10-K 1 d85722e10-k.txt FORM 10-K FOR FISCAL YEAR END DECEMBER 31, 1999 1 ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ---------- FORM 10-K [x] Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 1999 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 NO. 0-21411 ---------- COSTILLA ENERGY, INC. (Exact name of registrant as specified in its charter) ---------- DELAWARE 75-2658940 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 400 WEST ILLINOIS, SUITE 900 MIDLAND, TEXAS 79701 (Address of principal executive offices) (Zip code) (915) 683-3092 (Registrant's telephone number, including area code) Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act:

---------- Indicate by check mark 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 NO X -------- -------- Indicate by check mark if disclosure of delinquent filers 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. [ ] There is no current public market for the registrant's Common Stock. There are zero shares of registrant's Common Stock currently outstanding. All such shares were canceled as of the effective date of the registrant's Chapter 11 Bankruptcy Plan as described herein. ================================================================================ 2 COSTILLA ENERGY, INC. TABLE OF CONTENTS

3 PART I SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS Certain statements in this Form 10-K may be deemed to be "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended (the "Securities Act"), and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"). All statements, other than statements of historical facts, included in this Form 10-K that address activities, events or developments that Costilla Energy, Inc. ("Costilla" or the "Company") expects, projects, believes or anticipates will or may occur in the future are forward-looking statements. These statements are based on certain assumptions and analysis made by the Liquidating Trustee (as defined herein) in light of his perception of current conditions, expected future developments, advice of professionals and other factors it believes are appropriate in the circumstances. Such statements are subject to a number of assumptions, risks and uncertainties, including the outcome of litigation, changes in laws or regulations and other factors, many of which are beyond the control of the Company. ITEMS 1 AND 2. BUSINESS AND PROPERTIES. BACKGROUND AND RECENT DEVELOPMENTS Costilla filed a voluntary petition under Chapter 11 of the United States Bankruptcy Code (the "Bankruptcy Code") in the United States Bankruptcy Court for the Western District of Texas, Midland Division (the "Bankruptcy Court") on September 3, 1999. After that time, the Company operated its business as a debtor in possession under the Bankruptcy Code, including the filing of monthly operating reports containing unaudited financial information with the Bankruptcy Court. In February, 2000, the Company filed an initial plan of reorganization and disclosure statement. The disclosure statement contained certain unaudited financial information for the year ended December 31, 1999. The Company filed with the Securities and Exchange Commission (the "Commission") a Current Report on Form 8-K on March 3, 2000 attaching as an exhibit a copy of its operating report that it filed with the Bankruptcy Court for the period ended December 31, 1999, which set forth the unaudited financial information that was contained in the initial disclosure statement. Unaudited financial statements for the period ended December 31, 1999 are also included in this Form 10-K. On June 9, 2000, the Bankruptcy Court entered an order approving the sale of substantially all of the Company's oil and gas properties to Louis Dreyfus Natural Gas Corp. (the "Dreyfus Sale"). The base price for such properties was $133,250,000, subject to certain price adjustments pursuant to the asset purchase agreement between the parties. The sale was closed on June 15, 2000. As a result of the transaction, the Company received approximately $129,000,000 in cash at closing, and has received an additional sum of approximately $1,600,000 from approximately $2,000,000 which was escrowed with respect to asserted title defects. Following the sale of substantially all of its oil and gas properties, the Company took steps to reduce its general administrative and overhead costs in light of its reduced operations by, among other things, reducing its office space and number of employees to a level necessary to conduct post-closing sale matters and other continuing business operations in the bankruptcy. On September 15, 2000, the Bankruptcy Court approved and confirmed the Company's Plan of Reorganization (Liquidation) as Restated to Reflect All Amendments and Modifications (the "Plan"), effective October 1, 2000. The Plan provides, among other things, for the distribution of certain of the net proceeds from the Dreyfus Sale to the creditors, for the creation of certain trusts to liquidate and distribute the remaining assets of the Company and for the cancellation of all of the Company's common stock, preferred stock and other equity interests. These material features of the Plan may be summarized as follows: 1 4 o With respect to the distribution of the Dreyfus Sale proceeds, the estimated recovery for the various classes of claims under the Chapter 11 Plan as set forth in the Disclosure Statement With Respect to Debtor's Plan of Reorganization (Liquidation), as Amended, dated July 28, 2000 (the "Disclosure Statement"), are as follows (assuming net proceeds available for distribution of approximately $116,000,000 as provided in the Disclosure Statement and other assumptions provided therein): secured claims, 100%; administrative and priority claims, 100%; administrative convenience unsecured claims, 100%; general unsecured claims including the Company's 10 1/4% Senior Notes due 2006, 44%; and equity interests, 0. The amount available for distribution is subject to adjustments related to post-confirmation liquidation expenses and activities and reserves established therefore. Two distributions aggregating approximately 46% of the claim amounts have been made to the holders of general unsecured claims. See "Item 7. Management Discussion and Analysis of Financial Condition and Results of Operations." o The Plan creates The Costilla Liquidating Trust (the "Liquidating Trust"), and by operation of the confirmation order, approving the Plan, the Liquidating Trust has possession of and title to all of the Company's property. A trustee of the Liquidating Trust (the "Liquidating Trustee") has been appointed as provided in the Bankruptcy Court's order approving and confirming the Plan and has the power and authority to complete the liquidation of the remaining assets of the Company, including without limitation, the prosecution of claims, objections, preferential transfer claims and other lawsuits. The Liquidating Trustee is further authorized to take any action on behalf of the Company that would otherwise require the approval of shareholders, directors or officers of the Company without obtaining such approval. All of the officers and directors of the Company resigned prior to the effective date of the Plan (October 1, 2000). The Plan also provides for the creation of a separate directors' and officers' litigation trust with a separate trustee to investigate and pursue, if appropriate, any claims that the Company believes it may have against its former directors and officers. o All of the outstanding equity interests of the Company, including the Company's common stock and preferred stock and any options or other rights related thereto, were canceled pursuant to the terms of the Plan as of its effective date. Holders of equity interests are not entitled to any distributions under the Plan, unless all of the creditors are paid in full, with interest, and all of the costs and expenses of the trusts have been paid. Any such distribution would be made to the shareholders of the Company as of the effective date of the Plan in the order of the rights of such shareholders (i.e., first, to the preferred shareholders, and then, to the common shareholders). There were 50,000 shares of the Company's preferred stock and 14,101,580 shares of the Company's common stock outstanding on October 1, 2000, the effective date of the Plan. The Company believes that it is highly unlikely that any distributions will be made to the holders of equity interests of the Company. As a result of the foregoing, the Company will not have any future business operations other than with respect to the liquidation, distribution and related activities of the Liquidating Trustee under the Plan. In addition, the Company no longer has any shareholders. PRINCIPAL PROPERTIES The following information relates to the properties owned by the Company as of December 31, 1999, substantially all of which were sold in the Dreyfus Sale. Substantially similar information concerning the Company's business and properties was included in the initial disclosure statement filed with the Bankruptcy Court in February 2000 and made available to interested parties. The following table sets forth certain information, as of January 1, 2000, which relates to the principal oil and gas properties then owned by the Company. 2 5

OIL AND GAS RESERVES The Company's estimated total proved reserves of oil and gas as of January 1, 2000 were as follows:

The future net cash flows from the Company's estimated proved reserves as of January 1, 2000 were as follows (in thousands): ~~Future net cash flows before income taxes....................................... $ 140,127 Future net cash flows before income taxes, discounted at 10%.................... $ 93,248~~

The reserve estimates at January 1, 2000 are provided by the Debtor. There are numerous uncertainties in estimating quantities of proved reserves and in projecting future rates of production and the timing of development expenditures, including many factors beyond the control of the Company. The reserve data set forth in this Form 10-K are estimates only. Although the Company believes such estimates were reasonable, reserve estimates are imprecise and should be expected to change as additional information becomes available. Furthermore, estimates of oil and gas reserves, of necessity, are projections based on engineering data, and there are uncertainties inherent in the interpretation of such data as well as the projection of future rates of production and the timing of development expenditures. Reserve engineering is a subjective process of estimating underground accumulations of oil and gas that cannot be exactly measured, and the accuracy of any reserve estimate is a function of the quality of available data and of engineering and geological interpretation and judgment. Accordingly, estimates of the economically recoverable quantities of oil and gas attributable to any particular group of properties, classifications of such reserves based on risk of recovery, and estimates of the future net cash flows expected therefrom prepared by different engineers or by the same engineers at different times may vary substantially. Moreover, there can be no assurance that the reserves set forth herein will ultimately be produced or that the proved undeveloped reserves will be developed within the periods anticipated. Variances from the estimates contained herein could be material. In addition, the estimates of future net revenues from proved reserves and the present value thereof are based upon certain assumptions about production levels, prices and costs, which may not be correct. The Company emphasizes with respect to 3 6 such estimates that the discounted future net cash flows should not be construed as representative of the fair market value of the proved oil and gas properties that belonged to the Company, because discounted future net cash flows are based upon projected cash flows that do not provide for changes in oil and gas prices or for escalation of expenses and capital costs. The meaningfulness of such estimates is highly dependent upon the accuracy of the assumptions upon which they were based. Actual results may differ materially from the results estimated. In accordance with applicable requirements of the Commission, the estimated discounted future net revenues from estimated proved reserves are based on prices and costs as of the date of the estimate unless such prices or costs are contractually determined at such date. Subsequent to January 1, 2000 and prior to the Dreyfus Sale, the Debtor successfully drilled and completed an additional well in the Southwest Speaks Field. Based upon initial tests and results from this new well, additional proved reserves were estimated by the Company for the Southwest Speaks Field attributable to the new well representing proved developed reserves and two additional future drilling locations representing proved undeveloped reserves. If these additional reserves were included in the reserve estimates described above, the total proved reserves of the Company at January 1, 2000 and the future net cash flow attributable thereto would have been as follows:

PRODUCTION VOLUMES, PRICES AND COSTS The following table sets forth certain information regarding the Company's production volumes, average sales price and costs for the periods presented: 4 7

EXPLORATION AND DEVELOPMENT ACTIVITIES The Company drilled, or participated in the drilling of, the following number of wells during the periods indicated. At December 31, 1999, the Company was in the process of completing one gross (one net) well which is not reflected in the following table.

The Company did not own any drilling rigs and all of its drilling activities were conducted by independent contractors under standard drilling contracts. PRODUCTIVE WELL SUMMARY The following table sets forth the Company's gross and net interests in productive oil and gas wells as of December 31, 1999. Productive wells are producing wells and wells capable of production.

5 8 ACREAGE The following table sets forth certain information regarding the Company's developed and undeveloped leasehold acreage as of December 31, 1999. Acreage in which the Company's interest is limited to royalty, overriding royalty, mineral and similar interests is excluded.

EMPLOYEES At December 31, 1999, the Company had 68 full time employees. As the Company's operations were reduced through 2000, particularly after the Dreyfus Sale, the number of employees was significantly reduced. To encourage necessary employees to stay with the Company through the bankruptcy and liquidation process, certain retention payments were made as approved by the Bankruptcy Court. See "Item 11. Executive Compensation." Certain former employees of the Company have been employed by the Liquidating Trust. CURRENT STATUS As previously discussed, the Company sold substantially all of its assets, including the oil and gas properties referred to in the foregoing information, in the Dreyfus Sale. In addition, the Plan provides that the remaining assets of the Company were assigned to the Liquidating Trust on the effective date of the Plan, October 1, 2000, and all of the shares of common and preferred stock of the Company were canceled. As a result, the Company no longer has any properties or business operations. The Liquidating Trustee will liquidate the remaining assets for the benefit of the Company's creditors pursuant to the Plan, and any operations, litigation or other actions will be directed by the Liquidating Trustee under the supervision of the Bankruptcy Court. ITEM 3. LEGAL PROCEEDINGS. The Company and the Liquidating Trust continue to be under the supervision of the Bankruptcy Court in the Company's bankruptcy proceeding. The Bankruptcy Court will supervise the liquidation of the remaining Company assets, the use of cash to fund such liquidation (including potential lawsuits), the determination of the amount and validity of creditors' claims, the distribution of liquidation proceeds to the creditors, and all other matters related to consummation of the Plan. GNK, Inc. v. Graham D. Williford, Carl Ed Williford, Harriette Williford-Whatley, Homer Paul Bonner, in his capacity as Trustee of Eric Wayne Wilson Trust No. 1 and the Harriette Williford-Whatley 1987 Trust and Costilla Energy, Inc., Cause No. 97-311-B, in the District Court of Freestone County, Texas, 87th Judicial District. On August 18, 1999, a judgment was entered against the Company and the other defendants in this case. All of the defendants were found jointly and severally liable for actual damages in a total amount of $562,248.36. In addition, the Company was also found liable for additional actual damages of $2.00 and exemplary damages in the sum of $5,000,000. This proceeding was resolved by a Settlement Agreement entered into by and between the Company and GNK and approved by the Bankruptcy Court in September 2000. GNK was allowed a general unsecured claim in the amount of $737,995 and, among other things, the remainder of the GNK claim was disallowed in its entirety. 6 9 Thomas L. Jones v. Costilla Energy, Inc., Cause No. 99-02515-00-O-C, originally styled in the 94th Judicial District, Nueces County, Texas. This lawsuit has been removed to the United States Bankruptcy Court for the Western District of Texas, Midland Division. However, the case was heard in San Antonio Division for convenience of the Court and parties involved. The case involves plaintiff's claim for breach of contract, conversion and declaratory relief associated to alleged overriding royalty interest. The court granted the plaintiff's motion on summary judgment, determining that the plaintiff is entitled to a two percent overriding royalty interest in the subject property. Jones had filed a claim for $8.0 million in the Bankruptcy proceeding. This lawsuit was settled in August 2000 by agreement between the parties and approved by the Bankruptcy Court. Among other things, Mr. Jones was awarded an overriding royalty in an area of mutual interest and received a payment of $100,000 in full satisfaction of his claim. In addition to the foregoing, the Company is a defendant or codefendant in less significant lawsuits that arose in the ordinary course of business, most of which are identified in the Disclosure Statement. While the outcome of these lawsuits cannot be predicted with certainty, the Liquidating Trustee does not expect any of these to have a material adverse effect on the liquidation of the remaining assets or distribution to creditors. However, certain funds may be reserved from distribution by the Liquidating Trustee pending the outcome of these cases. The Liquidating Trustee may also initiate lawsuits on behalf of the Liquidating Trust in an effort to liquidate claims formerly held by the Company, in the sole discretion of the Liquidating Trustee. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. No matters were submitted to a vote of the Company's stockholders during the fourth quarter of the year ended December 31, 1999 or during 2000 through the time the Company's common stock was canceled under the Plan on October 1, 2000. 7 10 PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The Company completed its initial public offering of Common Stock on October 2, 1996. On October 3, 1996 the Common Stock commenced trading on the Nasdaq Stock Market's National Market under the trading symbol "COSE". In August 1999, the Company's Common Stock was delisted from the Nasdaq National Market, and was subsequently quoted on the OTC Bulletin Board under the symbol "COSE" or "COSE.OB". The following table sets forth the high and low sales prices for the periods presented (all information presented on or before August 16, 1999 is from Nasdaq; information presented after August 16, 1999 is from Bloomberg). There are no shares of the Company's Common Stock outstanding, all such shares having been canceled under the Plan on October 1, 2000, and therefore there is no current market for the Common Stock.

8 11 ITEM 6. SELECTED FINANCIAL DATA. The following table sets forth selected financial data of Costilla Energy, Inc. and its predecessors. See "Management's Discussion and Analysis of Financial Condition and Results of Operations." The historical information should be read in conjunction with the Consolidated Financial Statements and the Notes thereto included elsewhere herein. Costilla Energy, Inc. and its predecessors acquired significant producing oil and gas properties in certain of the periods presented which affect the comparability of the historical financial and operating information.

---------- (1) Adjusted EBITDA is presented because of its wide acceptance as a financial indicator of a company's ability to service or incur debt. Adjusted EBITDA (as used herein) is calculated by adding interest, income taxes, depreciation, depletion and amortization, impairment of oil and gas properties, exploration and abandonment costs and extraordinary items. Adjusted EBITDA should not be considered as an alternative to earnings (loss), or operating earnings (loss), as defined by generally accepted accounting principles, as indicators of the Company's financial performance or to cash flow as a measure of liquidity. 9 12 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. Since the Company no longer has properties or business operations, the following discussion presents certain historical comparisons of results of operations and an analysis of the estimated liquidation of the Company and its assets pursuant to the Plan. RESULTS OF OPERATIONS Year Ended December 31, 1999 Compared to Year Ended December 31, 1998 The Company's total oil and gas revenues for the year ended December 31, 1999 were $46,773,000, representing a decrease of $16,012,000 (25.5%) over revenues of $62,785,000 in 1998. The sale of predominantly oil producing properties and the decrease in oil prices of 7.5% were the primary factors in the decreased revenues. The average net oil price per barrel received in 1999 was $13.24 compared to $14.31 in 1998, a 7.5% decrease, and the average net gas price received in 1999 was $2.08 compared to $2.05 in 1998, a 1.6%increase. Of the above 1999 average net prices, hedging decreased revenue by $1.33 per Bbl for oil and increased revenue $.07 per Mcf for gas. Total hedging revenue in 1999 was $97,000 compared to $8,221,000 for 1998. Oil and gas production was 22,200 Mmcfe in 1999 compared to 28,770 Mmcfe in 1998, a 22.8% decrease. The 6,570 Mmcfe decrease was due to the sale of primarily oil producing properties during 1999. Gas production for 1999 was approximately flat compared to 1998. Interest and other revenues were $291,000 for the year ended December 31, 1999 compared to $551,000 in 1998, representing a decrease of $260,000. Of this decrease, $130,000 was related to a decrease in interest income due to a reduction in funds earning interest. Gain on sale of assets was $824,000 for 1999 compared to $266,000 for 1998, representing a increase of $558,000 (209.8%), due to the sale of Rocky Mountain properties in 1999 from which gains were recognized offset slightly by losses from other miscellaneous sales of U. S. and foreign properties. Oil and gas production costs for the year ended December 31, 1999 were $17,923,000 ($.81 per Mmcfe), compared to $27,366,000 in 1998 ($.95 per Mmcfe), representing a decrease of $9,443,000 (34.5%). On a per Mmcfe basis production costs decreased $0.14 (14.7%) due to a combination of lower production costs on newly completed gas wells, the sale of higher cost Rocky Mountain properties and the Company's continued cost containment efforts. General and administrative expenses for the year ended December 31, 1999 were $9,009,000, representing an decrease of $2,757,000 (23.4%) from 1998 of $11,766,000. The increase is primarily due to the reduction of personnel and related costs due to workforce reductions in December 1998 and May 1999 offset somewhat by costs related to the Company's workforce reductions and reorganization efforts of approximately $1,925,000 since May 1999. Exploration and abandonment expense increased to $13,062,000 for the year ended December 31, 1999 compared to $12,723,000 in 1998. The Company incurred $518,000 of seismic costs for the year ended December 31, 1999, compared to $2,361,000 in 1998. Dry hole and abandonment costs increased to $11,825,000 in 1999 from $8,872,000 in 1998. The Company incurred $719,000 of other geological and geophysical costs during the year as compared to $1,490,000 in 1998. Seismic and geological costs were significantly lower in 1999 as compared to 1998 due to the reduction in drilling activity. Dry hole costs are significantly reduced in 1999 compared to 1998 but were offset by a large increase in abandonment expenses due to the write off of abandoned prospects and expiring leases. 10 13 Depreciation, depletion and amortization ("D D & A") expense for the year ended December 31, 1999 was $18,336,000 compared to $32,447,000 for 1998, representing a decrease of $14,111,000 (43.5%). During the 1999 period, D D & A on oil and gas production was computed at an average rate of $.83 per Mcfe compared to $1.13 per Mcfe for 1998. The decrease was a result of less basis in remaining properties due to property sales, previous DD&A and impairments. Loss on termination of purchase option relates to the termination of the Pioneer acquisition. The costs, none of which are recoverable, were expensed. The $47,781,000 loss includes a cash payment of $25,000,000, the relinquishment of Costilla's right to a property interest of $3,558,000, 4,000,000 shares of common stock valued at $13,700,000 and capitalized interest, legal, accounting, engineering and due diligence costs of $5,523,000. There was no comparable cost in 1998. Impairment of oil and gas properties for the year ended December 31, 1999 was $11,863,000 compared to $59,678,000 for 1998. The FAS 121 impairment in 1999 was $1,766,000 for U.S. producing properties and an additional impairment of $10,097,000 due to near term expiration of acreage located in east Texas to which proved undeveloped reserves had been attributed. The loss on commodity transactions for the year ended December 31, 1999, was $4,000,000 compared to none for the same period in 1998. The loss was due to recording a liability in the amount of $1,226,000 for a gas call contract and $1,593,000 for the portion of the oil contract which did not qualify as hedges. An additional $1,140,000 of loss was due to the premiums on the non-hedge contracts being accounted for as losses on commodity transactions. On September 10, 1999, the counterparty to the hedging transactions elected an early termination of the contracts due to Costilla's bankruptcy filing. The cash-out values of these contracts have been capitalized on the Balance Sheet as deferred charges, and they will be amortized over the applicable period of such contract. In 1999, $41,000 was amortized as a loss on commodity transactions compared to none in 1998. Interest expense was $15,846,000 for the year ended December 31, 1999, compared to $19,596,000 for the comparable period in 1998. The $3,750,000 (19.1%) decrease was partially attributable to the Company's filing Chapter 11, discontinuing the accrual of interest on the 10 1/4% Senior Notes as of the Petition Date, which resulted in a savings of $6,047,000. Such savings were offset by additional interest expense on the secured debt due to higher outstanding balances in 1999 as compared to 1998. The average amounts of applicable interest-bearing debt in 1999 and 1998 were $210,928,000 and $195,863,000, respectively. The effective annualized interest rate in 1999 and 1998 was 10.0%. Year Ended December 31, 1998 Compared to Year Ended December 31, 1997 The Company's total oil and gas revenues for the year ended December 31, 1998 were $62,785,000, representing a decrease of $9,515,000 (13%) over revenues of $72,300,000 in 1997. Lower commodity prices accounted for a decrease in revenues of approximately $10,900,000, which was partially offset by an increase of approximately $1,400,000 due to an increase in production. The average net oil price per barrel received in 1998 was $14.31 compared to $17.77 in 1997, a 19% decrease, and the average net gas price received in 1998 was $2.05 compared to $2.29 in 1997, a 10% decrease. Of the above average net price, hedging increased revenue by $3.27 per Bbl for oil and $.11 per Mcf for gas. Total hedging revenue in 1998 was $8,221,000 compared to a loss of $1,225,000 for 1997. Oil and gas production was 28,768 Mmcfe in 1998 compared to 27,748 Mmcfe in 1997, a 4% increase. Of the 1,020 Mmcfe increase, approximately 6,468 Mmcfe was due to successful drilling activities and 3,156 Mmcfe was due to the Manti and Ballard acquisitions, less a loss of 3,630 Mmcfe on properties sold in 1997, and less 4,974 Mmce due to decline. Interest and other revenues were $551,000 for the year ended December 31, 1998 compared to $940,000 in 1997, representing a decrease of $389,000. Of this decrease, $48,000 was related to a decrease in interest income due to a reduction in funds earning interest. Gains on investment transactions related to the 11 14 interest rate swap also decreased from the year ended December 31, 1997 by $341,000 which was due to the reduced amount of time that the swap was accounted for as an investment. Gain on sale of assets was $266,000 for 1998 compared to $3,261,000 for 1997, representing a decrease of $2,995,000 (92%), due to no significant sales in 1998 from which gains were recognized. Oil and gas production costs for the year ended December 31, 1998 were $27,366,000 ($0.95 per Mmcfe), compared to $30,029,000 in 1997 ($1.08 per Mmcfe), representing a decrease of $2,663,000 (9%). On a per Mmcfe basis production costs decreased $0.13 (12%) due to a combination of lower production costs on newly completed gas wells, the sale of certain properties and the Company's continued cost containment efforts. General and administrative expenses for the year ended December 31, 1998 were $11,766,000, representing an increase of $3,359,000 (40%) from 1997 of $8,407,000. The increase is primarily due to additional personnel and related costs necessary to accommodate the Company's oil and gas activities, costs associated with the obligations of the Company to Ballard following the Ballard Acquisition and an increase in June 1998 from 50% to 100% ownership in Redeco. Also, increases in property taxes, bad debt expense and reduced administrative fees from the operation of wells sold in 1997 contributed to increased general and administrative expenses in 1998. The bad debt expense included a $476,000 charge for a note receivable due from a non-consolidated affiliate that is primarily owned by certain officers of the Company. Exploration and abandonment expense increased to $12,723,000 for the year ended December 31, 1998 compared to $6,588,000 in 1997. The Company incurred $2,361,000 of seismic costs for the year ended December 31, 1998, compared to $2,117,000 in 1997. The Company incurred $1,490,000 of other geological and geophysical costs during the year as compared to $887,000 in 1997. The increase in exploration and abandonments expense was primarily related to a decrease in the Company's success rate on exploratory wells to 52% in 1998 from 60% in 1997. Depreciation, depletion and amortization ("D D & A") expense for the year ended December 31, 1998 was $32,447,000 compared to $26,409,000 for 1997, representing an increase of $6,038,000 (23%). During the 1998 period, D D & A on oil and gas production was computed at an average rate of $1.13 per Mmcfe compared to $0.95 per Mmcfe for 1997. Approximately $7,297,000 and $3,562,000 of this increase was due to increased production on successful drilling activities in 1998 and acquisitions, respectively. These increases were partially offset by $4,390,000 of D D & A resulting from lower commodity prices that is reflected in impairment. The remainder of the increase was due primarily to the effect of lower oil and gas prices at December 31, 1998 than those experienced at December 31, 1997. Impairment of oil and gas properties for the year ended December 31, 1998 was $59,678,000 compared to $28,189,000 for 1997. The SFAS 121 impairment in 1998 was $23,548,000 for U.S. producing properties and $4,597,000 for Moldova properties. In addition, there was $433,000 of impairment for unproved properties, $26,710,000 for properties held for resale and $4,390,000 of additional D D & A due to lower commodity prices on U. S. properties reflected as impairment. Interest expense was $19,596,000 for the year ended December 31, 1998, compared to $12,979,000 for the comparable period in 1997. The $6,617,000 (51%) increase was attributable to increased levels of debt, offset slightly by a decrease in the effective interest rate. The average amounts of applicable interest-bearing debt in 1998 and 1997 were $195,863,000 and $128,207,000, respectively. The effective annualized interest rate in 1998 was 10.0%, as compared to 10.1% in 1997. Results of operations for the year ended December 31, 1998 included an extraordinary charge of $299,000 compared to $219,000 for the comparable period in 1997. These extraordinary charges related to the early extinguishments of the Company's bank credit facilities and consisted of the unamortized balance of previously capitalized debt issuance costs. 12 15 Year Ended December 31, 1997 Compared to Year Ended December 31, 1996 The Company's total oil and gas revenues for the year ended December 31, 1997 were $72,300,000, representing an increase of $18,381,000 (34%) over revenues of $53,919,000 in 1996. This increase was primarily due to successful drilling activities and the 1996 Acquisition, which accounted for approximately $11,099,000 and $9,214,000 of increased revenue, respectively. The Ballard Acquisition accounted for approximately $3,372,000 of the increase. Gas imbalances accounted for approximately $2,340,000 of the increase, with an average price of $1.56 per Mcf. Approximately 50% of the gas imbalance relates to production in prior periods against which a valuation allowance had been recorded due to uncertainty of ultimate collection. During the year ended December 31, 1997, uncertainties related to these imbalances were substantially reduced and the related valuation allowance reversed. Management does not expect similar effects from gas imbalances in future periods. These increases were partially offset by the $2,152,000 net effect of lower commodity prices. The average oil price per barrel received in 1997 was $17.77 compared to $19.87 in 1996, an 11% decrease, and the average gas price received in 1997 was $2.29 compared to $2.13 in 1996, a 7% increase. The sale of certain properties in April 97 and December 31, 1996 also partially offset the increased revenues in the amount of $3,607,000. Oil and gas production was 4,625 MBOE in 1997 compared to 3,260 MBOE in 1996, a 42% increase. Of the 1,365 MBOE increase, approximately 657 MBOE was due to successful drilling activities and 539 MBOE was due to the properties acquired in the 1996 Acquisition. Gas imbalances accounted for approximately 249 MBOE of the increase. The Ballard Acquisition properties accounted for approximately 219 MBOE of the increase. The sale of certain properties in April, 1997 and December 1996 partially offset the increased production volumes. Interest and other revenues were $940,000 for the year ended December 31, 1997 compared to $40,000 in 1996, representing an increase of $900,000. $223,000 of this increase was related to increased interest income due to increased funds earning interest. Gains on investment transactions of $510,000 were recorded for the year ended December 31, 1997 related to an interest rate swap contract which was marked-to-market. In the year ended December 31, 1996 losses of $195,000 were recognized on certain investment transactions. Losses of $146,000 related to an oil collar which was marked-to-market. No comparable transactions existed in 1996. Other income was $3,261,000 for the year ended December 31, 1997 compared to $1,067,000 for 1996, representing an increase of $2,194,000 (206%). Gains from the sale of certain oil and gas properties increased by approximately $2,118,000. The remainder of the increase was due primarily to a gain of approximately $70,000 recognized on the sale of the Company's interest in a partnership which owned the Independence Plaza Building in Midland, Texas. Oil and gas production costs for the year ended December 31, 1997 were $30,029,000 ($6.49 per BOE), compared to $21,774,000 in 1996 ($6.68 per BOE), representing an increase of $8,255,000 (38%), with approximately $4,026,000 of the increase relating to the 1996 Acquisition and $1,583,000 to successful drilling activities. The remainder of the increase was due primarily to increased treating and transportation costs due to increased gas production and, to a lesser extent, the Ballard Acquisition, offset in part by the sale of certain high operating cost properties in April 1997. On a per BOE basis, production costs decreased $0.19 (3%) due to a combination of the sale of certain high operating cost properties in April 1997, the gas imbalance volumes and lower production costs on newly completed wells. General and administrative expenses for the year ended December 31, 1997 were $8,407,000, representing an increase of $3,169,000 (66%) from 1996 of $5,238,000. The increase is primarily due to additional personnel and related costs necessary to accommodate the acceleration of the Company's oil and gas activities, the Ballard Acquisition, increased insurance costs and other costs for a full twelve month period related to becoming a public company in October, 1996. Exploration and abandonment expense increased to $6,588,000 for the year ended December 31, 1997 compared to $2,550,000 in 1996. The Company incurred $2,117,000 of seismic costs for the year ended December 31, 1997, compared to $913,000 in 1996. Dry hole and abandonment costs increased to $3,584,000 13 16 in 1997 from $1,524,000 in 1996. The Company incurred $887,000 of other geological and geophysical costs during the year ended December 31, 1997, compared to $113,000 in 1996. The increase in exploration and abandonments expense was primarily related to the Company's increased drilling activities in 1997 compared to a very low level of activity in 1996. D D & A expense for the year ended December 31, 1997 was $26,409,000 compared to $12,430,000 for 1996, representing an increase of $13,979,000 (112%). During the 1997 period, D D & A on oil and gas production was provided at an average rate of $5.71 per BOE compared to $3.81 per BOE for 1996. Approximately $3,751,000 of this increase was due to successful drilling activities, $3,078,000 related to the 1996 Acquisition and an additional $1,018,000 of the increase was due to the recording of gas imbalances. The remainder of the increase was due primarily to the effect of lower oil and gas prices at December 31, 1997 than those experienced at December 31, 1996. Impairment of oil and gas properties for the year ended December 31, 1997 was $28,189,000. No comparable expense was recorded in 1996. This impairment expense was determined under the guidelines of FAS 121 (Impairment of Long-Lived Assets) using estimates of net undiscounted cash flow and estimated present values for the Company's oil and gas reserves based upon the non-escalated prices used in the Company's December 31, 1997 reserve report. Interest expense was $12,979,000 for the year ended December 31, 1997, compared to $11,281,000 for the comparable period in 1996. The $1,698,000 (15%) increase was attributable primarily to increased levels of debt offset in part by a decrease in the effective interest rate. The average amounts of applicable interest-bearing debt in 1997 and 1996 were $128,207,000 and $95,671,000, respectively. The effective annualized interest rate in 1997 was 10.1%, as compared to 11.8% in 1996. Results of operations for the year ended December 31, 1997 include an extraordinary charge of $219,000 compared to $4,975,000 for the comparable period in 1996. These extraordinary charges related to the early extinguishment of the Company's prior bank credit facilities and consisted of the unamortized balance of previously capitalized debt issuance costs. 14 17 LIQUIDATION All of the Company's oil and gas properties were sold in the Dreyfus Sale. The remaining assets of the Company, which consisted principally of office furniture and equipment and potential claims against third parties, were transferred to the Liquidating Trust pursuant to the Plan as of the Plan's effective date, October 1, 2000. The Liquidating Trustee will liquidate the remaining assets and distribute the proceeds of liquidation (less costs and expenses related to the liquidation and the bankruptcy) in the discretion of the Liquidating Trustee under supervision of the Bankruptcy Court. Such liquidation may include liquidating claims formerly held by the Company by litigation or otherwise, as well as the sale of the remaining physical assets. In addition, the Bankruptcy Court will determine the validity and amount of certain claims against the Company in the bankruptcy as a result of disputes regarding and objections to such claims. The Liquidating Trustee intends to reserve certain funds from the proceeds of the Dreyfus Sale to cover the amount of certain disputed and contingent claims and to fund the costs of liquidation, claim resolution and similar matters, including attorney's fees. Such reserved amounts has reduced the amount available for distribution to creditors. The activities to be funded by the reserved amounts may result in additional amounts becoming available for distribution to creditors, but no assurances can be made as to the timing or amount of any future distributions. The following is a brief summary of the anticipated liquidation and distribution (based upon the assumptions and qualifications set forth in the Disclosure Statement): COSTILLA ENERGY INC. Distribution of Estimated Proceeds Per Plan

15 18 ALLOCATION OF NET ESTIMATED LIQUIDATION PROCEEDS TO SECURED, ADMINISTRATIVE, PRIORITY AND UNSECURED CLAIMANTS SUBJECT TO RESERVES (in thousands)

The foregoing information is based on certain assumptions and subject to qualifications set forth in the Disclosure Statement. It is likely that such assumptions may differ from actual circumstances and actual results may differ materially from the foregoing anticipated results. The initial distributions were subject to reduction to provide the above-described reserves. Certain of the reserves will be utilized to liquidate remaining assets, including potential lawsuits. No assurances can be made that the funds used to pay such expenditures will result in any additional amounts being available for distribution and may result in the loss of such funds. SUBSEQUENT DISTRIBUTIONS In November 2000 a distribution was made to Class 7 General Unsecured Creditors in the amount of $82.5 million, which represented approximately 43% of the total of Class 7 Claims. Also, in November 2000 all principal and non-default interest due to Bankers Trust pursuant to their Class 2 hedging claim was paid in the amount of approximately $21.1 million, including certain expenses and subject to repayment of any amount disallowed subsequent to the payment. A repayment of $.5 million was received by Costilla from Bankers Trust in January 2001. In March 2001 another distribution was made to Class 7 General Unsecured Creditors in the amount of $5.0 million, which brought the aggregate payments to approximately 46% of the total of Class 7 Claims. 16 19 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. For the financial statements and supplementary data required by this Item 8, see the Index to Consolidated Financial Statements on page F-1 in this Form 10-K. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. 17 20 PART III. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. The Company no longer has any officers or directors, the last of whom resigned on or about September 26, 2000. Under the Plan, the Liquidating Trustee has all of the management functions of the officers and directors of the Company and may cause the Company to take any action that might otherwise require the approval of the shareholders, officers or directors of the Company without obtaining such approval. ITEM 11. EXECUTIVE COMPENSATION. During the pending of the Company's bankruptcy proceeding prior to confirmation of the Plan, various officers and employees of the Company received compensation from the Company, including certain retention bonuses for remaining with the Company through specified periods or specified events such as the Dreyfus Sale or confirmation of the Plan. All such compensation arrangements were approved by the Bankruptcy Court and terminated and superceded all prior employment, termination and severance contracts and arrangements. All stock options held by officers, directors and employees were canceled under the terms of the Plan canceling all equity interests. The Compensation Committee of the Company's Board of Directors did not make any compensation decisions after those disclosed in prior filings. All other information relative to this Item has been rendered moot due to the bankruptcy and liquidation of the Company. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. Under the terms of the Plan, all of the shares of the Company's common stock were canceled and there are currently zero shares of common stock outstanding. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Since all of the officers and directors have resigned, there is no disclosure required under this Item. 18 21 PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. FINANCIAL STATEMENT SCHEDULES No Financial Statement Schedules are required with this report. For a list of the consolidated financial statements filed as a part of this report, see the Index to Consolidated Financial Statements on Page F-1. REPORTS ON FORM 8-K The Company has filed the following reports on Form 8-K since September 30, 1999: 1. Form 8-K reporting the filing of a plan of reorganization in the Company's bankruptcy proceeding, filed February 14, 2000. 2. Form 8-K reporting the filing of a disclosure statement in the Company's bankruptcy proceeding filed March 3, 2000. 3. Form 8-K reporting the Dreyfus Sale, filed June 22, 2000. 4. Form 8-K reporting confirmation of the Plan, filed October 13, 2000. EXHIBITS

19 22 4.2 Indenture dated as of October 1, 1996 by and between State Street Bank and Trust Company, as Trustee, and the Company, as Issuer; incorporated by reference to Registration Statement on Form S-1, File No. 333-08909 4.3 First Supplemental Indenture dated January 16, 1998 by and between State Street Bank and Trust Company, as Trustee, and the Company, as Issuer (including form of Global Certificate); incorporated by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1997 4.4 Form of Note; incorporated by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1997 4.5 Form of Stock Certificate; incorporated by reference to Registration Statement on Form S-1, File No. 333-08913 10.1 Option to Purchase Agreement dated December 16, 1998 between Pioneer Natural Resources USA, Inc., Pioneer Resources Producing, L.P. and the Company; incorporated by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1998 10.2 Purchase and Sale Agreement dated December 16, 1998 between Pioneer Natural Resources USA, Inc., Pioneer Resources Producing, L.P. and the Company; incorporated by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1998 10.3 Sixth Amendment to Amended and Restated Credit Agreement dated as of November 19, 1998 between Bankers Trust Company, as Agent, Union Bank of California, N.A., as Co-Agent, and the Company; incorporated by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1998 10.4 Purchase and Sale Agreement dated April 1, 1999 by and between Costilla Energy, Inc. and Pioneer Natural Resources USA, Inc. and Pioneer Resources Producing, L.P.; incorporated by reference to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1999 10.5 Seventh Amendment to Amended and Restated Credit Agreement dated as of March 9, 1999 between Bankers Trust Company, as Agent, Union Bank of California, N.A., as Co-Agent and Costilla Energy, Inc.; incorporated by reference to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1999 10.6 Eighth Amendment to Amended and Restated Credit Agreement dated as of March 9, 1999 between Bankers Trust Company, as Agent, Union Bank of California, N.A., as Co-Agent and Costilla Energy, Inc.; incorporated by reference to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1999 10.7 Purchase and Sale Agreement dated February 2, 1999 between Costilla Energy, Inc. and Ballard Petroleum LLC; incorporated by reference to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1999

20 23 10.8 Ninth Amendment to Amended and Restated Credit Agreement dated as of May 12, 1999 between Bankers Trust Company, as Agent, Union Bank of California, N.A., as Co-Agent and Costilla Energy, Inc.; incorporated by reference to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1999 10.9 Tenth Amendment to Amended and Restated Credit Agreement dated as of May 27, 1999 between Bankers Trust Company, as Agent, Union Bank of California, N.A., as Co-Agent and Costilla Energy, Inc.; incorporated by reference to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1999 10.10 Eleventh Amendment to Amended and Restated Credit Agreement dated as of June 17, 1999 between Bankers Trust Company, as Agent, Union Bank of California, N.A., as Co-Agent and Costilla Energy, Inc.; incorporated by reference to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1999 10.11 Twelfth Amendment to Amended and Restated Credit Agreement dated as of August 16, 1999 between Bankers Trust Company, as Agent, and the Company; incorporated by reference to the Company's Quarterly Report on Form 10-Q for the quarter ended September, 1999 10.12 Asset Purchase Agreement by and between Costilla Energy, Inc. and Louis Dreyfus Natural Gas Corp. dated April 20, 2000; incorporated by reference to the Company's Current Report on Form 8-K filed June 22, 2000

---------- *Filed herewith. All other exhibits are incorporated by reference to the filing indicated. 21 24 SIGNATURES 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, thereunto duly authorized. COSTILLA ENERGY, INC. Date: March 30, 2001 By: /s/ Bobby W. Page -------------------------------------------- Bobby W. Page, Plan Trustee of the Costilla Liquidating Trust Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacities and on the dates indicated. The registrant does not have any officers or directors, and the undersigned Trustee is fully and duly authorized by Bankruptcy Court Order to take action on behalf of the Company in place of and with all authority of the Company's officers and directors. Date: March 30, 2001 By: /s/ Bobby W. Page -------------------------------------------- Bobby W. Page, Plan Trustee of the Costilla Liquidating Trust 22 25 INDEX TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) Consolidated Financial Statements of Costilla Energy, Inc.: Consolidated Balance Sheets as of December 31, 1999 and 1998....................................... F - 2 Consolidated Statements of Operations for the years ended December 31, 1999, 1998 and 1997................................................................................... F - 3 Consolidated Statements of Stockholders' Equity (Deficit) for the years ended December 31, 1999, 1998 and 1997................................................................................... F - 4 Consolidated Statements of Cash Flows for the years ended December 31, 1999, 1998 and 1997................................................................................... F - 5 Notes to (Unaudited) Consolidated Financial Statements............................................ F - 7

F-1 26 COSTILLA ENERGY, INC. (DEBTOR-IN-POSSESSION) CONSOLIDATED BALANCE SHEETS (IN THOUSANDS)

See accompanying notes to consolidated financial statements. F-2 27 COSTILLA ENERGY, INC. (DEBTOR-IN-POSSESSION) CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE DATA)

See accompanying notes to consolidated financial statements. F-3 28 COSTILLA ENERGY, INC. (DEBTOR-IN-POSSESSION) CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT) (IN THOUSANDS)

See accompanying notes to consolidated financial statements. F-4 29 COSTILLA ENERGY, INC. (DEBTOR-IN-POSSESSION) CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS)

See accompanying notes to consolidated financial statements. F-5 30 COSTILLA ENERGY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (THE INFORMATION AND AMOUNTS FOR 1999 ARE UNAUDITED)

F-6 31 COSTILLA ENERGY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (THE INFORMATION AND AMOUNTS FOR 1999 ARE UNAUDITED) (1) ORGANIZATION AND NATURE OF OPERATIONS Costilla Energy, Inc. ("Costilla" or the "Company") was incorporated in Delaware in June 1996 to consolidate and continue the activities previously conducted by Costilla Energy, L.L.C., a Texas limited liability company, and its wholly owned subsidiaries, to acquire the assets of CSL Management Corporation ("CSL") (which owned certain office equipment used by the Company), and to acquire the stock of Valley Gathering Company ("Valley"). Costilla was formed for the purpose of conducting a $60 million initial public offering of common stock and a $100 million senior notes offering (the "Offerings"), which Offerings were completed in early October 1996. The Company is an oil and gas exploration and production concern with properties located principally in South and East Texas, the Rocky Mountains and the Permian Basin regions of the United States. (2) BANKRUPTCY PROCEEDINGS On September 3, 1999 (the "Petition Date"), the Company filed a voluntary petition for relief under Chapter 11 of U. S. Bankruptcy Code ("Chapter 11"). The filing was made in the U. S. Bankruptcy Court in Midland, Texas (the "Bankruptcy Court"). At December 31, 1999, the Company continued to operate as a debtor-in-possession subject to the supervision and orders of the Bankruptcy Court. The accompanying financial statements have been prepared on a going concern basis, which contemplates continuity of operations, realization of assets and liquidation of liabilities in the normal course of business. As a result of the bankruptcy filing, the sale of all of the Company's oil and gas assets in June 2000 and the confirmation of a plan of reorganization (liquidation) in September 2000, the carrying amounts of all assets may not be realized and certain liabilities will be settled for less than the amounts recorded. In addition, the common and preferred stock of the Company was cancelled effective October 1, 2000 pursuant to the confirmed plan. (3) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation As of December 31, 1999 and 1998, the consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. The Company proportionately consolidates less than 100%-owned oil and gas partnerships and joint ventures in accordance with industry practice. All significant accounts and transactions between the Company and its subsidiaries have been eliminated. At December 31, 1996 Costilla had three wholly owned subsidiaries: (i) Costilla Petroleum Corporation, a Texas corporation ("CPC"), which operated properties owned by Costilla and owned minor interests in the same properties, (ii) Statewide Minerals, Inc., a Texas corporation ("Statewide"), which had engaged in the purchase of small royalty and mineral interests; and (iii) Valley, which owned several small gas gathering systems, a small gas processing plant, certain salt water disposal systems and gas compressors. Costilla and CPC were the sole members of two Texas limited liability companies through which the Company's Moldova operations are conducted. On January 1, 1997 CPC was merged into its parent and Costilla assumed the business, assets and liabilities of CPC. On March 1, 1997 Valley was merged into its parent and Costilla assumed the business, assets and liabilities of Valley. On March 5, 1997 Statewide was dissolved. This dissolution was effected for administrative purposes subsequent to the sale on December 31, 1996 of substantially all of the assets of Statewide for net F-7 32 COSTILLA ENERGY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (THE INFORMATION AND AMOUNTS FOR 1999 ARE UNAUDITED) proceeds of approximately $3.0 million. The remaining unsold producing oil and gas properties were transferred to Costilla on December 31, 1996. Use of Estimates Preparation of the accompanying consolidated financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Cash and Cash Equivalents For purposes of the statements of cash flows, cash and cash equivalents include cash on hand and depository accounts held by banks. The Company considers all highly liquid investments with a remaining maturity of three months or less to be cash equivalents. Concentrations of Credit Risk Financial instruments that potentially expose the Company to concentrations of credit risk consist primarily of unsecured accounts receivable from unaffiliated working interest owners and crude oil and natural gas purchasers. For the year ended December 31, 1999, Costilla had sales to one purchaser which totaled in excess of 10% of total revenues. During the year ended December 31, 1998, the Company had sales to one purchaser which totaled 16% of total revenues. Trade Receivables Trade receivables generally consist of amounts due from outside working interest owners for their proportionate share of drilling and operating costs incurred by the Company, as operator of the related properties. These accounts are from a large number of major and independent oil companies, individuals and others who own interests in the properties operated by the Company. The oil and gas sales receivables are primarily from large oil and gas purchasers. Hedging and Derivative Financial Instruments Costilla used derivative financial instruments to reduce the Company's exposure to changes in the market price of natural gas and crude oil, to fix the price for natural gas and crude oil independently of the physical purchase or sale, and to manage interest rates. The types of commodity derivative financial instruments used by the Company were futures, swaps and options. The financial instruments that the Company accounts for as hedging contracts must meet the following criteria: the underlying asset or liability must expose the Company to price or interest rate risk that is not offset in another asset or liability, the hedging contract must reduce that price or interest rate risk, and the instrument must be designated as a hedge at the inception of the contract and throughout the contract period. In order to qualify as a hedge, there must be clear correlation between changes in the fair value of the financial instrument and the fair value of the underlying asset or liability such that changes in the market value of the financial instrument will be offset by the effect of price or interest rate changes on the exposed items. Premiums paid for commodity option contracts and interest rate swap agreements which qualify as hedges are amortized to oil and gas sales and interest expense, respectively, over the terms of the agreements. Unamortized premiums are included in other assets in the consolidated balance sheet. Amounts receivable under F-8 33 COSTILLA ENERGY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (THE INFORMATION AND AMOUNTS FOR 1999 ARE UNAUDITED) the commodity option contracts and interest rate swap agreements are accrued as an increase in oil and gas sales and a reduction of interest expense, respectively, for the applicable periods. When these derivative financial instruments cease to qualify as hedges, these instruments are classified as investments held for trading purposes. Investments held for trading purposes are marked to market at the end of each reporting period and the net balance change is recorded as other income (loss) in the consolidated statement of operations for the applicable period. In June 1998, the FASB issued Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS No. 133"). SFAS No. 133 establishes accounting and reporting standards requiring that every derivative instrument (including certain derivative instruments embedded in other contracts) be recorded in the balance sheet as either an asset or liability measured at its fair value. SFAS No. 133 requires that changes in the derivative's fair value be recognized currently in earnings unless specific hedge accounting criteria are met. Special accounting for qualifying hedges allows a derivative's gains and losses to offset related results on the hedged item in the income statement. Companies must formally document, designate, and assess the effectiveness of transactions that receive hedge accounting. SFAS No. 133 is effective for fiscal years beginning after June 15, 1999; however, beginning June 16, 1998, companies may implement the statement as of the beginning of any fiscal quarter. SFAS No. 133 cannot be applied retroactively and must be applied to (a) derivative instruments and (b) certain derivative instruments embedded in hybrid contracts that were issued, acquired, or substantively modified after December 31, 1997 (and, at the Company's election, before January 1, 1998.) The Company has not yet quantified the impact of adopting SFAS No. 133 on its financial statements and has not determined the timing of or method of adoption of SFAS No. 133. Oil and Gas Properties The Company uses the successful efforts method of accounting for oil and gas producing activities. Costs to acquire mineral interests in oil and gas properties, to drill and equip exploratory wells that find proved reserves, and to drill and equip development wells are capitalized. Costs to drill exploratory wells that do not find proved reserves, geological and geophysical costs, and costs of carrying and retaining unproved properties are expensed. Unproved oil and gas properties that are individually significant are periodically assessed for impairment of value, and a loss is recognized at the time of impairment by providing an impairment allowance. Other unproved properties are amortized based on the Company's experience of successful drilling and average holding period. Capitalized costs of producing oil and gas properties, after considering estimated dismantlement and abandonment costs and estimated salvage values, are depreciated and depleted by the unit-of-production method. Support equipment and other property and equipment are depreciated over their estimated useful lives of the assets, which range from 5 to 7 years. On sale or retirement of a complete unit of a proved property, the cost and related accumulated depreciation, depletion, and amortization are eliminated from the property accounts, and the resultant gain or loss is recognized. On retirement or sale of a partial unit of proved property, the amount received is treated as a reduction of the cost of the interest retained. On sale of an entire interest in an unproved property for cash or cash equivalent, gain or loss on the sale is recognized, taking into consideration the amount of any recorded impairment if the property had been assessed individually. If a partial interest in an unproved property is sold, the amount received is treated as a reduction of the cost of the interest retained. F-9 34 COSTILLA ENERGY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (THE INFORMATION AND AMOUNTS FOR 1999 ARE UNAUDITED) Impairment of Long-Lived Assets As of January 1, 1995, the Company adopted the provisions of Statement of Financial Accounting Standards No. 121 - Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of ("SFAS 121"). Consequently, the Company reviews its long-lived assets to be held and used, including oil and gas properties accounted for under the successful efforts method of accounting, whenever events or circumstances indicate that the carrying value of those assets may not be recoverable. An impairment loss is indicated if the sum of the expected undiscounted future cash flows, on a depletable unit basis, is less than the carrying amount of such assets. In this circumstance, the Company recognizes an impairment loss for the amount by which the carrying amount of the asset exceeds the fair value of the asset, as determined, based upon discounted future net cash flows. Long-lived assets and certain identifiable intangibles to be disposed of are recorded at the lower of their carrying amount or fair value less cost to sell. The fair value of the asset is determined based upon the related discounted future net cash flows or their estimated market values, in the case of non-producing properties. Deferred Charges The Company capitalized certain costs incurred in connection with the issuance of $180 million of senior notes and with obtaining the Revolving Credit Facility (see Note 8 for definitions and descriptions of each). These costs are being amortized over the lives of the related instruments. Revenue Recognition The Company uses the sales method of accounting for crude oil revenues. Under this method, revenues are recognized based on actual volumes of oil sold to purchasers. The Company uses the entitlements method of accounting for natural gas revenues. Under this method, revenues are recognized based on actual production of natural gas. As of December 31, 1999, the Company has recorded a net gas imbalance receivable for gas previously produced of approximately $1,879,000, comprised of approximately 1,144,000 Mcf at a net price of $1.64 per Mcf. As of December 31, 1998, the Company had recorded a net gas imbalance receivable for gas previously produced of approximately $1,532,227, comprised of approximately 974,296 Mcf at a net price of $1.58 per Mcf. Stock-based Compensation The Company accounts for employee stock-based compensation using the intrinsic value method prescribed by Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25"). Accordingly, the Company has only adopted the disclosure provisions of Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123"). See Note 14 for the pro forma disclosures of compensation expense determined under the fair-value provisions of SFAS 123. Income Taxes The Company accounts for income taxes in accordance with the provisions of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS 109"). Under the asset and liability method of SFAS 109, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Under SFAS 109, the effect on deferred tax assets and liabilities of a change in tax rate is recognized in income in the period that includes the enactment date. F-10 35 COSTILLA ENERGY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (THE INFORMATION AND AMOUNTS FOR 1999 ARE UNAUDITED) Loss Per Share In February, 1997 the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 128, "Earnings per Share" ("SFAS 128") which simplifies the existing standards for computing earnings per share ("EPS") and makes them comparable to international standards. In accordance with the provisions of SFAS 128, the Company adopted SFAS 128 in its year ended December 31, 1997 financial statements, although no restatement of prior period EPS information was necessary. Under SFAS 128, primary EPS is replaced by "basic" EPS, which excludes dilution and is computed by dividing income available to common stockholders by the weighted average number of common shares outstanding for the period. "Diluted" EPS, which is computed similarly to fully-diluted EPS, reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the entity. For the years ended December 31, 1999, 1998 and 1997, the computation of diluted net loss per share was antidilutive; therefore, the amounts reported for basic and diluted net loss per share were the same. Environmental The Company is subject to extensive Federal, state and local environmental laws and regulations. These laws, which are constantly changing, regulate the discharge of materials into the environment and may require the Company to remove or mitigate the environmental effects of the disposal or release of petroleum or chemical substances at various sites. Environmental expenditures are expensed or capitalized depending on their future economic benefit. Expenditures that relate to an existing condition caused by past operations and that have no future economic benefits are expensed. Liabilities for expenditures of a noncapital nature are recorded when environmental assessment and/or remediation is probable, and the costs can be reasonably estimated. Such liabilities are generally recorded at their undiscounted amounts unless the amount and timing of payments is fixed or reliably determinable. Reporting Comprehensive Income In June 1997, the FASB issued Statement of Financial Accounting Standards No. 130 "Reporting Comprehensive Income" ("SFAS 130") which establishes standards for reporting and display of comprehensive income and its components in a full set of general-purpose financial statements. Specifically, SFAS 130 requires that an enterprise (i) classify items of other comprehensive income by their nature in a financial statement and (ii) display the accumulated balance of other comprehensive income separately from retained earnings and additional paid-in capital in the equity section of a statement of financial position. This statement currently has no effect on the Company. Segment Reporting In June 1997, the FASB issued Statement of Financial Accounting Standards No. 131 "Disclosures about Segments of an Enterprise and Related Information" ("SFAS 131") which establishes standards for public business enterprises for reporting information about operating segments in annual financial statements and requires that such enterprises report selected information about operating segments in interim financial reports issued to shareholders. This statement also establishes standards for related disclosures about products and services, geographic areas and major customers. The Company implemented SFAS 131 during 1998. F-11 36 COSTILLA ENERGY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (THE INFORMATION AND AMOUNTS FOR 1999 ARE UNAUDITED) (4) ACQUISITIONS AND DISPOSITIONS OF OIL AND GAS PROPERTIES On August 28, 1997, the Company consummated the purchase from Ballard Petroleum LLC ("Ballard") of certain oil and gas properties for an adjusted purchase price of approximately $41.2 million (the "Ballard Acquisition"). The properties are located primarily in the Rocky Mountain region of the United States. The transaction was accounted for using the purchase method. The results of operations of the acquired properties are included in the Consolidated Statements of Operations as of the acquisition closing date, August 28, 1997. In addition, the Company and Ballard entered into an agreement that established an area of mutual interest in the Rocky Mountain region in which the parties would jointly own, acquire, explore and develop oil and gas properties. This agreement was terminated in connection with the Ballard Sale (as defined below). In March 1999 the Company closed a sale to Ballard (the "Ballard Sale") of substantially all of the assets the Company acquired from Ballard in the Ballard Acquisition. The oil and gas properties included in the sale are located primarily in the Rocky Mountain Region. The unadjusted cash purchase price for the sale was $14,150,000, of which $12,000,000 was utilized to reduce the Credit Facility. In addition to the sale of assets, the transaction relieved the Company of certain ongoing obligations to Ballard which the Company assumed in the Ballard Acquisition. In May and June 1999 the Company sold its remaining Rocky Mountain oil and gas properties for an adjusted purchase price of approximately $15.5 million, of which approximately $9.1 million was utilized to reduce the credit facility. Pro Forma Results of Operations (unaudited) The following table reflects the pro forma results of operations as though the Ballard Acquisition had occurred on January 1, 1997. The pro forma amounts are not necessarily indicative of the results that may be reported in the future.

Concho 1998 Sale. In November 1998, the Company consummated the sale of oil and gas properties to Concho Resources, Inc. for $8.1 million (the "Concho 1998 Sale"). These properties had assigned proved reserves of 16.7 Bcfe at October 1, 1998. Proceeds were used for general corporate purposes. (5) IMPAIRMENT OF LONG-LIVED ASSETS In order to determine whether an impairment had occurred at December 31, 1999 and 1998, the Company estimated the expected undiscounted future cash flows of its oil and gas properties on a depletable unit basis and compared such future cash flows to the carrying amount of the related oil and gas properties to determine if the carrying amount was recoverable. If the costs of a depletable unit did not appear to be recoverable, impairment on the depletable unit was recorded equal to the difference between the estimated present value and the costs. These estimates of net undiscounted cash flow and estimated present values for the Company's total proved and probable F-12 37 COSTILLA ENERGY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (THE INFORMATION AND AMOUNTS FOR 1999 ARE UNAUDITED) oil and gas reserves were based upon the escalated prices. Based on this process, a noncash pre-tax writedown of $11,863,000 compared to $59,678,000 for 1998, in the carrying amount of the Company's proved properties was recorded at December 31, 1999. (6) DERIVATIVE FINANCIAL INSTRUMENTS The Company utilizes derivative financial instruments to manage well-defined interest rate and commodity price risks. The Company is exposed to credit losses in the event of nonperformance by the counterparties to its interest rate swap agreements and its commodity hedges. The Company only deals with reputable financial institutions as counterparties and anticipates that such counterparties will be able to fully satisfy their obligations under the contracts. The Company does not obtain collateral or other security to support financial instruments subject to credit risk but monitors the credit standing of the counterparties. Commodity Hedges. The Company utilizes swap agreements to hedge the effect of price changes on future oil and gas production. The objective of its hedging activities is to achieve more predictable revenues and cash flows. In a typical swap arrangement, the Company receives the difference between a fixed price per unit of production and a price based upon a higher agreed to third party index. However, should the fixed price exceed the agreed third party index, the Company has to pay the difference. In the past, the Company utilized option contracts to hedge its production. In this case, if market prices of oil and gas exceeded the strike price of put options, the options would expire unexercised, therefore reducing the effective price received for oil and gas sales by the cost of the related option. If the market prices of oil and gas exceeded the strike price of call options, the Company would be obligated to pay the contracting counterparty an amount equal to the contracted volumes times the difference between the market price and the strike price, therefore reducing the effective price received for oil and gas sales by the amount paid to the counterparty. Gains or losses on swap agreements are recognized as an adjustment to sales revenue when the related transactions being hedged are finalized. Gains or losses from swap agreements that do not qualify for accounting treatment as hedges are recognized currently as other income or expense. The cash flows from such agreements are included in operating activities in the consolidated statements of cash flows. The net effect of the Company's commodity hedging activities increased oil and gas revenues for 1999 by $96,000 and $8.2 million in 1998. Revenues were reduced by $1.2 for the year ended December 31, 1997. The following table sets forth the future volumes hedged by year and the weighted-average strike price of the option contracts at December 31, 1998. There were no hedge contracts outstanding at December 31, 1999: F-13 38 COSTILLA ENERGY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (THE INFORMATION AND AMOUNTS FOR 1999 ARE UNAUDITED)

---------- (a) The lower price is the threshold level for the buyer, when the NYMEX falls below this price, the contract provides for no hedge. When the NYMEX is above the threshold level but below the fixed price, the buyer pays the seller (Costilla). If the NYMEX is above the fixed price, the seller pays the buyer. In February 1999, the terms of the 1999 contract was amended to provide for a fixed price of $15.00 per Bbl covering 5,000 Bbls of oil per day for February 1999 through December 1999, with no hedge provided for each trading day during the period covered on which the NYMEX price for WTI closes at less than $12.00 per Bbl. (b) In February 1999, the three year fixed price swap contract was amended for a new period of March 1999 through December 2000 covering 45,000 Mmbtu of gas per day at a fixed price of $2.20 per Mmbtu. In March 1999 the contract for the period March 1999 through December 1999 was liquidated resulting in cash proceeds to the Company of $3.2 million. In addition, a new contract was entered into covering 20,000 Mmbtu of gas per day at a fixed price of $1.96 per Mmbtu for the period March 1999 through December 1999. The referenced gas prices are based upon the price at which gas trades on the NYMEX. (7) FAIR VALUE OF FINANCIAL INSTRUMENTS The following table presents the carrying amounts and estimated fair values of the Company's financial instruments at December 31, 1999 and 1998. SFASB Statement No. 107, Disclosures about Fair Value of Financial Instruments, defines the fair value of a financial instrument as the amount at which the instrument could be exchanged in a current transaction between willing parties. F-14 39 COSTILLA ENERGY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (THE INFORMATION AND AMOUNTS FOR 1999 ARE UNAUDITED)

The carrying amounts shown in the table are included in the statement of consolidated balance sheets under the indicated captions. The following methods and assumptions were used to estimate the fair value of each class of financial instruments: Cash, trade receivables, notes receivable-other and trade payables: The carrying amounts approximate fair value because of the short maturity of those instruments. Commodity swap and option contracts: The carrying amount of the commodity option contracts comprises the unamortized premiums paid for the option contracts. The fair value of the commodity option contracts is estimated using option pricing models and essentially values the potential for the option contracts to become in-the-money through changes in commodity prices during the remaining terms. The fair value of the commodity swap contracts is based on quotes received from the counterparties to the swap contracts. Gas imbalances receivable: The carrying amount reflects the net quantity of gas imbalances receivable based upon current prices at December 31, 1999 and 1998. The fair value is comprised of the volumes of natural gas overproduced or underproduced valued at the average spot prices in effect at December 31, 1999 and 1998. Notes receivable-affiliate: The amounts reported relate to notes receivable from an affiliated company. The carrying amount at December 31, 1997 reflects an estimate of net present value using an assumed annual interest rate of 9% based upon the anticipated note payment schedule. At December 31, 1998, the Company has recorded a provision for the entire unpaid balance of the note receivable, to reflect the uncertainty of collection. Long-term debt: The fair value of the Company's long-term debt is based upon the quoted market price for the senior notes at December 31, 1999 and 1998, and the carrying amounts outstanding under the credit facilities at December 31, 1999 and 1998 (see Note 8 for a complete discussion of long-term debt). F-15 40 COSTILLA ENERGY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (THE INFORMATION AND AMOUNTS FOR 1999 ARE UNAUDITED) Interest rate swap agreements: At December 31, 1998 and 1997, the Company had an interest rate swap agreement outstanding with a notional amount of $24 million. The carrying amount is equal to the sum of the unamortized premiums paid for the agreement and the fair value. The fair value of the interest rate swap agreement was obtained from bank quotes and represents the estimated amount the Company would pay upon termination of the agreement at December 31, 1998 and 1997, taking into consideration interest rates at that date. (8) LONG-TERM DEBT Long-term debt consists of the following (thousands):

REVOLVING CREDIT FACILITY In August 1997, the Company entered into a credit agreement (the "Revolving Credit Facility") with Bankers Trust Company, as agent, to refinance its prior bank indebtedness and to finance a portion of the Ballard Acquisition purchase price. The Revolving Credit Facility provides for a maximum availability of $75.0 million, $40.0 million of which was borrowed at December 31, 1998, against an available borrowing base of $40.0 million at such date. Borrowings under the Revolving Credit Facility bear interest, at the Company's option, at a floating rate which is at or above the Lender's prime rate or above the applicable Eurodollar rate, depending on the percentage of committed funds which have been borrowed. Interest is payable quarterly as to base rate loans, and at the end of the applicable interest period as to Eurodollar loans. The borrowing base of the Revolving Credit Facility is automatically reduced by 5% each quarter beginning in September 1999, and payments of principal are required in each quarter in which the outstanding principal balance is greater than the reduced borrowing base. The remaining balance is payable on August 28, 2002, the maturity date of the Revolving Credit Facility. Under the Revolving Credit Facility, the Company is obligated to pay certain fees to the lender, including a commitment fee based on the unused portion of the commitment. The Revolving Credit Facility contains customary restrictive covenants (including restrictions on the payment of dividends and the incurrence of additional indebtedness) and requires the Company to maintain certain specified financial ratios. Borrowings under the Revolving Credit Facility are secured by substantially all of the assets of the Company. At December 31, 1999, the Company was in violation of certain covenant requirements of its Revolving Credit Facility. Due to this non-compliance in 1999, the Company has continued to classify the balance of its long-term debt under the Revolving Credit Facility as a current liability at December 31, 1999. F-16 41 COSTILLA ENERGY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (THE INFORMATION AND AMOUNTS FOR 1999 ARE UNAUDITED) Additionally, the amendment to the Revolving Credit Facility requires the Company to establish, on or before May 1, 1999, a lockbox arrangement with the lenders and cause the proceeds from its production to be deposited pursuant to such arrangement. So long as no Event of Default exists under the Revolving Credit Facility, the Company can use such funds for its general corporate purposes. In August 1997, the Company also entered into a second credit agreement (the "Acquisition Credit Facility") with Bankers Trust Company, as agent, to provide funds for a substantial portion of the Ballard Acquisition purchase price. The Acquisition Credit Facility was a term loan in the amount of $30.0 million and was paid in full from the proceeds of the sale of the 1998 Notes (as defined below). 10.25% SENIOR NOTES In October 1996, the Company issued $100 million aggregate principal amount of 10.25% Senior Notes due October 1, 2006 (the "Notes"). The Notes were sold at par and interest is payable April 1 and October 1, commencing April 1, 1997. The Notes may not be redeemed prior to October 1, 2001, and thereafter at a premium reducing to par, plus interest, by maturity. There is no mandatory redemption of the Notes required prior to maturity. The Notes are general unsecured senior obligations of the Company and rank equally in right of payment with all other senior indebtedness of the Company. The Notes are subject to an Indenture between the Company and a trustee. The Indenture restricts, among other things, the Company's ability to incur additional indebtedness, pay dividends or make certain other restricted payments, incur liens, engage in any sale and leaseback transactions, sell stock of subsidiaries, apply net proceeds from certain assets sales, merge or consolidate with any other person, sell, assign, transfer, lease, convey or otherwise dispose of substantially all of the assets of the Company, or enter into certain transactions with affiliates. Net proceeds from the sale of the Notes of approximately $96.1 million were used to repay existing indebtedness. In January 1998, the Company issued an additional $80 million aggregate principal amount of 10.25% Senior Notes due October 1, 2006 (the "1998 Notes"). The notes were sold at a premium (102.5%) and interest is payable April 1 and October 1, commencing April 1, 1998. The 1998 Notes may not be redeemed prior to October 1, 2001, and thereafter at a premium reducing to par, plus interest, by maturity. The 1998 Notes are subject to the same terms and conditions as the Notes. Net proceeds from the sale of the 1998 Notes of approximately $80.2 million were used to repay the Acquisition Credit Facility in full, all but $500,000 of the Revolving Credit Facility and the remainder was used for general corporate working capital needs. The Company paid interest on long-term debt of $15,443,958, $17,915,404, $12,198,937 in 1999, 1998 and 1997, respectively. (9) INCOME TAXES Concurrent with the Offerings, the Company became a tax paying entity for U.S. Federal income tax purposes. At that date, the tax basis of the Company's assets and liabilities exceeded the book basis by approximately $3,500,000, resulting in a deferred tax asset of approximately $1,200,000. A valuation allowance was provided for 100% of this deferred tax asset. F-17 42 COSTILLA ENERGY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (THE INFORMATION AND AMOUNTS FOR 1999 ARE UNAUDITED) Income tax provision (benefit) and amounts separately allocated were as follows (thousands):

In 1998 and 1997, the Company's effective tax rate differs from the U.S. Federal statutory rate primarily because of a valuation allowance established for net operating loss carryforwards, as discussed below. The tax effects of temporary differences that give rise to significant portions of deferred tax assets and deferred tax liabilities are as follows:

A valuation is provided for when it is more likely than not that some portion of the deferred tax assets will not be realized. Due to uncertainties arising from a lack of earnings history, it does not appear more likely than not that the Company will be able to utilize all the available carryforwards prior to their ultimate expiration. At December 31, 1999, the Company has net operating loss carryforwards of approximately $195.5 million, which are available to offset future regular taxable income, if any. The carryforwards expire December 31, 2011 through 2014. On December 17, 1998, concurrent with the issuance of common stock to Pioneer (as discussed in Note 18), the Company incurred a change of control under Sec. 382 of the Internal Revenue Code. As such, utilization of the net operating loss carryforwards in the amount of $79.0 million is limited to approximately $4.9 million per year through 2013. Any unused portion of the yearly limitation may be carried forward and added to the subsequent years limitation. F-18 43 COSTILLA ENERGY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (THE INFORMATION AND AMOUNTS FOR 1999 ARE UNAUDITED) (10) COMMITMENTS AND CONTINGENCIES Leases The Company leases equipment and office facilities under operating leases on which rental expense for the years ended December 31, 1999, 1998, and 1997 was $573,832, $617,680 and $376,978, respectively. Future minimum lease commitments under noncancellable operating leases at December 31, 1999 are as follows (thousands): 2000 ............................................ 526,436 2001 ............................................ 32,103 2002 ............................................ -- 2003 ............................................ -- Thereafter ............................................ --

Employment Agreements In 1996, the Company entered into employment agreements with three of its executive officers. The employment agreements are each for three years and each will automatically renew for successive one-year periods thereafter unless the employee is notified to the contrary. These employment agreements provide for base annual salary levels totaling $735,000 for 1999. Each employee would receive his salary for the remaining term of the applicable employment agreement if the Company were to terminate such person's employment other than for cause. With the exception of one of the Company's executive officers, if a voluntary termination were to occur after the second anniversary of the employee agreement, such person would be entitled to one year's salary from the date of termination. With the exception of one of the Company's executive officers, the employee agreements provide that the covered employee will not compete with the Company for a one year period following his voluntary cessation of employment or termination of employment for cause, in either case if such event occurs within the initial three-year term of the employee agreement. Exploration and Development In July 1995, the Republic of Moldova (located in Eastern Europe between Romania and the Ukraine) granted a Concession Agreement to Resource Development Company Limited, L.L.C. ("Redeco"), an entity not then affiliated with the Company. The Company paid Redeco $90,000 and bore the first $2.0 million of concession expenses in return for a 50.0% interest in Redeco. In June 1998 the Company purchased the 50% interest from the other member of Redeco for $350,000, forgiveness of $1.9 million of accounts payable to the Company and the conveyance to the other member of a net profit interest. Effective October 1, 1998, the Company acquired additional assets from affiliates of Redeco primarily consisting of Concession Agreements owned by such affiliates covering three areas in the Republic of Romania (the "Romanian Concessions"). Costilla paid $350,000, with an F-19 44 COSTILLA ENERGY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (THE INFORMATION AND AMOUNTS FOR 1999 ARE UNAUDITED) additional $206,250 due upon closing, for such assets and granted the Seller a net profits interest of 12 1/2% and 25% in both revenues from the Moldovan Concession arrangements and the Romanian Concessions, respectively. Subsequent to December 31, 1998, management of the Company has decided to discontinue its activities in Moldova and Romania and is presently seeking to dispose of these assets. The Company recorded an impairment of $4,597,000 at December 31, 1998, related to these investments. Letters of Credit As a result of certain bonding requirements, the Company has caused an irrevocable letter of credit to be issued by a bank totaling $96,000. As of December 31, 1999, no amount had been drawn on this letter of credit. (11) 401(k) PLAN The Company has established a qualified cash or deferred arrangement under IRS code section 401(k) covering substantially all employees. Under the plan, the employees have an option to make elective contributions of a portion of their eligible compensation, not to exceed specified annual limitations, to the plan and the Company has an option to match a percentage of the employee's contribution. The Company has made matching contributions to the plan totaling $111,903, $153,676, and $122,336, in 1999, 1998 and 19967, respectively. (12) CONVERTIBLE PREFERRED STOCK On June 3, 1998 the Company closed a private placement of 50,000 shares of its 7% (8% paid in kind) Series A Cumulative Convertible Preferred Stock (the "Preferred Stock") to Enron Capital & Trade Resources Corp. and Joint Energy Development Investments II Limited Partnership for a purchase price of $50.0 million (the "Convertible Preferred Stock Offering"). Dividends accrue and are payable quarterly, commencing September 15, 1998, in cash, or in certain instances in shares of the Company's common stock. The dividend rate is 7% for dividends paid in cash and 8% for dividends paid in shares of common stock. The holders of the Preferred Stock may, at any time, convert shares of Preferred Stock into shares of the Company's common stock at a current conversion price of $12.39, subject to future adjustments. The Registrant may, at its option, redeem the shares of Preferred stock after June 15, 2001, if the current common stock price exceeds the conversion price by 150%. The preferred may be redeemed on June 15, 2001, at a price of 107% which reduces to par by the year 2004. Net proceeds from the Convertible Preferred Stock Offering were $48.0 million, of which $29.0 million was used to repay all but $0.5 million of the Revolving Credit Facility and the remainder was used for general corporate purposes. (13) STOCK-BASED COMPENSATION Outside Directors Stock Option Plan The Outside Directors Stock Option Plan provides for the issuance of stock options to the outside directors of the Company. A total of 100,000 shares has been authorized and reserved for issuance under the plan, subject to adjustments to reflect changes in the Company's capitalization resulting from stock splits, stock dividends and similar events. Only outside directors are eligible to participate in the plan. Outside directors are those directors of the Company who are not executive officers or regular salaried employees of the Company as of the date the Option is granted. Under the plan, an option for 5,000 shares of Common Stock will be granted to each person who qualifies as an outside director each year that such person is elected as a director of the Company. The exercise F-20 45 COSTILLA ENERGY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (THE INFORMATION AND AMOUNTS FOR 1999 ARE UNAUDITED) price of each option granted under the plan will be the fair market value (as reported on the Nasdaq National Market) of the Common Stock at the time the option is granted and may be paid either in cash, shares of Common Stock or a broker-assisted cashless transaction. Each option will be exercisable immediately, and will expire ten years from the date of grant. During the years ended December 31, 1998 and 1997, options on 15,000 shares were granted under this plan, leaving 70,000 options available for future grant under the plan as of December 31, 1998. The options granted during 1998 and 1997 have a term of ten (10) years and an exercise price of $10.88 per share, a price equal to the market price on the date of grant. The weighted average fair value, as calculated under the provisions of FAS 123, of the options granted in 1998 was $5.88 per share. No options were granted in 1999. Bonus Incentive Plan The Bonus Incentive Plan provides that the Compensation Committee of the Board of Directors each year may award bonuses in cash, Common Stock, or some combination thereof, to those officers, directors, employees and advisors of the Company or a subsidiary of the Company, who the Committee determines have contributed to the success of the Company. A total of 150,000 shares of Common Stock has been authorized and reserved for issuance under the plan, subject to adjustments to reflect changes in the Company's capitalization resulting from stock splits, stock dividends and similar events. All officers, directors, employees and advisors of the Company or a subsidiary of the Company who have completed a minimum of 180 days of service and are employed or retained by the Company or such subsidiary on the last day of the plan year, are eligible to participate in the plan. Bonus awards will be determined based upon a number of factors, including performance and salary level of the participant and the financial performance of the Company and its subsidiaries. Bonuses, if any will be awarded after review and upon approval of the Committee within 120 days after the end of each fiscal year, subject to the terms and conditions of the plan. No awards under the Bonus Incentive Plan were made during the year ended December 31, 1999. 1996 Stock Option Plan The 1996 Stock Option Plan provides for the grant of both incentive stock options and non-qualifying stock options, as well as limited stock appreciation rights and supplemental bonuses, to the employees of the Company and its subsidiaries, including officers and directors who are salaried employees. A total of 4,000,000 shares of Common Stock has been authorized and reserved for issuance under the plan, subject to adjustments to reflect changes in the Company's capitalization resulting from stock splits, stock dividends and similar events. The plan is administered by the Compensation Committee. The Committee has the sole authority to interpret the plan, to determine the persons to whom the options will be granted, to determine the basis upon which the options will be granted, and to determine the exercise price, duration and other terms of the options to be granted under the plan; provided that (a) the exercise price of each option granted under the plan may not be less than the fair market value of the Common Stock on the date the option is granted (and for incentive stock options, 110% of fair market value if the employee is the beneficial owner of 10% or more the Company's voting securities), (b) the exercise price must be paid in cash, by surrendering previously owned shares of Common Stock upon the exercise of the option or by a promissory note or broker-assisted cashless exercise approved by the Compensation Committee, (c) the term of the option may not exceed ten years, and (d) no option is transferable other than by will, the laws of descent and distribution or pursuant to a qualified domestic relations order. Limited stock appreciation rights may be granted under the plan with respect to specified options, allowing the option holder to receive, in cash, the difference between the exercise price and the market value in the event of a change in control of the Company. The Committee may also grant supplemental bonuses under the plan which are cash bonuses not to exceed the amount of income tax liability incurred by a plan participant upon the exercise of a non-qualifying stock option or a limited F-21 46 COSTILLA ENERGY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (THE INFORMATION AND AMOUNTS FOR 1999 ARE UNAUDITED) stock appreciation right with respect to which the bonus was granted. The Board of Directors may amend without stockholder approval, in any respect other than any amendment that requires stockholder approval by law, and may modify any outstanding option, including the repricing of non-qualifying options, with the consent of the option holder. No options were issued under this plan during 1999, 1998 or 1997. During 1996, the Company granted 711,750 stock options pursuant to the 1996 Stock Option Plan, of which 1,500 shares were exercised in 1997. There were 547,750 options available for future grant under the plan as of December 31, 1998. The options granted during 1996 have a term of ten (10) years and an exercise price of $12.50 per share, a price equal to the market price on the date of the grant. The weighted average fair value, as calculated under the provision of SFAS 123, of the options granted in 1996 was $6.73 per share. The Company applies APB 25 and related Interpretations in accounting for its stock option awards. Accordingly, no compensation expense has been recognized for its stock option awards. If compensation expense for the stock option awards had been determined consistent with SFAS 123, the Company's net loss and net loss per share, for the year ended December 31, 1998 and 1997 would have been adjusted to the following pro forma amounts (in thousands, except per share amounts):

Under SFAS 123, the fair value of each stock option grant is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions used for grants in 1998 and 1997:

(14) RELATED PARTY TRANSACTIONS Certain members and officers of the Company have owned interests in and held positions with A&P Meter Service and Supply, Inc. ("A&P"), CSL, 511 Tex L.C. ("511 Tex"), and Valley. Advances from the Company to A&P have been consolidated into two promissory notes. The first note, which was originally executed December 31, 1994, totals $390,000, including accrued interest. The note bears interest at a floating rate equal to the "prime rate" plus 1.0%. No principal or interest payments are due until the maturity of the note at December 31, 2004. The note is secured by a second lien on A&P's accounts receivable, inventory and equipment. The second note is in the amount of $294,000, including accrued interest and is dated May 22, 1996. The note is unsecured and is payable upon demand. During 1998, the Company recorded a provision for the remaining unreserved balance of the notes receivable, to reflect the uncertainty of collection. During 1999, 1998 and 1997, the Company paid $54,159, $574,971 and $561,343, respectively, to A&P for goods and services provided. F-22 47 COSTILLA ENERGY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (THE INFORMATION AND AMOUNTS FOR 1999 ARE UNAUDITED) (15) OIL AND GAS EXPENDITURES The following table reflects costs incurred in oil and gas property acquisition, exploration and development activities:

(16) TERMINATION OF PIONEER ACQUISITION In September 1998, Costilla entered into an agreement with Pioneer Natural Resources USA, Inc. ("Pioneer") to acquire certain oil and gas properties (the Pioneer Acquisition Properties") for $410 million. As part of this agreement, Costilla made a $25 million forfeitable deposit plus an additional $26 million would be paid if the transaction did not close in December 1998. In December 1998, the previous agreement was terminated and replaced by a new agreement. Pioneer retained the $25 million deposit and Costilla issued three million shares of its common stock and relinquished its right to a property interest. In return, Costilla executed a new agreement to purchase the Pioneer Acquisition Properties for $294 million. This agreement terminated on March 31, 1999, and Costilla and Pioneer then entered into a new agreement whereby Costilla would acquire certain of the Pioneer Acquisition Properties for $250 million. In connection with the new agreement, the Company issued to Pioneer one million shares of its common stock. The new agreement terminated by its terms on April 15, 1999 and the related costs, none of which are recoverable, were expensed. The Company is reviewing potential causes of action against Pioneer related to this transaction. The loss on the termination of the Pioneer acquisition consists of the following:

F-23 48 COSTILLA ENERGY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (THE INFORMATION AND AMOUNTS FOR 1999 ARE UNAUDITED) (17) SUBSEQUENT EVENTS Debtor's Plan of Reorganization (Liquidation), Restated to Reflect All Amendments and Modifications (the "Chapter 11 Plan") of Costilla Energy, Inc. (the "Company") in its bankruptcy proceeding became effective on October 1, 2000 (the "Effective Date"). The Bankruptcy Court approved the Chapter 11 Plan by its Order Confirming Debtor's Plan of Reorganization (Liquidation), as Restated to Reflect All Amendments and Modifications entered on September 15, 2000. Substantially all of the oil and gas assets of the Company were sold on June 15, 2000. Accordingly, the material feature of the Chapter 11 Plan relate to the distribution of the proceeds from that sale, the creation of a liquidating trust, and the cancellation of all of the equity interests of the Company. With respect to the distribution of the sale proceeds, the estimated recovery for various classes of claims under the Chapter 11 Plan as set forth in the Disclosure Statement with respect to Debtor's Plan of Reorganization (Liquidation), as Amended (the "Disclosure Statement"), are as follows (assuming net proceeds available for distribution of approximately $116,000,000 as provide in the Disclosure Statement and other assumptions provided therein): secured claims, 100%; administrative and priority claims, 100%; administrative convenience unsecured claims, 100%; general unsecured claims including the Company's 10 1/4% Senior Notes due 2006, 44%; and equity interests, 0. The amount available for distribution is subject to adjustment related to post-confirmation liquidation expenses and activities. F-24 49 INDEX TO EXHIBITS

50 4.2 Indenture dated as of October 1, 1996 by and between State Street Bank and Trust Company, as Trustee, and the Company, as Issuer; incorporated by reference to Registration Statement on Form S-1, File No. 333-08909 4.3 First Supplemental Indenture dated January 16, 1998 by and between State Street Bank and Trust Company, as Trustee, and the Company, as Issuer (including form of Global Certificate); incorporated by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1997 4.4 Form of Note; incorporated by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1997 4.5 Form of Stock Certificate; incorporated by reference to Registration Statement on Form S-1, File No. 333-08913 10.1 Option to Purchase Agreement dated December 16, 1998 between Pioneer Natural Resources USA, Inc., Pioneer Resources Producing, L.P. and the Company; incorporated by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1998 10.2 Purchase and Sale Agreement dated December 16, 1998 between Pioneer Natural Resources USA, Inc., Pioneer Resources Producing, L.P. and the Company; incorporated by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1998 10.3 Sixth Amendment to Amended and Restated Credit Agreement dated as of November 19, 1998 between Bankers Trust Company, as Agent, Union Bank of California, N.A., as Co-Agent, and the Company; incorporated by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1998 10.4 Purchase and Sale Agreement dated April 1, 1999 by and between Costilla Energy, Inc. and Pioneer Natural Resources USA, Inc. and Pioneer Resources Producing, L.P.; incorporated by reference to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1999 10.5 Seventh Amendment to Amended and Restated Credit Agreement dated as of March 9, 1999 between Bankers Trust Company, as Agent, Union Bank of California, N.A., as Co-Agent and Costilla Energy, Inc.; incorporated by reference to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1999 10.6 Eighth Amendment to Amended and Restated Credit Agreement dated as of March 9, 1999 between Bankers Trust Company, as Agent, Union Bank of California, N.A., as Co-Agent and Costilla Energy, Inc.; incorporated by reference to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1999 10.7 Purchase and Sale Agreement dated February 2, 1999 between Costilla Energy, Inc. and Ballard Petroleum LLC; incorporated by reference to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1999

---------- * Filed herewith. All other exhibits are incorporated by reference to the filing indicated.

COSTILLA ENERGY INC 10-K