Keystone Royalty Corp. Non-Consolidated Financial Statements December 31, 2017 (Unaudited)

Transcription

1 Non-Consolidated Financial Statements December 31, 2017

2 Independent Practitioner s Review Engagement Report To the Shareholders of Keystone Royalty Corp.: We have reviewed the accompanying non-consolidated financial statements of Keystone Royalty Corp. that comprise the nonconsolidated balance sheet as at December 31, 2017, and the non-consolidated statements of income and retained earnings and cash flows for the year then ended, and a summary of significant accounting policies and other explanatory information. Practitioner s Responsibility Our responsibility is to express a conclusion on the accompanying non-consolidated financial statements based on our review. We conducted our review in accordance with Canadian generally accepted standards for review engagements, which require us to comply with relevant ethical requirements. A review of non-consolidated financial statements in accordance with Canadian generally accepted standards for review engagements is a limited assurance engagement. The practitioner performs procedures, primarily consisting of making inquiries of management and others within the entity, as appropriate, and applying analytical procedures, and evaluates the evidence obtained. The procedures performed in a review are substantially less in extent than, and vary in nature from, those performed in an audit conducted in accordance with Canadian generally accepted auditing standards. Accordingly, we do not express an audit opinion on these non-consolidated financial statements. Basis for Qualified Conclusion The reserve information necessary to calculate depletion, depreciation, and accretion using the unit-of-production method, including an amount for restoration and abandonment costs, is not readily available. Had the information been available to complete our review, we might have determined adjustments to be necessary to petroleum and natural gas properties, depletion and depreciation, and net income. Qualified Conclusion Except for the effect of adjustments, if any, which we might have determined to be necessary had we been able to complete our review of depletion, depreciation, and accretion as described in the previous paragraph, nothing has come to our attention that causes us to believe that these non-consolidated financial statements are not, in all material respects, in accordance with Canadian accounting standards for private enterprises. Regina, Saskatchewan April 16, 2018 Chartered Professional Accountants Suite 900, Royal Bank Building, th Avenue, Regina, Saskatchewan, S4P 0J3, Phone: (306) , 1 (877)

3 Non-Consolidated Balance Sheet As at December 31, 2017 Assets Current Cash (Note 3) $ 70,586 $ 293,105 Accounts receivable 2,784,777 2,060,698 Income taxes recoverable - 393,732 Prepaids 14,250 20,595 2,869,613 2,768,130 Property, plant and equipment (Note 4) 61,527,421 57,769,370 Investments (Note 5) 579, ,000 Investment in Villanova 4 Oil Corp. (Note 6) 1,085,526 1,085,526 Investment in KVL Properties Inc. (Note 7) 1,000,000 1,000,000 Liabilities Current $ 67,062,360 $ 63,353,026 Accounts payable and accrued liabilities (Note 8) $ 1,085,866 $ 525,514 Bank indebtedness (Note 9) 4,700,000 3,400,000 Income taxes payable 48,723-5,834,589 3,925,514 Future income taxes 2,039, ,322 Asset retirement obligation (Note 10) 1,629, ,611 9,503,470 5,122,447 Shareholders' Equity Share capital (Note 11) 30,794,996 30,707,741 Retained earnings 25,597,105 26,688,022 Contributed surplus (Note 11) 1,166, ,816 57,558,890 58,230,579 $ 67,062,360 $ 63,353,026 Approved on behalf of the Board: Director Director The accompanying notes are an integral part of these non-consolidated financial statements 1

4 Non-Consolidated Statement of Income and Retained Earnings Revenue Royalty income $ 11,522,042 $ 8,700,628 Oil and gas sales 3,303,077 2,728,658 Bonus consideration 495, ,546 Investment income and other 20,601 27,938 15,340,780 11,569,770 Expenses Depletion, depreciation and accretion 3,462,228 3,449,896 General and administrative 1,730,429 1,247,970 Interest 97, ,279 Production 1,205,121 1,082,256 Stock based compensation (Note 11) 412, ,391 6,907,794 6,241,792 Income before the undernoted items and income taxes 8,432,986 5,327,978 Other income (expenses) Realized gain on sale of investments - 102,669 Unrealized fair value loss on investments (457,251) (9,826) (457,251) 92,843 Income before income taxes 7,975,735 5,420,821 Income taxes Current 1,370, ,316 Future 1,266,934 1,291,487 2,637,347 1,884,803 Net income 5,338,388 3,536,018 Retained earnings, beginning of year 26,688,022 28,695,684 Dividends (6,429,305) (5,543,680) Retained earnings, end of year $ 25,597,105 $ 26,688,022 The accompanying notes are an integral part of these non-consolidated financial statements 2

5 Non-Consolidated Statement of Cash Flows Cash provided by (used in): Operating activities Net income $ 5,338,388 $ 3,536,018 Items not involving cash: Depletion, depreciation and accretion 3,462,228 3,449,896 Stock based compensation 412, ,391 Realized gain on sale of investments - (102,669) Unrealized fair value loss on investments 457,251 9,826 Future income taxes 1,266,934 1,291,487 Changes in non-cash working capital accounts Accounts receivable (724,080) (160,525) Prepaids 6,345 (20,595) Accounts payable and accrued liabilities 560, ,962 Income taxes recoverable 442, ,025 11,222,520 8,831,816 Financing activities Increase (decrease) in bank indebtedness 1,300,000 (2,050,000) Proceeds on share options exercised 6, ,000 Dividends (6,429,305) (5,543,680) (5,122,724) (7,194,680) Investing activities Purchases of property, plant and equipment (6,409,508) (1,345,261) Proceeds on disposal of property, plant and equipment 394, ,000 Purchase of investments (307,051) (1,293,030) Proceeds on disposal of investments - 995,792 (6,322,315) (1,467,499) Change in cash position (222,519) 169,637 Cash, beginning of year 293, ,468 Cash, end of year $ 70,586 $ 293,105 The accompanying notes are an integral part of these non-consolidated financial statements 3

6 1. Nature of operations Keystone Royalty Corp. (the "Company") is incorporated under the Business Corporations Act of Saskatchewan. The Company is primarily engaged in acquiring and managing oil and gas royalty assets. The Company s principal place of business is located at 2530 Sandra Schmirler Way, Regina, Saskatchewan, Canada, S4W 0M7. 2. Significant accounting policies The financial statements have been prepared in accordance with Canadian accounting standards for private enterprises, with the Company electing to report on a non-consolidated basis. The Company's significant accounting policies are as follows: Joint interest activities Certain areas of the Company's exploration, development and production activities are conducted jointly with others. These non-consolidated financial statements reflect only the Company's proportionate interest in such activities. Property, plant and equipment The Company follows the full cost method of accounting for petroleum and natural gas operations whereby all costs of acquiring, exploring and developing oil and natural gas properties and related reserves are capitalized. Such capitalized costs include land acquisitions, geological and geophysical expenditures, lease rentals on non-producing properties, expenditures of drilling both productive and non-productive wells, production equipment, asset retirement costs and the portion of general and administrative expenses directly attributable to exploration and development activities. The costs of acquiring and evaluating unproved properties are initially excluded from depletion calculations. These properties are assessed periodically to ascertain whether impairment has occurred. When proved reserves are assigned or the property is considered to be impaired, the cost of the property or the amount of impairment is added to the costs subject to depletion. Capitalized costs, plus estimated future development expenditures associated with proved reserves, are recognized as costs subject to depletion and depreciation expense using the unit of production method based on estimated proved reserves. For the purposes of this calculation, natural gas reserves and production volumes are converted to equivalent volumes of oil based on the energy equivalency ratio of six thousand cubic feet of natural gas to one barrel of oil. The Company places a limit on the carrying value of petroleum, natural gas and other properties and equipment, which may be depleted against revenues of future periods (the "ceiling test"). The carrying value is assessed to be recoverable when the sum of the present value of future cash flows expected to be derived from production of proved reserves, the lower of cost and market of unproved properties and the cost of major development projects exceeds the carrying value. When the carrying value is not assessed to be recoverable, an impairment loss is recognized to the extent that the carrying value of assets exceeds the sum of the present value of future cash flows expected to be derived from production of proved reserves, the lower of cost and market of unproved properties and the cost of major development projects. Proceeds from the sale of properties are applied against capitalized costs, without recognizing any gain or loss, unless such a sale would significantly alter the rate of depletion and depreciation by more than 20%. 4

7 Revenue recognition Revenue is made up of royalty income, working interest sales, bonus consideration and other income earned during the period. Royalty income and working interest sales represent the sale of crude oil, natural gas, natural gas liquids and other products. Royalty income is recognized as it accrues upon the terms of the underlying royalty contracts. Generally these contracts provide a monthly calculation of the royalties due based on a percentage of production revenue. Working interest sales are recognized as it accrues based on the underlying working interest agreements. Asset retirement obligation The Company recognizes a future asset retirement obligation as a liability in the year in which it incurs a legal obligation associated with the retirement of tangible long lived assets that results from the acquisition, construction, development and/or normal use of the assets based on the best estimate of the expenditure required to settle the obligation. The Company concurrently recognizes a corresponding increase in the carrying amount of the related long lived asset that is amortized over the life of the asset. The amount of the asset retirement obligation is estimated using the expected cash flow approach that reflects a range of possible outcomes discounted at a risk free interest rate based on management's best estimate. Subsequent to the initial measurement, the asset retirement obligation is adjusted at the end of each year to reflect the passage of time and changes in the estimated future cash flows underlying the obligation. Changes in the obligation due to the passage of time are recognized in income as an operating expense using the interest method. Changes in the obligation due to changes in estimated cash flows are recognized as an adjustment of the carrying amount of the related long lived asset that is amortized over the remaining life of the asset. Future Income taxes The Company uses the asset and liability method of accounting for income taxes. Under the asset and liability method, future tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amount of existing assets and liabilities and their respective tax bases. Future tax assets and liabilities are measured using enacted or substantively enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on future tax assets and liabilities of a change in tax rates is recognized in earnings in the year that includes the date of enactment or substantive enactment. Refundable taxes that will be recovered on the payment of qualifying dividends are recognized as a future income tax asset. Stock-based compensation The Company has a stock based compensation plan consisting of stock options and share appreciation rights which is described in note 11(c). Stock options and share appreciation rights granted to directors, officers and employees are accounted for in accordance with the calculated value method of accounting for stock based compensation. The Company determines the fair value of stock options on their grant date and records this amount as compensation expense over the period that the stock options vest, with a corresponding increase to contributed surplus. Upon the exercise of stock options, consideration received together with amounts previously recorded in contributed surplus is recorded as an increase in share capital. 5

8 Financial instruments Financial instruments are recorded at fair value on initial recognition. Freestanding derivative instruments that are not in a qualifying hedging relationship and equity instruments that are quoted in an active market are subsequently measured at fair value. All other financial instruments are subsequently recorded at cost or amortized cost, unless management has elected to carry the instruments at fair value. Transaction costs incurred on the acquisition of financial instruments measured subsequently at fair value are expensed as incurred. All other financial instruments are adjusted by transaction costs incurred on acquisition and financing costs, which are amortized using the straight line method. Financial assets are assessed for impairment on an annual basis at the end of the fiscal year, if there are indicators of impairment. If there is an indicator of impairment, the Company determines if there is a significant adverse change in the expected amount or timing of future cash flows from the financial asset. If there is a significant adverse change in the expected cash flows, the carrying value of the financial asset is reduced to the highest of the present value of the expected cash flows, the amount that could be realized from selling the financial asset or the amount the Company expects to realize by exercising its right to any collateral. If events and circumstances reverse in a future period, an impairment loss will be reversed to the extent of the improvement, not exceeding the initial carrying value. Use of estimates and measurement uncertainty The preparation of financial statements in conformity with Canadian accounting standards for private enterprises requires management to make judgments, estimates and assumptions that affect the application of accounting policies and the reported amounts of assets, liabilities, income and expenses. Actual results may differ from these estimates. Estimates and underlying assumptions are reviewed on an ongoing basis. Revisions to accounting estimates are recognized in the year in which the estimates are revised and in any future years affected. Items that required significant estimates and judgments to be made by management in the preparation of these non-consolidated financial statements are outlined below. Amounts recorded for depletion and depreciation of petroleum and natural gas properties, asset retirement obligations and the ceiling test are based on estimates of reserves, production rates, oil and natural gas prices, future costs and other relevant assumptions. Accounts receivable for royalty income and working interest sales are measured at the fair value, using estimates, per the terms of various royalty interest and working interest agreements. Stock based compensation is subject to the estimation of what the ultimate payout will be using the Black-Scholes pricing model which is based on significant assumptions such as expected volatility, forfeiture rates and expected term. The provision for income taxes is based on judgments in applying income tax law and estimates on the timing, likelihood and reversal of temporary differences between the accounting and tax bases of assets and liabilities. These above estimates are subject to measurement uncertainty and changes in these estimates could materially impact the non-consolidated financial statements of future periods. Investment in subsidiary The Company's investment in its wholly owned subsidiary, KVL Properties Inc., is accounted for in these non-consolidated financial statements at cost. Earnings from the investment are recognized only to the extent dividends are received or receivable. 6

9 3. Cash Long-lived assets Long-lived assets consist of property, plant and equipment. Long-lived assets held for use are measured and amortized as described in the applicable accounting policies. The Company performs impairment testing on long-lived assets held for use whenever events or changes in circumstances indicate that the carrying amount of an asset, or group of assets, may not be recoverable. The carrying amount of a longlived asset is not recoverable if the carrying amount exceeds the sum of the undiscounted future cash flows from its use and disposal. If the carrying amount is not recoverable, impairment is then measured as the amount by which the asset's carrying amount exceeds its fair value. Fair value is measured using quoted market prices. Any impairment is included in earnings for the year. Cash is deposited in financial institutions with a strong investment grade rating. 4. Property, plant and equipment 2017 Accumulated Net book Cost amortization value Petroleum, natural gas and other properties $ 81,117,618 $ 24,175,362 $ 56,942,256 Production equipment 5,623,369 1,038,204 4,585,165 $ 86,740,987 $ 25,213,566 $ 61,527, Accumulated Net book Cost amortization value Petroleum, natural gas and other properties $ 74,887,867 $ 20,953,755 $ 53,934,112 Production equipment 4,650, ,445 3,835,258 $ 79,538,570 $ 21,769,200 $ 57,769,370 Land and seismic costs associated with unproven properties that were excluded from property costs subject to depletion for 2017 totaled $45,450,560 (2016 $41,668,772). There were no general and administrative expenses capitalized during 2017 or At December 31, 2017, the ceiling test calculation was based upon the present value of future cash flows, estimated using internally generated reserves and third party forecast pricing. 7

10 5. Investments The Company has the following investments: Crescent Point Energy Corp. $ 574,800 $ 730,000 Sultran Ltd. 5,000 - $ 579,800 $ 730,000 The Company s investments in public market securities are recorded at fair value. 6. Investment in Villanova 4 Oil Corp. Common shares $ 1,085,526 $ 1,085,526 The investment represents a 2.22% ( %) interest in Villanova 4 Oil Corp. ("V4OC"), a private company. The Company is related to V4OC through common management. The Company holds 1,250,000 share purchase warrants at an exercise price of $0.50 per share and expire on September 29, Investment in KVL Properties Inc. Common shares $ 1,000,000 $ 1,000,000 The Company holds a 100% ownership interest in KVL Properties Inc. ("KVL"), a private company. KVL owns two office buildings situated on lands leased from the Regina Airport Authority, one of which houses the Company's head office. As at December 31, 2017, KVL had $4,064,710 of debt outstanding on the two office buildings, which is corporately guaranteed by the Company. The mortgage agreements have two years of term remaining. The guarantee will only be called in case of loan default by KVL. 8. Accounts payable and accrued liabilities The Company has $52,345 in government remittances included in accounts payable and accrued liabilities for 2017 ( $16,587). 8

11 9. Credit facility As at December 31, 2017, the Company had $4,700,000 ( $3,400,000) drawn on a $19,000,000 revolving operating demand loan at the National Bank of Canada with an interest rate ranging from prime plus 0.50% to 2.50% based on a calculation of net debt to cash flow. As the net debt to cash flow ratio never exceeded the minimum threshold, the effect rate for the year was prime plus 0.50%. The facility is secured by a general assignment of book debts, a $50,000,000 debenture with a floating charge over all assets of the Company with a negative pledge and undertaking to provide fixed charges on the Company's major producing petroleum properties at the request of the lender, as well as an assignment of revenues and monies under material contracts, as applicable. The Company is subject to certain reporting and financial covenants related to the revolving spending demand loan. The Company must maintain an adjusted working capital ratio of not less than 1.00:1.00 at all times. The Company was in compliance with all covenants as at December 31, Asset retirement obligation The Company has recorded an asset retirement obligation with respect to its petroleum and natural gas properties. The following table reconciles the Company's asset retirement obligation: Balance, beginning of year $ 424,611 $ 353,802 Provisions made during the year 1,187,152 51,494 Accretion expense 17,862 7,671 Change in estimates - 11,644 Balance, end of year $ 1,629,625 $ 424,611 The Company s asset retirement obligations result from its ownership interest in petroleum and natural gas properties. The total asset retirement obligation is estimated based on the Company s net ownership interest in all wells and facilities, estimated costs to reclaim and abandon these wells and facilities and the estimated timing of the costs to be incurred in future years. The Company has estimated the net present value of the asset retirement obligations to be $1,629,625 as at December 31, 2017 based on an undiscounted total future liability of $2,949,539. These payments are expected to be made over the next 20 years with the majority of costs to be incurred between 2027 and The discount factor, being the riskfree rate, is 2.25% ( %). The liability has been calculated using an inflation rate of 2.00% ( %) and an undiscounted abandonment cost per well of $50,000 ( $50,000) and $200,000 for facilities ( $200,000). The significant increase in the Company's asset retirement obligation during the year was a result of the acquisition of all the oil and gas assets of The Paddon Hughes Development Co. Ltd. 9

12 11. Share capital (a) Authorized: The authorized share capital of the Company consists of an unlimited number of Class A voting common shares, an unlimited number of Class B non-voting common shares, and an unlimited number of Class C preferred shares. (b) Issued and outstanding: Class A Common Number 2017 Number 2016 Balance, beginning of year 8,022,167 $30,707,741 7,891,554 $29,923,141 Issued on exercise of options 19,563 87, , ,600 Balance, end of year 8,041,730 $30,794,996 8,022,167 $30,707,741 During the year, 35,000 options were exercised or cancelled, resulting in 19,563 Class A shares being issued from treasury. Some Optionees elected to receive the net amount of Optioned Shares they were entitled to based on the difference between the (adjusted) Exercise Price and the Fair Market Value of the Optioned Shares being exercised, as more particularly set out in Section 3.01 of the Plan. The Company paid a quarterly dividend of $0.20 per share in 2017 ( $0.175). (c) Stock options: The Company has a stock option plan to provide options for directors, officers, employees and consultants to purchase common shares. The total aggregate amount of the stock options that can be issued cannot exceed ten percent of the outstanding common shares. The following table reconciles the changes in outstanding stock options: Number 2017 Exercise Price Number 2016 Exercise Price Outstanding, beginning of year 677,000 $ ,000 $7.57 Granted 83,000 $11.50 & $ ,000 $11.25 Exercised (35,000) $4.32 & $7.90 (160,000) $4.56 Outstanding, end of year 725,000 $ ,000 $8.48 Exercisable, end of year 430,500 $ ,333 $7.14 The stock options vest at a rate of one third in each of the first three years from the date of issue. All unexercised stock options will expire on the fifth anniversary from the date of issue. The stock option plan also provides that the exercise price of any unexercised options (whether vested or not) shall be reduced by the amount of cash dividends declared and payable subsequent to the date of the option grant, however, in no event will the exercise price of any option be less than $0.01 per share. 10

13 The following table summarizes the expiry terms and exercise prices of the Company's 725,000 outstanding stock options as at December 31, 2017: Number of stock options Weighted average remaining Number of stock options Exercise Price outstanding term (years) exercisable $ , ,000 $ , ,000 $ , ,333 $ , ,000 $ , ,667 $ , ,500 $ , $ , The per share fair value of the stock options granted during the year ended December 31, 2017 was estimated based on the date of grant using the Black Scholes option pricing model with the following assumptions: April 3, 2017 November 28, 2017 Grant price per share $11.50 $11.90 Risk free interest rate (%) 1.03% 1.62% Expected Life (years) 5 5 Expected volatility (%) 30.00% 30.00% Expected dividends - - Forfeitures - - Grant-date fair value per share $3.24 $3.49 (d) Contributed surplus: Balance, beginning of year $ 834,816 $ 908,025 Stock-based compensation 412, ,391 Transfer to share capital upon exercise (80,674) (385,600) Balance, end of year $ 1,166,789 $ 834, Related party transactions All related party transactions are in the normal course of operations and were measured at the exchange amount. Effective June 1, 2014, the Company entered into a Management Support Agreement with V4OC to receive ongoing support services and agreed to pay the greater of $100,000 ( $100,000) or 0.8% ( %) of the Company s gross annual operating revenue as compensation. In 2017, a total of $124,867 ( $100,000) has been incurred to V4OC under this agreement. The Management Support Agreement was terminated effective December 31, In addition, the Company participated as a 30% working interest partner in two V4OC operated wells in the period. At December 31, 2017, the Company had accounts payable to V4OC of $333,063 ( $21,114). The Company reimburses KVL for net operating costs and tenant expenses associated with its head office operations. Starting in October 2015, the Company received free rent for the head office from KVL. At December 31, 2017, the Company had accounts payable to KVL of $4,638 ( $5,099), and accounts receivable of $60,000 ( $30,000). The Company is also related to Lex Capital Corp. through common management and shareholders. At December 31, 2017, the Company had accounts receivable from Lex Capital Corp. of $nil ( $4,227). 11

14 13. Financial instruments Commodity price and foreign exchange risk The nature of the Company's operations result in exposure to fluctuations in commodity prices and exchange rates as crude oil and natural gas prices received are referenced to U.S. dollar denominated prices. The Company monitors, and when appropriate, may use derivative financial instruments to manage its exposure to these risks. Interest rate risk Interest rate risk is the risk that the value of a financial instrument might be adversely affected by a change in the interest rates. Changes in market interest rates may have an effect on the cash flows associated with some financial assets and liabilities, known as cash flow risk, and on the fair value of other financial assets or liabilities, known as price risk. The Company is exposed to interest rate cash flow risk with its credit facility as it is at a floating rate of prime plus an applicable margin ranging from 0.50% to 2.50% based on a calculation of net debt to cash flow. Credit risk management A substantial portion of the Company's accounts receivable are with customers and joint venture partners in the oil and gas industry and are subject to normal industry credit risks. Settlement terms are normally 30 days. Commodity price risks The Company has not undertaken any hedging activities. Credit concentration As at December 31, 2017, three customers accounted for 57% ( two customers at 38%) of accounts receivable. The Company believes that there is no unusual exposure with the collection of these receivables. 14. Capital management The Company s objectives when managing its capital are to maximize long term shareholder value and distribute a portion of excess cash while maintaining a level of financial flexibility which allows the Company to take advantage of opportunities such as land sale acquisitions, and other investment opportunities as they arise. The Company manages its capital structure and adjusts it as a result of changes in economic conditions and the risk characteristics of the underlying petroleum and natural gas assets. The Company considers its capital structure to include shareholders equity, the available credit line, and working capital. In order to maintain or adjust the capital structure, the Company may from time to time issue shares, adjust its capital spending or suspend or reduce dividend rates to manage current or forecasted debt levels. There were no changes in the Company s approach to capital management during the year. 15. Comparative figures Certain comparative figures have been reclassified to conform with current year presentation. 12