MANAGEMENT'S DISCUSSION AND ANALYSIS
The following is management's discussion and analysis ('MD&A') of the operating and financial results of Oilexco Incorporated for the year ended December 31, 2006. The information is provided as of March 26, 2007. The 2006 results have been compared to the results of 2005 and 2004. Effective December 31, 2005, management decided to change the reporting currency of the Company from Canadian dollars (C$) to United States dollars ($). Therefore, all 2006, 2005 figures and the restated comparative figures contained herein are expressed in US dollars unless otherwise stated.
This discussion and analysis should be read in conjunction with the Company's audited consolidated financial statements as at December 31, 2006 and 2005 and for each of the years in the three-year period ended December 2006, together with the accompanying notes, and the December 31, 2006 Annual Information Form. These documents and additional information about Oilexco Incorporated are available on SEDAR at www.sedar.com.
Barrel of oil equivalent (BOE) volumes are reported at 6:1 with 6 MCF = 1 BOE. All figures are in thousands of United States dollars unless otherwise noted.
BUSINESS OF THE COMPANY
Oilexco is an oil and gas exploration and production company headquartered in Calgary, Alberta, active in the United Kingdom. The Company's producing properties are located in the UK Central North Sea. Exploration activities are focused on the UK Central North Sea. The goal of Oilexco in the near term is to achieve oil production from its interests in the North Sea while carrying out an active exploration/development program on both its own properties and in various joint venture opportunities currently being considered by the Company.
Effective December 31, 2006, the Company sold 100% of its shares of Oilexco America, Inc. Accordingly, the US operation results are presented as discontinued operations in the consolidated financial statements and MD&A for the years ended December 31, 2006, 2005 and 2004.
Oilexco's operational activities throughout 2006 in the UK Central North Sea were focused on the development of the Brenda and Nicol oil fields, and the Company's ongoing exploration and appraisal drilling programs. In the second quarter the Company drilled and completed three of the planned four horizontal production wells at Brenda. The combined flow rate of the three wells on completion was 26,438 bbl/d, with a calculated production capacity of 44,000 bbl/d at an 8% reservoir drawdown. At Nicol, the single horizontal production well was drilled and completed in the third quarter. This well flowed oil at 10,165 bbl/d under test conditions, with a calculated production capacity of 12,000 bbl/d at an 8% reservoir drawdown. The sub sea installation phase commenced in the third quarter with the installation of the eight slot 'Multi-port Manifold' featuring a 1.2 megawatt multiphase pump, multiphase flow meter, multi-port selector valve, and control modules. This was followed by the pipelining operations in which eight kilometers of 10 inch production and six inch gas lift pipelines were laid from the Brenda Manifold to the Balmoral Floating Production Facility; and 10 kilometers of Six-inch production and three inch gas lift pipelines were laid from the Nicol wellhead to the Brenda Manifold. In October diving operations commenced on the 'hook-up' phase of the sub sea installation. In this phase the Nicol to Brenda pipelines and Brenda production wells were to be tied into the Brenda Manifold. In addition diving operations commenced below the Balmoral facility to tie-in the Brenda pipelines to the facility's infrastructure.
The final phase of the sub sea installation was interrupted by strike action taken by the union representing UK Divers against the Company's primary sub sea contractor on October 31st. This labor dispute suspended operations at the Brenda and Nicol developments at a time close to completion of the sub-sea installation phase. Settlement of the strike occurred on November 10th. The resolution of the labor action did not result in an immediate resumption of sub-sea saturation diving operations. This was due to the procedures of initiating a saturation dive operation. Once the procedures for implementing the sub sea diving operation were satisfied the weather conditions in the North Sea had deteriorated considerably. Severe winter weather and sea conditions well above historic averages were experienced during much of the first quarter of 2007. These conditions delayed the completion of the balance of the sub sea installation work scope as well as the topsides work at the Balmoral facility necessary to accept the Brenda and Nicol oil production well into the first quarter of 2007. The remaining work scope is limited, with final commissioning and first oil anticipated in late April 2007. The Company's current estimate of the increase in the cost of the developments, as a result of the labor action forcing completion of the sub sea installation into limited weather windows bounded by severe weather and sea conditions, is approximately $25 million. The majority of this amount consists of stand- by charges on sub sea installation and dive support vessels between operating weather windows.
In the second quarter the Company's wholly owned subsidiary also executed a Sale and Purchase Agreement with ConocoPhillips (COP) and ENI related to the Nicol Field. Under the terms of the agreement, COP and ENI will lift a joint total of 1.25 million barrels from their combined 30% ownership of Nicol. After the production milestone is reached, COP and ENI will relinquish their equity and Oilexco will then become the 100% owner of the Nicol Field. In return for the increased ownership, the Company paid COP and ENI's 30% share of the capital expenditures required to develop Nicol, currently estimated to be approximately $18.0 million. This amount does not include any apportioning of the Brenda/Nicol cost overrun due to the labor action in the fourth quarter and severe weather and sea conditions experienced in the fourth quarter and first quarter 2007.
Oilexco was the most active operator of exploration and appraisal wells in the UK North Sea in 2006, a distinction it carried over from 2005. Six exploratory wells were drilled in 2006 resulting in an oil discovery at Sheryl (one well and two side tracks) and dry holes at Palomino, Joy and Halibut. Appraisal drilling was undertaken at Sheryl and Shelley. At Sheryl, seven well bores were drilled in the third quarter from a single surface well bore to fully appraise the oil discovery made in the second quarter. The last Sheryl appraisal well was tested, yielding 1,915 bbl/d of 23º API oil from Eocene Tay sands. No further appraisal activity is necessary at Sheryl as the structure is fully appraised. The Company is currently evaluating field development options for Sheryl and will be in a position to make a firm decision after the drilling of the Constance exploratory well eight kilometers to the northeast in the fourth quarter of 2007. At Shelley, eight well bores were drilled in the fourth quarter from a single surface well bore to appraise a 1984 single well oil discovery. The last Shelley appraisal well bore was tested, yielding 3,082 bbl/d of 31º API oil from Paleocene Forties sands. Additional appraisal drilling will commence at Shelley in the second quarter 2007 to define the northern and southern limits of the Paleocene Forties reservoir. The Company has identified a development solution and is targeting first oil from Shelley in the second quarter of 2008.
In the second quarter the Company's wholly owned subsidiary Oilexco North Sea Limited executed a contract extension with Transocean for the semi-submersible Sedco 712 from March 23, 2008 to March 23, 2010. The total dollar value for the two-year extension is US$248 million, representing a day rate of $340,000 per day. This increase from $225,000 per day in the period March 23, 2007 to March 23, 2008, and $140,000 per day in the period March 23, 2006 to March 23, 2007 reflects the long-term increase in worldwide demand for offshore drilling equipment. In the fourth quarter the Company's wholly owned subsidiary Oilexco North Sea Limited also entered into a contract with a subsidiary of Diamond Offshore Drilling, Inc. for the semi-submersible Ocean Guardian. Oilexco has contracted the Ocean Guardian for a one year period commencing in April 2007 with an option to extend the contract for an additional year ending in April 2009. The contracted rig rate for the initial and option period is $350,000 per day. In March 2007 the company exercised this option. The total value of the two-year contract is $255.8 million. The Company considers the long-term contract for the Sedco 712 and Ocean Guardian a key component to its overall strategy, as it will allow the Company to continue its exploration and appraisal programs while accelerating its development projects. The contracts provide the Company guaranteed access to two drilling vessels with the ability to budget its capital spending without being exposed to the uncertainty of short term daily rig rates, in addition to allowing the Company flexibility to adjust its drilling schedule should circumstances require.
For 2007, Oilexco's Board of Directors has approved a capital budget of $410 million. These funds will be applied to new field development projects as well as the Company's on-going appraisal and exploration program. Two new oil development projects will be undertaken at Ptarmigan and Shelley. At Ptarmigan located 15 kilometers southwest of Brenda, Oilexco will pay 100% of a three appraisal well cluster to earn a 60% interest in a 1994 oil discovery in the Paleocene Forties sand which tested 1,889 bbl/d of 43° API oil. The drilling of the appraisal well cluster is expected to commence in the second quarter of 2007. The appraisal wells will define the extent of the structure to determine the field area as well as the placement of a single horizontal production well. Production form the single horizontal production well will flow through a 15 kilometer sub sea pipeline to the Company's Brenda manifold, then through the Brenda pipeline to the Balmoral Production facility. First oil from Ptarmigan is currently targeted for the fourth quarter 2007 to first quarter 2008. At Shelley, the Company is proceeding with the development of the Paleocene Forties sand oil accumulation appraised in the fourth quarter of 2006. Additional appraisal drilling is planned for the second quarter 2007 to define the northern and southern extent of the productive reservoir as well as the eventual placement of the horizontal production wells. Oil production from the horizontal production wells will be through a central manifold tied into the Sevan 3 Floating Production Vessel anchored over the field area. In the first quarter of 2007 the Company signed a letter of intent to charter the Sevan 3 for a five year fixed term plus an option for an additional five years. Total value of the five year fixed contract is approximately $370 million. Currently the Company has defined topsides facilities with oil treating capacity of 30,000 bbl/d and a water treating capacity of 60,000 bbl/d for the Sevan 3. The Company is targeting the Sevan 3 to come on contract and commence operations at Shelley in the second quarter of 2008. In the first quarter of 2007 the Royal Bank of Scotland plc agreed to provide a £40 million (approximately US$78.5 million) subordinated pre-development facility to the Company's wholly owned subsidiary Oilexco North Sea Limited as a supplement to its current credit facility. The subordinated facility allows the Company the opportunity to finance expenditures incurred in advance of filing a Field Development Plan. Funds have been drawn on this facility to reimburse the Company for initial payments made on sub sea production equipment purchased in 2006 to be utilized at the Ptarmigan and Shelley developments. The Company intends to fund additional expenditures related to these developments through its existing senior credit facility. The bulk of these expenditures are expected in the fourth quarter of 2007 and the first half of 2008. To utilize the senior facility for these projects, the borrowing base of the facility will need to increase from current levels. This is expected to occur once full reserves for these projects are added to the Company's reserve base by its independent evaluators, Sproule International Limited.
The 2007 exploration, appraisal and development drilling program will be significantly larger than the 2006 drilling campaign. Exploration wells will be drilled at Laurel Valley, Huntington and Constance. Appraisal wells will be drilled at Kildare, Ptarmigan, Shelley, Bugle and Black Horse. Development or production well operations consist of the completion of the fourth horizontal production well at Brenda, and the drilling and completion of horizontal production wells at Ptarmigan and Shelley. The Company will finance the exploration and appraisal portions of its 2007 drilling program from the proceeds of a $100 million equity offering which closed in March of 2007, and 'free' cash flow generated from oil production at the Brenda and Nicol fields after satisfaction of terms related to the Company's credit facilities with the Royal Bank of Scotland. Under the terms of the Company's credit facilities, cash flow from the Brenda and Nicol oil developments becomes 'free' for use by the Company after 1.56 million barrels of oil have been recovered net to the account of Oilexco from the developments, or 120 days of sustained production of 13,000 barrels per day has been achieved.
Oilexco finished the year ending December 31, 2006 in excellent financial condition. The Company had significant cash balances as at December 31, 2006 as a result of an equity financing that closed in December 2005 and withdrawals from the RBS loan facility. Capital assets increased from $196.1 million at December 31, 2005 to $467.7 million at December 31, 2006 as a result of drilling six exploration wells, 15 appraisal wells, five production wells and additions to the sub sea production equipment, pipelines and Balmoral topsides modifications for the Brenda and Nicol development. Current liabilities increased from $41.9 million at December 31, 2005 to $114.4 million at December 31, 2006, represented by a $55.6 million increase in accounts payable and accrued liabilities, and $58.0 million in the current portion of the bank loan. The long-term debt as at December 31, 2006 amounted to $193.3 million and relates to the Senior Facility. The Company experienced a net working capital deficiency of approximately $19.0 million at December 31, 2006 compared to $89.1 million in net working capital at December 31, 2005. The increase in share capital from $280.9 million at December 31, 2005 to $297.4 million at December 31, 2006 represents funds obtained from warrants and stock options exercised in 2006. The Company's 2007 UK North Sea exploration and appraisal drilling program will be fully funded by its cash reserves from a $100 million equity issue closed subsequent to the end of the period in the first quarter 2007 and internally generated 'free' cash flow. The Brenda and Nicol developments are funded by the Senior Facility and Junior Facility from the Royal Bank of Scotland. Purchases of long lead order items for the Company's 2007 development projects will be financed from a £40 million (approximately US$78.5 million) Pre- development Facility arranged through the Royal Bank of Scotland in the first quarter of 2007. Operating results were lower in 2006 than in the comparative period of 2005, but higher than the comparative period in 2004. Oil and gas sales for 2006 were lower than in 2005 due to reduced production levels at Balmoral as a result of maintenance and modifications to the facility required to accept oil production from the Brenda and Nicol developments. The increase in operating results in 2005 compared to 2004 reflected a full year of production from the Balmoral/Glamis oil production acquisition that was made in September of 2004. Oil prices increased in 2006 relative to comparative periods in 2005. The average price received for UK oil production for 2006 was $63.96 per barrel, whereas for 2005 it was $53.97 per barrel. Operating costs at the Balmoral facility in 2006 were significantly higher on a per unit basis than in 2005 mainly due to the reduced throughput levels and the maintenance and production enhancements made during the year. The Balmoral facility has high fixed costs relative to the amount of oil that is currently processed. However, the fixed component will decline dramatically in 2007 on a per unit basis when the Brenda/Nicol production comes on stream. General and administrative expenses increased significantly in 2006 versus 2005 and 2004 due to increases in staffing levels, support and activity required for the Brenda/Nicol development and the ongoing exploration and appraisal drilling program. General and administrative expenses are expected to rise again in 2007 due to the opening and staffing of a corporate office in London, and increased staffing in the Aberdeen and Calgary offices. A significant expense item in 2006 continued to be stock-based compensation. As in 2006 and prior years, the Company continued its compensation policy of combining share options with competitive salaries and benefits packages to attract the best qualified staff. The Company continued to issue share options during the year as its share equity base expanded and as it added new employees. Stock-based compensation expense is not expected to increase as rapidly in 2007 as in prior years.
As part of its loan facility agreement with the Royal Bank of Scotland, the Company participated in commodity contracts that involve a costless collar agreement to secure the Company's future cash flow by eliminating its exposure to oil prices below $40 per barrel for a portion of the anticipated production from Brenda and Nicol. As a result of higher oil prices at December 31, 2006 compared to those of January 25, 2006, the date at which the commodity contracts were signed, the Company recorded an unrealized loss of $5.0 million in its financial statements for the year ended December 31, 2006. This unrealized loss resulted from a mark-to-market valuation being significantly lower on January 25, 2006 than on December 31, 2006 due to oil price fluctuation. These are non cash items. The commodity contracts will not have a negative impact on the Company's cash flow unless the price of dated Brent exceeds a monthly average of $88 per barrel during the life of the commodity contracts.
The net loss increased in 2006 compared with 2005 and 2004. The increase in net loss is due to general and administrative expenses, stock-based compensation expense of $8.6 million, and a write down of $12.5 million reflecting an impairment of the Balmoral full cost asset, a portion of the UK cost center, due to the drilling of dry holes at Palomino and Joy in the first quarter of 2006. In addition a net unrealized loss on foreign exchange of $14.9 million, an unrealized loss on derivatives of $5.0 million, and interest and bank charges of $8.3 million contributed to the net loss for the period.
Negative funds flow from operating activities of $12.4 million was substantially higher in 2006 compared to 2005 and 2004. Negative funds flow from operating activities results from intense drilling activity in the North Sea combined with the commensurate overhead from the activity. Also, significant charges from items not involving cash relate to future income tax recovery of $44.4 million. Oil production from Brenda and Nicol, anticipated to commence in late April 2007, is expected to reverse this trend in the future.
Proved and Probable Reserve volumes and values increased in 2006 due to the successful development drilling program at Brenda, and the significant increase in oil prices in 2006. Proved reserves of light oil at December 31, 2006 were 26.6 MMBbls, an increase from the 24.6 MMBbls of light oil reported at December 31, 2005. Proved plus Probable reserves at December 31, 2006 increased to 42.9 MMBbls of light oil from 36.8 MMBbls of light oil reported at December 31, 2005. Proved plus Probable plus Possible light oil reserves were 56.7 MMBbls at December 31, 2006 an increase from 51.1 MMBbls reported at December 31, 2005. The Company's 2006 reserves were independently evaluated by Sproule International Limited. Complete disclosure of the Company's reserves as reported under the guidelines of National Instrument 51-101 can be found in the Company's Annual Information Form dated March 26, 2007, as filed on SEDAR at www.sedar.com.
Oilexco has been able to execute its business plan for the UK North Sea by its ability to access capital through the issuance of debt and equity, as well as having the foresight to contract two offshore semi- submersible drilling rigs for the long term. Oil production from the Brenda and Nicol developments is expected to commence in late April 2007. The resulting cash flow will fund the Company's business plan in 2007 and beyond.
SELECTED ANNUAL INFORMATION
The consolidated financial statements of the Company and the financial data contained in MD&A are prepared in accordance with Canadian Generally Accepted Accounting Principles ('GAAP'). The consolidated financial statements include the accounts of Oilexco Incorporated and its wholly-owned subsidiaries for the years ended December 31, 2006, 2005 and 2004. All inter-company transactions and balances have been eliminated on consolidation. Part of the Company's North Sea oil and gas activities and virtually all US activities are carried out jointly with others, and the consolidated financial statements reflect only the Company's proportionate interest in such activities.
Oil and gas revenues relate to the Company's interest in the Balmoral and Glamis fields in the UK North Sea, which was acquired in September 2004. The 2005 increase reflects a full year of revenue from these fields. The 2006 decrease in revenues reflects lower production levels due to maintenance work performed at the Balmoral production vessel, as well as no production from Glamis in 2006.
Long-term debt relates to the Senior Facility, for the development of Brenda and Nicol Fields.
As at December 31, 2006, other long-term liabilities included approximately $6.5 million in respect of asset retirement obligations, approximately $3.4 million for capital lease obligations and valuation of derivative contracts of approximately $5.0 million. The balances as at December 31, 2005 and 2004 relate entirely to asset retirement obligations.
RESULTS OF OPERATIONS
Sales of oil and gas in the UK North Sea of approximately $3.4 million in 2006 compared to $4.3 million and $0.7 million in 2005 and 2004, respectively, relate to the Company's interest in the Balmoral and Glamis fields acquired in September of 2004. The 2005 increase reflects a full year of revenue from these fields. The 2006 decrease in oil and gas revenues reflects lower production due to maintenance work performed at the Balmoral floating production vessel, as well as no production from Glamis in 2006.
The Company also realized income from inter-field tariffs of approximately $1.0 million in 2006, compared to $0.9 million in 2005. These represent the Company's interest in tariffs on third-party oil processed on the Balmoral floating production facility in the UK North Sea.
Interest income of approximately $4.4 million in 2006 compared to $0.8 million in 2005 and $0.6 million in 2004 resulted from interest earned on bank balances and short-term deposits, as the Company had significant cash balances in 2006 due to the funds raised for UK North Sea operations in December 2005.
Revenues and other income from US discontinued operations relates to the Oilexco America, Inc. operation, which was sold effective December 31, 2006.
Revenues and other income from Canadian discontinued operations relate to the Forgan, Saskatchewan, operation, which was sold in December 2004.
PRODUCTION AND PRICES Average daily production of oil and gas in the UK North Sea decreased from 217 BOEPD in 2005 to 145 BOEPD in 2006. The decrease reflects the fact that there was no production from Glamis in 2006 and lower production from Balmoral in 2006 due to maintenance work.
Average oil and natural gas prices in respect of the UK North Sea operations increased by 19% and 27% during 2006 and 2005, respectively. The increase is attributable to the increase in worldwide crude oil prices.
Average production and prices of US discontinued operations relate to the Oilexco America, Inc. operation, which was sold effective December 31, 2006.
Average production and prices of Canadian discontinued operations relate to the Forgan, Saskatchewan, operation, which was sold in December 2004.
The operating expenses from the UK North Sea represent the Company's interest in the oil and gas production costs of the Balmoral and Glamis Fields as well as the Company's share of operating costs of the Balmoral floating production facility. Therefore, the comparison of operating costs (especially per BOE) is not meaningful as a significant portion of operating costs relate to the floating production vessel, which currently operates below its capacity. Additionally, operating costs per BOE do not reflect the Company's share of inter-field tariff income, which offsets the relatively high fixed-cost component at the facility. The Company expects the UK North Sea operating costs per BOE to decrease in the second quarter of 2007 when the Brenda and Nicol fields production come on stream and are processed through the Balmoral floating production facility.
Operating expenses of US discontinued operations relate to the Oilexco America, Inc. operation, which was sold effective December 31, 2006.
Operating expenses of Canadian discontinued operations pertains to the Forgan, Saskatchewan, operation, which was sold in December 2004.
The continuous increase in general and administrative expenses during 2006 and 2005, relates mainly to the addition of new employees and consultants at the Head Office in Calgary and the Oilexco North Sea Limited office in Aberdeen as a result of continuous development of the Company's UK North Sea operation.
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