COASTAL ENERGY COMPANY (formerly PetroWorld Corp.) MANAGEMENT DISCUSSION AND ANALYSIS

Transcription

1 COASTAL ENERGY COMPANY (formerly PetroWorld Corp.) MANAGEMENT DISCUSSION AND ANALYSIS Years ended December 31, 2006 and 2005 (All amounts are expressed in thousands of US dollars unless otherwise stated) The following discussion is management s discussion and analysis of the results and financial condition of Coastal Energy Company (the Company ), formerly PetroWorld Corp. ( PetroWorld ) and should be read in conjunction with the accompanying audited consolidated financial statements for the years ended December 31, 2006 and 2005 and related notes thereto. As a result of the transaction discussed below in 2006 Highlights as the NuCoastal Acquisition, the audited consolidated financial statements are a continuation of the financial statements of NuCoastal Thailand Limited ( NuCoastal ) with the reverse takeover of PetroWorld effective September 25, The effective date of this MD&A is April 25, Additional information related to the Company, including the Company s Annual Information Form, is available on SEDAR at Overview The Company was incorporated in the Cayman Islands as PetroWorld Corp. under the Companies Law of the Cayman Islands on May 26, The Company is engaged in the acquisition and exploration of petroleum and natural gas properties and is listed on the Alternative Investment Market ( AIM ) of the London Stock Exchange under the symbol CEO and on the TSX Venture Exchange ( TSX-V ) under the symbol CEO. The functional and reporting currency of the Company and its subsidiaries is the US dollar ( USD ). The Company s principal oil and gas properties and assets are: (1) 100% direct ownership in the offshore Block G5/43 in the Gulf of Thailand which includes the Bua Ban and Songkhla oil fields. (2) a % indirect ownership in the onshore Block EU-1 and E5-N in the Phu Horm gas field located in the Khorat Plateau area of Thailand; (3) 36.1% indirect ownership of the onshore Block L15/43 surrounding the Phu Horm gas field and Block L27/43 located southeast of the Phu Horm gas field,; (4) 21.66% indirect ownership of the onshore Block L13/48 located immediately east of the Phu Horm gas field. The Company holds the onshore interests via its 36.1% ownership interest in Apico LLC ( Apico ) Highlights On September 25, 2006 three major transactions were consummated which enhanced the Company s asset base and strengthened the balance sheet of the Company: (a) PetroWorld acquired all of the issued and outstanding shares of NuCoastal in consideration for the issuance of 151,663,323 common shares of PetroWorld. PetroWorld issued enough shares to the shareholder of NuCoastal so that control passed to NuCoastal s shareholder. NuCoastal s reverse takeover of PetroWorld was completed for a total value of $33.8 million. As a result, and in accordance with Canadian generally accepted accounting principles ( Canadian GAAP ), the NuCoastal Acquisition has been accounted for as a reverse takeover, with NuCoastal being identified as the acquirer for accounting purposes. This transaction is referred to as the NuCoastal Acquisition throughout this MD&A and the Notes to the Consolidated Financial Statements (b) The Company acquired a 10.63% interest in Apico from PH Gas L.P. ( PHG ) in consideration for 36,419,562 common shares for a total cost of $22.0 million, increasing the Company s interest in Apico to 36.1%. This transaction is referred to as the Apico Acquisition throughout this MD&A and the Notes to the Consolidated Financial Statements (c) The Company completed a brokered financing (the Offering ) of 61,500,000 common shares of the Company at a price of $0.58 (Cdn$0.65) per share, raising gross proceeds of approximately $35.8 million (Cdn$40.0 million). Included within the 61,500,000 common shares, the Company issued 3,415,000 and 4,726,000 common shares to NuCoastal s shareholder and PHG, respectively, in consideration for approximately $2.0 million and $2.7 million of funds that had been advanced to Apico by NuCoastal s shareholder and PHG, respectively. The Company issued a further 1,500,000 common shares at the same price upon exercise of the over-allotment option for gross proceeds of $0.9 million (Cnd$1.0 million.) Net proceeds of the Offering were $29.2 million (net of issue costs of $2.8 million). The Company incurred a net loss of $4.1 million ($0.02 per share) for 2006 compared with net loss of $0.6 million ($0.00 per share) for Page 1 of 13

2 COASTAL ENERGY COMPANY (formerly PetroWorld Corp.) MANAGEMENT DISCUSSION AND ANALYSIS Years ended December 31, 2006 and 2005 (All amounts are expressed in thousands of US dollars unless otherwise stated) The Company changed its name from PetroWorld Corp. to Coastal Energy Company effective September 27, Effective October 4, 2006, the Company s trading symbols changed from PWC on the AIM and PWD on TSX-V to CEO on both exchanges to better reflect its name change to Coastal Energy Company. Its ISIN number was also changed to KY G Initial gas production from three wells in the Phu Horm gas field commenced in November 2006 and was producing at over 75 million cubic feet per day ( mmcf/d ) at year end. The Company has a 12.6% net interest in this gas field. The Company continued to conduct geological and development engineering studies on its assets in the G5/43 block, Gulf of Thailand; including a 3-D seismic shoot of 330 square kilometers over the western half of the Songkhla basin. The area covered by the seismic acquisition includes the Bua Ban oil field which is one of two fields the Company is looking to develop over the next months. The seismic will supplement existing 3-D over the Songkhla field. The Company also announced it had completed the drilling of the 1-12 Cobble Cuesta well in Gabbs Valley, Nevada. The exploration well reached a total depth of 5,198 feet and encountered oil shows throughout the Tertiary fractured volcanic section. The Company is conducting further analysis to determine if additional work is justified. Forward Looking Statements Certain information included in this discussion may constitute forward-looking statements. Forward looking statements are based on current expectations, estimates, and projections that involve various risks and uncertainties. These risks and uncertainties could cause or contribute to actual results that are materially different from those expressed or implied. Oil & Gas Reserves The Company s reserves were evaluated by Huddleston & Co., Inc. effective December 31, Selected data from their report follows. Their entire report is available on SEDAR at Natural gas is converted to equivalent barrels ( BOE ) at the energy equivalent conversion rate of six thousand cubic feet (6mcf) to one barrel ( 1bbl ) of crude oil, reflecting the approximate relative energy content. Reserve figures for 2005 reflect NuCoastal Thailand s 25.5% interest in APICO and 50% interest in Gulf of Thailand Block G5/43. Reserve figures for 2006 reflect Coastal Energy s 36.1% interest in APICO and 100% interest in Block G5/43. December 31, 2006 December 31, 2005 Oil and Gas Reserves Oil (Mbbls) Gas (MMcf) BOE (Mbbls) Oil (Mbbls) Gas (MMcf) BOE (Mbbls) Proved 5,743 45,386 13,307 2,638 42,846 9,779 Probable 10,814 50,759 19,274 4,515 2,404 4,916 Total 16,557 96,145 32,581 7,153 45,250 14,695 The following table summarizes the net present value of future revenues discounted at 10% before income taxes: Based on forecast prices at December 31. Based on constant prices at December 31, Proved $147,658 $75,211 $180,385 $113,135 Probable 386,170 25, ,560 75,476 Total $533,828 $101,108 $586,945 $186,611 The product prices used in the constant price and cost evaluations were US$59.80/bbl and US$4.927/Mcf for Thailand. The forecast prices used by Huddleston & Co., Inc. in their evaluation for 12/31/06 were taken Page 2 of 13

3 COASTAL ENERGY COMPANY (formerly PetroWorld Corp.) MANAGEMENT DISCUSSION AND ANALYSIS Years ended December 31, 2006 and 2005 (All amounts are expressed in thousands of US dollars unless otherwise stated) from the Gilbert Lausten Jung ( GLJ ) Petroleum Consultants website ( GLJ projected prices through 2017, and then applied a 2% per year escalation for the life of the properties and are as follows: Thailand Thailand Oil Gas Year ($/bbl) ($/Mcf) Future years are as per the price forecast published by Huddleston & Co., Inc. s report dated April 11, Oil & Gas Properties Summary of Oil & Gas Properties Thailand On-Shore Thailand Off-shore Nevada USA Totals Balance, December 31, 2004 $4,802 $826 $ - $5,628 Additions during the period: Exploration & development 3,040 3,925-6,965 Add (deduct) other item Equity earnings (loss) in Apico LLC (172) - - (172) Balance, December 31, ,670 4,751-12,421 Additions during the period: Exploration & development 11,247 4, ,730 Net assets acquired via NuCoastal Acquisition 57,540 1,402 58,942 Net assets acquired via Apico Acquisition 22, ,008 Advances associated with Apico Acquisition 2, ,750 Add (deduct) other item Equity earnings (loss) in Apico LLC Balance, December 31, 2006 $44,046 $66,367 $1,809 $112,222 (a) Thailand Onshore The Thailand onshore interests are held indirectly through the Company s equity investment in Apico. Apico is considered a significant equity investee. Apico s results of operations for the years ended December 31 and financial position as at December 31 are as follows: Total revenues $3,776 $- Total expenses 2, Income tax expense Net Income $792 $(684) Current assets $7,255 $9,609 Property, plant and equipment 68,336 17,737 Other assets 237 3,332 Total assets $75,828 $30,678 Current liabilities $6,260 $247 Non-current liabilities Members equity 69,467 30,431 Total liabilities and equity $75,828 $30,678 The Company holds a % working interest in Blocks EU-1 and E5-N in the Phu Horm gas field ( Phu Horm ) located in northeast Thailand. The Company also owns a 36.1% interest in Block L15/43, surrounding Phu Horm, and Block L27/43, which is located southeast of Phu Horm, as well as a 21.66% interest in Block L13/48, which is located immediately east of Phu Horm. Page 3 of 13

4 COASTAL ENERGY COMPANY (formerly PetroWorld Corp.) MANAGEMENT DISCUSSION AND ANALYSIS Years ended December 31, 2006 and 2005 (All amounts are expressed in thousands of US dollars unless otherwise stated) Production at the Phu Horm gas field commenced on November 30, 2006 and will supply the Nam Phong power plant with over 500 billion cubic feet of gas, plus condensate, under a 15 year Gas Sales Agreement with PTT Public Company Limited. Coastal s net interest of 12.6% is held through its equity investment in Apico which holds a 35% interest in the gas field. The other partners in the field include Hess Corporation (Operator - 35%), PTTEP (20%) and ExxonMobil (10%). Three wells at Phu Horm were producing at year end delivering in excess of 75mmcf/day to Nam Phong. The field was also producing in excess of 450 bbls of condensate per day. To provide incremental production capacity, a three well development drilling program, Phu Horm 6, 7 & 8, commenced in the third quarter of The Company expects these three development wells to deliver additional production capacity and allow for potential reserve additions over the Phu Horm gas field. The Company also holds a 36.1%interest in block L15/43 that surrounds Phu Horm. Work is being conducted to drill the Phu Horm South appraisal well on the southern extension of Phu Horm. The well will determine whether the productive Phu Horm reservoir extends beyond the Hess operated production license into the surrounding L15/43 concession. The Company also holds a 36.1% interest in block L27/43 which is located 50 km southeast of the L15 concession. Seismic operations were conducted and evaluated over the Dong Mun structure in An appraisal well is expected to be drilled in the third quarter of 2007 to evaluate the Dong Mun prospect. The appraisal well offers the opportunity to add reserves in close proximity to Phu Horm and Nam Phong infrastructure. In December 2006, the Thai Government formally ratified the L13/48 concession in which Coastal is a net 21.7% interest holder. The L13 concession holds the Si That discovery which tested gas in the Si That-2 well. Si That is located 40km east of Phu Horm. Similar to Dong Mun, Si That offers an appraisal opportunity for additional reserves with low geological and technical risk. The Si That appraisal well is expected to be drilled in (b) Thailand Offshore The Company maintains a 100% working interest in Block G5/43 (the Block ) in the Gulf of Thailand. The Block is approximately 17,110 square kilometres and average water depths are approximately 70 feet. Three successful wells were drilled by NuCoastal and PetroWorld on the Bua Ban oil field ( Bua Ban ) in August 2005 which confirmed proved and probable oil reserves of approximately 12 million barrels of oil. The three well program encountered the Lower Oligocene reservoir with estimated net pay ranging from feet and a confirmed oil column of feet. The Songkhla oil field, which is smaller than Bua Ban, was discovered in 1989 and originally tested 1,500 barrels of production per day and contains proved and probable oil reserves of approximately 4.2 million barrels. As part of a fast track development plan, environmental impact assessment and production area applications are currently being prepared for both the Songkhla and Bua Ban fields. The Company has begun contracting services for the Songkhla development and expects to be in production within the next 12 months. (c) Nevada The Company considers this asset to be non-core. The Company has a seismic option agreement with Cortez Exploration LLC ( Cortez ) to evaluate 44,604 acres of Federal Leases (the Leases ) located in Gabbs Valley, Nevada State, USA. The Company elected to commit for one-half of the drilling and land cost obligation, therefore it paid fifty (50%) percent of the land cost and forty-five (45%) percent of the drilling costs to earn a thirty (30%) percent working interest in the Leases and test well. In June 2006, PetroWorld acquired an interest in an additional 30,917 acres of Leases at a nominal cost. The Company completed the drilling of the 1-12 Cobble Cuesta well in Gabbs Valley, Nevada in the fourth quarter of The exploration well reached a total depth of 5,198 feet and encountered oil shows throughout the Tertiary fractured volcanic section. The Company is conducting further analysis to determine if additional work is justified. Page 4 of 13

5 COASTAL ENERGY COMPANY (formerly PetroWorld Corp.) MANAGEMENT DISCUSSION AND ANALYSIS Years ended December 31, 2006 and 2005 (All amounts are expressed in thousands of US dollars unless otherwise stated) Selected Annual Information Years ended December 31, Operating Expenses $2,787 $418 $79 Share of (earnings) loss of Apico, LLC (371) Foreign exchange loss 1, Net Loss 4, Per share basic and diluted $(0.02) $(0.00) $(0.00) Working capital (deficit) 14,020 (10,983) (3,562) Total assets 132,064 13,664 5,944 PetroWorld issued enough shares to NuCoastal so that control of the Company passed to the shareholder of NuCoastal. As a result, and in accordance with Canadian GAAP, the NuCoastal Acquisition was accounted for as a reverse takeover ( RTO ) that constitutes a business combination, with NuCoastal being identified as the acquirer for accounting purposes. As such, the comparative information contained in Selected Annual Information and Results from Operations below is that of NuCoastal. Total assets increased from $13.7 million at December 31, 2005 to $132.0 million at December 31, The increase is primarily related to cash and cash equivalents, which increased by $18.2 million from $0.1 million at December 31, 2005 to $18.3 million at December 31, 2006, investment in and advances to Apico, which increased by $36.3 million from $7.7 million at December 31, 2005 to $44.0 million at December 31, 2006 and property, plant and equipment, which increased by $64.0 million from $4.8 million at December 31, 2005 to $68.8 million at December 31, The vast majority of the increase in cash and cash equivalents was the result of net proceeds received from the Offering, which totalled $29.2 million. The increase in investment in and advances to Apico was the result of 4 components: the fair value of the 36,419,562 common shares issued to PHG pursuant to the Apico Acquisition was $22.0 million, a total of $11.2 million was invested in Apico as a result of cash calls related to its Thailand properties, of which $5.7 million was advanced directly to Apico by NuCoastal s shareholder, the fair value of the 4,726,000 common shares issued to PHG was $2.7 million and the Company s share of Apico s Income for the year ended December 31, 2006 was $0.4 million. Oil and gas properties increased by $58.9 million as a result of the NuCoastal Acquisition, (including properties acquired from PetroWorld) and $4.5 million incurred on oil and gas properties during the period. Cash Flow Analysis The increase in cash and cash equivalents of $18.2 million during the year ended December 31, 2006 was primarily the result of net proceeds of $29.2 million received for the equity offering. The Company also acquired $0.6 million of cash via the NuCoastal Acquisition. Items partially offsetting the increase were amounts spent on the property, plant and equipment of $1.3 million, cash payments of $10.9 million to Apico (of which $5.7 million were made by NuCoastal s shareholder as advances to the Company prior to the NuCoastal Acquisition) and net cash outflow of $5.6 million due to operating activities. Summary of Quarterly Results Q4 Q3 Q2 Q1 Q4 Q3 Q2 Q1 Operating expenses $2,588 $140 $23 $36 $224 $59 $58 $78 Share of (earnings) loss of Apico LLC (583) Foreign exchange (gain) loss 1,763 (38) (19) (68) (91) (7) Net (income) loss $3,768 $225 $83 $(22) $176 $95 $202 $123 Per share basic & diluted $0.02 $- $- $- $- $- $- $- Page 5 of 13

6 COASTAL ENERGY COMPANY (formerly PetroWorld Corp.) MANAGEMENT DISCUSSION AND ANALYSIS Years ended December 31, 2006 and 2005 (All amounts are expressed in thousands of US dollars unless otherwise stated) As previously discussed the amounts reported prior to September 25, 2006 are the historical information of NuCoastal Thailand Limited. Subsequent to September 25, 2006 the amounts reported include the results of PetroWorld. (a) Operating Expenses The increase in Q was primarily the result of the consolidation of operations of PetroWorld and NuCoastal (effective September 25, 2006) combined with additional professional fees, regulatory and listing fees and stock based compensation. The increase in Q was primarily the result of increased regulatory & listing fees. The increase in Q was primarily the result of increased professional fees. (b) Share of (earnings ) loss of Apico LLC Under the equity method of accounting, the Company records its share of net income / loss of Apico based on the reported quarterly net income / loss of Apico. Apico recorded its first quarter of profitability in Q4 2006, when the Phu Horm gas field began production. (c) Foreign exchange (gain) loss The foreign exchange gain/loss is a result of the Company carrying out transactions and maintaining certain assets and liabilities in currencies other than the US Dollar, including the Canadian Dollar, the British Pound and the Thai Baht. $0.9 million of the FX loss is attributable to the revaluation of the long-term Thailand tax liability created by the reverse takeover of PetroWorld. $0.7 million of the FX loss is attributable to the revaluation of the cash and cash equivalents as at December 31, 2006 which are held in non-us currencies. Liquidity and Capital Resources As at December 31, 2006, the Company had working capital of $14.0 million including cash and cash equivalents of $18.4 million, which, in management s opinion, is sufficient to cover ongoing obligations as they become due. Beginning with December 2006, Apico has been self-funding as a result of production from its Phu Horm interest and the Company has not had to make additional advancements to or investments in Apico. The Company presently has earnings from its interest in Apico, which is accounted for under the equity method on the income statement. In order to put the offshore Gulf of Thailand property into commercial production, substantial capital will be required. The additional sources of capital presently available to the Company for development are from the sale of equity or borrowings under a potential credit facility. (a) Share Capital 1,000,000,000 common shares with par value of $0.01 each As discussed in detail above, the Company issued the following shares of common stock on September 25, 2006: 151,663,323 for $33.8 million pursuant to the NuCoastal Acquisition 36,419,562 for $22.0 million pursuant to the Apico Acquisition 63,000,000 for $36.6 million pursuant to the Equity Offering As of the date of this report, the Company had 307,932,888 common shares outstanding. (b) Stock Options Following the reverse takeover of PetroWorld, the Company assumed all of PetroWorld s fully vested stock options. During 2006, the Company granted 12,100,000 stock options and 100,000 options were exercised leaving 15,250,000 options outstanding and exercisable per the following table: Page 6 of 13

7 COASTAL ENERGY COMPANY (formerly PetroWorld Corp.) MANAGEMENT DISCUSSION AND ANALYSIS Years ended December 31, 2006 and 2005 (All amounts are expressed in thousands of US dollars unless otherwise stated) Outstanding & Remaining Exercisable Exercise Price Expiry Date Contractual Life 1,350,000 $0.19 ( 0.10) January 25, Years 1,800,000 $0.66 ( 0.35) July 6, Years 12,100,000 $0.47 (Cdn0.55) December 27, Years 15,250,000 (c) Warrants Following the reverse takeover of PetroWorld, the Company assumed all of PetroWorld s warrants. There were no warrant transactions during the year ended December 31, The following table summarizes the outstanding and exercisable warrants at December 31, 2006: Outstanding & Exercisable Exercise Price Expiry Date 1,125,000 $0.66 ( 0.35) January 20, 2007 * 214,350 $0.66 ( 0.35) July 20, ,375,000 $1.31 ( 0.70) July 20, ,714,350 * All 1,125,000 warrants expired unexercised on January 20, 2007 Off-Balance Sheet Arrangements The Company has no off-balance sheet arrangements. Related Party Transactions Pursuant to the NuCoastal Acquisition, PetroWorld paid a success fee of $568 to Endeavour Financial International Corp. ( EFIC ), a company in which an officer and director was also an officer of PetroWorld. This amount was recorded in the liabilities acquired upon the acquisition of PetroWorld A non-executive director of the Company is an officer and director of a company which is the temporary operator of the Company s working interest in Gabbs Valley, Nevada. Included in accounts payable and accrued liabilities at December 31, 2006 and 2005 were $56 and $Nil, respectively, owed to this operator. These transactions, occurring in the normal course of operations, are measured at the exchange amount, which is the amount of consideration established and agreed to by the related parties. Commitments and Contingencies The Company is committed to payments under operating lease agreements for office space as follows: Year 2007 $ NuCoastal s shareholder provided a Letter of Credit to the Thailand Customs Department on behalf of the Company. This letter of credit, for $0.5 million, has not been drawn on and remains outstanding as of December 31, The Company is from time to time involved in various claims, legal proceedings and complaints arising in the ordinary course of business. The company does not believe that adverse decisions in any pending or threatened proceedings related to any matter, or any amount which it may be required to pay by reason thereof, will have a material effect on the financial condition or future results of operations of the Company. Page 7 of 13

8 COASTAL ENERGY COMPANY (formerly PetroWorld Corp.) MANAGEMENT DISCUSSION AND ANALYSIS Years ended December 31, 2006 and 2005 (All amounts are expressed in thousands of US dollars unless otherwise stated) Financial Instruments The Company s financial instruments are comprised of cash and cash equivalents, accounts receivable, amounts due to joint interest partners, amounts due to shareholder and accounts payable. The fair values of the financial instruments approximate their carrying values due to their short term nature. It is management s opinion that the Company is not exposed to interest risk arising from these financial instruments, but is exposed to currency, commodity and credit risk. The Company does not use derivative instruments to reduce these risks. Critical Accounting Policies and Estimates The Company s financial statements are prepared in accordance with Canadian GAAP, which require management to make judgments, estimates and assumptions which may have a significant impact on the financial statements. A detailed summary of the Company s significant accounting policies is included in Note 2 to the Consolidated Financial Statements. The following is a discussion of those accounting policies and estimates that are considered critical in the determination of the Company s financial results. (a) Capital Assets Full Costs Accounting The Company follows the full cost method of accounting as described in Note 2 to the Consolidated Financial Statements. Alternatively, the Company could follow the successful efforts method of Accounting whereby all costs related to non-productive wells were expensed in the period in which they were incurred. Under the full cost method of accounting, capitalized costs are subject to a country-by-country cost centre impairment test. Under the successful efforts method of accounting, the costs are aggregated on a property-by-property basis and the carrying value for each property is subject to an impairment test. These policies may result in a different carrying value for capital assets and a different net income. The Company has elected to follow the full cost method. Under full cost accounting, a limit is placed on the carrying value of the net capitalized costs in each cost centre in order to test impairment. Impairment exists when the carrying value of developed properties of a cost centre exceeds the estimated undiscounted future net cash flows associated with the cost centre s proved reserves. Costs relating to undeveloped properties are subject to individual impairment assessments until it can be determined whether or not proved reserves exist. If impairment is determined to exist, the costs carried on the balance sheet in excess of the discounted future net cash flows associated with the cost centre s proved plus probable reserves are charged to income. (b) Reserve Estimates Reserve estimates can have a significant impact on net income and the carrying value of capital assets. The process of estimating reserves requires significant judgment based on available geological, geophysical, engineering, and economic data, projected rates of production, estimated commodity price forecasts and the timing of future expenditures, all of which are subject to interpretation and uncertainty. Reserve estimates impact net earnings through depletion expense and the application of impairment tests. Revisions or changes in reserve estimates can have either a positive or negative impact on net income and can impact the carrying amounts of capital assets. (c) Asset Retirement Obligations The Company recognizes the estimated fair value of future retirement obligations associated with capital assets as a liability. The Company estimates the liability based on the estimated costs to abandon and reclaim its net ownership in tangible long-lived assets such as wells and facilities and the estimated timing of the costs to be incurred in future periods. Actual payments to settle the obligations may differ from estimated amounts. Page 8 of 13

9 COASTAL ENERGY COMPANY (formerly PetroWorld Corp.) MANAGEMENT DISCUSSION AND ANALYSIS Years ended December 31, 2006 and 2005 (All amounts are expressed in thousands of US dollars unless otherwise stated) (d) Stock-based Compensation The Company has a share option plan and uses the fair value method of accounting for all stock-based awards to non-employees and employees, including those that are direct awards of stock. Under the fair value method, employee compensation expense attributed to direct awards of stock is measured at the fair value of the award at the grant date using the Black-Scholes option-pricing model and is recognized over the vesting period of the award. If and when the stock options are ultimately exercised, the applicable amounts of contributed surplus are credited to share capital. (e) Income Taxes Future income taxes are recorded using the asset and liability method. 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 amounts of existing assets and liabilities and their respective tax bases. Future tax assets and liabilities are measured using the enacted or substantively enacted tax rates expected to apply when the asset is realized or the liability settled. The effect on future tax assets and liabilities of a change in tax rates is recognized in income in the period that substantive enactment or enactment occurs. To the extent that the Company does not consider it more likely than not that a future tax asset will be recovered, it provides a valuation allowance against the excess. Risks and Uncertainties (a) Going Concern The accompanying audited consolidated financial statements have been prepared by management in accordance with Canadian GAAP on a going concern basis, which assumes that the Company will continue in operation for the foreseeable future and accordingly will be able to realize its assets and discharge its liabilities in the normal course of operations. The Company is currently a development stage entity and has no direct revenue from production; however, the Company has earnings from its interest in Apico, which is accounted for under the equity method on the income statement. The Company s ability to continue as a going concern is dependent upon its ability to obtain additional financing or bring one of its resource properties into commercial production and ultimately achieve profitable operations. Although to date the Company has been successful in obtaining financing, there can be no assurance that the Company will be successful in raising additional share capital or generating revenue to generate sufficient cash flows to continue as a going concern. (b) Trends In recent years, the petroleum and natural gas exploration industry has seen significant growth, primarily as a result of increased global demand, led by India and China. During this period, prices for petroleum have steadily increased, resulting in multi-year price highs. Prior to this recent surge, large companies found it more feasible to grow their reserves and resources by purchasing companies or existing oilfields. However, with improving prices and increasing demand, a discernible need for the development of exploration projects has arisen. Junior companies have become key participants in identifying properties of merit to explore and develop. (c) Risks and Uncertainties The Company is subject to a number of risk factors due to the nature of the petroleum and gas business in which it is engaged, not the least of which are adverse movements in commodity prices, which are impossible to forecast. The Company is also subject to the oil and gas services sector which, at the present, has limited available capacity and therefore may demand premium rates. The Company seeks to counter these risks as far as possible by selecting exploration areas on the basis of their recognized geological potential to host economic returns. (d) Industry The Company is engaged in the acquisition of petroleum and natural gas properties, an inherently risky business, and there is no assurance that an economic petroleum and natural gas deposit will ever be Page 9 of 13

10 COASTAL ENERGY COMPANY (formerly PetroWorld Corp.) MANAGEMENT DISCUSSION AND ANALYSIS Years ended December 31, 2006 and 2005 (All amounts are expressed in thousands of US dollars unless otherwise stated) discovered and subsequently put into production. Most exploration projects do not result in the discovery of commercially viable petroleum and natural gas deposits. The geological focus of the Company is on areas in which the geological setting is well understood by management. (e) Petroleum and Gas Prices The price of petroleum and natural gas is affected by numerous factors beyond the control of the Company including global consumption and demand for petroleum and natural gas, international economic and political trends, fluctuations in the U.S. dollar and other currencies, interest rates, and inflation. While prices for petroleum and natural gas have increased significantly since the start of 2003, there is no assurance that this trend will continue or that current prices will be sustained. (f) Cash Flows and Additional Funding Requirements The Company presently has earnings from its interest in Apico, which is accounted for under the equity method on the income statement. In order to put the offshore Gulf of Thailand property into commercial production, substantial capital will be required. The sources of capital presently available to the Company for development are from the sale of equity or borrowings under a potential credit facility. The Company has sufficient financial resources to undertake its firm obligations for the next 12 months. (g) Environmental The Company s exploration activities are subject to extensive laws and regulations governing environmental protection. Although the Company closely follows and believes it is operating in compliance with all applicable environmental regulations, there can be no assurance that all future requirements will be achievable on reasonable terms. Failure to comply may result in enforcement actions causing operations to cease or be curtailed and may include corrective measures requiring capital expenditures. (h) Laws and Regulations The Company s exploration activities are subject to local laws and regulations governing prospecting, drilling, development, exports, taxes, labour standards, occupational health and safety, and other matters. Such laws and regulations are subject to change, can become more stringent and compliance can therefore become more costly. There are also many risks associated with operations in international markets, including changes in foreign governmental policies relating to crude oil and natural gas taxation, other political, economic or diplomatic developments, changing political conditions and international monetary fluctuations. These risks include: political and economic instability or war; the possibility that a foreign government may seize our property with or without compensation; confiscatory taxation; legal proceedings and claims arising from our foreign investments or operations; a foreign government attempting to renegotiate or revoke existing contractual arrangements, or failing to extend or renew such arrangements; fluctuating currency values and currency controls; and constrained natural gas markets dependent on demand in a single or limited geographical area. The Company applies the expertise of its management, its advisors, its employees and contractors to ensure compliance with current local laws. (i) Title to Resource Properties While the Company has undertaken customary due diligence in the verification of title to its resource properties, this should not be construed as a guarantee of title. The properties may be subject to prior unregistered Petroleum Agreements or transfers and title may be affected by undetected defects. (j) Dependence on Management The Company strongly depends on the business and technical expertise of its management team and there is little possibility that this dependence will decrease in the near term. Page 10 of 13

11 COASTAL ENERGY COMPANY (formerly PetroWorld Corp.) MANAGEMENT DISCUSSION AND ANALYSIS Years ended December 31, 2006 and 2005 (All amounts are expressed in thousands of US dollars unless otherwise stated) New Accounting Pronouncements (a) Comprehensive income The Canadian Institute of Chartered Accountants (CICA) issued Section 1530 of the CICA Handbook, Comprehensive Income which is effective for fiscal years beginning on or after October 1, It describes how to report and disclose comprehensive income and its components. Comprehensive income is the change in a company s net assets that results from transactions, events and circumstances from sources other than the company s shareholders. It includes items that would not normally be included in net earnings, such as: changes in the currency translation adjustment relating to self-sustaining foreign operations; unrealized gains or losses on available for-sale investments. The CICA also made changes to Section 3250 of the CICA handbook, Surplus, and reissued it as Section 3251, Equity. The section is also effective for fiscal years beginning on or after October 1, The changes in how to report and disclose equity and changes in equity are consistent with the new requirements of Section 1530, Comprehensive Income. Management does not believe that the adoption of this section will have a material impact on the financial statements. (b) Financial Instruments The CICA issued Section 3855 of the CICA Handbook, Financial Instruments Recognition and Measurement and Section 3861 Financial Instruments Disclosure and Presentation. These sections are effective for fiscal years beginning on or after October 1, It describes the standards for recognizing and measuring financial assets, financial liabilities and non-financial derivatives. These sections require that: all financial assets be measured at fair value, with some exceptions like loans and investments that are classified as held-to-maturity; all financial liabilities be measured at fair value if they are derivatives or classified as held for trading purposes. Other financial liabilities are measured at fair value; all derivative financial instruments be measured at fair value, even when they are part of a hedging relationship; and establish presentation and disclosure standards for financial instruments and non-financial derivatives. The Company is still in the process of evaluating whether the adoption of the sections will have a material effect on the Company s financial statements. (c) Hedges The CICA recently issued Section 3865 of the CICA Handbook, Hedges. The section is effective for fiscal years beginning on or after October 1, 2006, and describes when and how hedge accounting can be used. Hedging is an activity that may be used by a company to change an exposure to one or more risks by creating an offset between: changes in the cash flows attributable to a hedged item and a hedging item, or changes resulting from a risk exposure relating to a hedged item and a hedging item. Hedge accounting makes sure that all gains, losses, revenues and expenses from the derivative and the item it hedges are recorded in the statement of operations in the same period. Management does not believe that the adoption of this section will have a material impact on the financial statements. Page 11 of 13

12 COASTAL ENERGY COMPANY (formerly PetroWorld Corp.) MANAGEMENT DISCUSSION AND ANALYSIS Years ended December 31, 2006 and 2005 (All amounts are expressed in thousands of US dollars unless otherwise stated) (d) Accounting Changes The Accounting Standard Board has replaced section 1506, Accounting Changes, with a new section based on International Accounting Standards 8, Accounting Policies, changes in Accounting Estimates and Errors. The main features of the new sections are as follows: Voluntary changes in accounting policy are made only if they result in the financial statements providing reliable and more relevant information. Changes in accounting policies are applied retrospectively unless doing so is unpractical. Prior period errors are corrected retrospectively. New disclosures are required in respect of changes in accounting policies, changes in accounting estimates and correction of errors. The standard is effective for fiscal years beginning on or after January 1, Management does not believe that the adoption of this section will have a material impact on the financial statements. Disclosure Controls and Procedures Disclosure controls and procedures have been designed to ensure that information required to be disclosed by the Company is accumulated and communicated to the Company s management as appropriate to allow timely decisions regarding required disclosure. The Company s Chief Executive Officer and Chief Financial Officer have concluded, based on their evaluation as of the end of the period covered by the annual filings, that the Company s disclosure controls and procedures as of the end of such period are effective to provide reasonable assurance that material information related to the Company is made known to them by others within the Company. It should be noted that while the Company s Chief Executive Officer and Chief Financial Officer believe that the Company s disclosure controls and procedures provide a reasonable level of assurance that they are effective, they do not expect that the disclosure controls and procedures will prevent all errors and fraud. A control system, no matter how well conceived or operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Internal Control over Financial Reporting In addition, the certifying officers of the Company are responsible for designing internal controls over financial reporting or causing them to be designed under their supervision in order to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with Canadian GAAP. Following the acquisition of PetroWorld, work is ongoing to improve and modernize these controls and to ensure that they remain consistently applied. The Company realized that with the increasing complexity of the business and more demanding filing requirements of the TSX that additional financial personnel were needed. As a result, the Company hired a new Controller on November 3, 2006 and has implemented plans for the availability of dedicated resources. In 4Q 2006, the Company began implementing a consolidated oil and gas accounting system and migrating the Company s financial records onto this system. Management and the Board of Directors are working to mitigate the risk of a material misstatement in financial reporting; however, there can be no assurance that this risk can be reduced to less than a remote likelihood of a material misstatement. The Company has continually had in place systems relating to internal control over financial reporting and will continue to monitor internal controls as the Company s business evolves. The certifying officers have evaluated the design of the Company s internal control over financial reporting. Based on this evaluation as of December 31, 2006, the certifying officers have concluded that the Company s internal control over financial reporting, as defined in , is designed to provide reasonable assurance regarding the reliability of financial reporting and preparation of the financial statements for the year ended December 31, 2006, in accordance with Canadian GAAP. There has been no change in the Company s internal control over financial reporting that occurred during the most recently completed quarter that has materially affected, or is reasonably likely to materially affect, the Company s internal control over financial reporting. Page 12 of 13

13 COASTAL ENERGY COMPANY (formerly PetroWorld Corp.) MANAGEMENT DISCUSSION AND ANALYSIS Years ended December 31, 2006 and 2005 (All amounts are expressed in thousands of US dollars unless otherwise stated) Outlook The Company is continuing to work towards and continues to operate in the business segment of acquiring and exploring petroleum and natural gas properties. Page 13 of 13

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