UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2006

or

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                      to                     

Commission File Number: 1-16295

ENCORE ACQUISITION COMPANY

(Exact name of registrant as specified in its charter)

Delaware		75-2759650
(State or other jurisdiction		(IRS Employer
of incorporation)		Identification No.)
777 Main Street, Suite 1400, Fort Worth, Texas		76102
(Address of principal executive offices)		(Zip Code)

Registrant’s telephone number, including area code: (817) 877-9955

Not applicable
(Former name, former address and former fiscal year, if changed since last report)

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 þ No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer þ                     Accelerated filer o                     Non-accelerated filer o

Indicate by check mark whether the registrant is a shell company (as defined in Exchange Act Rule 12b-2). Yes o No þ

Number of shares of common stock, $0.01 par value, outstanding as of November 2, 2006 .................................................		52,973,057

 

 

ENCORE ACQUISITION COMPANY

INDEX

		Page
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets as of September 30, 2006 and December 31, 2005			1
Consolidated Statements of Operations for the three and nine months ended September 30, 2006 and 2005			2
Consolidated Statement of Stockholders’ Equity for the nine months ended September 30, 2006			3
Consolidated Statements of Cash Flows for the nine months ended September 30, 2006 and 2005			4
Notes to Consolidated Financial Statements			5
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			15
Item 3. Quantitative and Qualitative Disclosures About Market Risk			33
Item 4. Controls and Procedures			34
PART II. OTHER INFORMATION
Item 1A. Risk Factors			35
Item 6. Exhibits			35
Signature			36
Statement Showing Computation of Ratio of Earnings to Fixed Charges
Rule 13a-14(a)/15d-14(a) Certification (Principal Executive Officer)
Rule 13a-14(a)/15d-14(a) Certification (Principal Financial Officer)
Section 1350 Certification (Principal Executive Officer)
Section 1350 Certification (Principal Financial Officer)

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING INFORMATION

     Certain information included in this Quarterly Report on Form 10-Q (the “Report”) and other materials filed with the Securities and Exchange Commission (“SEC”), or in other written or oral statements made or to be made by us, other than statements of historical fact, are forward-looking statements as defined by the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. These forward-looking statements give our current expectations or forecasts of future events. You can identify our forward-looking statements by the fact that they do not relate strictly to historical or current facts. These statements may include words such as “anticipate”, “estimate”, “expect”, “project”, “intend”, “plan”, “believe”, “should”, “forecast”, “budget”, and other words and terms of similar meaning. Our actual results may differ significantly from the results discussed in the forward-looking statements. Such statements involve risks and uncertainties, including, but not limited to, the matters discussed in “Item 1A. Risk Factors” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2005 and in our other filings with the SEC. If one or more of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual outcomes may vary materially from those indicated. You should not place undue reliance on forward-looking statements. Each forward-looking statement speaks only as of the date of the particular statement. We undertake no responsibility to update forward-looking statements for changes related to these or any other factors that may occur subsequent to this filing for any reason.

ENCORE ACQUISITION COMPANY

GLOSSARY OF OIL AND NATURAL GAS TERMS

     The following are abbreviations and definitions of certain terms commonly used in the oil and natural gas industry and in this Report:

	•		Bbl. One stock tank barrel, or 42 U.S. gallons liquid volume, used in reference to oil or other liquid hydrocarbons.
	•		Bbl/D. One Bbl per day.
	•		BOE. One barrel of oil equivalent, calculated by converting natural gas to oil equivalent barrels at a ratio of six Mcf of natural gas to one Bbl of oil.
	•		BOE/D. One BOE per day.
	•		Encore or the Company. Encore Acquisition Company, a Delaware corporation, together with its subsidiaries.
	•		Gross Wells. The total wells, as the case may be, in which we have a working interest.
	•		LIBOR. London Interbank Offered Rate.
	•		MBbl. One thousand Bbls.
	•		Mcf. One thousand cubic feet of natural gas.
	•		Mcf/D. One Mcf per day.
	•		MBOE. One thousand BOE.
	•		MMBOE. One million BOE.
	•		MMcf. One million Mcf.
	•		Net Wells. Gross wells multiplied, as the case may be, by the percentage working interest owned by us.
	•		NYMEX. New York Mercantile Exchange.

See the Company’s Annual Report on Form 10-K for the year ended December 31, 2005 for definitions of additional oil and natural gas terms that may be used in this Report.

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

ENCORE ACQUISITION COMPANY

(in thousands, except share and per share amounts)

		September 30,				December 31,
		2006				2005
		(unaudited)
ASSETS
Current assets:
Cash and cash equivalents		$	539			$	1,654
Accounts receivable, net of allowance for doubtful accounts of $365 and $347, respectively			65,612				76,960
Inventory			15,434				11,231
Derivatives			15,837				8,826
Deferred taxes			24,034				29,030
Prepaid expenses			4,432				5,656
Total current assets			125,888				133,357
Properties and equipment, at cost — successful efforts method:
Proved properties			1,929,604				1,691,175
Unproved properties			48,550				37,646
Accumulated depletion, depreciation, and amortization			(335,891	)			(255,564	)
			1,642,263				1,473,257
Other property and equipment			17,732				15,894
Accumulated depreciation			(7,085	)			(5,366	)
			10,647				10,528
Goodwill			57,819				59,046
Derivatives			45,076				17,316
Other			22,586				12,201
Total assets		$	1,904,279			$	1,705,705
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable		$	16,904			$	27,281
Accrued and other current			93,148				86,399
Derivatives			41,315				68,850
Deferred premiums on derivative contracts			19,994				7,665
Total current liabilities			171,361				190,195
Derivatives			18,013				44,087
Future abandonment cost			14,865				14,430
Deferred taxes			273,935				213,268
Long-term debt			593,567				673,189
Deferred premiums on derivative contracts			36,109				22,476
Other			1,189				1,279
Total liabilities			1,109,039				1,158,924
Commitments and contingencies (see Note 14)			—				—
Stockholders’ equity:
Preferred stock, $.01 par value, 5,000,000 shares authorized, none issued and outstanding			—				—
Common stock, $.01 par value, 144,000,000 shares authorized, 52,973,057 and 48,784,846 issued and outstanding, respectively			530				488
Additional paid-in capital			454,355				316,619
Treasury stock, at cost, none and 11,169 shares, respectively			—				(375	)
Retained earnings			384,825				302,875
Accumulated other comprehensive loss			(44,470	)			(72,826	)
Total stockholders’ equity			795,240				546,781
Total liabilities and stockholders’ equity		$	1,904,279			$	1,705,705

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

ENCORE ACQUISITION COMPANY

(in thousands, except per share amounts)

(unaudited)

		Three months ended								Nine months ended
		September 30,								September 30,
		2006				2005				2006				2005
Revenues:
Oil		$	99,516			$	85,559			$	268,066			$	222,254
Natural gas			32,177				42,013				109,050				96,616
Oil marketing			46,004				—				106,036				—
Total revenues			177,697				127,572				483,152				318,870
Expenses:
Production:
Lease operations			24,478				18,410				70,332				49,627
Production, ad valorem, and severance taxes			13,560				12,526				38,382				31,425
Depletion, depreciation, and amortization			27,471				24,222				82,479				59,943
Exploration			12,322				4,830				18,347				11,238
General and administrative			6,250				5,064				18,199				13,396
Oil marketing			48,001				—				105,661				—
Derivative fair value loss (gain)			(33,363	)			1,612				(20,263	)			5,713
Loss on early redemption of debt			—				19,477				—				19,477
Other operating			976				2,520				3,573				5,822
Total expenses			99,695				88,661				316,710				196,641
Operating income			78,002				38,911				166,442				122,229
Other income (expenses):
Interest			(11,261	)			(9,264	)			(33,766	)			(23,671	)
Other			463				580				1,012				729
Total other income (expenses)			(10,798	)			(8,684	)			(32,754	)			(22,942	)
Income before income taxes			67,204				30,227				133,688				99,287
Current income tax benefit (provision)			(1,607	)			2,868				(2,709	)			1,478
Deferred income tax provision			(23,462	)			(12,241	)			(48,673	)			(34,459	)
Net income		$	42,135			$	20,854			$	82,306			$	66,306
Net income per common share:
Basic		$	0.80			$	0.43			$	1.60			$	1.36
Diluted		$	0.78			$	0.42			$	1.57			$	1.34
Weighted average common shares outstanding:
Basic			52,968				48,703				51,481				48,659
Diluted			53,776				49,584				52,375				49,481

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

ENCORE ACQUISITION COMPANY

(in thousands)

(unaudited)

																										Accumulated
		Shares of								Additional				Shares of												Other				Total
		Common				Common				Paid-in				Treasury				Treasury				Retained				Comprehensive				Stockholders’
		Stock				Stock				Capital				Stock				Stock				Earnings				Loss				Equity
Balance at December 31, 2005			48,785			$	488			$	316,619				(11	)		$	(375	)		$	302,875			$	(72,826	)		$	546,781
Exercise of stock options and vesting of restricted stock			206				2				3,325				—				—				—				—				3,327
Purchase of treasury stock			—				—				—				(7	)			(176	)			—				—				(176	)
Cancellation of treasury stock			(18	)			—				(195	)			18				551				(356	)			—				—
Issuance of common stock			4,000				40				127,061				—				—				—				—				127,101
Non-cash stock-based compensation			—				—				7,545				—				—				—				—				7,545
Components of comprehensive income:
Net income			—				—				—				—				—				82,306				—				82,306
Change in deferred hedge gain/loss (net of income taxes of $16,834)			—				—				—				—				—				—				28,356				28,356
Total comprehensive income																															110,662
Balance at September 30, 2006			52,973			$	530			$	454,355				—			$	—			$	384,825			$	(44,470	)		$	795,240

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

ENCORE ACQUISITION COMPANY

(in thousands)

(unaudited)

		Nine months ended
		September 30,
		2006				2005
Cash flows from operating activities:
Net income		$	82,306			$	66,306
Adjustments to reconcile net income to net cash provided by operating activities:
Depletion, depreciation, and amortization			82,479				59,943
Dry hole expense			12,542				6,970
Deferred taxes			48,673				34,459
Non-cash stock-based compensation expense			6,797				3,323
Non-cash derivative			(13,013	)			11,159
Loss on early redemption of debt			—				19,477
Other non-cash expense			5,644				2,799
Loss on disposition of assets			395				328
Changes in operating assets and liabilities:
Accounts receivable			11,579				(25,500	)
Other assets			(33,794	)			(28,694	)
Accounts payable			(2,047	)			2,716
Other liabilities			32,821				50,906
Net cash provided by operating activities			234,382				204,192
Cash flows from investing activities:
Purchases of other property and equipment			(3,450	)			(5,663	)
Deposit on acquisition of oil and natural gas properties			—				(5,186	)
Acquisition of oil and natural gas properties			(22,809	)			(49,770	)
Development of oil and natural gas properties			(241,502	)			(237,003	)
Other			(9,510	)			604
Net cash used in investing activities			(277,271	)			(297,018	)
Cash flows from financing activities:
Proceeds from issuance of common stock			128,000				—
Offering costs paid			(899	)			—
Proceeds from long-term debt			165,000				311,000
Payments on long-term debt			(245,000	)			(341,000	)
Proceeds from issuance of 6% notes			—				294,480
Redemption of 8 3/8% notes			—				(165,852	)
Payments of debt issuance costs			(147	)			(739	)
Cash overdrafts			(8,331	)			(4,892	)
Exercise of stock options and other			3,151				1,280
Net cash provided by financing activities			41,774				94,277
Increase (decrease) in cash and cash equivalents			(1,115	)			1,451
Cash and cash equivalents, beginning of period			1,654				1,103
Cash and cash equivalents, end of period		$	539			$	2,554

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

ENCORE ACQUISITION COMPANY

(unaudited)

Note 1. Formation of Encore

     Encore is a growing independent energy company engaged in the acquisition, development, exploitation, exploration, and production of onshore North American oil and natural gas reserves. Since the Company’s inception in 1998, Encore has sought to acquire high-quality assets with potential for upside through drilling, waterflood, and tertiary projects. Encore’s properties currently are located in four core areas: the Cedar Creek Anticline (“CCA”) in the Williston Basin of Montana and North Dakota; the Permian Basin of western Texas and southeastern New Mexico; the Mid-Continent area, which includes the Arkoma and Anadarko Basins of Oklahoma, the North Louisiana Salt Basin, the East Texas Basin, and the Barnett Shale of northern Texas; and the Rockies, which includes non-CCA assets in the Williston and Powder River Basins of Montana and North Dakota, and the Paradox Basin of southeastern Utah.

Note 2. Basis of Presentation

     In the opinion of management, the accompanying unaudited consolidated financial statements of Encore include all adjustments necessary to present fairly, in all material respects, our financial position as of September 30, 2006, results of operations for the three and nine months ended September 30, 2006 and 2005, and cash flows for the nine months ended September 30, 2006 and 2005. All adjustments are of a normal recurring nature. These interim results are not necessarily indicative of results for an entire year.

     Certain amounts and disclosures have been condensed or omitted from these consolidated financial statements pursuant to the rules and regulations of the SEC. Therefore, these consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes thereto included in the Company’s 2005 Annual Report on Form 10-K. Certain amounts in prior periods have been reclassified to conform to the current period presentation. Specifically, the Company reclassified the net gain/loss from the purchases and sales of third party oil volumes from Oil Revenues to Oil Marketing Revenues and Oil Marketing Expense and reclassified the related marketing transportation costs from Other Operating Expense to Oil Marketing Expense in the Company’s Consolidated Statements of Operations for the first and second quarter of 2006. These are changes in presentation only and do not affect previously reported Net Income or Earnings per Share for either period. The following table details the affected line items from the Company’s Consolidated Statements of Operations for the three months ended June 30, 2006 and March 31, 2006:

		Three months ended				Three months ended
		June 30, 2006				March 31, 2006
		(in thousands)
As Reported:
Oil revenues		$	94,128			$	78,686
Oil marketing revenues		$	—			$	—
Oil marketing expenses		$	—			$	—
Other operating expenses		$	1,960			$	2,529
As Reclassified:
Oil revenues		$	92,434			$	76,115
Oil marketing revenues		$	25,716			$	34,316
Oil marketing expenses		$	24,914			$	32,746
Other operating expenses		$	1,068			$	1,528

Oil Marketing Revenues and Expenses

     Oil Marketing Revenues derived from sales of oil purchased from third parties is recognized when persuasive evidence of a sales arrangement exists, delivery has occurred, the sales price is fixed or determinable, and collectibility is reasonably assured. Oil Marketing Expenses includes the cost of oil volumes purchased from third parties, as well as, transportation charges related to the purchased volumes, mostly in the form of pipeline tariffs. As the Company takes title to the oil and has risks and rewards of ownership, these transactions are presented gross in the Consolidated Statements of Operations, unless they meet the criteria for netting as outlined in Emerging Issues Task Force (“EITF”) Issue No. 04-13, “Accounting for Purchases and Sales of Inventory with the Same Counterparty” (“EITF 04-13”). (See “Buy/Sell” transactions below).

ENCORE ACQUISITION COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2006
(unaudited)

Buy/Sell Transactions

     EITF 04-13 requires that two or more inventory purchase and sale transactions with the same counterparty that are entered into in contemplation of one another be viewed as a single exchange transaction and netted in accordance with the provisions of Accounting Principles Board (“APB”) Opinion No. 29, “Accounting for Nonmonetary Transactions”. These types of transactions are commonly referred to as “Buy/Sell” transactions in the oil and gas industry.

     Produced Volumes. The net gain/loss from “Buy/Sell” transactions with produced oil volumes incurred by the Company is recorded as an adjustment to Oil Revenues. To qualify for this net treatment the sale and purchase must be with the same counterparty and be entered into in contemplation of each other.

     Third Party Marketing Volumes. The net gain/loss from “Buy/Sell” transactions with purchased oil volumes from third parties incurred by the Company is recorded as an adjustment to Oil Marketing Revenues. To qualify for this net treatment the sale and purchase must be with the same counterparty and be entered into in contemplation of each other.

Stock-based Compensation

     On January 1, 2006, the Company adopted the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123R”) using the “modified prospective” method. SFAS 123R is a revision of SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”) and supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”). See “Note 11. Incentive Stock Plan” for more information.

     During the three and nine months ended September 30, 2005, if compensation expense for the stock-based awards had been determined using the provisions of SFAS 123R, the Company’s net income and net income per share would have been adjusted to the pro forma amounts indicated below:

		Three months ended				Nine months ended
		September 30, 2005				September 30, 2005
		(in thousands, except per share amounts)
As Reported:
Non-cash stock-based compensation expense (net of taxes)		$	968			$	2,082
Net income		$	20,854			$	66,306
Basic net income per common share		$	0.43			$	1.36
Diluted net income per common share		$	0.42			$	1.34
Pro Forma:
Non-cash stock-based compensation expense (net of taxes)		$	1,715			$	3,333
Net income		$	20,107			$	65,055
Basic net income per common share		$	0.41			$	1.34
Diluted net income per common share		$	0.41			$	1.31

New Accounting Pronouncements

SFAS No. 157, “Fair Value Measurement” (“SFAS 157”)

     In September 2006, the Financial Accounting Standards Board issued SFAS 157. SFAS 157 clarifies the principle that fair value should be based on the assumptions market participants would use when pricing an asset or liability and establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. Under SFAS 157, fair value measurements would be separately disclosed by level within the fair value hierarchy. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. Early adoption is permitted. Encore has not yet determined the impact, if any, that the implementation of SFAS 157 will have on its results of operations or financial condition.

ENCORE ACQUISITION COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2006
(unaudited)

Note 3. Inventories

     Inventories are comprised principally of materials and supplies and oil in pipelines, which are stated at the lower of cost (determined on an average basis) or market. The Company’s inventories consisted of the following as of the dates indicated:

		September 30,				December 31,
		2006				2005
		(in thousands)
Warehouse inventory		$	11,599			$	9,019
Oil in pipelines			3,835				2,212
Total		$	15,434			$	11,231

Note 4. Crusader Acquisition and Goodwill

     On October 14, 2005, the Company purchased all of the outstanding capital stock of Crusader Energy Corporation (“Crusader”), a privately held, independent oil and natural gas company, for a purchase price of approximately $109.6 million, which includes cash paid to Crusader’s former shareholders of $79.1 million, the repayment of $29.7 million of Crusader’s debt, and transaction costs incurred of $0.7 million.

     The calculation of the total purchase price and the estimated allocation as of September 30, 2006 to the fair value of net assets acquired at October 14, 2005, are as follows (in thousands):

Calculation of total purchase price:

Cash paid to Crusader’s former owners		$	79,142
Crusader debt repaid			29,732
Transaction costs			707
Total purchase price		$	109,581

Allocation of purchase price to the fair value of assets acquired:
Cash		$	18,592
Other current assets			3,362
Proved oil and natural gas properties			85,388
Unproved oil and natural gas properties			6,863
Goodwill			19,911
Total assets acquired			134,116
Current liabilities			(7,485	)
Non-current liabilities			(1,190	)
Deferred taxes			(15,860	)
Total liabilities assumed			(24,535	)
Fair value of net assets acquired		$	109,581

     The purchase price allocation resulted in $19.9 million of goodwill primarily as the result of the difference between the fair value of acquired oil and natural gas properties and their lower carryover tax basis, which resulted in deferred taxes of $15.9 million. Management believes the goodwill will be recovered through operating synergies resulting from the close proximity of the properties acquired to our existing operations. None of the goodwill is deductible for income tax purposes.

ENCORE ACQUISITION COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2006
(unaudited)

Note 5. Derivative Financial Instruments

Commodity Contracts – Mark-to-Market Accounting: Previously designated as hedges

     Prior to July 2006, the Company used hedge accounting for certain of its derivative contracts, whereby the effective portion of changes in the fair value of the contract was deferred in accumulated other comprehensive loss (“AOCL”) included in stockholders’ equity in the accompanying Consolidated Balance Sheets rather than recognized in current period earnings. During July 2006, the Company elected to discontinue hedge accounting prospectively for all commodity derivatives which were previously accounted for as hedges. While this change has no effect on cash flows, results of operations are affected by mark-to-market gains and losses, which fluctuate with the swings in oil and natural gas prices. At the point of dedesignation, the gains and losses to be amortized to oil and natural gas revenues as effective hedges were established and deferred in AOCL. The amortization of these amounts is included in oil and natural gas revenues with the revenues from the hedged production. All mark-to-market gains and losses from July 2006 forward are recognized in earnings through “Derivative fair value loss (gain)” in the accompanying Consolidated Statements of Operations rather than deferring such amounts in AOCL.

     The following tables summarize the Company’s open commodity derivative instruments as of September 30, 2006:

Oil Derivative Instruments at September 30, 2006

		Daily				Average				Daily				Average				Daily				Average				Daily				Average				Fair
		Floor				Floor				Short Floor				Short Floor				Cap				Cap				Swap				Swap				Market
		Volume				Price				Volume				Price				Volume				Price				Volume				Price				Value
Period		(Bbl)				(per Bbl)				(Bbl)				(per Bbl)				(Bbl)				(per Bbl)				(Bbl)				(per Bbl)				(in thousands)
Oct. — Dec. 2006			13,000			$	45.00				—			$	—				1,000			$	29.88				3,000			$	37.27			$	(10,438	)
Jan. — Dec. 2007			8,000				53.75				—				—				—				—				3,000				36.75				(28,973	)
Jan. — June 2008			12,000				64.17				(4,000	)			50.00				—				—				1,000				58.59				8,336
July — Dec. 2008			8,000				66.25				(4,000	)			50.00				—				—				—				—				8,535
Jan. — Dec. 2009			5,000				70.00				(5,000	)			50.00				—				—				—				—				13,717
																																		$	(8,823	)

Natural Gas Derivative Instruments at September 30, 2006

		Daily				Average				Daily				Average				Daily				Average				Daily				Average				Fair
		Floor				Floor				Short Floor				Short Floor				Cap				Cap				Swap				Swap				Market
		Volume				Price				Volume				Price				Volume				Price				Volume				Price				Value
Period		(Mcf)				(per Mcf)				(Mcf)				(per Mcf)				(Mcf)				(per Mcf)				(Mcf)				(per Mcf)				(in thousands)
Oct. — Dec. 2006			32,500			$	6.17				—			$	—				5,000			$	5.68				12,500			$	5.02			$	3,149
Jan. — Dec. 2007			32,500				6.74				—				—				—				—				10,000				4.99				4,230
Jan. — Dec. 2008			10,000				6.25				—				—				—				—				—				—				2,651
																																		$	10,030

Commodity Contracts – Mark-to-Market Accounting: Basis Swaps

     In order to more effectively hedge the cash flows received on oil and natural gas production, the Company enters into financial instruments, commonly called basis swaps, whereby Encore swaps certain per Bbl or per Mcf floating market indices for a fixed amount. These market indices are a component of the price the Company is paid on its actual production and by fixing this component of the Company’s marketing price, Encore is able to realize a net price with a more consistent differential to NYMEX. The Company marks these contracts to market each quarter through “Derivative fair value loss (gain)” in the accompanying Consolidated Statements of Operations. Thus, as these contracts do not change the Company’s overall hedged volumes, amounts presented in the tables above are exclusive of any effect of these derivative instruments. As of September 30, 2006, the mark-to-market value of these basis swap contracts was a $0.4 million asset.

Commodity Contracts – Current Period Impact

     As a result of hedging transactions for oil and natural gas, the Company recognized a pre-tax reduction in oil and natural gas revenues of approximately $45.7 million and $40.2 million in the nine months ended September 30, 2006 and 2005, respectively,

ENCORE ACQUISITION COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2006
(unaudited)

and $14.4 million and $16.5 million for the three months ended September 30, 2006 and 2005, respectively. The Company also recognized in the accompanying Consolidated Statements of Operations derivative fair value gains and losses related to (i) changes in the market value since the date of dedesignation of derivative contracts which were previously designated as hedges, (ii) changes in the market value of basis swaps and certain other commodity derivatives that are not designated as hedges, (iii) settlements on derivative contracts not designated as hedges, (iv) and ineffectiveness of derivative contracts designated as hedges prior to July 2006. The following table summarizes the components of derivative fair value gains and losses for the three and nine months ended September 30, 2006 and 2005:

		Three months ended September 30,								Nine months ended September 30,
		2006				2005				2006				2005
						(in thousands)
Designated cash flow hedges:
Ineffectiveness — Derivative commodity contracts		$	—			$	2,212			$	1,748			$	6,878
Undesignated derivative contracts:
Mark-to-market loss (gain):
Interest rate swap			—				—				—				462
Commodity contracts			(34,280	)			(573	)			(20,819	)			(707	)
Settlements:
Interest rate swap			—				—				—				(312	)
Commodity contracts			917				(27	)			(1,192	)			(608	)
Total derivative fair value loss (gain)		$	(33,363	)		$	1,612			$	(20,263	)		$	5,713

     The Company had $56.1 million of derivative premiums payable recorded at September 30, 2006, of which $36.1 million is considered long-term and is recorded in “Deferred premiums on derivatives contracts” in the Company’s Consolidated Balance Sheets. The premiums relate to various oil and natural gas floor contracts and are payable on a monthly basis from October 2006 to January 2010.

Commodity Contracts – Future Period Impact

     The components of AOCL consisted of the following as of the dates indicated:

		September 30,				December 31,
		2006				2005
		(in thousands)
Deferred loss on commodity derivatives, net of tax		$	(44,470	)		$	(72,918	)
Deferred gain on interest rate swap, net of tax			—				92
Accumulated other comprehensive loss		$	(44,470	)		$	(72,826	)

     During the twelve months ending September 30, 2007, the Company expects to reclassify $54.9 million of net deferred losses associated with its dedesignated commodity contracts from AOCL to oil and natural gas revenues. The Company also expects to reclassify approximately $20.5 million of net deferred income tax benefits during the twelve months ending September 30, 2007 from AOCL to income tax benefit.

Note 6. Asset Retirement Obligations

     The Company’s primary asset retirement obligations relate to future plugging and abandonment expenses on oil and natural gas properties and related facilities disposal. The Company does not provide for a market risk premium associated with asset retirement obligations because a reliable estimate cannot be determined. The following table summarizes the changes in the Company’s future abandonment liability recorded in “Future abandonment cost” on the Company’s Consolidated Balance Sheets for the period from January 1, 2006 through September 30, 2006 (in thousands):

ENCORE ACQUISITION COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2006
(unaudited)

		Nine months ended
		September 30, 2006
Future abandonment liability at January 1, 2006		$	14,430
Wells drilled			107
Accretion expense			492
Plugging and abandonment costs incurred			(1,200	)
Revision of estimates			1,036
Future abandonment liability at September 30, 2006		$	14,865

Note 7. Debt

     The Company’s long-term debt consisted of the following as of the dates indicated:

		September 30,				December 31,
		2006				2005
		(in thousands)
Revolving credit facility		$	—			$	80,000
6 1/4% Senior Subordinated Notes due 2014 (the “6 1/4% Notes”)			150,000				150,000
6% Senior Subordinated Notes due 2015 (the “6% Notes”), net of unamortized discount of $5,000 and $5,317, respectively			295,000				294,683
7 1/4% Senior Subordinated Notes due 2017 (the “7 1/4% Notes”), net of unamortized discount of $1,433 and $1,494, respectively			148,567				148,506
Total		$	593,567			$	673,189

     The Company had $26.7 million of outstanding letters of credit at September 30, 2006. Any outstanding letters of credit reduce the availability under the Company’s revolving credit facility. As a result, the Company’s availability under its revolving credit facility was $523.3 million at September 30, 2006.

     On April 4, 2006, the Company closed a public offering of its common stock for net proceeds of approximately $127.1 million, a portion of which was used to reduce borrowings under the revolving credit facility. See “Note 10. Public Offering of Common Stock” for more information.

Note 8. Income Taxes

     The following table reconciles income tax expense with tax at the Federal statutory rate:

		Nine months ended
		September 30,
		2006				2005
		(in thousands)
Income before income taxes		$	133,688			$	99,287
Tax at statutory rate		$	46,791			$	34,750
State income taxes, net of federal benefit			3,118				1,911
Change in Texas franchise tax law			1,389				—
Section 43 credits			—				(2,664	)
Permanent and other			84				(1,016	)
Income tax provision		$	51,382			$	32,981

     The Company’s effective tax rate increased to 38.4 percent for the nine months ended September 30, 2006, as compared to 33.2 percent for the nine months ended September 30, 2005. The Enhanced Oil Recovery credits available under Section 43 are fully phased out for the 2006 tax year due to high oil prices in 2005. Therefore, no credits were generated during the nine months ended September 30, 2006. In addition, a Texas franchise tax reform measure was signed into law on May 18, 2006, which caused the Texas franchise tax to be applicable to numerous types of entities that previously were not subject to the tax, including several of our subsidiaries. The Company adjusted its net deferred tax balances using the new higher marginal tax rate it expects to be effective when those deferred taxes become current resulting in a charge of $1.4 million during the nine months ended September 30, 2006.

ENCORE ACQUISITION COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2006
(unaudited)

Note 9. Earnings Per Share (“EPS”)

     The following table sets forth basic and diluted EPS computations for the three and nine months ended September 30, 2006 and 2005:

		Three months ended								Nine months ended
		September 30,								September 30,
		2006				2005				2006				2005
		(in thousands, except per share data)
Numerator:
Net income		$	42,135			$	20,854			$	82,306			$	66,306
Denominator:
Denominator for basic EPS:
Weighted average shares outstanding			52,968				48,703				51,481				48,659
Effect of dilutive options and diluted restricted stock (a)			808				881				894				822
Denominator for diluted EPS			53,776				49,584				52,375				49,481
Net income per common share:
Basic		$	0.80			$	0.43			$	1.60			$	1.36
Diluted		$	0.78			$	0.42			$	1.57			$	1.34

Note 10. Public Offering of Common Stock

     On April 4, 2006, the Company closed a public offering of 4.0 million shares of the Company’s common stock at a price of $32.00 per share. The net proceeds of the offering, after deducting underwriting discounts and commissions and expenses of the offering, were approximately $127.1 million. The Company used the net proceeds to reduce borrowings under its revolving credit facility, to invest in oil and natural gas activities, and to pay general corporate expenses.

Note 11. Incentive Stock Plan

     During 2000, the Company’s Board of Directors (the “Board”) and stockholders approved the 2000 Incentive Stock Plan (the “Plan”). The Plan was amended and restated effective March 18, 2004. The purpose of the Plan is to attract, motivate, and retain selected employees of the Company and to provide the Company with the ability to offer incentives more directly linked to the profitability of the business and increases in shareholder value. All directors and full-time regular employees of the Company and its subsidiaries and affiliates are eligible to be granted awards under the Plan. The total number of shares of common stock reserved for issuance pursuant to the Plan is 4,500,000. As of September 30, 2006, there were 1,298,672 shares remaining under the Plan. The Plan provides for the granting of cash awards, incentive stock options, non-qualified stock options, restricted stock, and stock appreciation rights at the discretion of the Compensation Committee of the Board.

     The Plan contains the following individual limits:

	•		an employee may not be awarded more than 150,000 shares of common stock in any calendar year;
	•		a non-employee director may not be awarded more than 10,000 shares of common stock in any calendar year; and
	•		an employee may not receive awards consisting of cash (including cash awards that are granted as performance awards) in respect of any calendar year having a value determined on the grant date in excess of $1.0 million.

ENCORE ACQUISITION COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2006
(unaudited)

     All options that have been granted under the Plan have a strike price equal to the fair market value of our common stock on the date of grant. Additionally, all options have a ten-year life and vest equally over a three-year period. Restricted stock granted under the Plan vests over varying periods from one to five years, subject to performance-based vesting for certain members of senior management.

Adoption of SFAS 123R

     As previously discussed, on January 1, 2006, the Company adopted the provisions of SFAS 123R. SFAS 123R eliminates the option of using the intrinsic value method of accounting previously available, and requires companies to recognize in the financial statements the cost of employee services received in exchange for awards of equity instruments based on the grant date fair value of those awards.

     The Company adopted the provisions of SFAS 123R using the “modified prospective” method, under which compensation cost is recognized in the financial statements for (i) share-based payments granted after January 1, 2006 based on the requirements of SFAS 123R, and (ii) all unvested awards granted prior to January 1, 2006 based on criteria established in SFAS 123. As a result, the Company did not record a cumulative effect of accounting change related to the adoption.

     Under SFAS 123R, equity instruments are not considered issued until all vesting conditions lapse. This differs from APB 25, which required the recording of restricted stock to equity with an off-setting contra-equity account which was amortized to expense over the vesting period. Because unvested restricted stock is no longer considered issued, the contra-equity account, “Deferred compensation”, is no longer reported as a separate component of stockholders’ equity. Certain equity balances as originally reported in the Company’s 2005 Annual Report on Form 10-K have been retroactively restated to reflect the change. The following table summarizes the balances at December 31, 2005 as originally reported and as restated:

		December 31, 2005
		As Originally Reported				As Restated
		(in thousands)
Shares of common stock outstanding			49,368				48,785
Common stock		$	494			$	488
Additional paid-in capital		$	325,620			$	316,619
Deferred compensation		$	(9,007	)		$	—
Total stockholders’ equity		$	546,781			$	546,781

     As a result of adopting SFAS 123R, the Company’s income before income taxes and net income for the nine months ended September 30, 2006 are $1.1 million and $0.7 million lower, respectively, than if it had continued to account for share-based compensation under APB 25. Basic and diluted EPS for the nine months ended September 30, 2006 are each $0.01 per share lower than if the Company had continued to account for share-based compensation under APB 25.

     The compensation cost and income tax benefit related to the Plan that has been recorded in the accompanying Consolidated Statements of Operations for the nine months ended September 30, 2006 was $6.6 million and $2.4 million, respectively. During the nine months ended September 30, 2006, the Company also capitalized $0.9 million of stock-based compensation cost as a component of “Properties and equipment” in the accompanying Consolidated Balance Sheets. Stock-based compensation expense has been allocated to lease operations expense (“LOE”), general and administrative (“G&A”) expense, and exploration expense based on the allocation of the respective cash compensation.

Stock Options

     The fair value of each option award granted during the nine months ended September 30, 2006 and 2005 was estimated on the date of grant using a Black-Scholes option valuation model based on the assumptions noted in the following table. The expected volatility is based on a combination of the historical volatility of the Company’s stock and the historical stock volatility of certain peer companies for a period of time commensurate with the expected term of the award. For options granted in the nine months ended September 30, 2006 and 2005, the Company used the “simplified” method prescribed by SEC Staff Accounting Bulletin No. 107 to estimate the expected term of the options. The risk-free rate is based on the U.S Treasury yield curve in effect at the time of grant for periods commensurate with the expected terms of the options.

ENCORE ACQUISITION COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2006
(unaudited)

		Nine months ended September 30,
		2006				2005
Expected volatility			42.8	%			46.0	%
Expected dividend yield			0.0	%			0.0	%
Expected term (in years)			6.0				6.0
Risk-free interest rate			4.6	%			3.7	%

     A summary of options outstanding as of September 30, 2006, and changes during the nine months then ended is presented below:

										Weighted
						Weighted				Average				Aggregate
		Number of				Average				Remaining				Intrinsic
		Options				Strike Price				Contractual Term				Value
														(in thousands)
Outstanding at January 1, 2006			1,440,812			$	13.20
Granted			122,890				31.10
Forfeited			(46,837	)			24.51
Exercised			(178,024	)			13.15
Outstanding at September 30, 2006			1,338,841				14.46				6.3			$	14,138
Exercisable at September 30, 2006			1,070,165				11.89				5.8				13,389

     The weighted average fair value of individual options granted during the nine months ended September 30, 2006 was $14.96 per share. The total intrinsic value of options exercised during the nine months ended September 30, 2006 and 2005 was $2.4 million and $2.6 million, respectively. The Company received proceeds from the exercise of stock options of $2.3 million and $1.2 million and realized tax benefits related to the exercises of $0.9 million and $2.3 million during the nine months ended September 30, 2006 and 2005, respectively. At September 30, 2006, the Company had $2.1 million of total unrecognized compensation cost related to unvested stock options, which is expected to be recognized over a weighted average period of 1.9 years.

Restricted Stock

     As of September 30, 2006, there were 842,107 shares of unvested restricted stock outstanding, dependent only on continued employment for vesting. Of this amount, 331,209 shares were granted during the nine months ended September 30, 2006. Additionally, as of September 30, 2006, there were 67,202 shares of unvested restricted stock outstanding that depend on continued employment and certain performance measures for vesting, all of which were granted during the nine months ended September 30, 2006.

     A summary of the status of the Company’s unvested restricted stock outstanding as of September 30, 2006, and changes during the nine months then ended, is presented below:

						Weighted
						Average
		Number of				Grant Date
		Shares				Fair Value
Outstanding at January 1, 2006			583,274			$	20.53
Granted			428,609				31.17
Vested			(27,909	)			18.60
Forfeited			(74,665	)			24.92
Outstanding at September 30, 2006			909,309				25.25

     As of September 30, 2006, there was $12.8 million of total unrecognized compensation cost related to unvested, outstanding restricted stock, which is expected to be recognized over a weighted average period of 3.0 years. During the nine months ended

ENCORE ACQUISITION COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2006
(unaudited)

September 30, 2006 and 2005, there were 27,909 shares and 28,590 shares, respectively, that vested. Employees elected to satisfy minimum tax withholding obligations related to the vested restricted stock by allowing the Company to withhold 6,553 and 7,128 shares of common stock during the nine months ended September 30, 2006 and 2005, respectively.

Note 12. Comprehensive Income (Loss)

     Components of comprehensive income (loss), net of related tax, are as follows:

		Three months ended								Nine months ended
		September 30,								September 30,
		2006				2005				2006				2005
		(in thousands)
Net income		$	42,135			$	20,854			$	82,306			$	66,306
Change in deferred loss on commodity derivatives			8,894				(23,708	)			28,448				(53,864	)
Change in deferred gain on interest rate swap			(63	)			(53	)			(92	)			(315	)
Comprehensive income (loss)		$	50,966			$	(2,907	)		$	110,662			$	12,127

     See Note 5 above for a discussion on the Company’s discontinuance of hedge accounting.

Note 13. Financial Statements of Subsidiary Guarantors

     As of September 30, 2006, all of the Company’s subsidiaries were subsidiary guarantors of the Company’s outstanding notes. Since (i) each subsidiary guarantor is 100 percent owned by the Company, (ii) the Company has no assets or operations that are independent of its subsidiaries, (iii) the subsidiary guarantees are full and unconditional, and joint and several, and (iv) all of the Company’s subsidiaries are subsidiary guarantors, the Company has not included the financial statements of each subsidiary in this Report. The subsidiary guarantors may, without restriction, transfer funds to the Company in the form of cash dividends, loans, and advances.

Note 14. Commitments and Contingencies

     In August 2006, the Company entered into a fourth amendment to its non-cancelable operating lease for additional office space at its corporate headquarters. Payments due under the fourth amendment begin in May 2007 and continue through November 2013.

      In March 2006, the Company entered into a joint development agreement with a major oil company to develop seven natural gas fields in West Texas. The Company is required to drill a total of 24 commitment wells and may be required to advance funds to pay the partner’s 70 percent share of drilling costs for each well. Should the Company advance funds, repayment will only be made through the monthly receipt of future proceeds of oil and natural gas sales.

Note 15. Related Party Transactions

     The Company paid $2.8 million and $0.8 million to affiliates of Hanover Compressor Company (“Hanover”) in the nine months ended September 30, 2006 and 2005, respectively, for compressors and field compression services. Mr. I. Jon Brumley, the Chairman of the Board, also serves as a director of Hanover.

ENCORE ACQUISITION COMPANY

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

     This document contains forward-looking statements, which give our current expectations or forecasts of future events. Actual results may differ materially from those discussed in our forward-looking statements due to many factors, including, but not limited to, those set forth under “Item 1A. Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2005. The following discussion should be read in conjunction with the consolidated financial statements and notes thereto included in “Item 1. Financial Statements” of this Report and in “Item 8. Financial Statements and Supplementary Data” of our 2005 Annual Report on Form 10-K.

Introduction

     This management’s discussion and analysis of financial condition and results of operations is intended to provide investors with information regarding our financial condition and results of operations. The following will be discussed and analyzed:

	•		Third Quarter 2006 Highlights
	•		Results of Operations
			— Comparison of Quarter Ended September 30, 2006 to Quarter Ended September 30, 2005
			— Comparison of Nine Months Ended September 30, 2006 to Nine Months Ended September 30, 2005
	•		Capital Resources
	•		Capital Commitments
	•		Liquidity
	•		Contingencies
	•		Critical Accounting Policies and Estimates
	•		New Accounting Pronouncements

Third Quarter 2006 Highlights

     Our financial and operating results for the quarter ended September 30, 2006 included the following highlights:

	•		During the third quarter of 2006, we had oil and natural gas revenues of $131.7 million. This represents a 3 percent increase over the $127.6 million of oil and natural gas revenues reported for the third quarter of 2005.
	•		Our realized average oil price for the third quarter of 2006, including the effects of hedging, increased $3.86 per Bbl to $54.80 per Bbl as compared to $50.94 per Bbl in the third quarter of 2005. Our realized average natural gas price for the third quarter of 2006, including the effects of hedging, decreased $1.77 per Mcf to $5.88 per Mcf as compared to $7.65 per Mcf in the third quarter of 2005.
	•		As expected, our oil wellhead differential to the average NYMEX price improved in the third quarter of 2006 as compared to the second quarter of 2006. The narrowing of our oil wellhead differential was due to improving market conditions in the Rocky Mountain refining area, which has positively affected the wellhead price we received on our CCA and Williston Basin properties.
	•		Production volumes for the third quarter of 2006 increased 5 percent to 29,651 BOE/D (2.7 MMBOE for the quarter), compared with third quarter 2005 production of 28,202 BOE/D (2.6 MMBOE for the quarter). The rise in production volumes was attributable to our development program and acquisitions completed in the second half of 2005. Oil represented 67 percent and 65 percent of our total production volumes in the third quarter of 2006 and 2005, respectively.
	•		During the third quarter of 2006, we generated cash flows from operating activities of $102.9 million. This represents a 19 percent increase over the $86.7 million of cash flows from operating activities we reported for the third quarter of 2005.
	•		We reported net income of $42.1 million, or $0.78 per diluted share, in the third quarter of 2006, as compared to $20.9 million of net income, or $0.42 per diluted share, for the third quarter of 2005. The increase in net income was due primarily to net pre-tax derivative fair value gains of $33.4 million, increasing net income by approximately $0.39 per diluted share.
	•		We invested $102.1 million in oil and natural gas activities during the third quarter of 2006 (excluding related asset retirement obligations). Of this amount, we invested $95.2 million in development, exploitation, high-pressure air injection (“HPAI”) expansion, and exploration activities, which yielded 65 gross (17.8 net) productive wells, and $6.9 million in acquiring proved properties and undeveloped leases. We operated between 9 and 12 drilling rigs during the third quarter of 2006, including 4 rigs related to our West Texas joint development agreement.

ENCORE ACQUISITION COMPANY

Results of Operations

Comparison of Quarter Ended September 30, 2006 to Quarter Ended September 30, 2005

     Below is a comparison of our operations during the third quarter of 2006 with the third quarter of 2005.

     Revenues and production. The following table illustrates the primary components of oil and natural gas revenues for the three months ended September 30, 2006 and 2005, as well as each quarter’s respective oil and natural gas volumes:

		Three months ended September 30,								Increase / (Decrease)
		2006				2005
		(in thousands, except per unit and per day amounts)
Revenues:
Oil wellhead		$	112,959			$	97,563			$	15,396
Oil hedges			(13,443	)			(12,004	)			(1,439	)
Total oil revenues		$	99,516			$	85,559			$	13,957				16	%
Natural gas wellhead		$	33,144			$	46,515			$	(13,371	)
Natural gas hedges			(967	)			(4,502	)			3,535
Total natural gas revenues		$	32,177			$	42,013			$	(9,836	)			-23	%
Combined wellhead		$	146,103			$	144,078			$	2,025
Combined hedges			(14,410	)			(16,506	)			2,096
Total combined oil and natural gas revenues			131,693				127,572				4,121				3	%
Oil marketing revenues			46,004				—				46,004
Total revenues		$	177,697			$	127,572			$	50,125
Revenues ($/Unit):
Oil wellhead		$	62.20			$	58.09			$	4.11
Oil hedges			(7.40	)			(7.15	)			(0.25	)
Total oil revenues		$	54.80			$	50.94			$	3.86				8	%
Natural gas wellhead		$	6.06			$	8.47			$	(2.41	)
Natural gas hedges			(0.18	)			(0.82	)			0.64
Total natural gas revenues		$	5.88			$	7.65			$	(1.77	)			-23	%
Combined wellhead		$	53.56			$	55.52			$	(1.96	)
Combined hedges			(5.28	)			(6.35	)			1.07
Total combined oil and natural gas revenues		$	48.28			$	49.17			$	(0.89	)			-2	%
Total production volumes:
Oil (Bbls)			1,816				1,680				136				8	%
Natural gas (Mcf)			5,471				5,489				(18	)			0	%
Combined (BOE)			2,728				2,595				133				5	%
Daily production volumes:
Oil (Bbls/D)			19,740				18,257				1,483				8	%
Natural gas (Mcf/D)			59,463				59,666				(203	)			0	%
Combined (BOE/D)			29,651				28,202				1,449				5	%
Average NYMEX prices:
Oil (per Bbl)		$	70.48			$	63.19			$	7.29				12	%
Natural gas (per Mcf)		$	6.17			$	9.64			$	(3.47	)			-36	%