest on the Unsecured Notes as long as, as a condition precedent thereto, (i) no Default or Event of Default then exists or reasonably could be expected to result therefrom, and (ii) Borrower, at such time, after giving effect thereto, has at least an aggregate amount of $5,000,000 of Availability and unrestricted immediately available cash on hand reserving as an additional deduction from Availability an amount determined by Agent in its sole discretion that would be sufficient to maintain Borrower's and its Subsidiaries' accounts payable and other current liabilities within reasonable terms. 7.25 Non-Consent Operations. Become a non-consenting party with respect to (a) any operations under any operating agreement, unit agreement, governmental order or otherwise associated with any Oil and Gas Property having Proved Developed Producing Reserves with a NYMEX value of $100,000 or more on which neither Borrower nor any of its Affiliates is the operator unless Borrower shall have provided reasonable prior written notice to Agent of Borrower's intention to become a non- consenting party with respect thereto, such notice to be not less than 5 days prior to Borrower becoming a non-consenting party (except in cases in which the period for notice of non-consent under the applicable agreement, order or other arrangement pertaining to the operation is less than 5 days, in which case Borrower shall provide prior notice to Agent which is not less than the period for notice of non-consent thereunder), or (b) any operations under any operating agreement, unit agreement, governmental order or otherwise associated with any Oil and Gas Property on which Borrower or any of its Affiliates is the operator. 7.26 Waivers of Rights Relating to Oil and Gas Properties. Waive any right relating to any of the Oil and Gas Properties other than waivers and consents relating to immaterial easements, rights of way and other similar rights which the waiver thereof does not have an adverse effect on the value of such Oil and Gas Property to which it pertains, does not impair or adversely affect any Lien held by the Agent for the benefit of the Lender Group, and could not reasonably be expected to result in a Material Adverse Change. 7.27 Contracts for Sale of Production. Enter into, renew, extend or continue beyond its original scheduled maturing date any contract for the sale of Hydrocarbons or other products produced from the Oil and Gas Properties except (a) for a period of one month or less at a fixed price or (b) for contracts which do not (I) require sales of minimum quantities by Borrower or any of its Subsidiaries, (II) involve any advance payments or other advances to or by Borrower or any of its Subsidiaries, (III) provide for a sale price of less than 70% of (A) for oil, the NYMEX EDQ calendar month price as reported by The New York Merchantile Exchange on NYMEX.com or in a comparable oil and gas industry publication of nationally recognized standing (or an equivalent price in the event that such NYMEX EDQ calendar month price is no longer reported) for the appropriate category of oil covered by such contract, and (B) for gas, the spot price for the appropriate category of gas covered by such contract, and (IV) constitute Indebtedness or otherwise involve any material undertaking by Borrower or any of its Subsidiaries. 7.28 Exploration. Neither Borrower nor any of its Subsidiaries shall conduct, consent to or participate in any exploratory oil and gas activities or operations having authorities for expenditures of $1,000,000 or more in the aggregate during any fiscal year attributable to Borrower's or such Subsidiaries' interest therein on a combined basis. 8. EVENTS OF DEFAULT. Any one or more of the following events shall constitute an event of default (each, an "Event of Default") under this Agreement: 8.1 If Borrower or any other Loan Party fails to pay when due and payable or when declared due and payable, any portion of the Obligations (whether of principal, interest (including any interest which, but for the provisions of the Bankruptcy Code, would have accrued on such amounts), fees and charges due the Lender Group, reimbursement of Lender Group Expenses, or other amounts constituting Obligations); provided, however, that in the case of Overadvances that are caused by the charging of interest, fees or Lender Group Expenses to the Loan Account, such event shall not constitute an Event of Default if, within 5 Business Days of incurring such Overadvance, Borrower or any other Loan Party repays, or otherwise eliminates such Overadvance; 8.2 (a) If Borrower fails or neglects to perform, keep, or observe any term, provision, condition, covenant, or agreement contained in Section 6.2 (Collateral Reporting), 6.3 (Financial Statements, Reports, Certificates), 6.4 (Tax Returns), 6.14 (Employee Benefits), or 6.15 (Leases) of this Agreement and such failure continues for a period of 5 Business Days; (b) If Borrower fails or neglects to perform, keep, or observe any term, provision, condition, covenant, or agreement contained in Section 6.1 (Accounting System), 6.7 (Title to Equipment), 6.8 (Maintenance of Oil and Gas Property Collateral and Equipment), 6.12 (Location of Inventory and Equipment), or 6.13 (Compliance with Laws) of this Agreement and such failure continues for a period of 15 Business Days following the date upon which Borrower or any other Loan Party first became aware (or, with the exercise of reasonable diligence, would have become aware) of the occurrence of such failure or neglect; or (c) If Borrower or any other Loan Party fails or neglects to perform, keep, or observe any other term, provision, condition, covenant, or agreement contained in this Agreement, or in any of the other Loan Documents (giving effect to any grace periods, cure periods, or required notices, if any, expressly provided for in such Loan Documents); in each case, other than any such term, provision, condition, covenant, or agreement that is the subject of another provision of this Section 8, in which event such other provision of this Section 8 shall govern; provided that, during any period of time that any such failure or neglect of Borrower or such other Loan Party referred to in this paragraph exists, even if such failure or neglect is not yet an Event of Default by virtue of the existence of a grace or cure period or the pre-condition of the giving of a notice, neither Agent nor any Lender shall be required during such period to make Advances to Borrower; 8.3 [Intentionally omitted]; 8.4 If any material portion of Borrower's or any other Loan Party's properties or assets is attached, seized, subjected to a writ or distress warrant, or is levied upon, or comes into the possession of any third Person; 8.5 If an Insolvency Proceeding is commenced by Borrower or any other Loan Party; 8.6 If an Insolvency Proceeding is commenced against Borrower or any other Loan Party and any of the following events occur: (a) Borrower or such Loan Party, as the case may be, consents to the institution of the Insolvency Proceeding against it; (b) the petition commencing the Insolvency Proceeding is not timely controverted; (c) the petition commencing the Insolvency Proceeding is not dismissed within 60 calendar days of the date of the filing thereof; provided, however, that, during the pendency of such period, Agent, Foothill, and any other member of the Lender Group shall be relieved of its obligation to extend credit hereunder; (d) an interim trustee is appointed to take possession of all or a substantial portion of the properties or assets of, or to operate all or any substantial portion of the business of, Borrower or such Loan Party, as the case may be; or (e) an order for relief shall have been issued or entered therein; 8.7 If Borrower or any other Loan Party is enjoined, restrained, or in any way prevented by court order from continuing to conduct all or any material part of its business affairs; 8.8 If a notice of Lien, levy, or assessment is filed of record with respect to any of Borrower's or any other Loan Party's properties or assets by the United States Government, or any department, agency, or instrumentality thereof, or by any state, county, municipal, or governmental agency, or if any taxes or debts owing at any time hereafter to any one or more of such entities becomes a Lien, whether choate or otherwise, upon any of Borrower's or any other Loan Party's properties or assets and the same is not paid on the payment date thereof; 8.9 If a judgment, in excess of $100,000 individually or in the aggregate for all judgments, becomes a Lien or encumbrance upon any material portion of Borrower's or any other Loan Party's properties or assets and such Lien or encumbrance remains unpaid or the enforcement or execution thereof is not bonded against and stayed an amount and manner satisfactory to Agent; 8.10 If a claim (other than a judgment), in excess of $100,000 individually or in the aggregate for all claims (other than judgments), becomes a Lien or encumbrance (other than a Permitted Lien) upon any material portion of Borrower's or any other Loan Party's properties or assets and such Lien or encumbrance remains unpaid or the enforcement or execution thereof is not bonded against and stayed an amount and manner satisfactory to Agent; 8.12 If there is (a) a default by Borrower or any other Loan Party in any material agreement (including the Unsecured Notes or the Unsecured Notes Indenture) to which Borrower or any other Loan Party is a party with one or more third Persons and such default (i) occurs at the final maturity of the obligations thereunder, or (ii) results in a right by such third Person(s), irrespective of whether exercised, to accelerate the maturity of Borrower's or any other Loan Party's obligations thereunder, to terminate such agreement, or to refuse to renew such agreement pursuant to an automatic renewal right therein, or (b) any payment default under the Unsecured Notes or the Unsecured Notes Indenture; 8.12 If Borrower or any other Loan Party makes any payment on account of Indebtedness that has been contractually subordinated in right of payment to the payment of the Obligations, except to the extent such payment is permitted by the terms of the subordination provisions applicable to such Indebtedness; 8.13 If any material misstatement or misrepresentation exists now or hereafter in any warranty, representation, statement, or report made to the Lender Group by Borrower or any other Loan Party or any officer, employee, agent, or director of Borrower or any other Loan Party, or if any such warranty or representation is withdrawn; 8.14 If the obligation of any Guarantor under its Guaranty Agreement or under any Loan Document is limited or terminated by operation of law or by such Guarantor thereunder; 8.15 If this Agreement or any other Loan Document that purports to create a Lien, shall, for any reason, fail or cease to create a valid and perfected and, except to the extent permitted by the terms hereof or thereof, first priority Lien on or security interest in the Collateral covered hereby or thereby; or 8.16 Any provision of any Loan Document shall at any time for any reason be declared to be null and void, or the validity or enforceability thereof shall be contested by any Borrower or any other Loan Party, or a proceeding shall be commenced by Borrower or any other Loan Party, or by any Governmental Authority having jurisdiction over Borrower or any other Loan Party, seeking to establish the invalidity or unenforceability thereof, or Borrower or any other Loan Party shall deny that Borrower or any other Loan Party has any liability or obligation purported to be created under any Loan Document. 9. THE LENDER GROUP'S RIGHTS AND REMEDIES. 9.1 Rights and Remedies. Upon the occurrence, and during the continuation, of an Event of Default, the Required Lenders (at their election but without notice of their election and without demand) may, except to the extent otherwise expressly provided or required below, authorize and instruct Agent to do any one or more of the following on behalf of the Lender Group (and Agent, acting upon the instructions of the Required Lenders, shall do the same on behalf of the Lender Group), all of which are authorized by Borrower: (a) Declare all Obligations, whether evidenced by this Agreement, by any of the other Loan Documents, or otherwise, immediately due and payable; (b) Cease advancing money or extending credit to or for the benefit of Borrower under this Agreement, under any of the Loan Documents, or under any other agreement between Borrower and the Lender Group; (c) Terminate this Agreement and any of the other Loan Documents as to any future liability or obligation of the Lender Group, but without affecting Agent's rights and security interests, for the benefit of the Lender Group, in the Collateral and without affecting the Obligations; (d) Settle or adjust disputes and claims directly with Account Debtors for amounts and upon terms which Agent considers advisable, and in such cases, Agent will credit Borrower's Loan Account with only the net amounts received by Agent in payment of such disputed Accounts after deducting all Lender Group Expenses incurred or expended in connection therewith; (e) Cause Borrower to hold all returned Inventory in trust for the Lender Group, segregate all returned Inventory from all other property of Borrower or in Borrower's possession and conspicuously label said returned Inventory as the property of the Lender Group; (f) Without notice to or demand upon Borrower or any guarantor, make such payments and do such acts as Agent considers necessary or reasonable to protect its security interests in the Collateral. Borrower agrees to assemble the Personal Property Collateral if Agent so requires, and to make the Personal Property Collateral available to Agent as Agent may designate. Borrower authorizes Agent to enter the premises where the Personal Property Collateral is located, to take and maintain possession of the Personal Property Collateral, or any part of it, and to pay, purchase, contest, or compromise any encumbrance, charge, or Lien that in Agent's determination appears to conflict with the Agent's Liens and to pay all expenses incurred in connection therewith. With respect to any of Borrower's owned or leased premises, Borrower hereby grants Agent a license to enter into possession of such premises and to occupy the same, without charge, for up to 120 days in order to exercise any of the Lender Group's rights or remedies provided herein, at law, in equity, or otherwise; (g) Without notice to Borrower (such notice being expressly waived), and without constituting a retention of any collateral in satisfaction of an obligation (within the meaning of the Code), set off and apply to the Obligations any and all (i) balances and deposits of Borrower held by the Lender Group (including any amounts received in the Lockbox Accounts), or (ii) indebtedness at any time owing to or for the credit or the account of Borrower held by the Lender Group; (h) Hold, as cash collateral, any and all balances and deposits of Borrower held by the Lender Group, and any amounts received in the Lockbox Accounts, to secure the full and final repayment of all of the Obligations; (i) Ship, reclaim, recover, store, finish, maintain, repair, prepare for sale, advertise for sale, and sell (in the manner provided for herein) the Personal Property Collateral. Borrower hereby grants to Agent a license or other right to use, without charge, Borrower's labels, patents, copyrights, rights of use of any name, trade secrets, trade names, trademarks, service marks, and advertising matter, or any property of a similar nature, as it pertains to the Personal Property Collateral, in completing production of, advertising for sale, and selling any Personal Property Collateral and Borrower's rights under all licenses and all franchise agreements shall inure to the Lender Group's benefit; (j) Sell the Personal Property Collateral at either a public or private sale, or both, by way of one or more contracts or transactions, for cash or on terms, in such manner and at such places (including Borrower's premises) as Agent determines is commercially reasonable. It is not necessary that the Personal Property Collateral be present at any such sale; (k) Agent shall give notice of the disposition of the Personal Property Collateral as follows: (1) Agent shall give Borrower and each holder of a security interest in the Personal Property Collateral who has filed with Agent a written request for notice, a notice in writing of the time and place of public sale, or, if the sale is a private sale or some other disposition other than a public sale is to be made of the Personal Property Collateral, then the time on or after which the private sale or other disposition is to be made; (2) The notice shall be personally delivered or mailed, postage prepaid, to Borrower as provided in Section 12, at least 5 days before the date fixed for the sale, or at least 5 days before the date on or after which the private sale or other disposition is to be made; no notice needs to be given prior to the disposition of any portion of the Personal Property Collateral that is perishable or threatens to decline speedily in value or that is of a type customarily sold on a recognized market. Notice to Persons other than Borrower claiming an interest in the Personal Property Collateral shall be sent to such addresses as they have furnished to Agent; (3) If the sale is to be a public sale, Agent also shall give notice of the time and place by publishing a notice one time at least 5 days before the date of the sale in a newspaper of general circulation in the county in which the sale is to be held; (l) The Lender Group may credit bid and purchase at any public sale; (m) The Lender Group shall have all other rights and remedies available to it at law or in equity pursuant to any other Loan Documents; and (n) Any deficiency that exists after disposition of the Personal Property Collateral as provided above will be paid immediately by Borrower. Any excess will be returned, without interest and subject to the rights of third Persons, by Agent to Borrower. 9.2 Remedies Cumulative. The rights and remedies of the Lender Group under this Agreement, the other Loan Documents, and all other agreements shall be cumulative. The Lender Group shall have all other rights and remedies not inconsistent herewith as provided under the Code, by law, or in equity. No exercise by the Lender Group of one right or remedy shall be deemed an election, and no waiver by the Lender Group of any Event of Default shall be deemed a continuing waiver. No delay by the Lender Group shall constitute a waiver, election, or acquiescence by it. Nothing in this Agreement in any way limits, impairs or reduces any rights of the Lender Group under the Oil and Gas Property Mortgages or the Real Property Mortgages or any of the other Loan Documents. 10. TAXES AND EXPENSES. If Borrower fails to pay any monies (whether taxes, assessments, insurance premiums, or, in the case of leased properties or assets, rents or other amounts payable under such leases) due to third Persons, or fails to make any deposits or furnish any required proof of payment or deposit, all as required under the terms of this Agreement, then, to the extent that Agent determines that such failure by Borrower could result in a Material Adverse Change, in its discretion and without prior notice to Borrower, Agent may do any or all of the following: (a) make payment of the same or any part thereof; (b) set up such reserves in Borrower's Loan Account as Agent deems necessary to protect the Lender Group from the exposure created by such failure; or (c) obtain and maintain insurance policies of the type described in Section 6.10, and take any action with respect to such policies as Agent deems prudent. Any such amounts paid by Agent shall constitute Lender Group Expenses. Any such payments made by Agent shall not constitute an agreement by the Lender Group to make similar payments in the future or a waiver by the Lender Group of any Event of Default under this Agreement. Agent need not inquire as to, or contest the validity of, any such expense, tax, or Lien and the receipt of the usual official notice for the payment thereof shall be conclusive evidence that the same was validly due and owing. 11. WAIVERS; INDEMNIFICATION. 11.1 Demand; Protest; etc. Borrower waives demand, protest, notice of protest, notice of default or dishonor, notice of payment and nonpayment, nonpayment at maturity, release, compromise, settlement, extension, or renewal of accounts, documents, instruments, chattel paper, and guarantees at any time held by the Lender Group on which Borrower may in any way be liable. 11.2 The Lender Group's Liability for Collateral. Borrower hereby agrees that: (a) so long as the Lender Group complies with its obligations, if any, under Section 9207 of the Code, the Lender Group shall not in any way or manner be liable or responsible for: (i) the safekeeping of the Collateral; (ii) any loss or damage thereto occurring or arising in any manner or fashion from any cause; (iii) any diminution in the value thereof; or (iv) any act or default of any carrier, warehouseman, bailee, forwarding agency, or other Person; and (b) all risk of loss, damage, or destruction of the Collateral shall be borne by Borrower. 11.3 Indemnification. Borrower shall pay, indemnify, defend, and hold the Agent-Related Persons, the Lender-Related Persons with respect to each Lender, each Participant, and each of their respective officers, directors, employees, counsel, agents, and attorneys-in-fact (each, an "Indemnified Person") harmless (to the fullest extent permitted by law) from and against any and all claims, demands, suits, actions, investigations, proceedings, and damages, and all reasonable attorneys fees and disbursements and other costs and expenses actually incurred in connection therewith (as and when they are incurred and irrespective of whether suit is brought), at any time asserted against, imposed upon, or incurred by any of them in connection with or as a result of or related to the execution, delivery, enforcement, performance, and administration of this Agreement and any other Loan Documents or the transactions contemplated herein, and with respect to any investigation, litigation, or proceeding related to this Agreement, any other Loan Document, or the use of the proceeds of the credit provided hereunder (irrespective of whether any Indemnified Person is a party thereto), or any act, omission, event or circumstance in any manner related thereto (all the foregoing, collectively, the "Indemnified Liabilities"). Borrower shall have no obligation to any Indemnified Person under this Section 11.3 with respect to any Indemnified Liability that a court of competent jurisdiction finally determines to have resulted from the gross negligence or willful misconduct of such Indemnified Person. This provision shall survive the termination of this Agreement and the repayment of the other Obligations. 12. NOTICES. Unless otherwise provided in this Agreement, all notices or demands by any party relating to this Agreement or any other Loan Document shall be in writing and (except for financial statements and other informational documents which may be sent by first-class mail, postage prepaid) shall be personally delivered or sent by registered or certified mail (postage prepaid, return receipt requested), overnight courier, or telefacsimile to the relevant party at its address set forth below: If to Borrower: Southwest Royalties, Inc. 407 North Big Spring Street, Suite 300 Midland, Texas 79701 Attn: President Fax No. 915.688.0191 with copies to: Baker, Donelson, Bearman & Caldwell, P.C. 1800 Republic Centre 635 Chestnut Street Chattanooga, Tennessee 37450 Attn: J. Porter Durham, Esq. Fax No. 425.756.3447 If to Agent or the Lender Group in care of Agent: FOOTHILL CAPITAL CORPORATION 2450 Colorado Avenue, Suite 3000 West Santa Monica, California 90404 Attn: Business Finance Division Manager Fax No. 310.453.7413 with copies to: Patton Boggs LLP 2001 Ross Avenue, Suite 3000 Dallas, Texas 75201 Attn: James C. Chadwick, Esq. Fax No. 214.758.1550 The parties hereto may change the address at which they are to receive notices hereunder, by notice in writing in the foregoing manner given to all other parties. All notices or demands sent in accordance with this Section 12, other than notices by the Lender Group in connection with Sections 9504 or 9505 of the Code, shall be deemed received on the earlier of the date of actual receipt or 3 days after the deposit thereof in the mail. Borrower acknowledges and agrees that notices sent by the Lender Group in connection with Sections 9504 or 9505 of the Code shall be deemed sent when deposited in the mail or personally delivered, or, where permitted by law, transmitted telefacsimile or other similar method set forth above. 13. CHOICE OF LAW AND VENUE; SERVICE OF PROCESS; JURY TRIAL WAIVER. THE VALIDITY OF THIS AGREEMENT AND THE OTHER LOAN DOCUMENTS (UNLESS EXPRESSLY PROVIDED TO THE CONTRARY IN ANOTHER LOAN DOCUMENT IN RESPECT OF SUCH OTHER LOAN DOCUMENT), THE CONSTRUCTION, INTERPRETATION, AND ENFORCEMENT HEREOF AND THEREOF, AND THE RIGHTS OF THE PARTIES HERETO AND THERETO WITH RESPECT TO ALL MATTERS ARISING HEREUNDER OR THEREUNDER OR RELATED HERETO OR THERETO SHALL BE DETERMINED UNDER, GOVERNED BY, AND CONSTRUED IN ACCORDANCE WITH THE LAWS OF THE STATE OF CALIFORNIA. THE PARTIES AGREE THAT ALL ACTIONS OR PROCEEDINGS ARISING IN CONNECTION WITH THIS AGREEMENT AND THE OTHER LOAN DOCUMENTS SHALL BE TRIED AND LITIGATED ONLY IN THE STATE AND FEDERAL COURTS LOCATED IN THE COUNTY OF LOS ANGELES, STATE OF CALIFORNIA, PROVIDED, HOWEVER, THAT ANY SUIT SEEKING ENFORCEMENT AGAINST ANY COLLATERAL OR OTHER PROPERTY MAY BE BROUGHT, AT AGENT'S OPTION, IN THE COURTS OF ANY JURISDICTION WHERE AGENT ELECTS TO BRING SUCH ACTION OR WHERE SUCH COLLATERAL OR OTHER PROPERTY MAY BE FOUND. BORROWER AND THE LENDER GROUP WAIVE, TO THE EXTENT PERMITTED UNDER APPLICABLE LAW, ANY RIGHT EACH MAY HAVE TO ASSERT THE DOCTRINE OF FORUM NON CONVENIENS OR TO OBJECT TO VENUE TO THE EXTENT ANY PROCEEDING IS BROUGHT IN ACCORDANCE WITH THIS SECTION 13. BORROWER HEREBY IRREVOCABLY DESIGNATES CT CORPORATION SYSTEM WITH OFFICES AT 818 WEST SEVENTH STREET, LOS ANGELES, CALIFORNIA, 90017 AS THE DESIGNEE, APPOINTEE AND AGENT OF BORROWER TO RECEIVE, FOR AND ON BEHALF OF BORROWER, SERVICE OF PROCESS IN SUCH RESPECTIVE JURISDICTIONS IN ANY LEGAL ACTION OR PROCEEDING WITH RESPECT TO THE LOAN DOCUMENTS. IT IS UNDERSTOOD THAT SUCH PROCESS SERVED ON SUCH AGENT WILL BE PROMPTLY FORWARDED BY OVERNIGHT COURIER TO BORROWER AT ITS ADDRESS SET FORTH IN THE PREAMBLE TO THIS AGREEMENT, BUT THE FAILURE OF BORROWER TO RECEIVE SUCH COPY SHALL NOT AFFECT IN ANY WAY THE SERVICE OF SUCH PROCESS. IN THE EVENT THAT CT CORPORATION SYSTEM RESIGNS OR CEASES TO SERVE AS THE BORROWER'S AGENT FOR SERVICE OF PROCESS HEREUNDER, BORROWER AGREES FORTHWITH (i) TO DESIGNATE ANOTHER AGENT FOR SERVICE OF PROCESS IN LOS ANGELES, CALIFORNIA; AND (ii) TO GIVE PROMPT WRITTEN NOTICE TO THE LENDER GROUP OF THE NAME AND ADDRESS OF SUCH AGENT. BORROWER FURTHER IRREVOCABLY CONSENTS TO THE SERVICE OF PROCESS OF ANY OF THE AFOREMENTIONED COURTS IN ANY SUCH ACTION OR PROCEEDING BY THE MAILING OF COPIES THEREOF BY REGISTERED OR CERTIFIED MAIL, POSTAGE REPAID, TO BORROWER AT ITS SAID ADDRESS, SUCH SERVICE TO BECOME EFFECTIVE THIRTY (30) DAYS AFTER SUCH MAILING. BORROWER AND THE LENDER GROUP HEREBY WAIVE THEIR RESPECTIVE RIGHTS TO A JURY TRIAL OF ANY CLAIM OR CAUSE OF ACTION BASED UPON OR ARISING OUT OF ANY OF THE LOAN DOCUMENTS OR ANY OF THE TRANSACTIONS CONTEMPLATED THEREIN, INCLUDING CONTRACT CLAIMS, TORT CLAIMS, BREACH OF DUTY CLAIMS, AND ALL OTHER COMMON LAW OR STATUTORY CLAIMS. BORROWER AND THE LENDER GROUP REPRESENT THAT EACH HAS REVIEWED THIS WAIVER AND EACH KNOWINGLY AND VOLUNTARILY WAIVES ITS JURY TRIAL RIGHTS FOLLOWING CONSULTATION WITH LEGAL COUNSEL. IN THE EVENT OF LITIGATION, A COPY OF THIS AGREEMENT MAY BE FILED AS A WRITTEN CONSENT TO A TRIAL BY THE COURT. 14. DESTRUCTION OF BORROWER'S DOCUMENTS. All documents, schedules, invoices, agings, or other papers delivered to any one or more members of the Lender Group may be destroyed or otherwise disposed of by such member of the Lender Group 4 months after they are delivered to or received by such member of the Lender Group, unless Borrower requests, in writing, the return of said documents, schedules, or other papers and makes arrangements, at Borrower's expense, for their return. 15. ASSIGNMENTS AND PARTICIPATIONS; SUCCESSORS. 15.1 Assignments and Participations. (a) Any Lender may, with the written consent of Agent, assign and delegate to one or more assignees (provided that no written consent of Agent shall be required in connection with any assignment and delegation by a Lender to an Eligible Transferee) (each an "Assignee") all, or any ratable part of all, of the Obligations, the Commitments and the other rights and obligations of such Lender hereunder and under the other Loan Documents, in a minimum amount of $5,000,000 (except that such minimum amount shall not apply in connection with any assignment and delegation by a Lender (x) to any Affiliate (other than individuals) of, or any fund, money market account, investment account or other account managed by, a pre-existing Lender under this Agreement or (y) of the entire Obligations, Commitments and other rights and obligations of such Lender hereunder and under the other Loan Documents); provided, however, that Borrower and Agent may continue to deal solely and directly with such Lender in connection with the interest so assigned to an Assignee until (i) written notice of such assignment, together with payment instructions, addresses and related information with respect to the Assignee, shall have been given to Borrower and Agent by such Lender and the Assignee; (ii) such Lender and its Assignee shall have delivered to Borrower and Agent an Assignment and Acceptance ("Assignment and Acceptance") in form and substance satisfactory to Agent; and (iii) the assignor Lender or Assignee has paid to Agent for Agent's sole and separate account a processing fee in the amount of $5,000. Anything contained herein to the contrary notwithstanding, the consent of Agent shall not be required (and payment of any fees shall not be required) if such assignment is in connection with any merger, consolidation, sale, transfer, or other disposition of all or any substantial portion of the business or loan portfolio of such Lender. (b) From and after the date that Agent notifies the assignor Lender that it has received an executed Assignment and Acceptance and payment of the above-referenced processing fee, (i) the Assignee thereunder shall be a party hereto and, to the extent that rights and obligations hereunder have been assigned to it pursuant to such Assignment and Acceptance, shall have the rights and obligations of a Lender under the Loan Documents, and (ii) the assignor Lender shall, to the extent that rights and obligations hereunder and under the other Loan Documents have been assigned by it pursuant to such Assignment and Acceptance, relinquish its rights (except with respect to Section 11.3 hereof) and be released from its obligations under this Agreement (and in the case of an Assignment and Acceptance covering all or the remaining portion of an assigning Lender's rights and obligations under this Agreement and the other Loan Documents, such Lender shall cease to be a party hereto and thereto), and such assignment shall effect a novation between Borrower and the Assignee. (c) By executing and delivering an Assignment and Acceptance, the assigning Lender thereunder and the Assignee thereunder confirm to and agree with each other and the other parties hereto as follows: (1) other than as provided in such Assignment and Acceptance, such assigning Lender makes no representation or warranty and assumes no responsibility with respect to any statements, warranties or representations made in or in connection with this Agreement or the execution, legality, validity, enforceability, genuineness, sufficiency or value of this Agreement or any other Loan Document furnished pursuant hereto; (2) such assigning Lender makes no representation or warranty and assumes no responsibility with respect to the financial condition of Borrower or the performance or observance by Borrower of any of its obligations under this Agreement or any other Loan Document furnished pursuant hereto; (3) such Assignee confirms that it has received a copy of this Agreement, together with such other documents and information as it has deemed appropriate to make its own credit analysis and decision to enter into such Assignment and Acceptance; (4) such Assignee will, independently and without reliance upon Agent, such assigning Lender or any other Lender, and based on such documents and information as it shall deem appropriate at the time, continue to make its own credit decisions in taking or not taking action under this Agreement; (5) such Assignee appoints and authorizes Agent to take such action as agent on its behalf and to exercise such powers under this Agreement as are delegated to Agent by the terms hereof, together with such powers as are reasonably incidental thereto; and (6) such Assignee agrees that it will perform in accordance with their terms all of the obligations which by the terms of this Agreement are required to be performed by it as a Lender. (d) Immediately upon each Assignee's making its processing fee payment under the Assignment and Acceptance, this Agreement shall be deemed to be amended to the extent, but only to the extent, necessary to reflect the addition of the Assignee and the resulting adjustment of the Commitments arising therefrom. The Commitment allocated to each Assignee shall reduce such Commitments of the assigning Lender pro tanto. (e) Any Lender may at any time, with the written consent of Agent, sell to one or more commercial banks, financial institutions, or other Persons not Affiliates of such Lender (a "Participant") participating interests in the Obligations, the Commitment, and the other rights and interests of that Lender (the "originating Lender") hereunder and under the other Loan Documents (provided that no written consent of Agent shall be required in connection with any sale of any such participating interests by a Lender to an Eligible Transferee); provided, however, that (i) the originating Lender's obligations under this Agreement shall remain unchanged, (ii) the originating Lender shall remain solely responsible for the performance of such obligations, (iii) Borrower and Agent shall continue to deal solely and directly with the originating Lender in connection with the originating Lender's rights and obligations under this Agreement and the other Loan Documents, (iv) no Lender shall transfer or grant any participating interest under which the Participant has the sole and exclusive right to approve any amendment to, or any consent or waiver with respect to, this Agreement or any other Loan Document, except to the extent such amendment to, or consent or waiver with respect to this Agreement or of any other Loan Document would (A) extend the final maturity date of the Obligations hereunder in which such Participant is participating; (B) reduce the interest rate applicable to the Obligations hereunder in which such Participant is participating; (C) release all or a material portion of the Collateral or guaranties (except to the extent expressly provided herein or in any of the Loan Documents) supporting the Obligations hereunder in which such Participant is participating; (D) postpone the payment of, or reduce the amount of, the interest or fees payable to such Participant through such Lender; or (E) change the amount or due dates of scheduled principal repayments or prepayments or premiums; and (v) all amounts payable by Borrower hereunder shall be determined as if such Lender had not sold such participation; except that, if amounts outstanding under this Agreement are due and unpaid, or shall have been declared or shall have become due and payable upon the occurrence of an Event of Default, each Participant shall be deemed to have the right of set-off in respect of its participating interest in amounts owing under this Agreement to the same extent as if the amount of its participating interest were owing directly to it as a Lender under this Agreement. The rights of any Participant only shall be derivative through the originating Lender with whom such Participant participates and no Participant shall have any direct rights as to the other Lenders, Agent, Borrower, the Collections, the Collateral, or otherwise in respect of the Obligations. No Participant shall have the right to participate directly in the making of decisions by the Lenders among themselves. (f) In connection with any such assignment or participation or proposed assignment or participation, a Lender may disclose all documents and information which it now or hereafter may have relating to Borrower or Borrower's business. (g) Any other provision in this Agreement notwithstanding, any Lender may at any time create a security interest in, or pledge, all or any portion of its rights under and interest in this Agreement in favor of any Federal Reserve Bank in accordance with Regulation A of the Federal Reserve Bank or U.S. Treasury Regulation 31 CFR 203.14, and such Federal Reserve Bank may enforce such pledge or security interest in any manner permitted under applicable law. 15.2 Successors. This Agreement shall bind and inure to the benefit of the respective successors and assigns of each of the parties; provided, however, that Borrower may not assign this Agreement or any rights or duties hereunder without the Lenders' prior written consent and any prohibited assignment shall be absolutely void ab initio. No consent to assignment by the Lenders shall release Borrower from its Obligations. A Lender may assign this Agreement and the other Loan Documents and its rights and duties hereunder and thereunder pursuant to Section 15.1 hereof and, except as expressly required pursuant to Section 15.1 hereof, no consent or approval by Borrower is required in connection with any such assignment. 16. AMENDMENTS; WAIVERS 16.1 Amendments and Waivers. No amendment or waiver of any provision of this Agreement or any other Loan Document, and no consent with respect to any departure by Borrower therefrom, shall be effective unless the same shall be in writing and signed by the Required Lenders (or by Agent at the written request of the Required Lenders) and Borrower and then any such waiver or consent shall be effective only in the specific instance and for the specific purpose for which given; provided, however, that no such waiver, amendment, or consent shall, unless in writing and signed by all the Lenders and Borrower and acknowledged by Agent, do any of the following: (a) increase or extend the Commitment of any Lender; (b) postpone or delay any date fixed by this Agreement or any other Loan Document for any payment of principal, interest, fees or other amounts due to the Lenders (or any of them) hereunder or under any other Loan Document; (c) reduce the principal of, or the rate of interest specified herein on any Loan, or any fees or other amounts payable hereunder or under any other Loan Document; (d) change the percentage of the Commitments or Obligations, as the case may be, that is required for the Lenders or any of them to take any action hereunder; (f) amend this Section or any provision of the Agreement providing for consent or other action by all Lenders; (g) release Collateral other than as permitted by Section 17.11; (h) change the definition of "Required Lenders"; (i) release Borrower or Guarantor from any Obligation for the payment of money; or (j) amend any of the provisions of Article 17. and, provided further, however, that no amendment, waiver or consent shall, unless in writing and signed by Agent, affect the rights or duties of Agent under this Agreement or any other Loan Document; and, provided further, however, that no amendment, waiver or consent shall, unless in writing and signed by Foothill in its individual capacity as a Lender, affect the specific rights or duties of Foothill in its individual capacity as a Lender (as contrasted with rights or duties of Foothill as a member of the Lender Group) under this Agreement or any other Loan Document. The foregoing notwithstanding, any amendment, modification, waiver, consent, termination, or release of or with respect to any provision of this Agreement or any other Loan Document that relates only to the relationship of the Lender Group among themselves, and that does not affect the rights or obligations of Borrower, shall not require consent by or the agreement of Borrower. 16.2 No Waivers; Cumulative Remedies. No failure by Agent or any Lender to exercise any right, remedy, or option under this Agreement, any other Loan Document, or any present or future supplement hereto or thereto, or in any other agreement between or among Borrower and Agent or any Lender, or delay by Agent or any Lender in exercising the same, will operate as a waiver thereof. No waiver by Agent or any Lender will be effective unless it is in writing, and then only to the extent specifically stated. No waiver by Agent or the Lenders on any occasion shall affect or diminish Agent's and each Lender's rights thereafter to require strict performance by Borrower of any provision of this Agreement. Agent's and each Lender's rights under this Agreement and the other Loan Documents will be cumulative and not exclusive of any other right or remedy which Agent or any Lender may have. 17. AGENT; THE LENDER GROUP. 17.1 Appointment and Authorization of Agent. Each Lender hereby designates and appoints Foothill as its agent under this Agreement and the other Loan Documents and each Lender hereby irrevocably authorizes Agent to take such action on its behalf under the provisions of this Agreement and each other Loan Document and to exercise such powers and perform such duties as are expressly delegated to it by the terms of this Agreement or any other Loan Document, together with such powers as are reasonably incidental thereto. Agent agrees to act as such on the express conditions contained in this Article 17. The provisions of this Article 17 are solely for the benefit of Agent and the Lenders, and Borrower shall have no rights as a third party beneficiary of any of the provisions contained herein; provided, however, that certain of the provisions of Section 17.10 hereof also shall be for the benefit of Borrower. Any provision to the contrary contained elsewhere in this Agreement or in any other Loan Document notwithstanding, Agent shall not have any duties or responsibilities, except those expressly set forth herein, nor shall Agent have or be deemed to have any fiduciary relationship with any Lender, and no implied covenants, functions, responsibilities, duties, obligations or liabilities shall be read into this Agreement or any other Loan Document or otherwise exist against Agent; it being expressly understood and agreed that the use of the word "Agent" is for convenience only, that Foothill is merely the representative of the Lenders, and has only the contractual duties set forth herein. Except as expressly otherwise provided in this Agreement, Agent shall have and may use its sole discretion with respect to exercising or refraining from exercising any discretionary rights or taking or refraining from taking any actions which Agent is expressly entitled to take or assert under or pursuant to this Agreement and the other Loan Documents. Without limiting the generality of the foregoing, or of any other provision of the Loan Documents that provides rights or powers to Agent, Lenders agree that Agent shall have the right to exercise the following powers as long as this Agreement remains in effect: (a) maintain, in accordance with its customary business practices, ledgers and records reflecting the status of the Advances, the Collateral, the Collections, and related matters; (b) execute or file any and all financing or similar statements or notices, amendments, renewals, supplements, documents, instruments, proofs of claim, notices and other written agreements with respect to the Loan Documents; (c) make Advances for itself or on behalf of Lenders as provided in the Loan Documents; (d) exclusively receive, apply, and distribute the Collections as provided in the Loan Documents; (e) open and maintain such bank accounts and lock boxes as Agent deems necessary and appropriate in accordance with the Loan Documents for the foregoing purposes with respect to the Collateral and the Collections; (f) perform, exercise, and enforce any and all other rights and remedies of the Lender Group with respect to Borrower, the Obligations, the Collateral, the Collections, or otherwise related to any of same as provided in the Loan Documents; and (g) incur and pay such Lender Group Expenses as Agent may deem necessary or appropriate for the performance and fulfillment of its functions and powers pursuant to the Loan Documents. 17.2 Delegation of Duties. Except as otherwise provided in this section, Agent may execute any of its duties under this Agreement or any other Loan Document by or through agents, employees or attorneys-in-fact and shall be entitled to advice of counsel concerning all matters pertaining to such duties. Agent shall not be responsible for the negligence or misconduct of any agent or attorney-in-fact that it selects as long as such selection was made in compliance with this section and without gross negligence or willful misconduct. 17.3 Liability of Agent. None of the Agent-Related Persons shall (i) be liable for any action taken or omitted to be taken by any of them under or in connection with this Agreement or any other Loan Document or the transactions contemplated hereby (except for its own gross negligence or willful misconduct), or (ii) be responsible in any manner to any of the Lenders for any recital, statement, representation or warranty made by Borrower or any Subsidiary or Affiliate of Borrower, or any officer or director thereof, contained in this Agreement or in any other Loan Document, or in any certificate, report, statement or other document referred to or provided for in, or received by Agent under or in connection with, this Agreement or any other Loan Document, or the validity, effectiveness, genuineness, enforceability or sufficiency of this Agreement or any other Loan Document, or for any failure of Borrower or any other party to any Loan Document to perform its obligations hereunder or thereunder. No Agent-Related Person shall be under any obligation to any Lender to ascertain or to inquire as to the observance or performance of any of the agreements contained in, or conditions of, this Agreement or any other Loan Document, or to inspect the properties, books or records of Borrower or any of Borrower's Subsidiaries or Affiliates. 17.4 Reliance by Agent. Agent shall be entitled to rely, and shall be fully protected in relying, upon any writing, resolution, notice, consent, certificate, affidavit, letter, telegraph, facsimile, telex or telephone message, statement or other document or conversation believed by it to be genuine and correct and to have been signed, sent, or made by the proper Person or Persons, and upon advice and statements of legal counsel (including counsel to Borrower or counsel to any Lender), independent accountants and other experts selected by Agent. Agent shall be fully justified in failing or refusing to take any action under this Agreement or any other Loan Document unless it shall first receive such advice or concurrence of the Lenders as it deems appropriate and until such instructions are received, Agent shall act, or refrain from acting, as it deems advisable. If Agent so requests, it shall first be indemnified to its reasonable satisfaction by Lenders against any and all liability and expense that may be incurred by it by reason of taking or continuing to take any such action. Agent shall in all cases be fully protected in acting, or in refraining from acting, under this Agreement or any other Loan Document in accordance with a request or consent of the Lenders and such request and any action taken or failure to act pursuant thereto shall be binding upon all of the Lenders. 17.5 Notice of Default or Event of Default. Agent shall not be deemed to have knowledge or notice of the occurrence of any Default or Event of Default, except with respect to defaults in the payment of principal, interest, fees, and expenses required to be paid to Agent for the account of the Lenders, except with respect to Events of Default of which Agent has actual knowledge, unless Agent shall have received written notice from a Lender or Borrower referring to this Agreement, describing such Default or Event of Default, and stating that such notice is a "notice of default." Agent promptly will notify the Lenders of its receipt of any such notice or of any Event of Default of which Agent has actual knowledge. If any Lender obtains actual knowledge of any Event of Default, such Lender promptly shall notify the other Lenders and Agent of such Event of Default. Each Lender shall be solely responsible for giving any notices to its Participants, if any. Subject to Section 17.4, Agent shall take such action with respect to such Default or Event of Default as may be requested by the Required Lenders in accordance with Section 9; provided, however, that unless and until Agent has received any such request, Agent may (but shall not be obligated to) take such action, or refrain from taking such action, with respect to such Default or Event of Default as it shall deem advisable. 17.6 Credit Decision. Each Lender acknowledges that none of the Agent-Related Persons has made any representation or warranty to it, and that no act by Agent hereinafter taken, including any review of the affairs of Borrower and its Subsidiaries or Affiliates, shall be deemed to constitute any representation or warranty by any Agent-Related Person to any Lender. Each Lender represents to Agent that it has, independently and without reliance upon any Agent-Related Person and based on such documents and information as it has deemed appropriate, made its own appraisal of and investigation into the business, prospects, operations, property, financial and other condition and creditworthiness of Borrower and any other Person (other than the Lender Group) party to a Loan Document, and all applicable bank regulatory laws relating to the transactions contemplated hereby, and made its own decision to enter into this Agreement and to extend credit to Borrower. Each Lender also represents that it will, independently and without reliance upon any Agent-Related Person and based on such documents and information as it shall deem appropriate at the time, continue to make its own credit analysis, appraisals and decisions in taking or not taking action under this Agreement and the other Loan Documents, and to make such investigations as it deems necessary to inform itself as to the business, prospects, operations, property, financial and other condition and creditworthiness of Borrower and any other Person (other than the Lender Group) party to a Loan Document. Except for notices, reports and other documents expressly herein required to be furnished to the Lenders by Agent, Agent shall not have any duty or responsibility to provide any Lender with any credit or other information concerning the business, prospects, operations, property, financial and other condition or creditworthiness of Borrower and any other Person party to a Loan Document that may come into the possession of any of the Agent-Related Persons. 17.7 Costs and Expenses; Indemnification. Agent may incur and pay Lender Group Expenses to the extent Agent deems reasonably necessary or appropriate for the performance and fulfillment of its functions, powers, and obligations pursuant to the Loan Documents, including without limiting the generality of the foregoing, court costs, reasonable attorneys fees and expenses, costs of collection by outside collection agencies and auctioneer fees and costs of security guards or insurance premiums paid to maintain the Collateral, whether or not Borrower is obligated to reimburse Agent or Lenders for such expenses pursuant to the Loan Agreement or otherwise. Agent is authorized and directed to deduct and retain sufficient amounts from Collections to reimburse Agent for such out-of-pocket costs and expenses prior to the distribution of any amounts to Lenders. In the event Agent is not reimbursed for such costs and expenses from Collections, each Lender hereby agrees that it is and shall be obligated to pay to or reimburse Agent for the amount of such Lender's Pro Rata Share thereof. Whether or not the transactions contemplated hereby are consummated, the Lenders shall indemnify upon demand the Agent-Related Persons (to the extent not reimbursed by or on behalf of Borrower and without limiting the obligation of Borrower to do so), according to their Pro Rata Shares, from and against any and all Indemnified Liabilities; provided, however, that no Lender shall be liable for the payment to the Agent-Related Persons of any portion of such Indemnified Liabilities resulting solely from such Person's gross negligence or willful misconduct. Without limitation of the foregoing, each Lender shall reimburse Agent upon demand for its ratable share of any costs or out-of-pocket expenses (including attorneys fees and expenses) incurred by Agent in connection with the preparation, execution, delivery, administration, modification, amendment or enforcement (whether through negotiations, legal proceedings or otherwise) of, or legal advice in respect of rights or responsibilities under, this Agreement, any other Loan Document, or any document contemplated by or referred to herein, to the extent that Agent is not reimbursed for such expenses by or on behalf of Borrower. The undertaking in this section shall survive the payment of all Obligations hereunder and the resignation or replacement of Agent. 17.8 Agent in Individual Capacity. Foothill and its Affiliates may make loans to, issue letters of credit for the account of, accept deposits from, acquire equity interests in and generally engage in any kind of banking, trust, financial advisory, underwriting or other business with Borrower and its Subsidiaries and Affiliates and any other Person (other than the Lender Group) party to any Loan Documents as though Foothill were not Agent hereunder and without notice to or consent of the Lenders. The Lenders acknowledge that, pursuant to such activities, Foothill or its Affiliates may receive information regarding Borrower or its Affiliates and any other Person (other than the Lender Group) party to any Loan Documents that is subject to confidentiality obligations in favor of Borrower or such other Person and that prohibit the disclosure of such information to the Lenders, and the Lenders acknowledge that, in such circumstances (and in the absence of a waiver of such confidentiality obligations, which waiver Agent will use its reasonable best efforts to obtain), Agent shall be under no obligation to provide such information to them. With respect to the Foothill Loans and Agent Advances, Foothill shall have the same rights and powers under this Agreement as any other Lender and may exercise the same as though it were not Agent, and the terms "Lender" and "Lenders" include Foothill in its individual capacity. 17.9 Successor Agent. Agent may resign as Agent upon 45 days notice to the Lenders. If Agent resigns under this Agreement, the Required Lenders shall appoint a successor Agent for the Lenders. If no successor Agent is appointed prior to the effective date of the resignation of Agent, Agent shall appoint, after consulting with the Lenders, a successor Agent and such appointed successor Agent shall be deemed acceptable to the Lenders. If Agent has materially breached or failed to perform any material provision of this Agreement or of applicable law, the Required Lenders may agree in writing to remove and replace Agent with a successor Agent from among the Lenders. In any such event, upon the acceptance of its appointment as successor Agent hereunder, such successor Agent shall succeed to all the rights, powers and duties of the retiring Agent and the term "Agent" shall mean such successor Agent and the retiring Agent's appointment, powers and duties as Agent shall be terminated. After any retiring Agent's resignation hereunder as Agent, the provisions of this Section 17 shall inure to its benefit as to any actions taken or omitted to be taken by it while it was Agent under this Agreement. If no successor Agent has accepted appointment as Agent by the date which is 45 days following a retiring Agent's notice of resignation, the retiring Agent's resignation shall nevertheless thereupon become effective and the Lenders shall perform all of the duties of Agent hereunder until such time, if any, as the Lenders appoint a successor Agent as provided for above. 17.10 Withholding Tax. (a) If any Lender is a "foreign corporation, partnership or trust" within the meaning of the IRC and such Lender claims exemption from, or a reduction of, U.S. withholding tax under Sections 1441 or 1442 of the IRC, such Lender agrees with and in favor of Agent and Borrower, to deliver to Agent and Borrower: (i) if such Lender claims an exemption from, or a reduction of, withholding tax under a United States tax treaty, properly completed IRS Forms 1001 and W-8 before the payment of any interest in the first calendar year and before the payment of any interest in each third succeeding calendar year during which interest may be paid under this Agreement; (ii) if such Lender claims that interest paid under this Agreement is exempt from United States withholding tax because it is effectively connected with a United States trade or business of such Lender, two properly completed and executed copies of IRS Form 4224 before the payment of any interest is due in the first taxable year of such Lender and in each succeeding taxable year of such Lender during which interest may be paid under this Agreement, and IRS Form W-9; and (iii) such other form or forms as may be required under the IRC or other laws of the United States as a condition to exemption from, or reduction of, United States withholding tax. Such Lender agrees promptly to notify Agent and Borrower of any change in circumstances which would modify or render invalid any claimed exemption or reduction. (b) If any Lender claims exemption from, or reduction of, withholding tax under a United States tax treaty by providing IRS Form 1001 and such Lender sells, assigns, grants a participation in, or otherwise transfers all or part of the Obligations of Borrower to such Lender, such Lender agrees to notify Agent of the percentage amount in which it is no longer the beneficial owner of Obligations of Borrower to such Lender. To the extent of such percentage amount, Agent will treat such Lender's IRS Form 1001 as no longer valid. (c) If any Lender claiming exemption from United States withholding tax by filing IRS Form 4224 with Agent sells, assigns, grants a participation in, or otherwise transfers all or part of the Obligations of Borrower to such Lender, such Lender agrees to undertake sole responsibility for complying with the withholding tax requirements imposed by Sections 1441 and 1442 of the IRC. (d) If any Lender is entitled to a reduction in the applicable withholding tax, Agent may withhold from any interest payment to such Lender an amount equivalent to the applicable withholding tax after taking into account such reduction. If the forms or other documentation required by subsection (a) of this Section are not delivered to Agent, then Agent may withhold from any interest payment to such Lender not providing such forms or other documentation an amount equivalent to the applicable withholding tax. (e) If the IRS or any other Governmental Authority of the United States or other jurisdiction asserts a claim that Agent did not properly withhold tax from amounts paid to or for the account of any Lender (because the appropriate form was not delivered, was not properly executed, or because such Lender failed to notify Agent of a change in circumstances which rendered the exemption from, or reduction of, withholding tax ineffective, or for any other reason) such Lender shall indemnify Agent fully for all amounts paid, directly or indirectly, by Agent as tax or otherwise, including penalties and interest, and including any taxes imposed by any jurisdiction on the amounts payable to Agent under this Section, together with all costs and expenses (including attorneys fees and expenses). The obligation of the Lenders under this subsection shall survive the payment of all Obligations and the resignation or replacement of Agent. 17.11 Collateral Matters. (a) The Lenders hereby irrevocably authorize Agent, at its option and in its sole discretion, to release any Lien on any Collateral (i) upon the termination of the Commitments and payment and satisfaction in full by Borrower of all Obligations; (ii) constituting property being sold or disposed of if a release is required or desirable in connection therewith and if Borrower certifies to Agent that the sale or disposition is permitted under Section 7.4 of this Agreement or the other Loan Documents (and Agent may rely conclusively on any such certificate, without further inquiry); (iii) constituting property in which Borrower owned no interest at the time the security interest was granted or at any time thereafter; or (iv) constituting property leased to Borrower under a lease that has expired or is terminated in a transaction permitted under this Agreement. Except as provided above, Agent will not execute and deliver a release of any Lien on any Collateral without the prior written authorization of (y) if the release is of all or substantially all of the Collateral, of all of the Lenders, or (z) otherwise, all of the Lenders. Upon request by Agent or Borrower at any time, the Lenders will confirm in writing Agent's authority to release any such Liens on particular types or items of Collateral pursuant to this Section 17.11; provided, however, that (1) Agent shall not be required to execute any document necessary to evidence such release on terms that, in Agent's opinion, would expose Agent to liability or create any obligation or entail any consequence other than the release of such Lien without recourse, representation, or warranty, and (2) such release shall not in any manner discharge, affect, or impair the Obligations or any Liens (other than those expressly being released) upon (or obligations of Borrower in respect of) all interests retained by Borrower, including, the proceeds of any sale, all of which shall continue to constitute part of the Collateral. (c) Agent shall have no obligation whatsoever to any of the Lenders to assure that the Collateral exists or is owned by Borrower or is cared for, protected, or insured or has been encumbered, or that the Agent's Liens have been properly or sufficiently or lawfully created, perfected, protected, or enforced or are entitled to any particular priority, or to exercise at all or in any particular manner or under any duty of care, disclosure or fidelity, or to continue exercising, any of the rights, authorities and powers granted or available to Agent pursuant to any of the Loan Documents, it being understood and agreed that in respect of the Collateral, or any act, omission or event related thereto, subject to the terms and conditions contained herein, Agent may act in any manner it may deem appropriate, in its sole discretion given Agent's own interest in the Collateral in its capacity as one of the Lenders and that Agent shall have no other duty or liability whatsoever to any Lender as to any of the foregoing, except as otherwise provided herein. 17.12 Restrictions on Actions by Lenders; Sharing of Payments. (a) Each of the Lenders agrees that it shall not, without the express consent of Agent, and that it shall, to the extent it is lawfully entitled to do so, upon the request of Agent, set off against the Obligations, any amounts owing by such Lender to Borrower or any accounts of Borrower now or hereafter maintained with such Lender. Each of the Lenders further agrees that it shall not, unless specifically requested to do so by Agent, take or cause to be taken any action, including, the commencement of any legal or equitable proceedings, to foreclose any Lien on, or otherwise enforce any security interest in, any of the Collateral the purpose of which is, or could be, to give such Lender any preference or priority against the other Lenders with respect to the Collateral. (b) Subject to Section 17.8, if, at any time or times any Lender shall receive (i) by payment, foreclosure, setoff or otherwise, any proceeds of Collateral or any payments with respect to the Obligations arising under, or relating to, this Agreement or the other Loan Documents, except for any such proceeds or payments received by such Lender from Agent pursuant to the terms of this Agreement, or (ii) payments from Agent in excess of such Lender's ratable portion of all such distributions by Agent, such Lender promptly shall (1) turn the same over to Agent, in kind, and with such endorsements as may be required to negotiate the same to Agent, or in same day funds, as applicable, for the account of all of the Lenders and for application to the Obligations in accordance with the applicable provisions of this Agreement, or (2) purchase, without recourse or warranty, an undivided interest and participation in the Obligations owed to the other Lenders so that such excess payment received shall be applied ratably as among the Lenders in accordance with their Pro Rata Shares; provided, however, that if all or part of such excess payment received by the purchasing party is thereafter recovered from it, those purchases of participations shall be rescinded in whole or in part, as applicable, and the applicable portion of the purchase price paid therefor shall be returned to such purchasing party, but without interest except to the extent that such purchasing party is required to pay interest in connection with the recovery of the excess payment. 17.13 Agency for Perfection. Agent and each Lender hereby appoints each other Lender as agent for the purpose of perfecting the Agent's Liens in assets which, in accordance with Article 9 of the UCC can be perfected only by possession. Should any Lender obtain possession of any such Collateral, such Lender shall notify Agent thereof, and, promptly upon Agent's request therefor shall deliver such Collateral to Agent or in accordance with Agent's instructions. 17.14 Payments by Agent to the Lenders. All payments to be made by Agent to the Lenders shall be made by bank wire transfer or internal transfer of immediately available funds to: If to Foothill: The Chase Manhattan Bank New York, New York ABA # 021-000-021 Credit: Foothill Capital Corporation Account No. 323-266193 Re: Southwest Royalties, Inc. If to Foothill Income Trust, L.P.: The Chase Manhattan Bank New York, New York ABA # 021-000-021 Credit: Foothill Income Trust, L.P. Account No. 323-008062 Re: Southwest Royalties, Inc. or pursuant to such other wire transfer instructions as each party may designate for itself by written notice to Agent. Concurrently with each such payment, Agent shall identify whether such payment (or any portion thereof) represents principal, premium or interest on revolving advances or otherwise. 17.15 Concerning the Collateral and Related Loan Documents. Each member of the Lender Group authorizes and directs Agent to enter into this Agreement and the other Loan Documents relating to the Collateral, for the benefit of the Lender Group. Each member of the Lender Group agrees that any action taken by Agent or all Lenders, as applicable, in accordance with the terms of this Agreement or the other Loan Documents relating to the Collateral and the exercise by Agent or all Lenders, as applicable, of their respective powers set forth therein or herein, together with such other powers that are reasonably incidental thereto, shall be binding upon all of the Lenders. 17.16 Field Audits and Examination Reports; Confidentiality; Disclaimers by Lenders; Other Reports and Information. By signing this Agreement, each Lender: (a) is deemed to have requested that Agent furnish such Lender, promptly after it becomes available, a copy of each field audit or examination report (each a "Report" and collectively, "Reports") prepared by Agent, and Agent shall so furnish each Lender with such Reports; (b) expressly agrees and acknowledges that neither Foothill nor Agent (i) makes any representation or warranty as to the accuracy of any Report, or (ii) shall be liable for any information contained in any Report; (c) expressly agrees and acknowledges that the Reports are not comprehensive audits or examinations, that Agent or other party performing any audit or examination will inspect only specific information regarding Borrower and will rely significantly upon Borrower's books and records, as well as on representations of Borrower's personnel; (d) agrees to keep all Reports and other material, non-public information regarding Borrower and its Subsidiaries and their operations, assets, and existing and contemplated business plans in a confidential manner; it being understood and agreed by Borrower that in any event such Lender may make disclosures (a) to counsel for and other advisors, accountants, and auditors to such Lender, (b) reasonably required by any bona fide potential or actual Assignee, transferee, or Participant in connection with any contemplated or actual assignment or transfer by such Lender of an interest herein or any participation interest in such Lender's rights hereunder, (c) of information that has become public by disclosures made by Persons other than such Lender, its Affiliates, assignees, transferees, or participants, or (d) as required or requested by any court, governmental or administrative agency, pursuant to any subpoena or other legal process, or by any law, statute, regulation, or court order; provided, however, that, unless prohibited by applicable law, statute, regulation, or court order, such Lender shall notify Borrower of any request by any court, governmental or administrative agency, or pursuant to any subpoena or other legal process for disclosure of any such non- public material information concurrent with, or where practicable, prior to the disclosure thereof; and (e) without limiting the generality of any other indemnification provision contained in this Agreement, agrees: (i) to hold Agent and any such other Lender preparing a Report harmless from any action the indemnifying Lender may take or conclusion the indemnifying Lender may reach or draw from any Report in connection with any loans or other credit accommodations that the indemnifying Lender has made or may make to Borrower, or the indemnifying Lender's participation in, or the indemnifying Lender's purchase of, a loan or loans of Borrower; and (ii) to pay and protect, and indemnify, defend and hold Agent and any such other Lender preparing a Report harmless from and against, the claims, actions, proceedings, damages, costs, expenses and other amounts (including, attorney costs) incurred by Agent and any such other Lender preparing a Report as the direct or indirect result of any third parties who might obtain all or part of any Report through the indemnifying Lender. In addition to the foregoing: (x) Any Lender may from time to time request of Agent in writing that Agent provide to such Lender a copy of any report or document provided by Borrower to Agent that has not been contemporaneously provided by Borrower to such Lender, and, upon receipt of such request, Agent shall provide a copy of same to such Lender promptly upon receipt thereof from Borrower; (y) To the extent that Agent is entitled, under any provision of the Loan Documents, to request additional reports or information from Borrower, any Lender may, from time to time, reasonably request Agent to exercise such right as specified in such Lender's notice to Agent, whereupon Agent promptly shall request of Borrower the additional reports or information specified by such Lender, and, upon receipt thereof from Borrower, Agent promptly shall provide a copy of same to such Lender; and (z) Any time that Agent renders to Borrower a statement regarding the Loan Account, Agent shall send a copy of such statement to each Lender. 17.17 Several Obligations; No Liability. Notwithstanding that certain of the Loan Documents now or hereafter may have been or will be executed only by or in favor of Agent in its capacity as such, and not by or in favor of the Lenders, any and all obligations on the part of Agent (if any) to make any credit available hereunder shall constitute the several (and not joint) obligations of the respective Lenders on a ratable basis, according to their respective Commitments, to make an amount of such credit not to exceed, in principal amount, at any one time outstanding, the amount of their respective Commitments. Nothing contained herein shall confer upon any Lender any interest in, or subject any Lender to any liability for, or in respect of, the business, assets, profits, losses, or liabilities of any other Lender. Each Lender shall be solely responsible for notifying its Participants of any matters relating to the Loan Documents to the extent any such notice may be required, and no Lender shall have any obligation, duty, or liability to any Participant of any other Lender. Except as provided in Section 17.7, no member of the Lender Group shall have any liability for the acts or any other member of the Lender Group. No Lender shall be responsible to Borrower or any other Person for any failure by any other Lender to fulfill its obligations to make credit available hereunder, nor to advance for it or on its behalf in connection with its Commitment, nor to take any other action on its behalf hereunder or in connection with the financing contemplated herein. 18. GENERAL PROVISIONS. 18.1 Effectiveness. This Agreement shall be binding and deemed effective when executed by Borrower and each member of the Lender Group whose signature is provided for on the signature pages hereof. 18.2 Section Headings. Headings and numbers have been set forth herein for convenience only. Unless the contrary is compelled by the context, everything contained in each section applies equally to this entire Agreement. 18.3 Interpretation. Neither this Agreement nor any uncertainty or ambiguity herein shall be construed or resolved against the Lender Group or Borrower, whether under any rule of construction or otherwise. On the contrary, this Agreement has been reviewed by all parties and shall be construed and interpreted according to the ordinary meaning of the words used so as to fairly accomplish the purposes and intentions of all parties hereto. 18.4 Severability of Provisions. Each provision of this Agreement shall be severable from every other provision of this Agreement for the purpose of determining the legal enforceability of any specific provision. 18.5 Amendments in Writing. This Agreement can only be amended by a writing signed by Agent, the requisite Lenders, and Borrower. 18.6 Counterparts; Telefacsimile Execution. This Agreement may be executed in any number of counterparts and by different parties on separate counterparts, each of which, when executed and delivered, shall be deemed to be an original, and all of which, when taken together, shall constitute but one and the same Agreement. Delivery of an executed counterpart of this Agreement by telefacsimile shall be equally as effective as delivery of an original executed counterpart of this Agreement. Any party delivering an executed counterpart of this Agreement by telefacsimile also shall deliver an original executed counterpart of this Agreement but the failure to deliver an original executed counterpart shall not affect the validity, enforceability, and binding effect of this Agreement. The forgoing shall apply to each other Loan Document mutatis mutandis. 18.7 Revival and Reinstatement of Obligations. If the incurrence or payment of the Obligations by Borrower or any guarantor of the Obligations or the transfer by either or both of such parties to the Lender Group of any property of either or both of such parties should for any reason subsequently be declared to be void or voidable under any state or federal law relating to creditors' rights, including provisions of the Bankruptcy Code relating to fraudulent conveyances, preferences, and other voidable or recoverable payments of money or transfers of property (collectively, a "Voidable Transfer"), and if the Lender Group is required to repay or restore, in whole or in part, any such Voidable Transfer, or elects to do so upon the reasonable advice of its counsel, then, as to any such Voidable Transfer, or the amount thereof that the Lender Group is required or elects to repay or restore, and as to all reasonable costs, expenses, and attorneys fees of the Lender Group related thereto, the liability of Borrower or such guarantor automatically shall be revived, reinstated, and restored and shall exist as though such Voidable Transfer had never been made. 18.8 Integration. THIS AGREEMENT AND THE OTHER LOAN DOCUMENTS REPRESENT THE ENTIRE UNDERSTANDING AND FINAL AGREEMENT AMONG THE PARTIES WITH RESPECT TO THE TRANSACTIONS CONTEMPLATED HEREBY AND THEREBY, AND THE SAME MAY NOT BE CONTRADICTED OR QUALIFIED BY EVIDENCE OF PRIOR, ORAL OR WRITTEN AGREEMENTS BETWEEN OR AMONG THE PARTIES OR CONTEMPORANEOUS OR SUBSEQUENT ORAL AGREEMENTS BETWEEN OR AMONG THE PARTIES. THERE ARE NO UNWRITTEN ORAL AGREEMENTS BETWEEN OR AMONG THE PARTIES. 18.9 Amendment and Restatement; Release. This Agreement and the obligations of Borrower set forth herein constitute an amendment, modification and restatement, but not an extinguishment or novation, of obligations of the Borrower originally owed to the Prior Lenders and/or the predecessors in interest to Prior Lenders (the "Prior Obligations"), the Prior Lenders having assigned all of such Prior Obligations (together with all Liens and security documents securing the same) to Agent and the Lender Group pursuant to the Prior Lender Assignment Agreements. This Agreement and the other Loan Documents are not intended as, and shall not be construed as, a release, impairment or novation of the Prior Obligations or the other indebtedness, liabilities and obligations of Borrower or any of the other Loan Parties under the agreements, documents and instruments executed in connection therewith or relating thereto or the Liens granted therein, all of which Liens are hereby modified and affirmed. BORROWER AND EACH OTHER LOAN PARTY HEREBY VOLUNTARILY AND KNOWINGLY RELEASE AND FOREVER DISCHARGE AGENT AND EACH OF THE LENDERS, ITS PREDECESSORS, AGENTS, EMPLOYEES, ATTORNEYS, SUCCESSORS AND ASSIGNS, FROM ALL POSSIBLE CLAIMS, DEMANDS, ACTIONS, CAUSES OF ACTION, DAMAGES, COSTS, EXPENSES, AND LIABILITIES WHATSOEVER, KNOWN OR UNKNOWN, ANTICIPATED OR UNANTICIPATED, SUSPECTED OR UNSUSPECTED, FIXED, CONTINGENT, OR CONDITIONAL, AT LAW OR IN EQUITY, ORIGINATING IN WHOLE OR IN PART ON OR BEFORE THE DATE THIS AGREEMENT IS EXECUTED, WHICH BORROWER AND SUCH OTHER LOAN PARTIES, INDIVIDUALLY OR COLLECTIVELY, MAY NOW OR HEREAFTER HAVE AGAINST AGENT, ANY OF THE LENDERS, ITS PREDECESSORS, AGENTS, EMPLOYEES, ATTORNEYS, SUCCESSORS AND ASSIGNS, IF ANY, AND IRRESPECTIVE OF WHETHER ANY SUCH CLAIMS ARISE OUT OF CONTRACT, TORT, VIOLATION OF LAW OR REGULATIONS, OR OTHERWISE, AND ARISING FROM ANY ADVANCES, LETTERS OF CREDIT OR OTHER INDEBTEDNESS, INCLUDING, WITHOUT LIMITATION, ANY CONTRACTING FOR, CHARGING, TAKING, RESERVING, COLLECTING OR RECEIVING INTEREST IN EXCESS OF THE HIGHEST LAWFUL RATE APPLICABLE, THE EXERCISE OF ANY RIGHTS AND REMEDIES UNDER THE AGREEMENT OR OTHER TRANSACTION DOCUMENTS, AND NEGOTIATION FOR AND EXECUTION OF THIS AGREEMENT. 18.10. Borrower's Waiver of Rights Under Texas Deceptive Trade Practices Act. BORROWER HEREBY WAIVES ITS RIGHTS UNDER THE DECEPTIVE TRADE PRACTICES-CONSUMER PROTECTION ACT, SECTION 17.41 ET SEQ. TEXAS BUSINESS & COMMERCE CODE, A LAW THAT GIVES CONSUMERS SPECIAL RIGHTS AND PROTECTIONS. AFTER CONSULTATION WITH AN ATTORNEY OF BORROWER'S OWN SELECTION, BORROWER VOLUNTARILY CONSENTS TO THIS WAIVER. BORROWER EXPRESSLY WARRANTS AND REPRESENTS THAT BORROWER (A) IS NOT IN A SIGNIFICANTLY DISPARATE BARGAINING POSITION RELATIVE TO AGENT AND/OR ANY LENDER, AND (B) HAS BEEN REPRESENTED BY LEGAL COUNSEL IN CONNECTION WITH THE TRANSACTIONS CONTEMPLATED BY THIS AGREEMENT AND THE OTHER LOAN DOCUMENTS. [Remainder of Page Intentionally Blank; Signature Pages Follow.] IN WITNESS WHEREOF, the parties hereto have caused this Agreement to be executed. BORROWER: SOUTHWEST ROYALTIES, INC. a Delaware corporation By /s/ Bill E. Coggin Title: Vice President AGENT: FOOTHILL CAPITAL CORPORATION, a California corporation, as Agent for the Lenders By:/s/ Scott D. Ryan Title: Vice President LENDER: FOOTHILL CAPITAL CORPORATION, a California corporation, as a Lender By: /s/ Scott D. Ryan Title: Vice President FOOTHILL INCOME TRUST, L.P., a Delaware limited partnership By: FIT GP, LLC, a Delaware limited liability company, its general partner By: /s/ Dennis R. Ascher Title: Managing Member SCHEDULE C-1 TO AMENDED AND RESTATED LOAN AND SECURITY AGREEMENT BY AND AMONG SOUTHWEST ROYALTIES, INC., THE LENDERS SIGNATORY THERETO, AND FOOTHILL CAPITAL CORPORATION, AS AGENT FOR THE LENDERS COMMITMENTS Name of Lender Commitment Foothill Capital $30,000,000 Corporation Foothill Income Trust, L.P. $20,000,000 SCHEDULE 6.12 TO AMENDED AND RESTATED LOAN AND SECURITY AGREEMENT BY AND AMONG SOUTHWEST ROYALTIES, INC., THE LENDERS SIGNATORY THERETO, AND FOOTHILL CAPITAL CORPORATION, AS AGENT FOR THE LENDERS LOCATIONS OF INVENTORY AND EQUIPMENT State Counties Alabama All Delaware All Kansas All Louisiana All Montana All New Mexico All North Dakota All Oklahoma All Texas All Wyoming All EXHIBIT B-1 TO AMENDED AND RESTATED LOAN AND SECURITY AGREEMENT BY AND AMONG SOUTHWEST ROYALTIES, INC., THE LENDERS SIGNATORY THERETO, AND FOOTHILL CAPITAL CORPORATION, AS AGENT FOR THE LENDERS MORTGAGES, OPINIONS, CERTIFICATES AND CERTAIN OTHER REQUIRED ITEMS AND INFORMATION 1. Agent has received each of the following documents, in form and substance satisfactory to Agent, duly executed (and acknowledged, as the case may be) by the Borrowing Base Entity that is the owner thereof and all other necessary parties and all formalities contemplated thereunder have been completed, and each such document shall be in full force and effect and shall have been recorded in each office required by Agent: (a) Oil and Gas Property Mortgages, dated as of the Closing Date, covering the Applicable Oil and Gas Property on which the Proved Reserves are located (the "Applicable Oil and Gas Property"); (b) Copies of the governmental permits, approvals and orders for each well and each unit pertaining to the Applicable Oil and Gas Property; (c) Transfer Order Letters for each well on the Applicable Oil and Gas Property; (d) Assignments in form and substance acceptable to Agent of each Material Contract pertaining to the Applicable Oil and Gas Property which either (i) affects any Borrowing Base Entity's title to such Oil and Gas Property or otherwise affects the value, use or operation of such Oil and Gas Property in any material respect or (ii) creates or evidences a material obligation or liability on the part of Borrower or any or its Subsidiaries, together with copies of each such Material Contract. 2. Agent has received a certificate of insurance, together with the endorsements thereto with respect to the Applicable Oil and Gas Property and the insurable risks associated therewith as described in Section 6.10, with Agent for the benefit of the Lender Group being named thereon as loss payee and additional insured, all in form and substance of which shall be satisfactory to Agent and its counsel. 3. Agent has received copies of all Material Contracts relating to the Applicable Oil and Gas Property, and such contracts shall be in form and substance satisfactory to Agent. 4. Agent has received an opinion of Borrower's counsel covering the Oil and Gas Property Mortgages covering the Applicable Oil and Gas Property and matters pertaining thereto, including the due execution, delivery and enforceability thereof, and creation of lien thereunder, in form and substance satisfactory to Agent in its sole discretion. 5. Agent has received (i) appraisals of the Applicable Oil and Gas Property in the form of Reserve Reports prepared by Borrower and audited by Ryder Scott Company, Pollard Gore & Harrison or another firm of independent petroleum engineers selected by Borrower and acceptable to Agent (including, but not limited to, appraisals, verifications and liquidation analyses of the Proved Reserves thereof categorized by "Proved Developed Producing Reserves," "Proved Developed Non- Producing Reserves," "Proved Undeveloped Reserves," and other), in each case satisfactory to Agent, and (ii) title opinions for the Applicable Oil and Gas Property issued to Agent for the benefit of the Lender Group by a legal counsel to Borrower that is experienced in the examination of title to the Applicable Oil and Gas Property and is satisfactory to Agent, each of which title opinions shall be in form and substance satisfactory to Agent and: (A) have been updated within 15 days after the date of the filing of the Applicable Oil and Gas Property Mortgage to confirm the priority of the Lien created by the Applicable Oil and Gas Property Mortgage, and (B) opine as to such matters incident to the Applicable Oil and Gas Property as Agent may reasonably request including the following with respect to the Mineral Interests in the Applicable Oil and Gas Property: (I) The Borrowing Base Entity that is the grantor under the Applicable Oil and Gas Property Mortgage covering the Applicable Oil and Gas Properties (the "Applicable Borrowing Base Entity") has Defensible Title to such Oil and Gas Properties to the extent of the Mineral Interests as specified therein, free and clear of all Liens and defects except Permitted Liens. (II) The Applicable Borrowing Base Entity is entitled to receive, after giving effect to all royalties, overriding royalties and other burdens payable out of production, a decimal share of all Hydrocarbons produced and sold from such Oil and Gas Properties, before and after payout, not less than set forth in the opinion. (III) The operating interest in such Oil and Gas Properties of the Applicable Borrowing Base Entity, is not obligated to bear a decimal share of all costs and expenses from the operation thereof in excess of that set forth therein. (IV) The Liens created by the Oil and Gas Property Mortgage are valid and enforceable first priority mortgage Liens which are first in right and prior in time and superior to all other Liens against such Mineral Interests and other Oil and Gas Properties other than Permitted Liens. 6. Borrower has delivered to Agent evidence satisfactory to Agent confirming that each of the producing wells located on the Applicable Oil and Gas Property is (i) covered by the title opinions required under the Agreement and (ii) described in the legal description contained in an Oil and Gas Property Mortgage which has been duly executed and delivered to Agent. 7. If reasonably requested by Agent, Agent has received a phase- I environmental report with respect to the Applicable Oil and Gas Property, and the environmental consultants, the scope of the reports or surveys, and the results thereof shall be reasonably acceptable to Agent in its sole discretion. 8. Agent has received all financing statements and fixture filings required by Agent, duly executed by each Borrowing Base Entity that is the owner of the Applicable Oil and Gas Property and all other necessary parties and all formalities contemplated thereunder have been completed, and Agent shall have received searches of all recording offices requested by Agent reflecting the filing of all such financing statements and fixture filings, together with searches of such other offices as Agent may require, each dated as of a date acceptable to Agent. 9. Borrower has delivered to Agent additional information concerning the Applicable Oil and Gas Property of the type contemplated (without regard to value) by Schedules 5.1(a), 5.1(b), 5.1(c) and 5.2(b), with such information being presented in substantially the same format as in such Schedules. 10. All other documents and legal matters in connection with the Applicable Oil and Gas Properties and the purchase or ownership thereof have been delivered, executed, or recorded and are in form and substance satisfactory to Agent and its counsel. EXHIBIT C-1 TO AMENDED AND RESTATED LOAN AND SECURITY AGREEMENT BY AND AMONG SOUTHWEST ROYALTIES, INC., THE LENDERS SIGNATORY THERETO, AND FOOTHILL CAPITAL CORPORATION, AS AGENT FOR THE LENDERS FORM OF COMPLIANCE CERTIFICATE [COMPANY LETTERHEAD] Foothill Capital Corporation, as agent 2450 Colorado Avenue, Suite 3000 West Santa Monica, California 90404 RE: Compliance Certificate In accordance with our Amended and Restated Loan and Security Agreement ("Agreement") dated as of August 17, 2000, I hereby certify: All financial reports, statements or computer prepared information of any kind or nature delivered or caused to be delivered to Foothill have been prepared in accordance with GAAP consistently applied and fairly present the financial condition of Borrower, except as follows: Borrower is in timely compliance with all representations, warranties, and covenants as defined within the Agreement, except as follows: On the date of delivery of such certificate to Foothill there does not exist any condition or event which constitutes an Event of Default, as defined within the Agreement, except as follows: As of the date hereof, the amount of the Revolving Facility Usage, as defined in the Agreement, does not exceed the Availability, as defined in the Agreement. PLEASE ATTACH A SCHEDULE OF FINANCIAL COVENANTS (AND CALCULATIONS THEREOF), INCLUDING YEAR TO DATE CAPITAL EXPENDITURES, TO THIS COMPLIANCE CERTIFICATE. SOUTHWEST ROYALTIES, INC., a Delaware corporation By: Name: Title: EXHIBIT T-1 TO AMENDED AND RESTATED LOAN AND SECURITY AGREEMENT BY AND AMONG SOUTHWEST ROYALTIES, INC., THE LENDERS SIGNATORY THERETO, AND FOOTHILL CAPITAL CORPORATION, AS AGENT FOR THE LENDERS Letter in Lieu of Division or Transfer Orders __________ ___, 20__ VIA CERTIFIED MAIL RETURN RECEIPT REQUESTED TO: Re: Letter in Lieu of Transfer Order Ladies and Gentlemen: [Pursuant to the Mortgage, a copy of which is enclosed with this letter,] Southwest Royalties, Inc. (hereinafter collectively referred to as the "Company") has granted to Foothill Capital Corporation, a California corporation, as agent (in such capacity together with its successors in such capacity, "Agent") for one or more lenders (such lenders, together with their respective successors and assigns, the "Lenders"), a lien on and security interest in the [property interests described on Schedule I attached hereto] [oil and gas properties of the Company] (the "Properties"), including without limitation a collateral assignment and transfer of all of the present and future production and proceeds of production from the Properties. We understand that, pursuant to division orders, transfer orders, letters-in-lieu thereof or other agreements, you are currently disbursing proceeds of the production from the Properties to the Company or its designees. The Company and Agent on behalf of the Lenders hereby give you written notice of the matters set forth above and the collateral assignment and transfer to Agent for the benefit of the Lenders of all accounts from the sale of [Hydrocarbons (as defined in the Mortgage)], [oil, gas and other hydrocarbons] from the Properties and products and proceeds thereof. Furthermore, you are hereby authorized and directed to commence paying, immediately upon your receipt of this letter, 100% of all proceeds of production distributed by you and attributable to the interest of the Company in the Properties, less royalty, overriding royalty and applicable severance and ad valorem taxes, directly to Agent for the benefit of the Lenders at the following address: The Chase Manhattan Bank, N.A. 4 New York Plaza, 15th Floor New York, New York 10004 ABA #021-000-021 Account Number 323-266193 Credit: Foothill Capital Corporation Re: Southwest Royalties, Inc. You are hereby further authorized and directed to continue to pay royalty, overriding royalty and applicable severance and ad valorem taxes to the appropriate parties. You are hereby further authorized and directed to change your records in accordance with this letter effective immediately upon your receipt of this letter. If you require the execution of a division or transfer order, please forward the division or transfer order to Agent at its address listed below. In order that we have a record evidencing your acceptance of this letter, we request that you sign two copies of this letter in the space provided below and return them to Agent at 2450 Colorado Avenue, Suite 3000 West, Santa Monica, California 90404, Attn: Business Finance Division Manager (Fax No. 310.453.7413) and to Company at 407 North Big Spring Street, Suite 300, Midland, Texas 79701, Attn: President (Fax No. 915.688.0191) in the enclosed, self-addressed envelope. If you have further requirements concerning this transfer, please notify Agent at the address specified above. None of the terms or provisions of this letter may be changed without the prior written consent of Agent and Company. Sincerely, SOUTHWEST ROYALTIES, INC. By: ___________________________ Name: Title: FOOTHILL CAPITAL CORPORATION, as Agent By: ______________________________ Name: Title: ACCEPTED AND AGREED this ____ day of ___________, ______, and our records have been changed effective with _____________________, 20__ production. ___________________________________________ By: ____________________________________ Name: ____________________________________ Title: ____________________________________ SCHEDULE I Attachment to Letter in Lieu of Transfer Order DIVISI OPERATO WELL FIEL LOCATIO COUNT STAT INTERESOPERATO NET ON R WELL NAME D N Y E T OWNER R REVENUE ORDER # INTERES # T EXHIBIT 6.2 TO AMENDED AND RESTATED LOAN AND SECURITY AGREEMENT BY AND AMONG SOUTHWEST ROYALTIES, INC., THE LENDERS SIGNATORY THERETO, AND FOOTHILL CAPITAL CORPORATION, AS AGENT FOR THE LENDERS FORM OF BORROWING BASE CERTIFICATE Southwest Royalties, Inc. - Form of Borrowing Base Certificate as of ___, 2000 Advances to Borrower at any one time shall not exceed an amount equal to the lesser of: I. "Maximum $50,000,0 Amount": 00 (or) II. The "Borrowing Base" less the aggregate amount of the "Reserves Against Availability" : (or) III. the "Unsecured Note $________ Indebtedness Limitation" ___ II. The "Borrowing Base" less the aggregate amount of the "Reserves Against Availability" : The "Borrowing Base" is: Proved Developed Producing Reserves as of __/__/__: Less Ineligible Proved Developed Producing Reserves: Eligible Proved Developed Producing Reserves: Advance Rate 45% Availability prior to "Reserves Against Availability" "Reserves Against Availability" include: LSA Def. (a) Accounts Payable Greater than 90 Days from Invoice: - (b) Past Due Taxes or Other Governmental Charges: - (c) Certain Other Liens (d) 180 Day P&A Escrows (e) Estimated Net P&A - (f) 180 Day Rents Reserve (g) Amounts owed by Borrower subject to Certain Other Liens: - (h) Reserves for Gas/Oil Imbalances - Sub-total of Reserves Availability after "Reserves Against Availability" Other Reserves under Section 2.1 -----END PRIVACY-ENHANCED MESSAGE-----