Allis Chalmers Energy 10-K/A 2005 FY Annual report (amended)

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D. C. 20549

Form 10-K/A

Amendment No. 2

(Mark One)
þ	ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
	FOR THE FISCAL YEAR ENDED DECEMBER 31, 2005
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 1-2199

ALLIS-CHALMERS ENERGY INC.

(Exact name of registrant as specified in its charter)

Delaware	39-0126090
(State or other jurisdiction of	(I.R.S. Employer
incorporation or organization)	Identification No.)
5075 WESTHEIMER, SUITE 890, HOUSTON, TEXAS	77056 (Zip code)
(Address of principal executive offices)

(713)369-0550

Registrant’s telephone number, including area code

SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:

Title of Security:	Name of Exchange:
Common Stock, par value $0.01 per share	American Stock Exchange

SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:

NONE

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o     No þ

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d).  Yes o     No þ

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 if disclosure of delinquent filers pursuant to ITEM 405 ofRegulation 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 thisForm 10-K or any amendment to thisForm 10-K. þ

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” inRule 12b-2 of the Exchange Act (Check one):

Large accelerated filer o     Accelerated filer o     Non-accelerated filerþ

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

The aggregate market value of the common equity held by non-affiliates of the registrant, computed using the average of the closing price of the common stock of $5.65 per share on June 30, 2005, as reported on the American Stock Exchange, was approximately $46,064,970 (affiliates included for this computation only: directors, executive officers and holders of more than 5% of the registrant’s common stock).

At June 1, 2006 there were 18,492,760 shares of common stock outstanding.

EXPLANATORY NOTE

ThisForm 10-K/A-2 is being filed by Allis-Chalmers Energy Inc. to provide additional accounting disclosures under Item 8 and to correct the issued and expiration dates of certain warrants previously disclosed under Item 5.

As required byRule 12b-15 under the Securities Exchange Act of 1934, as amended, which we refer to as the Exchange Act, new certifications by our Chief Executive Officer and Chief Financial Officer are being filed as exhibits to thisForm 10-K/A-2 under Item 15 of Part IV.

For purposes of thisForm 10-K/A-2, and in accordance withRule 12b-15 under the Exchange Act, each item of our Annual Report onForm 10-K for the year ended December 31, 2005, as originally filed on March 22, 2006, that is affected by this amendment, has been amended and restated in its entirety. No attempt has been made in thisForm 10-K/A-2 to modify or update other disclosures as presented in the originalForm 10-K, except as required to reflect such amendments.

As used herein, “Allis-Chalmers”, “we”, “our” and “us” may refer to Allis-Chalmers Energy Inc. or its subsidiaries. The use of these terms is not intended to connote any particular corporate status or relationships.

2005FORM 10-K/A-2 CONTENTS

Item			Page
PART II
	5.	Market for Registrant’s Common Equity and Related Stockholder Matters		1
	8.	Financial Statements		3
PART IV
	15.	Exhibits and Financial Statement Schedules		45
		Signatures		46
Certification of CEO pursuant to Section 302
Certification of CFO pursuant to Section 302
Certification of CEO and CFO pursuant to 18 U.S.C. 1350

i

PART II

ITEM 5.   MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.

MARKET PRICE INFORMATION

Our common stock is traded on the American Stock Exchange under the symbol “ALY”. Prior to September 13, 2004, our common stock was quoted on the OTC Bulletin Board and traded sporadically. The following table sets forth, for periods prior to September 13, 2004, high and low bid information for the common stock, as reported on the OTC Bulletin Board, during the periods indicated, and for periods since September 13, 2004, high and low sale prices of our common stock reported on the American Stock Exchange. The quotations reported on the OTC Bulletin Board reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not represent actual transactions. Share prices for periods prior to June 10, 2004, set forth herein have been adjusted to give retroactive effect to aone-to-five reverse stock split effected June 10, 2004.

Calendar Quarter	High		Low
2003
First Quarter		4.50		.55
Second Quarter		5.00		2.25
Third Quarter		4.50		2.60
Fourth Quarter		6.00		2.60
2004
First Quarter		10.05		2.55
Second Quarter		10.25		4.25
Third Quarter		9.75		4.75
Fourth Quarter		5.40		3.25
2005
First Quarter		7.25		3.64
Second Quarter		6.00		4.38
Third Quarter		14.70		5.65
Fourth Quarter		13.75		8.61

Holders

As of March 14, 2006, there were approximately 2,040 holders of record of our common stock. On March 14, 2006, the last sale price for our common stock reported on the American Stock Exchange was $13.55 per share.

Dividends

No dividends were declared or paid during the past three years, and no dividends are anticipated to be declared or paid in the foreseeable future. Our credit facilities and the indenture governing our senior notes restrict our ability to pay dividends on our common stock.

1

EQUITY COMPENSATION PLAN INFORMATION

The following table provides information as of December 31, 2005 with respect to the shares of our common stock that may be issued under our existing equity compensation plans.

	Number of
	Securities to be		Weighted
	Issued Upon		Average Exercise		Number of Securities
	Exercise of		Price of		Remaining Available
	Outstanding		Outstanding		for Future Issuance
	Options, Warrants		Options, Warrants		Under Equity
Plan Category	and Rights		and Rights		Compensation Plans
Equity compensation plans approved by security holders		2,756,067	$	5.18		210,100
Equity compensation plans not approved by security holders		489,243	$	2.97		—
Total		3,245,310	$	4.85		210,100

Equity Compensation Plans Not Approved By Security Holders

These plans comprise the following:

In 1999 and 2000, the Board compensated former and continuing Board members who had served from 1989 to March 31, 1999 without compensation by issuing promissory notes totaling $325,000 and by granting stock options to these same individuals. Options to purchase 4,800 shares of common stock were granted with an exercise price of $13.75. These options vested immediately and expire in March 2010. As of December 31, 2005, none of these options had been exercised.

On May 31, 2001, our Board granted to one of our directors, Leonard Toboroff, an option to purchase 100,000 shares of common stock at $2.50 per share, expiring in October 2011. The option was granted for services provided by Mr. Toboroff to OilQuip prior to our merger with OilQuip Rentals, Inc., including providing financial advisory services, assisting in OilQuip’s capital structure and assisting OilQuip in finding strategic acquisition opportunities. None of these options have been exercised.

In February 2002, we issued warrants to purchase 233,000 shares of our common stock at an exercise price of $0.75 per share and warrants to purchase 67,000 shares of our common stock at an exercise price of $5.00 per share in connection with a subordinated debt financing. The warrants to purchase 233,000 shares were redeemed during December 2004 for $1.5 million. The remaining 67,000 warrants are currently outstanding and expire in February 2012.

In connection with the private placement in April 2004, we issued warrants for the purchase of 800,000 shares of our common stock at an exercise price of $2.50 per share. A total of 486,557 of these warrants were exercised in 2005. Warrants for 4,000 shares of our common stock at an exercise price of $4.65 were also issued in May 2004 and remain outstanding as of December 31, 2005.

2

ITEM 8.   FINANCIAL STATEMENTS.

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders

Allis-Chalmers Energy Inc.

Houston, Texas

We have audited the accompanying consolidated balance sheets of Allis-Chalmers Energy Inc. and subsidiaries as of December 31, 2005 and 2004, and the related consolidated statements of operations, stockholders’ equity and cash flows for the years then ended. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Allis-Chalmers Energy Inc. and subsidiaries as of December 31, 2005 and 2004, and the consolidated results of their operations and their cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States of America.

/s/  UHY Mann Frankfort Stein & Lipp CPAs, LLP

Houston, Texas

March 21, 2006

3

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors

Allis-Chalmers Energy Inc.

Houston, Texas

We have audited the accompanying consolidated statements of operations, stockholders’ equity and cash flows for the year ended December 31, 2003 of Allis-Chalmers Energy Inc. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audit.

We conducted our audit in accordance with the Standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the results of its consolidated operations and cash flows for the year ended December 31, 2003 of Allis-Chalmers Energy Inc., in conformity with accounting principles generally accepted in the United States of America.

As discussed in Note-2 to the consolidated financial statements, the Company restated the consolidated financial statements as of and for the year ended December 31, 2003.

/s/  GORDON, HUGHES & BANKS, LLP

Greenwood Village, Colorado

March 3, 2004, except as to Note 11 which date is

June 10, 2004 and Notes 2 and 17 which date is February 10, 2005 and

Note 2 which date is August 5, 2005.

4

ALLIS-CHALMERS ENERGY INC.

CONSOLIDATED BALANCE SHEETS

	December 31,
	2005		2004
	(In thousands, except for share amounts)
ASSETS
Cash and cash equivalents	$	1,920	$	7,344
Trade receivables, net of allowance for doubtful accounts of $383 and $265 at December 31, 2005 and 2004, respectively		26,964		12,986
Inventory		5,945		2,373
Lease receivable, current		—		180
Prepaid expenses and other		823		1,495
Total current assets		35,652		24,378
Property and equipment, at costs net of accumulated depreciation of $9,996 and $5,251 at December 31, 2005 and 2004, respectively		80,574		37,679
Goodwill		12,417		11,776
Other intangible assets, net of accumulated amortization of $3,163 and $2,036 at December 31, 2005 and 2004, respectively		6,783		5,057
Debt issuance costs, net of accumulated amortization of $299 and $828 at December 31, 2005 and 2004, respectively		1,298		685
Lease receivable, less current portion		—		558
Other assets		631		59
Total assets	$	137,355	$	80,192
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current maturities of long-term debt	$	5,632	$	5,541
Trade accounts payable		9,018		5,694
Accrued salaries, benefits and payroll taxes		1,271		615
Accrued interest		289		470
Accrued expenses		4,350		1,852
Accounts payable, related parties		60		740
Total current liabilities		20,620		14,912
Accrued postretirement benefit obligations		335		687
Long-term debt, net of current maturities		54,937		24,932
Other long-term liabilities		588		129
Total liabilities		76,480		40,660
Commitments and Contingencies
Minority interest		—		4,423
Stockholders’ Equity
Preferred stock, $0.01 par value (25,000,000 shares authorized, none issued)		—		—
Common stock, $0.01 par value (100,000,000 shares authorized;16,859,988 issued and outstanding at December 31, 2005 and 20,000,000 shares authorized and 13,611,525 issued and outstanding at December 31, 2004)		169		136
Capital in excess of par value		58,889		40,331
Retained earnings (deficit)		1,817		(5,358	)
Total stockholders’ equity		60,875		35,109
Total liabilities and stockholders’ equity	$	137,355	$	80,192

The accompanying Notes are an integral part of the Consolidated Financial Statements.

5

ALLIS-CHALMERS ENERGY INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

	Years Ended December 31,
	2005			2004			2003
				(Restated)			(Restated)
	(In thousands, except per
	share amounts)
Revenues	$	105,344		$	47,726		$	32,724
Cost of revenues
Direct costs		69,889			32,598			21,977
Depreciation		4,874			2,702			2,052
Gross margin		30,581			12,426			8,695
General and administrative expense		15,928			7,135			5,285
Amortization		1,787			876			884
Post-retirement medical costs		(352	)		188			(99	)
Income from operations		13,218			4,227			2,625
Other income (expense):
Interest expense		(4,397	)		(2,808	)		(2,467	)
Settlement on lawsuit		—			—			1,034
Gain on sale of interest in AirComp		—			—			2,433
Other		186			304			15
Total other income (expense)		(4,211	)		(2,504	)		1,015
Income before minority interest and income taxes		9,007			1,723			3,640
Minority interest in income of subsidiaries		(488	)		(321	)		(343	)
Provision for income taxes		(1,344	)		(514	)		(370	)
Net income		7,175			888			2,927
Preferred stock dividend		—			(124	)		(656	)
Net income attributed to common stockholders	$	7,175		$	764		$	2,271
Income per common share — basic	$	0.48		$	0.10		$	0.58
Income per common share — diluted	$	0.44		$	0.09		$	0.50
Weighted average number of common shares outstanding:
Basic		14,832			7,930			3,927
Diluted		16,238			9,510			5,850

The accompanying Notes are an integral part of the Consolidated Financial Statements.

6

ALLIS-CHALMERS ENERGY INC.

CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY

					Capital in			Retained
	Common Stock				Excess of			Earnings
	Shares		Amount		Par Value			(Deficit)			Total
	(In thousands, except share amounts)
Balances, December 31, 2002		3,926,668	$	39	$	10,143		$	(9,173	)	$	1,009
Net income (restated)		—		—		—			2,927			2,927
Effect of consolidation of AirComp		—		—		955			—			955
Accrual of preferred dividends		—		—		(350	)		—			(350	)
Balances, December 31, 2003, as restated		3,926,668		39		10,748			(6,246	)		4,541
Net income		—		—		—			888			888
Issuance of common stock:
Acquisitions		1,868,466		19		8,592			—			8,611
Private placement		6,081,301		61		15,600			—			15,661
Services		17,000		—		99			—			99
Conversion of preferred stock		1,718,090		17		4,278			—			4,295
Issuance of stock purchase warrants		—		—		1,138			—			1,138
Accrual of preferred dividends		—		—		(124	)		—			(124	)
Balances, December 31, 2004		13,611,525		136		40,331			(5,358	)		35,109
Net income		—		—		—			7,175			7,175
Issuance of common stock:
Acquisitions		411,275		4		1,746			—			1,750
Secondary public offering		1,761,034		18		15,441			—			15,459
Stock options and warrants exercised		1,076,154		11		1,371			—			1,382
Balances, December 31, 2005		16,859,988	$	169	$	58,889		$	1,817		$	60,875

The accompanying Notes are an integral part of the Consolidated Financial Statements.

7

ALLIS-CHALMERS ENERGY INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

	Years Ended December 31,
	2005			2004			2003
							(Restated)
	(In thousands)
Cash Flows from Operating Activities:
Net income	$	7,175		$	888		$	2,927
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation		4,874			2,702			2,052
Amortization		1,787			876			884
Write-off of deferred financing fees due to refinancing		653			—			—
Issuance of stock options for services		—			14			—
Amortization of discount on debt		9			350			516
(Gain) on change in PBO liability		(352	)		—			(125	)
(Gain) on settlement of lawsuit		—			—			(1,034	)
(Gain) on sale of interest in AirComp		—			—			(2,433	)
Minority interest in income of subsidiaries		488			321			343
(Gain) loss on sale of property		(669	)		—			82
Changes in working capital:
(Increase) in accounts receivable		(10,437	)		(2,292	)		(4,414	)
(Increase) in due from related party		—			(7	)		—
(Increase) in other current assets		(2,143	)		(612	)		(1,260	)
Decrease (increase) in other assets		(936	)		(19	)		1
Decrease in lease deposit		—			—			525
Increase in accounts payable		2,373			1,140			2,251
(Decrease) increase in accrued interest		324			299			(126	)
(Decrease) increase in accrued expenses		(97	)		(276	)		397
(Decrease) increase in other long-term liabilities		86			(141	)		—
Increase in accrued salaries,benefits and payroll taxes		443			19			1,293
Net cash provided by operating activities		3,578			3,262			1,879
Cash Flows from Investing Activities:
Acquisitions, net of cash acquired		(36,888	)		(4,459	)		—
Purchase of property and equipment		(17,767	)		(4,603	)		(5,354	)
Proceeds from sale of property and equipment		1,579			—			843
Net cash used in investing activities		(53,076	)		(9,062	)		(4,511	)
Cash Flows from Financing Activities:
Proceeds from issuance of long-term debt		56,251			8,169			14,127
Payments on long-term debt		(28,202	)		(13,259	)		(10,826	)
Payments on related party debt		(1,522	)		(246	)		(246	)
Net borrowings on lines of credit		2,527			689			1,138
Proceeds from issuance of common stock		15,459			16,883			—
Proceeds from exercise of options and warrants		1,382			—			—
Debt issuance costs		(1,821	)		(391	)		(408	)
Net cash provided by financing activities		44,074			11,845			3,785
Net increase (decrease) in cash and cash equivalents		(5,424	)		6,045			1,153
Cash and cash equivalents at beginning of year		7,344			1,299			146
Cash and cash equivalents at end of year	$	1,920		$	7,344		$	1,299

The accompanying Notes are an integral part of the Consolidated Financial Statements.

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ALLIS-CHALMERS ENERGY INC.

Notes to Consolidated Financial Statements

NOTE 1 — NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Organization of Business

Allis-Chalmers Energy Inc. (“Allis-Chalmers” or “We”) was incorporated in Delaware in 1913. OilQuip Rentals, Inc. (“OilQuip”), an oil and gas rental company, was incorporated on February 4, 2000 to find and acquire acquisition targets to operate as subsidiaries.

On February 6, 2001, OilQuip, through its subsidiary, Mountain Compressed Air Inc. (“Mountain Air”), a Texas corporation, acquired certain assets of Mountain Air Drilling Service Co., Inc, whose business consisted of providing equipment and trained personnel in the Four Corners area of the southwestern United States. Mountain Air primarily provided compressed air equipment and related products and services and trained operators to companies in the business of drilling for natural gas. On May 9, 2001, OilQuip merged into a subsidiary of Allis-Chalmers Energy Inc. In the merger, all of OilQuip’s outstanding common stock was converted into 2.0 million shares of Allis-Chalmers’ common stock. For legal purposes, Allis-Chalmers acquired OilQuip, the parent company of Mountain Air. However, for accounting purposes, OilQuip was treated as the acquiring company in a reverse acquisition of Allis-Chalmers.

On February 6, 2002, we acquired 81% of the outstanding stock of Allis-Chalmers Tubular Services Inc. (“Tubular”), formerly known as Jens’ Oilfield Service, Inc., which supplies highly specialized equipment and operations to install casing and production tubing required to drill and complete oil and gas wells. On February 2, 2002, we also purchased substantially all of the outstanding common stock and preferred stock of Strata Directional Technology, Inc. (“Strata”), which provides high-end directional and horizontal drilling services for specific targeted reservoirs that cannot be reached vertically.

In July 2003, through its subsidiary Mountain Air, we entered into a limited liability company operating agreement with a division of M-I L.L.C. (“M-I”), a joint venture between Smith International and Schlumberger N.V. (Schlumberger Limited), to form a Texas limited liability company named AirComp LLC (“AirComp”). The assets contributed by Mountain Air were recorded at Mountain Air’s historical cost of $6.3 million, and the assets contributed by M-I were recorded at fair market value of $10.3 million. We originally owned 55% and M-I originally owned 45% of AirComp. As a result of our controlling interest and operating control, we consolidated AirComp in our financial statements. AirComp is in the compressed air drilling services segment.

On September 23, 2004, we acquired 100% of the outstanding stock of Safco-Oil Field Products, Inc. (“Safco”) for $1.0 million. Safco leases spiral drill pipe and provides related oilfield services to the oil drilling industry.

On September 30, 2004, we acquired the remaining 19% of Tubular’ in exchange for 1.3 million shares of our common stock. The total value of the consideration paid to the seller, Jens Mortensen, was $6.4 million which was equal to the number of shares of common stock issued to Mr. Mortensen multiplied by the last sale price ($4.95) of the common stock as reported on the American Stock Exchange on the date of issuance.

On November 10, 2004, AirComp acquired substantially all the assets of Diamond Air Drilling Services, Inc. and Marquis Bit Co., L.L.C. collectively (“Diamond Air”) for $4.6 million in cash and the assumption of approximately $450,000 of accrued liabilities. We contributed $2.5 million and M-I L.L.C. contributed $2.1 million to AirComp LLC in order to fund the purchase. Diamond Air provides air drilling technology and products to the oil and gas industry in West Texas, New Mexico and Oklahoma. Diamond Air is a leading provider of air hammers and hammer bit products.

On December 10, 2004, we acquired Downhole Injection Services, LLC (“Downhole”) for approximately $1.1 million in cash, 568,466 shares of common stock and payment or assumption of $950,000 of debt. Downhole is headquartered in Midland, Texas, and provides chemical treatments to wells by inserting small diameter, stainless steel coiled tubing into producing oil and gas wells.

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ALLIS-CHALMERS ENERGY INC.

Notes to Consolidated Financial Statements — (Continued)

On April 1, 2005, we acquired 100% of the outstanding stock of Delta Rental Service, Inc. (“Delta”) for $4.6 million in cash, 223,114 shares of our common stock and two promissory notes totaling $350,000. Delta, located in Lafayette, Louisiana, is a rental tool company providing specialty rental items to the oil and gas industry such as spiral heavy weight drill pipe, test plugs used to test blow-out preventors, well head retrieval tools, spacer spools and assorted handling tools.

On May 1, 2005, we acquired 100% of the outstanding capital stock of Capcoil Tubing Services, Inc. (“Capcoil”) for $2.7 million in cash, 168,161 shares of our common stock and the payment or assumption of approximately $1.3 million of debt. Capcoil, located in Kilgore, Texas, is engaged in downhole well servicing by providing coil tubing services to enhance production from existing wells.

On July 11, 2005, we acquired the compressed air drilling assets of W.T. Enterprises, Inc. (“W.T.”), based in South Texas, for $6.0 million in cash. The equipment includes compressors, boosters, mist pumps and vehicles.

On July 11, 2005, we acquired from M-I its 45% interest in AirComp and subordinated note in the principal amount of $4.8 million issued by AirComp, for which we paid M-I $7.1 million in cash and issued to M-I a $4.0 million subordinated note bearing interest at 5% per annum. As a result, we now own 100% of AirComp.

Effective August 1, 2005, we acquired 100% of the outstanding capital stock of Target Energy Inc. (“Target”) for $1.3 million in cash and forgiveness of a lease receivable of approximately $0.6 million. The results of Target are included in our directional and horizontal drilling segment as their Measure While Drilling equipment is utilized in that segment.

On September 1, 2005, we acquired the casing and tubing service assets of Patterson Services, Inc. for approximately $15.6 million. These assets are located in Corpus Christi, Texas; Kilgore, Texas; Lafayette, Louisiana and Houma, Louisiana.

Vulnerabilities and Concentrations

We provide oilfield services in several regions, including the states of Texas, Utah, Louisiana, Colorado, Oklahoma, and New Mexico, the Gulf of Mexico and southern portions of Mexico. The nature of our operations and the many regions in which we operate subject us to changing economic, regulatory and political conditions. We are vulnerable to near-term and long-term changes in the demand for and prices of oil and natural gas and the related demand for oilfield service operations.

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America 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. Future events and their effects cannot be perceived with certainty. Accordingly, our accounting estimates require the exercise of judgment. While management believes that the estimates and assumptions used in the preparation of the consolidated financial statements are appropriate, actual results could differ from those estimates. Estimates are used for, but are not limited to, determining the following: allowance for doubtful accounts, recoverability of long-lived assets and intangibles, useful lives used in depreciation and amortization, income taxes and valuation allowances. The accounting estimates used in the preparation of the consolidated financial statements

10

ALLIS-CHALMERS ENERGY INC.

Notes to Consolidated Financial Statements — (Continued)

may change as new events occur, as more experience is acquired, as additional information is obtained and as our operating environment changes.

Principles of Consolidation

The consolidated financial statements include the accounts of Allis-Chalmers and its subsidiaries. Our subsidiaries at December 31, 2005 are Oil Quip, Mountain Air, Tubular, Strata, AirComp, Safco, Downhole, Delta, Capcoil and Target. All significant inter-company transactions have been eliminated.

Revenue Recognition

We provide rental equipment and drilling services to our customers at per day and per job contractual rates and recognize the drilling related revenue as the work progresses and when collectibility is reasonably assured. Payments from customers for the cost of oilfield rental equipment that is damaged or lost-in-hole are reflected as revenues. We recognized revenue from damaged or lost-in-hole equipment of $970,000, $41,000 and $252,000 for the years ended December 31, 2005, 2004 and 2003, respectively. The Securities and Exchange Commission’s (SEC) Staff Accounting Bulletin (SAB) No. 104,Revenue Recognition In Financial Statements(“SAB No. 104”), provides guidance on the SEC staff’s views on the application of generally accepted accounting principles to selected revenue recognition issues. Our revenue recognition policy is in accordance with generally accepted accounting principles and SAB No. 104.

Allowance for Doubtful Accounts

Accounts receivable are customer obligations due under normal trade terms. We sell our services to oil and natural gas exploration and production companies. We perform continuing credit evaluations of its customers’ financial condition and although we generally does not require collateral, letters of credit may be required from customers in certain circumstances.

We record an allowance for doubtful accounts based on specifically identified amounts that are determined uncollectible. We have a limited number of customers with individually large amounts due at any given date. Any unanticipated change in any one of these customer’s credit worthiness or other matters affecting the collectibility of amounts due from such customers could have a material effect on the results of operations in the period in which such changes or events occur. After all attempts to collect a receivable have failed, the receivable is written off against the allowance. As of December 31, 2005 and 2004, we had recorded an allowance for doubtful accounts of $383,000 and $265,000 respectively. Bad debt expense was $219,000, $104,000 and $136,000 for the years ended December 31, 2005, 2004 and 2003, respectively.

Cash Equivalents

We consider all highly liquid investments with an original maturity of three months or less at the time of purchase to be cash equivalents.

Inventories

Inventories are stated at the lower of cost or market. Cost is determined using the first — in, first — out (“FIFO”) method or the average cost method, which approximates FIFO, and includes the cost of materials, labor and manufacturing overhead.

Property and Equipment

Property and equipment is recorded at cost less accumulated depreciation. Certain equipment held under capital leases are classified as equipment and the related obligations are recorded as liabilities.

11

ALLIS-CHALMERS ENERGY INC.

Notes to Consolidated Financial Statements — (Continued)

Maintenance and repairs, which do not improve or extend the life of the related assets, are charged to operations when incurred. Refurbishments and renewals are capitalized when the value of the equipment is enhanced for an extended period. When property and equipment are sold or otherwise disposed of, the asset account and related accumulated depreciation account are relieved, and any gain or loss is included in operations.

The cost of property and equipment currently in service is depreciated over the estimated useful lives of the related assets, which range from three to twenty years. Depreciation is computed on the straight-line method for financial reporting purposes. Capital leases are amortized using the straight-line method over the estimated useful lives of the assets and lease amortization is included in depreciation expense. Depreciation expense charged to operations was $4.9 million, $2.7 million and $2.1 million for the years ended December 31, 2005, 2004 and 2003, respectively.

Goodwill, Intangible Assets and Amortization

Goodwill, including goodwill associated with equity method investments, and other intangible assets with infinite lives are not amortized, but tested for impairment annually or more frequently if circumstances indicate that impairment may exist. Intangible assets with finite useful lives are amortized either on a straight-line basis over the asset’s estimated useful life or on a basis that reflects the pattern in which the economic benefits of the intangible assets are realized.

We perform impairment tests on the carrying value of our goodwill on an annual basis as of December 31st for each of our reportable segments. As of December 31, 2005 and 2004, no evidence of impairment exists.

Impairment of Long-Lived Assets

Long-lived assets, which include property, plant and equipment and other intangible assets, and certain other assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. An impairment loss is recorded in the period in which it is determined that the carrying amount is not recoverable. The determination of recoverability is made based upon the estimated undiscounted future net cash flows, excluding interest expense. The impairment loss is determined by comparing the fair value, as determined by a discounted cash flow analysis, with the carrying value of the related assets.

Financial Instruments

Financial instruments consist of cash and cash equivalents, accounts receivable and payable, and debt. The carrying value of cash and cash equivalents and accounts receivable and payable approximate fair value due to their short-term nature. We believe the fair values and the carrying value of our debt would not be materially different due to the instruments’ interest rates approximating market rates for similar borrowings at December 31, 2005 and 2004.

Concentration of Credit and Customer Risk

Financial instruments that potentially subject us to concentrations of credit risk consist principally of cash and cash equivalents and trade accounts receivable. We transact our business with several financial institutions. However, the amount on deposit in two financial institutions exceeded the $100,000 federally insured limit at December 31, 2005 by a total of $2.0 million. Management believes that the financial institutions are financially sound and the risk of loss is minimal.

We sell our services to major and independent domestic and international oil and gas companies. We perform ongoing credit valuations of our customers and provide allowances for probable credit losses where

12

ALLIS-CHALMERS ENERGY INC.

Notes to Consolidated Financial Statements — (Continued)

appropriate. In 2005, none of our customers accounted for more than 10% of our consolidated revenues. In the year ended December 31, 2004, Matyep in Mexico represented 10.8%, and Burlington Resources represented 10.1% of our consolidated revenues, respectively. In the year ended December 31, 2003, Matyep, Burlington Resources, Inc., and El Paso Energy Corporation represented 10.2%, 11.1% and 14.1%, respectively, of our consolidated revenues. Revenues from Matyep represented 94.5%, 98.0% and 100% of our international revenues in 2005, 2004 and 2003, respectively.

Debt Issuance Costs

The costs related to the issuance of debt are capitalized and amortized to interest expense using the straight-line method, which approximates the interest method, over the maturity periods of the related debt.

Income Taxes

We use the liability method for determining our income taxes, under which current and deferred tax liabilities and assets are recorded in accordance with enacted tax laws and rates. Under this method, the amounts of deferred tax liabilities and assets at the end of each period are determined using the tax rate expected to be in effect when taxes are actually paid or recovered. Future tax benefits are recognized to the extent that realization of such benefits is more likely than not.

Deferred income taxes are provided for the estimated income tax effect of temporary differences between financial and tax bases in assets and liabilities. Deferred tax assets are also provided for certain tax credit carryforwards. A valuation allowance to reduce deferred tax assets is established when it is more likely than not that some portion or all of the deferred tax assets will not be realized.

Stock-Based Compensation

We account for our stock-based compensation using Accounting Principle Board Opinion No. 25 (“APB No. 25”). Under APB No. 25, compensation expense is recognized for stock options with an exercise price that is less than the market price on the grant date of the option. For stock options with exercise prices at or above the market value of the stock on the grant date, we adopted the disclosure-only provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123,Accounting For Stock-Based Compensation(“SFAS 123”). We also adopted the disclosure-only provisions of SFAS No. 123 for the stock options granted to our employees and directors. Accordingly, no compensation cost has been recognized under APB No. 25. Had compensation expense for the options granted been recorded based on the fair value at the grant date for the options, consistent with the provisions of SFAS 123, our net income/(loss) and net income/(loss) per share

13

ALLIS-CHALMERS ENERGY INC.

Notes to Consolidated Financial Statements — (Continued)

for the years ended December 31, 2005, 2004, and 2003 would have been decreased to the pro forma amounts indicated below (in thousands, except per share amounts):

		For the Years Ended December 31,
		2005			2004			2003
					(Restated)			(Restated)
Net income attributed to common stockholders as reported:		$	7,175		$	764		$	2,271
Less total stock based employee compensation expense determined under fair value based method for all awards net of tax related effects			(4,284	)		(1,072	)		(2,314	)
Pro-forma net income (loss) attributed to common stockholders		$	2,891		$	(308	)	$	(43	)
Net income/(loss) per common share:
Basic	As reported	$	0.48		$	0.10		$	0.58
	Pro forma	$	0.19		$	(0.04	)	$	(0.01	)
Diluted	As reported	$	0.44		$	0.09		$	0.50
	Pro forma	$	0.18		$	(0.04	)	$	(0.01	)

Options were granted in 2005, 2004 and 2003. See Note 12 for further disclosures regarding stock options. The following assumptions were applied in determining the pro forma compensation costs:

	For the Years Ended December 31,
	2005		2004		2003
Expected dividend yield		—		—		—
Expected price volatility		84.28%		89.76%		265.08%
Risk-free interest rate		5.6%		7.00%		6.25%
Expected life of options		7 years		7 years		7 years
Weighted average fair value of options
granted at market value	$	5.02	$	3.19	$	2.78

Segments of an Enterprise and Related Information

We disclose the results of our segments in accordance with SFAS No. 131,Disclosures About Segments Of An Enterprise And Related Information(“SFAS No. 131”). We designate the internal organization that is used by management for allocating resources and assessing performance as the source of our reportable segments. SFAS No. 131 also requires disclosures about products and services, geographic areas and major customers Please see Note 18 for further disclosure of segment information in accordance with SFAS No. 131.

Pension and Other Post Retirement Benefits

SFAS No. 132,Employer’s Disclosures About Pension And Other Post Retirement Benefits(“SFAS No. 132”), requires certain disclosures about employers’ pension and other post retirement benefit plans and specifies the accounting and measurement or recognition of those plans. SFAS No. 132 requires disclosure of information on changes in the benefit obligations and fair values of the plan assets that facilitates financial analysis. Please see Note 3 for further disclosure in accordance with SFAS No. 132.

Income Per Common Share

We compute income per common share in accordance with the provisions of SFAS No. 128,Earnings Per Share(“SFAS No. 128”). SFAS No. 128 requires companies with complex capital structures to present

14

ALLIS-CHALMERS ENERGY INC.

Notes to Consolidated Financial Statements — (Continued)

basic and diluted earnings per share. Basic earnings per share are computed on the basis of the weighted average number of shares of common stock outstanding during the period. For periods through April 12, 2004, preferred dividends are deducted from net income and have been considered in the calculation of income available to common stockholders in computing basic earnings per share. Diluted earnings per share is similar to basic earnings per share, but presents the dilutive effect on a per share basis of potential common shares (e.g., convertible preferred stock, stock options, etc.) as if they had been converted. Potential dilutive common shares that have an anti-dilutive effect (e.g., those that increase income per share) are excluded from diluted earnings per share.

The components of basic and diluted earnings per share are as follows (in thousands, except per share amounts):

	For the Years Ended December 31,
	2005		2004		2003
			(Restated)		(Restated)
Numerator:
Net income available for common stockholders	$	7,175	$	764	$	2,271
Plus income impact of assumed conversions:
Preferred stock dividends/interest		—		124		656
Net income applicable to common stockholders plus assumed conversions	$	7,175	$	888	$	2,927
Denominator:
Denominator for basic earnings per share — weighted average shares outstanding		14,832		7,930		3,927
Effect of potentially dilutive common shares:
Convertible preferred stock and employee and director stock options		1,406		1,580		1,923
Weighted average shares outstanding and assumed conversions		16,238		9,510		5,850
Basic earnings per share	$	0.48	$	0.10	$	0.58
Diluted earnings per share	$	0.44	$	0.09	$	0.50

Reclassification

Certain prior period balances have been reclassified to conform to current year presentation.

New Accounting Pronouncements

In May 2005, the FASB issued SFAS No. 154,Accounting Changes and Error Corrections. SFAS No. 154 requires retroactive application of a voluntary change in accounting principle to prior period financial statements unless it is impracticable. SFAS No. 154 also requires that a change in the method of depreciation, amortization or depletion for long-lived, non-financial assets be accounted for as a change in accounting estimate that is affected by a change in accounting principle. SFAS No. 154 replaces APB Opinion No. 20, “Accounting Changes” and SFAS No. 3, “Reporting Accounting Changes in Interim Financial Statements”. SFAS No. 154 is effective for fiscal years beginning after December 15, 2005. We will adopt the provisions of SFAS No. 154 as of January 1, 2006 and do not expect that its adoption will have a material impact on our results of operations or financial condition.

15

ALLIS-CHALMERS ENERGY INC.

Notes to Consolidated Financial Statements — (Continued)

In December 2004, the FASB issued SFAS No. 123R,Share-Based Payment. SFAS No. 123R revises SFAS No. 123,Accounting for Stock-Based Compensation, and focuses on accounting for share-based payments for services by employer to employee. The statement requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values. We will adopt SFAS No. 123R as of January 1, 2006 and will use the modified prospective transition method, utilizing the Black-Scholes option pricing model for the calculation of the fair value of our employee stock options. Under the modified prospective method, stock option awards that are granted, modified or settled after January 1, 2006 will be measured and accounted for in accordance with SFAS No. 123R. Compensation cost for awards granted prior to, but not vested, as of January 1, 2006 would be based on the grant date attributes originally used to value those awards for pro forma purposes under SFAS No. 123. We believe that the adoption of this standard will result in an expense of approximately $3.2 million, or a reduction in diluted earnings per share of approximately $0.18 per share. This estimate assumes no additional grants of stock options beyond those outstanding as of December 31, 2005. This estimate is based on many assumptions including the level of stock option grants expected in 2006, our stock price, and significant assumptions in the option valuation model including volatility and the expected life of options. Actual expenses could differ from the estimate.

In November 2004, the FASB issued SFAS No. 151,Inventory Costs — an Amendment of ARB No. 43, Chapter 4, which amends the guidance in ARB No. 43 to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs and wasted material. SFAS No. 151 requires that these items be recognized as current period charges. In addition, SFAS No. 151 requires the allocation of fixed production overheads to inventory based on the normal capacity of the production facilities. We are required to adopt provisions of SFAS 151, on a prospective basis, as of January 1, 2006. We do not believe the adoption of SFAS 151 will have a material impact on our future results of operations.

NOTE 2 — RESTATEMENT

Earnings Per Share

We understated diluted earnings per share due to an incorrect calculation of our weighted shares outstanding for the third quarter of 2003, for each of the first three quarters of 2004, for the years ended December 31, 2003 and 2004 and for the quarter ended March 31, 2005. In addition, we understated basic earnings per share due to an incorrect calculation of our weighted average basic shares outstanding for the quarter ended September 30, 2004. Consequently, we have restated our financial statements for each of those periods. The incorrect calculation resulted from a mathematical error and an improper application of SFAS No. 128. The effect of the restatement is to reduce weighted average basic and diluted shares outstanding for the three and nine months ended September 30, 2004. Consequently, weighted average basic and diluted earnings per share for the three and nine months ended September 30, 2004 were increased.

A restated earnings per share calculation for all affected periods reflecting the above adjustments to our results as previously restated (see following section), is presented below (amounts in thousands, except per share amounts):

	Three Months Ended March 31, 2005
	As
	Previously					As
	Reported		Adjustments			Restated
Income per common share- diluted	$	0.09	$	0.02		$	0.11
Weighted average number of common shares outstanding:
Diluted		17,789		(3,094	)		14,695

16

ALLIS-CHALMERS ENERGY INC.

Notes to Consolidated Financial Statements — (Continued)

	Year Ended December 31, 2004
	As
	Previously					As
	Reported		Adjustments			Restated
Income per common share- diluted	$	0.07	$	0.02		$	0.09
Weighted average number of common shares outstanding:
Diluted		11,959		(2,449	)		9,510

��

	Three Months Ended September 30, 2004
	As
	Previously					As
	Reported		Adjustments			Restated
Income per common share — basic	$	0.04	$	0.02		$	0.06
Income per common share- diluted	$	0.04	$	0.01		$	0.05
Weighted average number of common shares outstanding:
Basic		11,599		(3,301	)		8,298
Diluted		14,407		(4,579	)		9,828

	Three Months Ended June 30, 2004
	As
	Previously					As
	Reported		Adjustments			Restated
Income per common share- diluted	$	0.04	$	0.01		$	0.05
Weighted average number of common shares outstanding:
Diluted		10,237		(2,618	)		7,619

	Three Months Ended March 31, 2004
	As
	Previously				As
	Reported		Adjustments		Restated
Income per common share- diluted	$	0.05	$	0.03	$	0.08
Weighted average number of common shares outstanding:
Diluted		5,762		478		6,240

	Year Ended December 31, 2003
	As
	Previously				As
	Reported		Adjustments		Restated
Income per common share- diluted	$	0.39	$	0.11	$	0.50
Weighted average number of common shares outstanding:
Diluted		5,761		89		5,850

17

ALLIS-CHALMERS ENERGY INC.

Notes to Consolidated Financial Statements — (Continued)

	Three Months Ended September 30, 2003
	As
	Previously					As
	Reported		Adjustments			Restated
Income per common share- diluted	$	0.60	$	(0.01	)	$	0.59
Weighted average number of common shares outstanding:
Diluted		5,761		208			5,969

AirComp Acquisition

In connection with the formation of AirComp LLC in 2003, we, along with M-I L.L.C. contributed assets to AirComp in exchange for a 55% interest and 45% interest, respectively, in AirComp. We originally accounted for the formation of AirComp as a joint venture. However in February 2005, we determined that the transaction should have been accounted for using purchase accounting pursuant to SFAS No. 141,Business Combinationsand recorded the sale of an interest in a subsidiary, in accordance with SEC Staff Accounting Bulletin No. 51,Accounting for Sales of Stock by a Subsidiary. Consequently, we restated our financial statements for the quarter ended September 30, 2003, for the year ended December 31, 2003 and for the three quarters ended September 30, 2004, to reflect the following adjustments:

Increase in Book Value of Fixed Assets.

Under joint venture accounting, we originally recorded the value of the assets contributed by M-I to AirComp at M-I’s historical cost of $6.9 million. Under purchase accounting, we increased the recorded value of the assets contributed by M-I by approximately $3.3 million to $10.3 million to reflect their fair market value as determined by a third party appraisal. In addition, under joint venture accounting, we established negative goodwill which reduced fixed assets in the amount of $1.6 million. The negative goodwill was amortized by us over the lives of the related fixed assets. Under purchase accounting, we increased fixed assets by $1.6 million to reverse the negative goodwill previously recorded and reversed amortization expenses recorded in 2004. Therefore, the cost of fixed assets was increased by a total of $4.9 million at the time of acquisition. As a result of the increase in fixed assets and the reversal of amortization of negative goodwill, depreciation expense increased by $98,000 for the year ended December 31, 2003.

Increase in Minority Interest and Capital in Excess of Par Value.

Under purchase accounting, minority interest was increased by $1.5 million, which was partially offset by minority interest expense of $44,000 for the year ended December 31, 2003. Under purchase accounting, the capital in excess of par was increased by $955,000.

18

ALLIS-CHALMERS ENERGY INC.

Notes to Consolidated Financial Statements — (Continued)

A restated consolidated balance sheet, reflecting the above adjustments follows (in thousands):

	At December 31, 2003
	As
	Previously			Restatement		As
	Reported			Adjustments		Restated
Assets
Cash and cash equivalents	$	1,299		$	—	$	1,299
Trade receivables, net		8,823			—		8,823
Lease receivable, current		180			—		180
Prepaid expenses and other		887			—		887
Total current assets		11,189			—		11,189
Property and equipment, net		26,339			4,789		31,128
Goodwill		7,661			—		7,661
Other intangible assets, net		2,290			—		2,290
Debt issuance costs, net		567			—		567
Lease receivable, less current portion		787			—		787
Other		40			—		40
Total Assets	$	48,873		$	4,789	$	53,662
Liabilities and Stockholders’ Equity
Current maturities of long-term debt	$	3,992		$	—	$	3,992
Trade accounts payable		3,133			—		3,133
Accrued salaries, benefits and payroll taxes		591			—		591
Accrued interest		152			—		152
Accrued expenses		1,761			—		1,761
Accounts payable, related parties		787			—		787
Total current liabilities		10,416			—		10,416
Accrued postretirement benefit obligations		545			—		545
Long-term debt, net of current maturities		28,241			—		28,241
Other long-term liabilities		270			—		270
Redeemable warrants		1,500			—		1,500
Redeemable convertible preferred stock and dividends		4,171			—		4,171
Total Liabilities		45,143			—		45,143
Commitments and contingencies
Minority interests		2,523			1,455		3,978
Stockholders’ Equity
Common stock		39			—		39
Capital in excess of par value		9,793			955		10,748
Accumulated (deficit)		(8,625	)		2,379		(6,246	)
Total Stockholders’ Equity		1,207			3,334		4,541
Total Liabilities and Stockholders’ Equity	$	48,873		$	4,789	$	53,662

19

ALLIS-CHALMERS ENERGY INC.

Notes to Consolidated Financial Statements — (Continued)

Increase in Net Income.

Under joint venture accounting, no gain or loss was recognized in connection with the formation of AirComp. Under purchase accounting, we recorded a $2.4 million non-operating gain in the third quarter of 2003.

As a result of the increase in fixed assets, depreciation expense was increased for the year ended December 31, 2003 by $98,000 and minority interest expense decreased by $44,000, resulting in a reduction in net income attributable to common stockholders of $54,000. However, as a result of recording the non-operating gain, net income attributed to common stockholders increased by $2.4 million for the year ended December 31, 2003.

A restated consolidated income statement reflecting the above adjustments follows (in thousands, except per share amounts):

	Year Ended December 31, 2003
	As
	Previously			Restatement			As
	Reported			Adjustments			Restated
Revenue	$	32,724		$	—		$	32,724
Cost of revenues
Direct costs		21,977			—			21,977
Depreciation		1,954			98			2,052
Gross margin		8,793			(98	)		8,695
General and administrative expense		5,285			—			5,285
Amortization		884			—			884
Income (loss) from operations		2,624			(98	)		2,526
Other income (expense):
Interest, net		(2,464	)		—			(2,464	)
Settlement on lawsuit		1,034			—			1,034
Gain on sale of stock in a subsidiary		—			2,433			2,433
Other		111			—			111
Total other income (expense)		(1,319	)		2,433			1,114
Net income before minority interest and income taxes		1,305			2,335			3,640
Minority interest in income of subsidiaries		(387	)		44			(343	)
Provision for foreign income tax		(370	)		—			(370	)
Net income		548			2,379			2,927
Preferred stock dividend		(656	)		—			(656	)
Net income (loss) attributed to common stockholders	$	(108	)	$	2,379		$	2,271
Net income per common share — basic	$	(0.03	)				$	0.58
Net income per common share — diluted	$	(0.03	)				$	0.39
Weighted average number of common shares outstanding:
Basic		3,927						3,927
Diluted		5,761						5,761

20

ALLIS-CHALMERS ENERGY INC.

Notes to Consolidated Financial Statements — (Continued)

A restated consolidated statement of cash flows reflecting the adjustments follows (in thousands):

	Year Ended December 31, 2003
	As
	Previously			Restatement			As
	Reported			Adjustments			Restated
Cash Flows From Operating Activities:
Net income	$	548		$	2,379		$	2,927
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization expense		2,838			98			2,936
Amortization of discount on debt		516			—			516
(Gain) on change PBO liability		(125	)		—			(125	)
(Gain) on settlement of lawsuit		(1,034	)		—			(1,034	)
(Gain) on sale of interest in AirComp		—			(2,433	)		(2,433	)
Minority interest in income of subsidiaries		387			(44	)		343
Loss on sale of property		82			—			82
Changes in operating assets and liabilities:
(Increase) in accounts receivable		(4,414	)		—			(4,414	)
(Increase) in other current assets		(1,260	)		—			(1,260	)
Decrease in other assets		1			—			1
Decrease in lease deposit		525			—			525
Increase in accounts payable		2,251			—			2,251
(Decrease) in accrued interest		(126	)		—			(126	)
Increase in accrued expenses		397			—			397
Increase in accrued employee benefits and payroll taxes		1,293			—			1,293
Net cash provided by operating activities		1,879			—			1,879
Cash Flows From Investing Activities:
Purchase of equipment		(5,354	)		—			(5,354	)
Proceeds from sale of equipment		843			—			843
Net cash used by investing activities		(4,511	)		—			(4,511	)
Cash Flows From Financing Activities:
Proceeds from issuance of long-term debt		14,127			—			14,127
Repayments of long-term debt		(10,826	)		—			(10,826	)
Repayments on related party debt		(246	)		—			(246	)
Borrowing on lines of credit		30,537			—			30,537
Repayments on lines of credit		(29,399	)		—			(29,399	)
Debt issuance costs		(408	)		—			(408	)
Net cash provided by financing activities		3,785			—			3,785
Net decrease in cash and cash equivalents		1,153			—			1,153
Cash and cash equivalents at beginning of the year		146			—			146
Cash and cash equivalents at end of the period	$	1,299		$	—		$	1,299
Supplemental information:
Interest paid	$	2,341		$	—		$	2,341

21

ALLIS-CHALMERS ENERGY INC.

Notes to Consolidated Financial Statements — (Continued)

In addition, the 2004 financial statements have been restated from the previously filed interim financial statements included inForm 10-Q for the first, second and third quarters of 2004. The effect of the restatement on the individual quarterly financial statements is as follows (in thousands, except per share amounts):

	Three Months			Three Months			Three Months
	Ended			Ended			Ended
	March 31,			June 30,			September 30,
	2004			2004			2004
Net income (loss) attributed to common stockholders
Previously reported	$	501		$	434		$	576
Adjustment — depreciation expense		(139	)		(79	)		(79	)
Adjustment — minority interest expense		22			22			22
Restated	$	384		$	377		$	519
Net income (loss) per share, basic
Previously reported	$	0.13		$	0.07		$	0.05
Total adjustments		(0.03	)		(0.01	)		(0.01	)
Restated	$	0.10		$	0.06		$	0.04

In addition, the accompanying 2003 financial statements have been restated from the previously filed interim financial statements included inForm 10-Q for the first, second and third quarters of 2003. An adjustment was recorded in the fourth quarter of 2003 to reflect a change in estimate of the recoverability of foreign taxes paid in 2002 and 2003. The effect of the significant fourth quarter adjustment on the individual quarterly financial statements is as follows (in thousands, except per share amounts):

	Three Months			Three Months			Three Months
	Ended			Ended			Ended
	March 31,			June 30,			September 30,
	2003			2003			2003
Net income (loss) attributed to common stockholders
Previously reported	$	(183	)	$	(330	)	$	1,136
Adjustment — gain on sale of stock in a subsidiary		—			—			2,433
Adjustment — depreciation expense		—			—			(49	)
Adjustment — minority interest expense		—			—			22
Adjustment — foreign tax expense		(158	)		(92	)		(93	)
Restated	$	(341	)	$	(422	)	$	3,449
Net income (loss) per share, basic and diluted
Previously reported	$	(0.05	)	$	(0.08	)	$	0.29
Total adjustments		(0.04	)		(0.03	)		0.58
Restated	$	(0.09	)	$	(0.11	)	$	0.87

NOTE 3 —  POST RETIREMENT BENEFIT OBLIGATIONS

Medical And Life

Pursuant to the Plan of Reorganization that was confirmed by the Bankruptcy Court after acceptances by our creditors and stockholders and was consummated on December 2, 1988, we assumed the contractual obligation to Simplicity Manufacturing, Inc. (SMI) to reimburse SMI for 50% of the actual cost of medical and life insurance claims for a select group of retirees (SMI Retirees) of the prior Simplicity Manufacturing

22

ALLIS-CHALMERS ENERGY INC.

Notes to Consolidated Financial Statements — (Continued)

Division of Allis-Chalmers. The actuarial present value of the expected retiree benefit obligation is determined by an actuary and is the amount that results from applying actuarial assumptions to (1) historical claims-cost data, (2) estimates for the time value of money (through discounts for interest) and (3) the probability of payment (including decrements for death, disability, withdrawal, or retirement) between today and expected date of benefit payments. As of December 31, 2005, 2004 and 2003, we have post-retirement benefit obligations of $335,000, $687,000 and $545,000, respectively.

401(k) Savings Plan

On June 30, 2003, we adopted the 401(k) Profit Sharing Plan (the “Plan”). The Plan is a defined contribution savings plan designed to provide retirement income to our eligible employees. The Plan is intended to be qualified under Section 401(k) of the Internal Revenue Code of 1986, as amended. It is funded by voluntary pre-tax contributions from eligible employees who may contribute a percentage of their eligible compensation, limited and subject to statutory limits. The Plan is also funded by discretionary matching employer contributions from us. Eligible employees cannot participate in the Plan until they have attained the age of 21 and completed six-months of service with us. Each participant is 100% vested with respect to the participants’ contributions while our matching contributions are vested over a three-year period in accordance with the Plan document. Contributions are invested, as directed by the participant, in investment funds available under the Plan. Matching contributions of approximately $114,000, $35,000 and $10,000 were paid in 2005, 2004 and 2003, respectively.

NOTE 4 — ACQUISITIONS

In July 2003, through our subsidiary Mountain Air, we entered into a limited liability company operating agreement with a division of M-I, a joint venture between Smith International and Schlumberger N.V. (Schlumberger Limited), to form AirComp, a Texas limited liability company. The assets contributed by Mountain Air were recorded at Mountain Air’s historical cost of $6.3 million, and the assets contributed by M-I were recorded at a fair market value of $10.3 million. We originally owned 55% and M-I originally owned 45% of AirComp. As a result of our controlling interest and operating control, we consolidated AirComp in our financial statements. AirComp comprises the compressed air drilling services segment.

In September 2004, we acquired 100% of the outstanding stock of Safco for $1.0 million. Safco leases spiral drill pipe and provides related oilfield services to the oil drilling industry.

In September 2004, we acquired the remaining 19% of Tubular in exchange for 1.3 million shares of our common stock. The total value of the consideration paid to the seller, Jens Mortensen, was $6.4 million which was equal to the number of shares of common stock issued to Mr. Mortensen (1.3 million) multiplied by the last sale price ($4.95) of the common stock as reported on the American Stock Exchange on the date of issuance. This amount was treated as a contribution to stockholders’ equity. On the balance sheet, the $1.9 million minority interest in Tubular was eliminated. The balance of the contribution of $4.4 million was allocated as follows: In June 2004, we obtained an appraisal of the fixed assets of Tubular which valued the fixed assets at $20.1 million. The book value of the fixed assets was $15.8 million and the fixed assets appraised value was $4.3 million over the book value. We increased the value of our fixed assets by 19% of the amount of the excess of the appraised value over the book value, or $.8 million. The remaining balance of $3.6 million was allocated to goodwill.

In November 2004, AirComp acquired substantially all the assets of Diamond Air for $4.6 million in cash and the assumption of approximately $450,000 of accrued liabilities. We contributed $2.5 million andM-I L.L.C. contributed $2.1 million to AirComp LLC in order to fund the purchase. Goodwill of $375,000 and other intangible assets of $2.3 million were recorded in connection with the acquisition. Diamond Air provides air drilling technology and products to the oil and gas industry in West Texas, New Mexico and Oklahoma. Diamond Air is a leading provider of air hammers and hammer bit products.

23

ALLIS-CHALMERS ENERGY INC.

Notes to Consolidated Financial Statements — (Continued)

In December 2004, we acquired Downhole for approximately $1.1 million in cash, 568,466 shares of our common stock and the assumption of approximately $950,000 of debt. Goodwill of $442,000 and other intangible assets of $795,000 were recorded in connection with the acquisition. Downhole provides economical chemical treatments to wells by inserting small diameter, stainless steel coiled tubing into producing oil and gas wells.

On April 1, 2005, we acquired 100% of the outstanding stock of Delta for $4.6 million in cash, 223,114 shares of our common stock and two promissory notes totaling $350,000. The purchase price was allocated to fixed assets and inventory. Delta, located in Lafayette, Louisiana, is a rental tool company providing specialty rental items to the oil and gas industry such as spiral heavy weight drill pipe, test plugs used to test blow-out preventors, well head retrieval tools, spacer spools and assorted handling tools.

On May 1, 2005, we acquired 100% of the outstanding capital stock of Capcoil for $2.7 million in cash, 168,161 shares of our common stock and the payment or assumption of approximately $1.3 million of debt. Capcoil, located in Kilgore, Texas, is engaged in downhole well servicing by providing coil tubing services to enhance production from existing wells. Goodwill of $184,000 and other identifiable intangible assets of $1.4 million were recorded in connection with the acquisition.

On July 11, 2005, we acquired the compressed air drilling assets of W.T., based in South Texas, for $6.0 million in cash. The equipment includes compressors, boosters, mist pumps and vehicles. Goodwill of $82,000 and other identifiable intangible assets of $1.5 million were recorded in connection with the acquisition.

On July 11, 2005, we acquired from M-I its 45% interest in AirComp and subordinated note in the principal amount of $4.8 million issued by AirComp, for which we paid M-I $7.1 million in cash and issued to M-I a $4.0 million subordinated note bearing interest at 5% per annum. As a result, we now own 100% of AirComp

Effective August 1, 2005, we acquired 100% of the outstanding capital stock of Target for $1.3 million in cash and forgiveness of a lease receivable of approximately $0.6 million. The purchase price was allocated to the fixed assets of Target and resulted in the recording of a $0.8 million deferred tax liability. The results of Target are included in our directional and horizontal drilling segment as their Measure While Drilling equipment is utilized in that segment.

On September 1, 2005, we acquired the casing and tubing service assets of Patterson Services, Inc. for approximately $15.6 million. These assets are located in Corpus Christi, Texas; Kilgore, Texas; Lafayette, Louisiana and Houma, Louisiana.

The acquisitions were accounted for using the purchase method of accounting. The results of operations of the acquired entities since the date of acquisition are included in our consolidated income statement.

The following unaudited pro forma consolidated summary financial information for the year ended December 31, 2005 illustrates the effects of the acquisitions of Delta, Capcoil, W.T. and the minority interest in AirComp as if the acquisitions had occurred as of January 1, 2005, based on the historical results of the acquisitions. The following unaudited pro forma consolidated summary financial information for the years ended December 31, 2004 and 2003 illustrates the effects of the acquisitions of Diamond Air, Downhole, Delta, Capcoil, W.T. and the minority interest in AirComp as if the acquisitions had occurred as of beginning

24

ALLIS-CHALMERS ENERGY INC.

Notes to Consolidated Financial Statements — (Continued)

of the period, based on the historical results of the acquisitions (unaudited) (in thousands, except per share amounts):

	Years Ended December 31,
	2005		2004		2003
Revenues	$	110,383	$	70,988	$	52,588
Operating income	$	14,143	$	8,233	$	4,276
Net income	$	8,180	$	4,000	$	2,459
Net income per common share
Basic	$	0.55	$	0.46	$	0.53
Diluted	$	0.50	$	0.48	$	0.48

NOTE 5 — INVENTORIES

Inventories are comprised of the following (in thousands):

	December 31,		December 31,
	2005		2004
Hammer bits
Finished goods	$	1,402	$	857
Work in process		787		385
Raw materials		233		151
Total hammer bits		2,422		1,393
Hammers		584		417
Drive pipe		666		—
Rental supplies		64		—
Chemicals		201		254
Coiled tubing and related inventory		1,145		309
Shop supplies and related inventory		863		—
Total inventory	$	5,945	$	2,373

NOTE 6 — PROPERTY AND OTHER INTANGIBLE ASSETS

Property and equipment is comprised of the following at December 31 (in thousands):

	Depreciation
	Period	2005			2004
Land	—	$	27		$	27
Building and improvements	15-20 years		637			633
Transportation equipment	3-7 years		7,772			4,854
Machinery and equipment	3-20 years		77,002			36,411
Furniture, computers, software and leasehold improvements	3-7 years		2,073			1,005
Construction in progress — equipment	N/A		3,059			—
Total			90,570			42,930
Less: accumulated depreciation			(9,996	)		(5,251	)
Property and equipment, net		$	80,574		$	37,679

25

ALLIS-CHALMERS ENERGY INC.

Notes to Consolidated Financial Statements — (Continued)

The net book value of equipment recorded under capital leases was $908 and $0 at December 31, 2005 and 2004, respectively.

Intangible assets are as follows at December 31 (in thousands):

	Amortization
	Period	2005			2004
Intellectual property	20 years	$	1,009		$	1,009
Non-compete agreements	3-5 years		4,630			2,856
Patent	15 years		496			496
Other intangible assets	3-10 years		3,811			2,732
Total		$	9,946		$	7,093
Less: accumulated amortization			(3,163	)		(2,036	)
Intangibles assets, net		$	6,783		$	5,057

	2005						2004
	Gross		Accumulated		Current Year		Gross		Accumulated		Current Year
	Value		Amortization		Amortization		Value		Amortization		Amortization
Intellectual property	$	1,009	$	293	$	54	$	1,009	$	239	$	56
Non-compete agreements		4,630		1,916		884		2,856		1,032		300
Patent		496		39		33		496		6		6
Other intangible assets		3,811		915		277		2,732		759		420
Total	$	9,946	$	3,163	$	1,248	$	7,093	$	2,036	$	782

Future amortization of intangible assets at December 31, 2005 is as follows (in thousands):

	Intangible Amortization by Period
	Years Ended December 31,
									2010 and
	2006		2007		2008		2009		Thereafter
Intellectual property	$	55	$	55	$	55	$	55	$	496
Non-compete agreements		1,043		804		480		327		60
Patent		33		33		33		33		325
Other intangible assets		395		370		359		359		1,413
Total Intangible Amortization	$	1,526	$	1,262	$	927	$	774	$	2,294

26

ALLIS-CHALMERS ENERGY INC.

Notes to Consolidated Financial Statements — (Continued)

NOTE 7 — INCOME TAXES

The income tax provision consists of the following (in thousands):

	Years Ended December 31,
	2005		2004		2003
Current Provision
Federal	$	123	$	—	$	—
State		595		—		—
Foreign		626		514		370
	$	1,344	$	514	$	370

We are required to file a consolidated U.S. federal income tax return. We pay foreign income taxes in Mexico related to Allis-Chalmers Tubular Services’ Mexico revenues. There are approximately $1.6 million of U.S. foreign tax credits available to us and of that amount, the available U.S. foreign tax credits may or may not be recoverable by us depending upon the availability of taxable income in future years and therefore, have not been recorded as an asset as of December 31, 2005. Our foreign tax credits begin to expire in the year 2007.

The following table reconciles the U.S. statutory tax rate to our actual tax rate:

	Years Ended December 31,
	2005			2004			2003
Income tax expense based on the U.S. statutory tax rate		34.0	%		34.0	%		34.0	%
State taxes, net of federal benefit		6.1			—			—
Foreign income at other than U.S. rate		7.3			36.6			11.2
Valuation allowances		(98.7	)		(209.4	)		28.6
Nondeductible items, permanent differences and other		67.1			175.4			(62.6	)
Effective tax rate		15.8	%		36.6	%		11.2	%

Temporary differences are differences between the tax basis of assets and liabilities and their reported amounts in the financial statements that will result in differences between income for tax purposes and income for financial statement purposes in future years. A valuation allowance is established for deferred tax assets when management, based upon available information, considers it more likely than not that a benefit from such assets will not be realized. We have recorded a valuation allowance equal to the excess of deferred tax assets over deferred tax liabilities as we were unable to determine that it is more likely than not that the deferred tax asset will be realized.

The Tax Reform Act of 1986 contains provisions that limit the utilization of net operating loss and tax credit carry forwards if there has been a “change of ownership” as described in Section 382 of the Internal Revenue Code. Such a change of ownership may limit the our utilization of our net operating loss and tax credit carry forwards, and could be triggered by a public offering or by subsequent sales of securities by us or our stockholders.

27

ALLIS-CHALMERS ENERGY INC.

Notes to Consolidated Financial Statements — (Continued)

Deferred income tax assets and the related allowance as of December 31, were as follows (in thousands):

	2005			2004
Deferred non-current income tax assets:
Net future (taxable) deductible items	$	384		$	533
Net operating loss carry forwards		5,656			4,894
A-C Reorganization Trust claims		29,098			30,112
Total deferred non-current income tax assets		35,138			35,539
Valuation allowance		(27,131	)		(30,367	)
Net deferred non-current income taxes	$	8,007		$	5,172
Deferred non-current income tax liabilities
Depreciation	$	(8,007	)	$	(5,172	)
Net deferred income tax assets	$	—		$	—

Net operating loss carry forwards for tax purposes at December 31, 2005 and 2004 were estimated to be $16.6 million and $14.5 million, respectively, expiring through 2024.

Net future tax-deductible items relate primarily to timing differences. Our 1988 Plan of Reorganization established the A-C Reorganization Trust to settle claims and to make distributions to creditors and certain stockholders. We transferred cash and certain other property to the A-C Reorganization Trust on December 2, 1988. Payments made by us to the A-C Reorganization Trust did not generate tax deductions for us upon the transfer but generate deductions for us as the A-C Reorganization Trust makes payments to holders of claims.

The Plan of Reorganization also created a trust to process and liquidate product liability claims. Payments made by the A-C Reorganization Trust to the product liability trust did not generate current tax deductions for us upon the payment but generate deductions for us as the product liability trust makes payments to liquidate claims or incurs other expenses.

We believe the above-named trusts are grantor trusts and therefore we include the income or loss of these trusts in our income or loss for tax purposes, resulting in an adjustment of the tax basis of net operating and capital loss carry forwards. The income or loss of these trusts is not included in our results of operations for financial reporting purposes.

28

ALLIS-CHALMERS ENERGY INC.

Notes to Consolidated Financial Statements — (Continued)

NOTE 8 — DEBT

Our long-term debt consists of the following: (in thousands)

	December 31,
	2005		2004
Bank term loans	$	42,090	$	13,373
Revolving line of credit		6,400		3,873
Subordinated note payable to M-I LLC		4,000		4,818
Subordinated seller note		3,031		4,000
Seller note		850		1,600
Notes payable under non-compete agreements		698		664
Notes payable to former directors		96		402
Notes payable to former shareholders		—		49
Real estate loan		548		—
Vendor financing		—		1,164
Equipment & vehicle installment notes		1,939		530
Capital lease obligations		917		—
Total debt		60,569		30,473
Less: short-term debt and current maturities		5,632		5,541
Long-term debt obligations	$	54,937	$	24,932

As of December 31, 2005 and 2004, our debt was approximately $60.6 million and $30.5 million, respectively. Our weighted average interest rate for all of our outstanding debt was approximately 7.5% at December 31, 2005 and 7.3% at December 31, 2004.

Maturities of debt obligations at December 31, 2005 are as follows (in thousands):

	Debt		Capital Leases		Total
Year Ending:
December 31, 2006	$	5,158	$	474	$	5,632
December 31, 2007		49,620		443		50,063
December 31, 2008		4,267		—		4,267
December 31, 2009		69		—		69
December 31, 2010		538		—		538
Thereafter		—		—		—
Total	$	59,652	$	917	$	60,569

  Bank loans and line of credit agreements

On July 11, 2005, we replaced our previous credit agreement with a new agreement that provided for the following senior secured credit facilities:

•  A $13.0 million revolving line of credit. Borrowings were limited to 85% of eligible accounts receivable plus 50% of eligible inventory (up to a maximum of $2.0 million of borrowings based on inventory). This line of credit was used to finance working capital requirements and other general corporate purposes, including the issuance of standby letters of credit. Outstanding borrowings under

29

ALLIS-CHALMERS ENERGY INC.

Notes to Consolidated Financial Statements — (Continued)

this line of credit were $6.4 million at a margin above prime and LIBOR rates plus margin averaging approximately 8.1% as of December 31, 2005.

•  Two term loans totaling $42.0 million. Outstanding borrowings under these term loans were $42.0 million as of December 31, 2005. These loans were at LIBOR rates plus a margin which averages approximately 7.8%.

We borrowed against the July 2005 facilities to refinance our prior credit facility and the AirComp credit facility, to fund the acquisition of M-I’s interest in AirComp and the air drilling assets of W.T. and to pay transaction costs related to the refinancing and the acquisitions. We incurred debt retirement expense of $1.1 million related to the refinancing. This amount includes prepayment penalties and the write-off of deferred financing fees of the previous financing, which has been included in interest expense in the consolidated statement of operations.

Borrowings under the July 2005 credit facilities were to mature in July 2007. Amounts outstanding under the term loans as of July 2006 were to be repaid in monthly principal payments based on a 48 month repayment schedule with the remaining balance due at maturity. Additionally, during the second year, we were to be required to prepay the remaining balance of the term loans by 75% of excess cash flow, if any, after debt service and capital expenditures. The interest rate payable on borrowings was based on a margin over the London Interbank Offered Rate, referred to as LIBOR, or the prime rate, and there was a 0.5% fee on the undrawn portion of the revolving line of credit. The margin over LIBOR was to increase by 1.0% in the second year. The credit facilities were secured by substantially all of our assets and contain customary events of default and financial and other covenants, including limitations on our ability to incur additional indebtedness, make capital expenditures, pay dividends or make other distributions, create liens and sell assets.

All amounts outstanding under our July 2005 credit agreement were paid off with the proceeds of our senior notes offering in January 2006. We executed an amended and restated credit agreement which provides a $25.0 million revolving line of credit (See Note 22).

Prior to July 11, 2005, we had a credit agreement dated December 7, 2004 that provided for the following credit facilities:

•  A $10.0 million revolving line of credit. Borrowings were limited to 85% of eligible accounts receivables, as defined. Outstanding borrowings under this line of credit were $2.4 million as of December 31, 2004.

•  A term loan in the amount of $6.3 million to be repaid in monthly payments of principal of $105,583 per month. We were also required to prepay this term loan by an amount equal to 20% of receipts from our largest customer in Mexico. Proceeds of the term loan were used to prepay the term loan owed by Tubular Services and to prepay the 12% $2.4 million subordinated note and retire its related warrants. The outstanding balance was $6.3 million as of December 31, 2004.

•  A $6.0 million capital expenditure and acquisition line of credit. Borrowings under this facility were payable monthly over four years beginning in January 2006. Availability of this capital expenditure term loan facility was subject to security acceptable to the lender in the form of equipment or other acquired collateral. There were no outstanding borrowings as of December 31, 2004.

These credit facilities were to mature on December 31, 2007 and were secured by liens on substantially all of our assets. The agreement governing these credit facilities contained customary events of default and financial covenants. It also limited our ability to incur additional indebtedness, make capital expenditures, pay dividends or make other distributions, create liens and sell assets. Interest accrued at an adjustable rate based on the prime rate and was 6.25% as of December 31, 2004. We paid a 0.5% per annum fee on the undrawn portion of the revolving line of credit and the capital expenditure line.

30

ALLIS-CHALMERS ENERGY INC.

Notes to Consolidated Financial Statements — (Continued)

In connection with the acquisition of Tubular and Strata in 2002, we issued a 12% secured subordinated note in the original amount of $3.0 million. In connection with this subordinated note, we issued redeemable warrants valued at $1.5 million, which were recorded as a discount to the subordinated debt and as a liability. The discount was amortized over the life of the subordinated note beginning February 6, 2002 as additional interest expense of which $350,000 and $300,000 were recognized in the years ended December 31, 2004 and December 31, 2003, respectively. The debt was recorded at $2.7 million at December 31, 2003, net of the unamortized portion of the put obligation. On December 7, 2004, we prepaid the $2.4 million balance of the 12% subordinated note and retired the $1.5 million of warrants, with a portion of the proceeds from our $6.3 million bank term loan.

Prior to July 11, 2005, our AirComp subsidiary had the credit facilities described below. These credit facilities were repaid in connection with our acquisition of the minority interest in AirComp and the refinancing of our bank credit facilities described above.

•  A $3.5 million bank line of credit. Interest accrued at an adjustable rate based on the prime rate. We paid a 0.5% per annum fee on the undrawn portion. Borrowings under the line of credit were subject to a borrowing base consisting of 80% of eligible accounts receivable. The balance at December 31, 2004 was $1.5 million.

•  A $7.1 million term loan that accrued interest at an adjustable rate based on either LIBOR or the prime rate. Principal payments of $286,000 plus interest were due quarterly, with a final maturity date of June 27, 2007. The balance at December 31, 2004 was $6.8 million.

•  A “delayed draw” term loan facility in the amount of $1.5 million to be used for capital expenditures. Interest accrued at an adjustable rate based on either the LIBOR or the prime rate. Quarterly principal payments were to commence on March 31, 2006 in an amount equal to 5.0% of the outstanding balance as of December 31, 2005, with a final maturity of June 27, 2007. There were no borrowings outstanding under this facility as of December 31, 2004.

The AirComp credit facilities were secured by liens on substantially all of AirComp’s assets. The agreement governing these credit facilities contained customary events of default and required that AirComp satisfy various financial covenants. It also limited AirComp’s ability to incur additional indebtedness, make capital expenditures, pay dividends or make other distributions, create liens and sell assets. We guaranteed 55% of the obligations of AirComp under these facilities.

Tubular had two bank term loans with a remaining balance totaling $90,000 and $263,000 at December 31, 2005 and 2004, with interest accruing at a floating interest rate based on prime plus 2.0%. The interest rate was 9.25% and 7.25% at December 31, 2005 and 2004. Monthly principal payments are $13,000 plus interest. The maturity date of one of the loans, with a balance of $60,000, was September 17, 2006, while the second loan, with a balance of $30,000, had a final maturity of January 12, 2007. The balances of these two loans were repaid in full in January 2006 with the proceeds from our senior notes offering.

Notes payable and real estate loan

AirComp had a subordinated note payable to M-I in the amount of $4.8 million bearing interest at an annual rate of 5.0%. In 2007 each party had the right to cause AirComp to sell its assets (or the other party may buy out such party’s interest), and in such event this note (including accrued interest) was due and payable. The note was also due and payable if M-I sells its interest in AirComp or upon a termination of AirComp. At December 31, 2004, $376,000 of interest was included in accrued interest. On July 11, 2005, we acquired from M-I its 45% equity interest in AirComp and the subordinated note in the principal amount of $4.8 million issued by AirComp, for which we paid M-I $7.1 million in cash and issued a new $4.0 million subordinated note bearing interest at 5% per annum. The subordinated note issued to M-I requires quarterly interest payments and the principal amount is due October 9, 2007. Contingent upon a future equity offering,

31

ALLIS-CHALMERS ENERGY INC.

Notes to Consolidated Financial Statements — (Continued)

the subordinated note is convertible into up to 700,000 shares of our common stock at a conversion price equal to the market value of the common stock at the time of conversion.

Tubular had a subordinated note payable to Jens Mortensen, the seller of Tubular and one of our directors, in the amount of $4.0 million with a fixed interest rate of 7.5%. Interest was payable quarterly and the final maturity of the note is January 31, 2006. The subordinated note was subordinated to the rights of our bank lenders. The balance outstanding for this note at December 31, 2005 and 2004 was $3.0 and $4.0 million, respectively. The balance of this subordinated note was repaid in full in January 2006 with proceeds from our senior notes offering.

As part of the acquisition of Mountain Air in 2001, we issued a note to the sellers of Mountain Air in the original amount of $2.2 million accruing interest at a rate of 5.75% per annum. The note was reduced to $1.5 million as a result of the settlement of a legal action against the sellers in 2003. In March 2005, we reached an agreement with the sellers and holders of the note as a result of an action brought against us by the sellers. Under the terms of the agreement, we paid the holders of the note $1.0 million in cash, and agreed to pay an additional $350,000 on June 1, 2006, and an additional $150,000 on June 1, 2007, in settlement of all claims. (See Note 16). At December 31, 2005 and 2004 the outstanding amounts due were $500,000 and $1.6 million, including accrued interest.

In connection with the purchase of Delta, we issued to the sellers a note in the amount of $350,000. The note bears interest at 2% and the principal and accrued interest is due on April 1, 2006.

In connection with the purchase of Tubular, we agreed to pay a total of $1.2 million to Mr. Mortensen in exchange for a non-compete agreement. Monthly payments of $20,576 are due under this agreement through January 31, 2007. In connection with the purchase of Safco, we also agreed to pay a total of $150,000 to the sellers in exchange for a non-compete agreement. We are required to make annual payments of $50,000 through September 30, 2007. In connection with the purchase of Capcoil, we agreed to pay a total of $500,000 to two management employees in exchange for non-compete agreements. We are required to make annual payments of $110,000 through May 2008. Total amounts due under non-compete agreements at December 31, 2005 and 2004 were $698,000 and $664,000, respectively.

In 2000 we compensated directors, including current directors Nederlander and Toboroff, who served on the board of directors from 1989 to March 31, 1999 without compensation, by issuing promissory notes totaling $325,000. The notes bear interest at the rate of 5.0%. At December 31, 2005 and 2004, the principal and accrued interest on these notes totaled approximately $96,000 and $402,000, respectively.

Our subsidiary, Downhole, had notes payable to two former shareholders totaling $49,000. We were required to make monthly payments of $8,878 through June 30, 2005. At December 31, 2005 and 2004, the amounts outstanding were $0 and $49,000.

We also have a real estate loan which is payable in equal monthly installments of $4,344 with the remaining outstanding balance due on January 1, 2010. The loan has a floating interest rate based on prime plus 2.0%. The outstanding principal balance was $548,000 at December 31, 2005. The balance of this loan was prepaid in full in January 2006 with proceeds from our senior notes offering.

Other debt

In December 2003, Strata, our directional drilling subsidiary, entered into a financing agreement with a major supplier of downhole motors for repayment of motor lease and repair cost totaling $1.7 million. The agreement provided for repayment of all amounts not later than December 30, 2005. Payment of interest was due monthly and principal payments of $582,000 were due on April 2005 and December 2005. The interest rate was fixed at 8.0%. As of December 31, 2005 and 2004, the outstanding balance was $0 and $1.2 million.

32

ALLIS-CHALMERS ENERGY INC.

Notes to Consolidated Financial Statements — (Continued)

We have various equipment financing loans with interest rates ranging from 5% to 11.5% and terms ranging from 2 to 5 years. As of December 31, 2005 and 2004, the outstanding balances for equipment financing loans were $1.9 million and $530,000, respectively. We also have various capital leases with terms that expire in 2008. As of December 31, 2005 and 2004, amounts outstanding under capital leases were $917,000 and $0, respectively. In January 2006, we prepaid $350,000 of the outstanding equipment loans with proceeds from our senior notes offering.

NOTE 9 — COMMITMENTS AND CONTINGENCIES

We have placed orders for capital equipment totaling $6.8 million to be received and paid for through 2006. Of this amount, $3.1 million is for six measurement while drilling kits and ancillary equipment for our directional drilling segment and $3.7 million is for two new capillary tubing units and two new coil tubing units for our production services segment. Of the $6.8 million in orders, we are firmly committed to approximately $4.4 million as the balance may be subject to cancellation with minimal loss of prior cash deposits, if any.

We rent office space on a five-year lease which expires November 2009. We also rent certain other facilities and shop yards for equipment storage and maintenance. Facility rent expense for the years ended December 31, 2005, 2004 and 2003 was $987,000, $577,000, and $370,000, respectively.

At December 31, 2005, future minimum rental commitments for all operating leases are as follows (in thousands):

Years Ending:
December 31, 2006	$	926
December 31, 2007		833
December 31, 2008		629
December 31, 2009		446
December 31, 2010		44
Thereafter		—
Total	$	2,878

NOTE 10 — STOCKHOLDERS’ EQUITY

In connection with the formation of AirComp in July 2003, we eliminated $955,000 of our negative investment in the assets contributed to AirComp. Under purchase accounting, we recognized a $955,000 increase in stockholders equity. For the year ended December 31, 2003, we accrued $350,000 of dividends payable to the Preferred Stock holders. No dividends were declared or paid.

On March 3, 2004, we entered into an agreement with an investment banking firm whereby they would provide underwriting and fundraising activities on our behalf. In exchange for their services, the investment banking firm received a stock purchase warrant to purchase 340,000 shares of common stock at an exercise price of $2.50 per share. The warrant was exercised in August of 2005. The fair value of the total warrants issued in connection with the fundraising activities was established in accordance with the Black-Scholes valuation model and as a result, $641,000 was added to stockholders’ equity. The following assumptions were utilized to determine fair value: no dividend yield; expected volatility of 89.7%; risk free interest rate of 7.00%; and expected life of five years.

During 2004, we issued two warrants (“Warrants A and B”) for the purchase of 233,000 total shares of our common stock at an exercise price of $0.75 per share and one warrant for the purchase of 67,000 shares of our common stock at an exercise price of $5.00 per share (“Warrant C”) in connection with their

33

ALLIS-CHALMERS ENERGY INC.

Notes to Consolidated Financial Statements — (Continued)

subordinated debt financing. Warrants A and B were redeemed for a total of $1,500,000 on December 7, 2004. The fair value of Warrant C was established in accordance with the Black-Scholes valuation model and as a result, $47,000 was added to stockholders’ equity. The following assumptions were utilized to determine fair value: no dividend yield; expected volatility of 67.24%; risk free interest rate of 5.00%; and expected life of four years.

On April 2, 2004, we completed the following transactions:

•  In exchange for an investment of $2.0 million, we issued 620,000 shares of our common stock for a purchase price equal to $2.50 per share, and issued warrants to purchase 800,000 shares of our common stock at an exercise price of $2.50 per share, expiring on April 1, 2006, to an investor group (the “Investor Group”) consisting of entities affiliated with Donald and Christopher Engel and directors Robert Nederlander and Leonard Toboroff. The aggregate purchase price for the common stock was $1.55 million and the fair value for the warrants was $450,000.

•  Energy Spectrum converted its 3,500,000 shares of Series A 10% Cumulative Convertible Preferred Stock, including accrued dividend rights, into 1,718,090 shares of common stock. Energy Spectrum was granted the preferred stock in connection with the Strata acquisition.

On August 10, 2004, we completed the private placement of 3,504,667 shares of our common stock at a price of $3.00 per share. Our net proceeds, after selling commissions and expenses, were approximately $9.6 million. We issued shares pursuant to an exemption from the Securities Act of 1933, and agreed to subsequently register the common stock under the Securities Act of 1933 to allow investors to resell the common stock in public markets.

On September 30, 2004, we completed the private placement of 1,956,634 shares of our common stock at a price of $3.00 per share. Our net proceeds, after selling commission and expenses, were approximately $5.3 million. We issued shares pursuant to an exemption from the Securities Act of 1933, and agreed to subsequently register the common stock under the Securities Act of 1933 to allow investors to resell the common stock in public markets.

On September 30, 2004, we issued 1.3 million shares of common stock to Jens Mortensen, a director, in exchange for his 19% interest in Tubular. As a result of this transaction, we own 100% of Tubular. The total value of the consideration paid to Jens was $6.4 million, which was equal to the number of shares of common stock issued to Mr. Mortensen multiplied by the last sale price ($4.95) of the common stock as reported on the American Stock Exchange on the date of issuance. This amount was treated as a contribution to stockholders equity.

On December 10, 2004, we acquired Downhole for approximately $1.1 million in cash, 568,466 shares of our common stock and payment or assumption of $950,000 of debt. Approximately $2.2 million, the value of the common stock issued to Downhole’s sellers based on the closing price of our common stock issued at the date of the acquisition, was added to stockholders’ equity.

As of January 1, 2005, in relation to the acquisition of Downhole, we executed a business development agreement with CTTV Investments LLC, an affiliate of ChevronTexaco Inc., whereby we issued 20,000 shares of our common stock to CTTV and further agreed to issue up to an additional 60,000 shares to CTTV contingent upon our subsidiaries receiving certain levels of revenues in 2005 from ChevronTexaco and its affiliates. CTTV was a minority owner of Downhole, which we acquired in 2004. Based on the terms of the agreement, no additional shares were issued in 2005.

On April 1, 2005, we acquired 100% of the outstanding stock of Delta, for $4.6 million in cash, 223,114 shares of our common stock and two promissory notes totaling $350,000. Approximately $1.0 million, the value of the common stock issued to Delta’s sellers based on the closing price of our common stock issued at the date of the acquisition, was added to stockholders’ equity.

34

ALLIS-CHALMERS ENERGY INC.

Notes to Consolidated Financial Statements — (Continued)

On May 1, 2005, we acquired 100% of the outstanding capital stock of Capcoil for $2.7 million in cash, 168,161 shares of our common stock and the payment or assumption of approximately $1.3 million of debt. Approximately $750,000, the value of the common stock issued to Capcoil’s sellers based on the closing price of our common stock issued at the date of the acquisition, was added to stockholders’ equity.

In August 2005, our stockholders approved an amendment to our certificate of incorporation to increase the authorized number of shares of our common stock from 20 million to 100 million and to increase our authorized preferred stock from 10 million shares to 25 million shares and, we completed a secondary public offering in which we sold 1,761,034 shares for approximately $15.5 million, net of expenses.

We also had options and warrants exercised during 2005. Those exercises resulted in 1,076,154 shares of our common stock being issued for $1.4 million.

NOTE 11 — REVERSE STOCK SPLIT

We effected a reverse stock split on June 10, 2004. As a result of the reverse stock split, every five shares of our common stock was combined into one share of common stock. The reverse stock split reduced the number of shares of outstanding common stock from 31,393,789 to approximately 6,265,000 and reduced the number of our stockholders from 6,070 to approximately 2,140. All share and related amounts presented have been retroactively adjusted for the stock split.

NOTE 12 — STOCK OPTIONS

In 2000, we issued stock options and promissory notes to certain current and former directors as compensation for services as directors (See Note 8), and our Board of Directors granted stock options to these same individuals. Options to purchase 4,800 shares of our common stock were granted with an exercise price of $13.75 per share. These options vested immediately and may be exercised any time prior to March 28, 2010. As of December 31, 2005, none of the stock options had been exercised. No compensation expense has been recorded for these options that were issued with an exercise price equal to the fair value of the common stock at the date of grant.

On May 31, 2001, the Board granted to Leonard Toboroff, one of our directors, an option to purchase 100,000 shares of our common stock at $2.50 per share, exercisable for 10 years from October 15, 2001. The option was granted for services provided by Mr. Toboroff to OilQuip prior to the merger, including providing financial advisory services, assisting in OilQuip’s capital structure and assisting OilQuip in finding strategic acquisition opportunities. We recorded compensation expense of $500,000 for the issuance of the option for the year ended December 31, 2001.

The 2003 Incentive Stock Plan, as amended, permits us to grant to our key employees and outside directors various forms of stock incentives, including, among others, incentive and non-qualified stock options and restricted stock. Stock incentive terms are not to be in excess of ten years. As disclosed in Note 1, we account for our stock-based compensation using APB No. 25. We have adopted the disclosure-only provisions of SFAS No. 123 for the stock options granted to our employees and directors. Accordingly, no compensation cost has been recognized for these options.

35

ALLIS-CHALMERS ENERGY INC.

Notes to Consolidated Financial Statements — (Continued)

A summary of our stock option activity and related information is as follows:

	December 31, 2005					December 31, 2004					December 31, 2003
	Shares			Weighted Ave.		Shares			Weighted Avg.		Shares		Weighted Avg.
	Under			Exercise		Under			Exercise		Under		Exercise
	Option			Price		Option			Price		Option		Price
Beginning balance		1,215,000		$	3.20		973,300		$	2.78		104,800	$	3.00
Granted		1,695,000			6.44		248,000			4.85		868,500		2.75
Canceled		(15,300	)		3.33		(6,300	)		2.78		—		—
Exercised		(33,833	)		2.80		—			—		—		—
Ending balance		2,860,867		$	5.10		1,215,000		$	3.20		973,300	$	2.78

The following table summarizes additional information about our stock options outstanding as of December 31, 2005:

				Weighted Average
		Shares Under		Remaining
Exercise Price		Option		Contractual Life	Options Exercisable		Exercise Price
$	2.50		100,000	5.79 years		100,000	$	2.50
$	2.75		829,067	7.96 years		829,067	$	2.75
$	3.86		920,000	9.09 years		306,667	$	3.86
$	4.85		259,000	8.73 years		172,667	$	4.85
$	4.87		154,000	9.40 years		51,333	$	4.87
$	10.85		594,000	9.96 years		198,000	$	10.85
$	13.75		4,800	4.24 years		4,800	$	13.75
$	5.11		2,860,867	8.82 years		1,662,534	$	4.22

NOTE 13 — STOCK PURCHASE WARRANTS

In conjunction with the Mountain Air purchase by OilQuip in February of 2001, Mountain Air issued a common stock warrant for 620,000 shares to a third-party investment firm that assisted us in its initial identification and purchase of the Mountain Air assets. The warrant entitles the holder to acquire up to 620,000 shares of common stock of Mountain Air at an exercise price of $.01 per share over a nine-year period commencing on February 7, 2001. The fair value of the warrants was established in accordance with the Black-Scholes valuation model and as a result $200,000 was added to stockholders’ equity.

We issued two warrants (“Warrants A and B”) for the purchase of 233,000 total shares of our common stock at an exercise price of $0.75 per share and one warrant for the purchase of 67,000 shares of our common stock at an exercise price of $5.00 per share (“Warrant C”) in connection with our subordinated debt financing for Mountain Air in 2001. Warrants A and B were subject to cash redemption provisions (“puts”) of $600,000 and $900,000, respectively. The warrants were recorded at their redemption value and were recorded as a discount to the subordinated debt and as a liability. The discount was amortized as additional interest expense over the life of the debt instrument. The fair value of Warrant C was established in accordance with the Black-Scholes valuation model and as a result $47,000 was added to stockholders’ equity. Warrant C is still outstanding at December 31, 2005.

On February 6, 2002, in connection with the acquisition of substantially all of the outstanding stock of Strata, we issued a warrant for the purchase of 87,500 shares of our common stock at an exercise price of $0.75 per share over the term of four years. The fair value of the warrant was established in accordance with

36

ALLIS-CHALMERS ENERGY INC.

Notes to Consolidated Financial Statements — (Continued)

the Black-Scholes valuation model and as a result $267,000 was added to stockholders’ equity. The warrants were exercised and sold in our August 2005 public offering.

In connection with the Strata Acquisition, on February 19, 2003, we issued Energy Spectrum an additional warrant to purchase 175,000 shares of our common stock at an exercise price of $0.75 per share. The fair value of the warrant was established in accordance with the Black-Scholes valuation model and as a result $306,000 was added to stockholders’ equity. This transaction was recorded similar to a preferred share dividend. The warrants were exercised and sold in our August 2005 public offering.

In March 2004, we issued a warrant to purchase 340,000 shares of our common stock at an exercise price of $2.50 per share to Morgan Joseph & Co., in consideration of financial advisory services provided by Morgan Joseph pursuant to the April 2004 private placement. The fair value of the warrants was established in accordance with the Black-Scholes valuation model and as a result $626,000 was included as a cost of the private placement and an increase in stockholders’ equity. The warrants were exercised and sold in our August 2005 public offering.

In April 2004, we issued warrants to purchase 20,000 shares of common stock at an exercise price of $0.75 per share to Wells Fargo Credit, Inc., in connection with the extension of credit by Wells Fargo Credit Inc. The fair value of the warrants was established in accordance with the Black-Scholes valuation model and as a result $48,000 was added to stockholders’ equity. The related debt discount was amortized over the life of the credit agreement. The warrants were exercised in our August 2005 public offering.

In April 2004, we completed a private placement of 620,000 shares of common stock and warrants to purchase 800,000 shares of common stock to the following investors: Christopher Engel; Donald Engel; the Engel Defined Benefit Plan; RER Corp., a corporation wholly-owned by director Robert Nederlander; and Leonard Toboroff, a director. The investors invested $1,550,000 in exchange for 620,000 shares of common stock for a purchase price equal to $2.50 per share, and invested $450,000 in exchange for warrants to purchase 800,000 shares of common stock at an exercise of $2.50 per share, expiring on April 1, 2006. A total of 486,557 of these warrants were exercised in 2005.

In May 2004, we issued a warrant to purchase 3,000 shares of our common stock at an exercise price of $4.75 per share to Jeffrey R. Freedman in consideration of financial advisory services to be provided by Mr. Freedman pursuant to a consulting agreement. The warrants were exercised in May 2004. Mr. Freedman was also granted 16,000 warrants in May of 2004 exercisable at $4.65 per share. These warrants were exercised in November of 2005.

Warrants for 4,000 shares of our common stock at an exercise price of $4.65 were also issued in May 2004 and remain outstanding as of December 31, 2005.

NOTE 14 — LEASE RECEIVABLE

In June 2002, our subsidiary, Strata, sold its MWD assets to a third party for $1.3 million. Under the terms of the sale, we would receive at least $15,000 per month for thirty-six months. After thirty-six months, the purchaser had the option to pay the remaining balance or continue paying a minimum of $15,000 per month for twenty-four additional months. After the expiration of the additional twenty-four months, the purchaser would repay any remaining balance. This transaction had been accounted for as a direct financing lease with the nominal residual gain from the asset sale deferred into income over the life of the lease. In August of 2005, we acquired 100% of the outstanding stock of the buyer and the balance of the lease receivable was part of the consideration of the acquisition. During the years ended December 31, 2005, 2004 and 2003, we received a total of $146,000, $229,000, and $251,000, respectively, in payments from the third party related to this lease.

37

ALLIS-CHALMERS ENERGY INC.

Notes to Consolidated Financial Statements — (Continued)

NOTE 15 — RELATED PARTY TRANSACTIONS

In July 2005, we entered into a lease of a yard in Buffalo, Texas which is part owned by our Chief Operating Officer, David Wilde. The monthly rent is $3,500.

Alya H. Hidayatallah, the daughter of our Chairman and Chief Executive Officer, Munawar H. Hidayatallah, has served as our Vice President-Planning and Development since April 2005. In 2005, we paid Ms. Hidayatallah a salary at a rate of $80,000 per annum.

At December 31, 2005 and 2004, we owed our Chief Executive Officer, $0 and $175,000, respectively, related to deferred compensation. In March and April of 2005 we paid all amounts due Mr. Hidayatallah.

Until December 2004, our Chief Executive Officer and Chairman, Munawar H. Hidayatallah and his wife were personal guarantors of substantially all of the financing extended to us by commercial banks. In December 2004, we refinanced most of our outstanding bank debt and obtained the release of certain guarantees. After the refinancing, Mr. Hidayatallah continued to guarantee the Tubular $4.0 million subordinated seller note until July 2005. We paid Mr. Hidayatallah an annual guarantee fee equal to one-quarter of one percent of the total amount of the debt guaranteed by Mr. Hidayatallah. These fees aggregated to $7,250 during 2005 and were paid quarterly, in arrears, based upon the average amount of debt outstanding in the prior quarter.

In April 2004, we entered into an oral consulting agreement with Leonard Toboroff, one of our directors, pursuant to which we pay him $10,000 per month to advise us regarding financing and acquisition opportunities.

Jens Mortensen, one of our directors, is the former owner of Tubular and held a 19% minority interest in Tubular until September 30, 2004. He was also the holder of a $4.0 million subordinated note payable issued by Tubular and at December 31, 2005 was owed $60,000 in accrued interest and $267,000 related to a non-compete agreement. (See Note 8). The subordinated note was repaid in January of 2006 (See Note 22) and the accrued interest was paid in January 2006. Mr. Mortensen, formerly the sole proprietor of Tubular, owns a shop yard which he leases to Jens’ on a monthly basis. Lease payments made under the terms of the lease were $16,800, $28,800 and $28,800 for the years ended December 31, 2005, 2004 and 2003, respectively. In addition, Mr. Mortensen and members of his family own 100% of Tex-Mex Rental & Supply Co., a Texas corporation, that sold approximately $0, $167,000 and $173,000 of equipment and other supplies to Tubular for the years ended December 31, 2005, 2004 and 2003, respectively.

As described in Note 8, several of our former directors were issued promissory notes in 2000 in lieu of compensation for services. Our current maturities of long-term debt includes $96,000 and $402,000 as of December 31, 2005 and 2004, respectively, relative to these notes.

NOTE 16 — SETTLEMENT OF LAWSUIT

In June 2003, our subsidiary, Mountain Air, filed a lawsuit against the former owners of Mountain Air Drilling Service Company for breach of the asset purchase agreement pursuant to which Mountain Air acquired Mountain Air Drilling Services Company, alleging that the sellers stored hazardous materials on the property leased by us without our consent and violated the non-compete clause in the asset purchase agreement. On July 15, 2003, we entered into a settlement agreement with the sellers. As of the date of the agreement, we owed the sellers a total of $2.6 million including $2.2 million in principal and approximately $363,000 in accrued interest. As part of the settlement agreement, the note payable to the sellers was reduced from $2.2 million to $1.5 million and the due date of the note payable was extended from February 6, 2006 to September 30, 2007. The lump-sum payment due the sellers at that date was $1.9 million. We recorded a one-time gain on the reduction of the note payable to the sellers of $1.0 million in the third quarter of 2003. The gain was calculated by discounting the note payable to $1.5 million using a present value calculation and

38

ALLIS-CHALMERS ENERGY INC.

Notes to Consolidated Financial Statements — (Continued)

accreting the note payable to $1.9 million the amount due in September 2007. In March 2005, we reached an agreement with the sellers to settle an action brought by the sellers under the note. Under the terms of the agreement, we paid $1.0 million in April of 2005 and will pay $350,000 on June 1, 2006 and the remaining $150,000 on June 1, 2007, in settlement of all claims.

NOTE 17 — GAIN ON SALE OF INTEREST IN A SUBSIDIARY

In July 2003, through the subsidiary Mountain Air, we entered into a limited liability company operating agreement with a division of M-I to form a Texas limited liability company named AirComp. Both companies contributed assets with a combined value of $16.6 million to AirComp. The contributed assets from Mountain Air were contributed at a historical book value of approximately $6.3 million and the assets contributed byM-I were contributed at a fair market value of approximately $10.3 million. Prior to the formation of AirComp, we owned 100% of Mountain Air and after the formation of AirComp, Mountain Air owned 55% and M-I owned 45% of the business combination. The business combination was accounted for as a purchase and we recorded a one-time non-operating gain on the sale of the 45% interest in the subsidiary of approximately $2,433,000. The gain was calculated after recording the assets contributed by M-I of approximately $10.3 million less the subordinated note issued to M-I in the amount of approximately $4.8 million, recording minority interest of approximately $2,049,000 and an increase in equity of $955,000 in accordance with Staff Accounting Bulletin No. 51 (“SAB 51”). We have not recorded any deferred income taxes because the increase in assets and gain is a permanent timing difference. We have adopted a policy that any gain or loss in the future incurred on the sale in the stock or an interest of a subsidiary would be recognized as such in the income statement.

39

ALLIS-CHALMERS ENERGY INC.

Notes to Consolidated Financial Statements — (Continued)

NOTE 18 — SEGMENT INFORMATION

At December 31, 2005, we had five operating segments including: Directional Drilling Services (Strata and Target), Compressed Air Drilling Services (AirComp), Casing and Tubing Services (Tubular), Rental Tools (Safco and Delta) and Production Services (Downhole and Capcoil). All of the segments provide services to the energy industry. The revenues, operating income (loss), depreciation and amortization, capital expenditures and assets of each of the reporting segments plus the Corporate function are reported below for (in thousands):

	Years Ended December 31,
	2005			2004			2003
							(Restated)
Revenues:
Directional drilling services	$	43,901		$	24,787		$	16,008
Compressed air drilling services		25,662			11,561			6,679
Casing and tubing services		20,932			10,391			10,037
Rental tools		5,059			611			—
Production services		9,790			376			—
Total revenues	$	105,344		$	47,726		$	32,724
Operating Income (Loss):
Directional drilling services	$	7,389		$	3,061		$	1,103
Compressed air drilling services		5,612			1,169			17
Casing and tubing services		4,994			3,217			3,628
Rental tools		1,300			(71	)		—
Production services		(99	)		4			—
General corporate		(5,978	)		(3,153	)		(2,123	)
Total income from operations	$	13,218		$	4,227		$	2,625
Depreciation and Amortization Expense:
Directional drilling services	$	887		$	466		$	275
Compressed air drilling services		1,946			1,329			1,139
Casing and tubing services		2,006			1,597			1,413
Rental tools		492			40			—
Production services		912			26			—
General corporate		418			120			109
Total depreciation and amortization expense	$	6,661		$	3,578		$	2,936

40

ALLIS-CHALMERS ENERGY INC.

Notes to Consolidated Financial Statements — (Continued)

	Years Ended December 31,
	2005		2004		2003
					(Restated)
Capital Expenditures:
Directional drilling services	$	2,922	$	1,552	$	1,066
Compressed air drilling services		7,008		1,399		2,093
Casing and tubing services		5,207		1,285		2,176
Rental tools		435		232		—
Production services		1,514		106		—
General corporate		681		29		19
Total capital expenditures	$	17,767	$	4,603	$	5,354
Goodwill:
Directional drilling services	$	4,168	$	4,168	$	4,168
Compressed air drilling services		3,950		3,510		3,493
Casing and tubing services		3,673		3,673		—
Rental tools		—		—		—
Production services		626		425		—
General corporate		—		—		—
Total goodwill	$	12,417	$	11,776	$	7,661

	As of December 31,
	2005		2004		2003
Assets:
Directional drilling services	$	20,960	$	14,166	$	11,529
Compressed air drilling services		46,045		29,147		22,735
Casing and tubing services		45,351		21,197		18,191
Rental tools		8,034		1,291		—
Production services		12,282		5,806		—
General corporate		4,683		8,585		1,207
Total assets	$	137,355	$	80,192	$	53,662

	Years Ended December 31,
	2005		2004		2003
Revenues:
United States	$	98,583	$	42,466	$	28,995
International		6,761		5,260		3,729
Total	$	105,344	$	47,726	$	32,724

41

ALLIS-CHALMERS ENERGY INC.

Notes to Consolidated Financial Statements — (Continued)

NOTE 19 — SUPPLEMENTAL CASH FLOWS INFORMATION (in thousands)

	Years Ended December 31,
	2005		2004			2003
	(Restated)
Interest paid	$	3,924	$	2,159		$	2,341
Income taxes paid	$	676	$	514		$	370
Other non-cash investing and financing transactions:
Sale of property & equipment in connection with direct financing lease (Note 14)
(Gain) on settlement of debt	$	—	$	—		$	(1,034	)
Amortization of discount on debt		—		—			442
Purchase of equipment financed through assumption of debt or accounts payable		592		—			906
	$	592	$	—		$	314
AirComp formation:
Issuance of debt to joint venture by M-I	$	—	$	—		$	(4,818	)
Contribution of property, plant and equipment by M-I to joint venture		—		—			10,268
Increase in minority interest		—		—			(2,063	)
(Gain) on sale of stock in a subsidiary		—		—			(2,433	)
Difference of our investment cost basis in AirComp and their share of underlying equity of net assets of AirComp		—		—			(954	)
Net cash paid in connection with the joint venture	$	—	$	—		$	—
Non-cash investing and financing transactions in connection with acquisitions:
Fair value of net assets acquired	$	—	$	(4,867	)	$	—
Goodwill and other intangibles		—		(3,839	)		—
Value of common stock, issued		1,750		2,177			—
Value of minority interest contribution		—		2,070			—
	$	1,750	$	(4,459	)	$	—
Acquisition of the remaining 19% of Jens:
Fair value of net assets acquired	$	—	$	(813	)	$	—
Goodwill and other intangibles		—		(3,676	)		—
Value of common stock issued		—		6,434			—
Value of minority interest retirement		—		(1,945	)		—
	$	—	$	—		$	—

42

ALLIS-CHALMERS ENERGY INC.

Notes to Consolidated Financial Statements — (Continued)

NOTE 20 — QUARTERLY RESULTS (UNAUDITED) (in thousands, except per share amounts)

	First		Second		Third		Fourth
	Quarter		Quarter		Quarter		Quarter
	(Restated)
Year 2005
Revenues	$	19,334	$	23,588	$	28,908	$	33,514
Operating income		2,247		2,914		3,524		4,533
Net income		1,567		1,769		1,293		2,546
Preferred stock dividend		—		—		—		—
Net income attributed to common shares	$	1,567	$	1,769	$	1,293	$	2,546
Income per common share:
Basic	$	0.12	$	0.13	$	0.09	$	0.15
Diluted	$	0.11	$	0.12	$	0.08	$	0.14

	First			Second			Third		Fourth
	Quarter			Quarter			Quarter		Quarter
	(Restated)
Year 2004
Revenues	$	9,661		$	11,422		$	11,906	$	14,737
Operating income		1,030			1,150			1,237		810
Net income (loss)		472			413			515		(512	)
Preferred stock dividend		(88	)		(36	)		—		—
Net income (loss) attributed to common shares	$	384		$	377		$	515	$	(512	)
Income (loss) per common share:
Basic	$	0.10		$	0.06		$	0.06	$	(0.04	)
Diluted	$	0.08		$	0.05		$	0.05	$	(0.04	)

NOTE 21 — LEGAL MATTERS

We are named from time to time in legal proceedings related to our activities prior to our bankruptcy in 1988; however, we believe that we were discharged from liability for all such claims in the bankruptcy and believe the likelihood of a material loss relating to any such legal proceeding is remote.

We are involved in various other legal proceedings in the ordinary course of business. The legal proceedings are at different stages; however, we believe that the likelihood of material loss relating to any such legal proceeding is remote.

NOTE 22 — SUBSEQUENT EVENTS

In January of 2006, we acquired 100% of the outstanding stock of Specialty Rental Tools, Inc. (“Specialty”) for $96.0 million in cash. Specialty, located in Lafayette, Louisiana, is engaged in the rental of high quality drill pipe, heavy weight spiral drill pipe, tubing work strings, blow-out preventors, choke manifolds and various valves and handling tools for oil and natural gas drilling. During the nine months ended September 30, 2005, Specialty generated aggregate revenues of $21.8 million.

43

ALLIS-CHALMERS ENERGY INC.

Notes to Consolidated Financial Statements — (Continued)

In January of 2006, we closed on a private offering, to qualified institutional buyers pursuant to Rule 144A under the Securities Act of 1933, of $160.0 million principal amount of our 9.0% senior notes due 2014, which we refer to as our senior notes. The proceeds of the offering were used to fund the acquisition of Specialty, to repay existing debt and for general corporate purposes.

In January of 2006, we amended and restated our July 2005 credit agreement to increase our borrowing capacity by exchanging the existing two year $55.0 million facility for a new four year $25.0 million facility. We refer to the July 2005 credit agreement, as so amended and restated, as our new credit agreement. All amounts outstanding under the previous $55.0 million credit facility were repaid with proceeds from the issuance of our senior notes. The new credit agreement’s interest rate is based on a margin over LIBOR or the prime rate, and there is a 0.5% fee for the undrawn portion. The credit facility is secured by a first priority lien on substantially all of our assets.

In January 2006, with proceeds from the sale of our senior notes we also prepaid the $3.0 million subordinated seller note due to Jens Mortensen, the $548,000 real estate loan and $430,000 in various outstanding term and equipment loans.

In February of 2006, David Groshoff resigned from our Board of Directors and the Audit Committee. Mr. Groshoff served on our Board since 1999, initially under an agreement on behalf of the Pension Benefit Guaranty Corporation, which is a client of Mr. Groshoff’s employer. That agreement permitted the PBGC to appoint a member to our Board so long as the PBGC held a minimum number of shares of our stock. The PBGC sold all its holdings in our stock in August 2005. As an investment management employee of JPMorgan Asset Management, Mr. Groshoff is subject to his employer’s policies which generally prohibit employees from serving on public company boards of directors without a meaningful client interest in such companies. In light of the PBGC’s sale of our stock, these policies required Mr. Groshoff’s resignation from our Board. In March 2006, Robert Nederlander was appointed to the Audit Committee to replace Mr. Groshoff.

Through March 13, 2006, we received proceeds of approximately $784,000 from the exercise of 313,000 warrants.

44

PART IV

ITEM 15.   EXHIBITS AND FINANCIAL STATEMENT SCHEDULES

(b) Exhibits

The exhibits listed on the Exhibit Index set forth immediately following the signature page of this Annual Report onForm 10-K/A-2 are filed as part of thisForm 10-K/A-2.

45

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on July 21, 2006.

/s/  MUNAWAR H. HIDAYATALLAH

Munawar H. Hidayatallah
Chief Executive Officer and Chairman

46

EXHIBIT INDEX

Exhibit			Description
	31	.1	Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
	31	.2	Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
	32	.1	Certification of the Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.