Notes to the Consolidated Financial Statements. DeeThree Exploration Ltd Annual Report

Transcription

1 Notes to the Consolidated Financial Statements DeeThree Exploration Ltd Annual Report

2 Contents Highlights 1 Letter to Shareholders 3 Operations Review 9 Management s Discussion and Analysis 23 Management s Report 43 Independent Auditors Report 44 Financial Statements 45 Notes to Financial Statements 48 Corporate Information 60 Abbreviations and Conversion of Units IBC Corporate Profile DeeThree Exploration Ltd. is an emerging Calgary based resource company actively engaged in natural gas and crude oil exploration, development and production in key areas of the Western Canadian Sedimentary Basin. DeeThree commenced operations in 2007 as a private company focused on creating long-term shareholder value through prudent operational and financial management. On June 25, 2009, DeeThree completed a reverse takeover of Royal Capital Corp., a public capital pool company, thereby providing liquidity for shareholders and the opportunity for the Company to expand its future growth programs. DeeThree has created a platform for growth through a sound business strategy that includes low risk development, high impact exploration and strategic acquisitions. In the Company s core operating area located in the Lethbridge region of southern Alberta, DeeThree is shifting focus from the shallow gas potential of its extensive land base to the prospective Bakken light oil. The newly acquired Brazeau, West Pembina and Peace River Arch areas of Alberta are prospective for natural gas, light crude oil and natural gas liquids, providing the Company with a more balanced and diverse production base. Common shares of DeeThree Exploration Ltd. are listed for trading on the Toronto Stock Exchange under the symbol DTX.

3 Shifting Focus Highlights Years Ended December 31, Change 2008 (000s, except per share amounts) ($) ($) (%) ($) Financial Oil and gas revenues 7,073 5, ,649 Funds from operations (1) 1,607 1, Per share basic and diluted (13) 0.03 Net loss 6,714 2, Per share basic and diluted Capital expenditures 22,193 8, ,773 Working capital (deficiency) 28, ,501 (2,710) Shareholders equity 66,767 24, ,676 (000s) (#) (#) (%) (#) Share Data (2) At year-end 32,937 15, ,965 Weighted average basic and diluted 23,102 13, ,965 (%) Operating Production Natural gas (mcf/d) 4,258 3, Crude oil and NGLs (bbls/d) Total (boe/d) Average wellhead prices Natural gas ($/mcf) Crude oil and NGLs ($/bbl) Total ($/boe) Operating cost ($/boe) Operating netback ($/boe) Reserves Proved (mboe) 1,327 1,713 (23) 952 Proved plus probable (mboe) 1,599 2,060 (22) 1,178 Total net present value proved plus probable (10% discount, before tax) ($000s) 19,435 29,271 (34) 23,449 Gross (net) wells drilled Gas (#) 5 (5.0) 8 (8.0) (38) (-38) ( ) Oil (#) 2 (2.0) ( ) ( ) ( ) Standing (#) 1 (1.0) ( ) ( ) ( ) Dry and abandoned (#) 8 (8.0) 2 (2.0) 300 (300) ( ) Total (#) 16 (16.0) 10 (10.0) 60 (60) ( ) Average working interest (%) (1) Funds from operations and funds from operations per share are not recognized measures under Canadian generally accepted accounting principles. Refer to the commentary in the Management s Discussion and Analysis under the heading Non-GAAP Terms for further discussion. (2) Shares outstanding have been adjusted to reflect the reverse takeover as described in note 1 to the financial statements as if it occurred at the beginning of the year. (3) Product prices include realized gains/losses from physical fixed priced contracts. (4) For a description of the boe conversion ratio, refer to the commentary in the Management's Discussion and Analysis under the heading Other Measurements.

4 For DeeThree, 2010 was a year of significant change: a year of exciting accomplishments as well as drilling challenges, but ultimately a year that saw the Company make a strategic shift in focus.

5 Shifting Focus Letter to Shareholders Looking Back In late 2008, DeeThree Exploration Ltd. acquired an impressive start-up package in the Lethbridge, Alberta area. The acquisition included base production of 500 boe/d (99% natural gas), 220,000 acres of undeveloped land, ownership in over 200 kilometres of pipelines along with six booster compressor stations and two gas processing/sales facilities. The original three-year development commitment required the Company to drill 30 wells (ten wells per year) and shoot four townships of 3-D seismic data over the term of the commitment. We began developing our shallow gas prospects in the area, which offered a diverse assortment of exploration and development targets with multi-zone potential. DeeThree achieved great success throughout 2009 developing these horizons, substantially improving our Company s oil and gas revenues, growing production and increasing reserves, but 2010 proved to be more of a challenge. Drilling results fell short of our expectations and, coupled with depressed natural gas prices, we saw a reduction to the Company s reserves base and resulting net present value. In the spring of 2010, interest began heating up in the area due to the potential of the Alberta Bakken light oil play. Although we were aware of this resource play from existing test data, we did not expect the sudden surge in industry interest and activity. Area land sale prices soared from under $100 per acre to over $1,800 per acre, with major industry players investing over $180 million on Crown land in the southern Alberta Bakken fairway. DeeThree s land position and infrastructure was in the heart of the play. Understanding the Bakken The Alberta Bakken light oil play stretches over 250 kilometres from southern Alberta into Montana and shares many geological characteristics with the Saskatchewan Bakken. The Bakken interval is characterized by a series of regionally extensive, organic-rich mudstones, siltstones and sandstones capped by the Banff formation carbonates. The Exshaw shale is a regionally significant hydrocarbon source rock and is thermally mature in the Lethbridge area where DeeThree has substantial land holdings. Horizontal multi-stage fracturing technology is targeting light oil (>35 API gravity) generated and trapped within the Bakken and Exshaw formations at depths ranging from 1,350 to 2,125 metres. Potential also exists within the Mississippian Lodgepole, Devonian Big Valley (Three Forks) and Devonian

6 DeeThree Exploration Ltd Annual Report Nisku formations. DeeThree has estimated ultimate recovery is potentially 200,000 barrels of oil per well at an all-in drilling cost starting at approximately $3.5 million each. In terms of economics, these wells could be very profitable, especially with current oil prices. Shifting Focus With the Alberta Bakken set to become the next emerging light oil resource play in Western Canada, and given DeeThree s 250+ sections of prospective land at Lethbridge along with ownership of extensive facilities and pipeline infrastructure over the area, our Company began shifting focus from the shallow gas potential of our land base to prospective Bakken light oil. To support this shift, in April 2010, the Company successfully negotiated a two-year extension to the original term lease agreement. The extension involved a commitment to drill an additional 20 wells (ten wells per year). Consequently, we spent a great deal of time and effort throughout 2010 evaluating our land base and the Bakken potential. In June, we further enhanced the DeeThree technical team through the addition of Mr. Clayton Thatcher (geophysicist), and subsequent to year-end, Mr. Tyler Klatt (geologist). Both of these professionals have extensive experience in the area and are welcome additions to our Company. DeeThree also completed three equity financings throughout the year totaling $52 million, thereby continuing to maintain a strong balance sheet as we move into the development of this new resource play. In December, we spud our first planned vertical stratigraphic well into the deeper Bakken zones. The well was successfully drilled to the planned vertical depth with the target section cored, retrieved and analyzed. Subsequent to year-end, we successfully drilled a horizontal leg, and with continued positive results, installed a 15-stage frac assembly. The well is currently awaiting fracture stimulation operations. DeeThree has two additional licenced stratigraphic vertical wells that will be cored along with testing additional land blocks, and we are currently in various stages of acquiring several multi-well pad sites. Throughout 2011, our Company plans to drill another six Bakken locations on our Lethbridge

7 Shifting Focus DeeThree s large, prospective land base and ownership of extensive facilities and pipeline infrastructure in the Lethbridge area have ideally positioned the Company to capitalize on the emerging Bakken oil play. LEGEND DeeThree Land Recent Land Sales DeeThree Initial Bakken Focus Area Bakken Light Oil Fairway Lethbridge Bakken Change in Environment DeeThree Operated Pipelines Bakken Penetrations Recent Bakken Licences DeeThree Bakken Horizontal Wells ALBERTA SASKATCHEWAN MANITOBA Lethbridge Alberta Bakken Bakken Shale ND Bakken Potential MONTANA Williston Basin SD

8 DeeThree Exploration Ltd Annual Report property, utilizing one dedicated rig with the possibility of engaging a second rig depending on results. We expect to follow up each of the vertical wells with multi-lateral horizontal wellbores and the implementation of multi-stage fracturing completion technology. Looking Ahead On March 22, 2011 (and effective January 1, 2011), DeeThree acquired approximately 1,830 boe/d (40% light crude oil and NGLs) of primarily high working interest, operated production and reserves in the Brazeau, West Pembina and Peace River Arch areas of west central and northwestern Alberta, respectively, for cash consideration of $125 million. The acquisition was financed through a combination of net proceeds of $122.5 million from a bought deal common share offering as well as existing working capital. This acquisition of producing assets is highly strategic to our Company s future growth and complements our emerging Alberta Bakken light oil play, providing an additional high quality resource play along with a more balanced and diverse production base. (More detailed information on the acquired assets is included in the Operations Review section of this report.) We will continue to pursue strategic acquisitions that are complementary to our operations, while offering productivity enhancement potential and additional exploratory acreage that also meet our strict financial criteria. For 2011, the Company had an approved capital budget of $32 million for operating activities in our core Lethbridge area; however, with the closing of our newly acquired properties, the Board approved an increase of $10 million to include the drilling of an additional six horizontal wells in the Brazeau and Peace River Arch areas. We expect that this program will be funded through our current working capital, increased credit facility and internally generated cash flow. With a shift in focus towards Bakken oil along with our newly acquired properties, it is anticipated that by the end of 2011, DeeThree will be a more balanced resource company with approximately 60% light crude oil and NGLs production. DeeThree is well positioned to capitalize on the emerging Alberta Bakken light oil resource play with its enviable land position and supporting infrastructure in the area. The Bakken offers our Company tremendous opportunity and value, which is being reflected in our stock price that has increased 187% over the past year to as high as $5.45 per

9 Shifting Focus The Bakken offers our Company tremendous opportunity and value, which is being reflected in our stock price that has increased 187% over the past year. DeeThree Stock Price ($/share) share. This potential value, however, has yet to be reflected in our Company s reserves evaluation. In closing, we believe DeeThree has the financial flexibility, the focused strategy and the right team in place to take advantage of the opportunities that lie before us. I sincerely thank our board members, employees, consultants and business associates for their efforts over the past year. To our shareholders, I thank you for your continued support and confidence in our Company. This is an extremely exciting time for DeeThree. We clearly have momentum and we have great people who are dedicated to making 2011 a rewarding and successful year JAN FEB MAR APR MAY JUN JUL AUG SEP OCT NOV DEC JAN FEB On behalf of the Board of Directors, Martin Cheyne President & Chief Executive Officer March 24, 2011

10 DeeThree Exploration Ltd Annual Report Given the current weak natural gas price environment, DeeThree s operational strategy is shifting focus to the emerging Alberta Bakken light oil resource play as well as to oil and liquids properties recently acquired in central and northwestern Alberta, providing a more balanced product portfolio.

11 Shifting Focus Operations Review Operational Strategy Since commencing active operations in 2007, DeeThree has created value by focusing its efforts in a well-defined core area Lethbridge, Alberta and maintaining majority ownership in production, reserves, infrastructure, seismic data and undeveloped land. During the current weak natural gas price environment, DeeThree s 2011 operational efforts on low risk development and seismically directed natural gas opportunities will be minimized. Instead, the Lethbridge area will now play focus to an emerging deep, unconventional light oil play in the Bakken formations. With its large area land base, DeeThree is well positioned to exploit and develop this emerging oil play, which will govern the majority of the Company s operations in 2011 and beyond. During the first quarter of 2011, DeeThree acquired producing assets (40% light crude oil and NGLs) at Brazeau in Alberta s West Pembina region and in the Peace River Arch area of northwestern Alberta. This acquisition is highly strategic to the Company s future growth and complements its emerging Alberta Bakken light oil play, providing an additional high quality resource play along with a more balanced product portfolio. Northern Alberta Peace River Arch Brazeau/ West Pembina Lethbridge Edmonton Calgary

12 DeeThree Exploration Ltd Annual Report Property Focus: Lethbridge Multi-Zone Targets Barons: Gas Bow Island: Gas Ravinement Surface Upper Bow Island Mannville: Gas & Oil Upper Mannville Tight Channels Lower Bow Island Sunburst Channel Sands Upper Mannville Lower Mannville Reardon Mississippian: Oil Mississippian Unconformity Bakken: Oil Big Valley: Oil Reardon Lower Banff Bakken

13 Shifting Focus Shifting Focus Property Focus: Lethbridge The Lethbridge area is characterized as having multi-zone, relatively shallow and underexploited potential, providing a solid base of natural gas production. During 2011, however, this area will play focus to an emerging deep, unconventional light oil play in the Bakken formations. L E G E N D DeeThree Land DeeThree Facilities DeeThree Operated Pipelines DeeThree Operated Wells DeeThree 3-D Seismic Lethbridge 100 producing wells (97% average working interest) 540 boe/d year-end production Multi-zone gas from the shallow Milk River, Medicine Hat, Barons, Bow Island and Sunburst formations Multi-zone light crude oil from the deep Bakken, Exshaw, Mississippian Lodgepole, Devonian Big Valley (Three Forks) and Devonian Nisku formations 222,000 net acres of undeveloped land 100% ownership in gas transportation and processing infrastructure

14 DeeThree Exploration Ltd Annual Report The Lethbridge operating area is located approximately 216 kilometres southeast of Calgary, Alberta and is accessible year round. The Company entered this area in November 2008 through a property acquisition and development commitment to a major producer. The Lethbridge area is characterized as having multi-zone, relatively shallow and underexploited potential in the Milk River, Medicine Hat, Barons, Bow Island and Sunburst formations, providing a solid base of natural gas production. Additionally, significant exploration and development upside exists in the deeper Cretaceous, Jurassic and Mississippian intervals, which were confirmed by DeeThree s drilling results in 2009 and Along with the predictable production base, the property includes ownership in significant underutilized gas transportation and processing infrastructure. Ownership in the related infrastructure (including over 200 kilometres of pipelines, six booster compressor stations and two gas processing/sales facilities) is a key strategic feature of the property that reduces the Company s cost structure for the area, offers the potential for future gas processing revenues and minimizes on-stream times. DeeThree has leased approximately 248,000 net acres (including 222,000 undeveloped acres) from the freehold lessor and has obtained ownership in seismic data covering a large portion of the lands. Under the terms of the commitment, the Company is required to drill 30 wells in the area over a three-year period commencing November 14, 2008 (ten wells per year). In addition, DeeThree has committed to shooting four townships of seismic data over the same period (one township in year one, two townships in year two and one township in year three). On April 13, 2010, the Company executed a two-year extension to its amended lease agreement, which is part of a lease issuance, seismic and drilling commitment agreement. This extension involves a commitment to drill an additional 20 wells over the two-year period (ten wells per year) into the Mississippian horizon and expires on November 13, During 2010, DeeThree made significant strides towards fulfilling its seismic and drilling commitment. Building off the success of its 2009 drilling program, which included new seismically identified pools, DeeThree s exploration and development activities in 2010 continued with the drilling of 16 gross (16.0 net) wells. As at December 31, 2010, DeeThree drilled 26 of the original 30 commitment wells and had completed over 90% of the total seismic commitment. With the 3-D seismic data obtained during the Company s 2009 program, DeeThree directed its 2010 drilling towards evaluating numerous play types and zones. Of particular note was the exploration success in the Warner area, which included new seismically identified oil and natural gas pools. DeeThree also successfully added production and reserves as a result of development drilling of offsetting wells into existing producing natural gas pools. During the year, DeeThree invested significant capital in expanding its facility and pipeline infrastructure. An 18-kilometre pipeline was constructed, enabling access to a key land block in the Warner area. In addition, a refrigeration unit was installed at the Company s main sales facility, which allows for the processing of liquids-rich natural gas. Production at the beginning of 2010 from the Lethbridge area was approximately 3.9 mmcf/d or 650 boe/d. Through successful drilling activities and pipeline projects completed throughout the year, DeeThree averaged over 675 boe/d for 2010.

15 Shifting Focus DeeThree directed its 2010 drilling towards evaluating numerous play types and zones. Of particular note was the exploration success in the Warner area, which included new seismically identified oil and natural gas pools. The Lethbridge property was the primary focus of DeeThree s operations in 2010 and will continue to be a key component of the Company s business plan in 2011 and beyond. Due to depressed current and forecasted natural gas prices, DeeThree s 2011 operational efforts on low risk development and seismically directed natural gas opportunities will be minimized. Instead, the Lethbridge area will now play focus to an emerging deep, unconventional light oil play in the Bakken formations. The Bakken interval is characterized by a series of regionally extensive, organic-rich mudstones, siltstones and sandstones capped by the Lodgepole and Banff formation carbonates. The underlying Exshaw shale is a regionally significant hydrocarbon source rock and is considered thermally mature in the Lethbridge area where DeeThree has substantial land holdings. Horizontal multi-stage fracturing technology is targeting light oil (>35 API gravity) generated and trapped within the Bakken and Exshaw formations at depths ranging from 1,350 to 2,125 metres. Additionally, potential exists within the Mississippian Lodgepole, Devonian Big Valley (Three Forks) and Devonian Nisku formations. The Company is well positioned to capitalize on this emerging play with a large, prospective land base in the Lethbridge area along with ownership of extensive facilities and pipeline infrastructure over the area. In early 2011, DeeThree successfully drilled its first vertical Bakken stratigraphic test well, and with positive information from the coring data, successfully completed a horizontal leg. The well is currently awaiting fracture stimulation operations. With an additional six-well drilling program planned for the remainder of 2011, further exploration and development of the Alberta Bakken will be DeeThree s primary objective.

16 DeeThree Exploration Ltd Annual Report Property Focus: New Core Areas Peace River Arch Brazeau/ West Pembina 137 producing wells (approximately 42% average working interest) 1,830 boe/d year-end production 32,000 net acres of undeveloped land Ownership in facilities and gas processing infrastructure On March 22, 2011 (and effective January 1, 2011), DeeThree acquired approximately 1,830 boe/d (40% light crude oil and NGLs) of operated production and reserves in the Brazeau, West Pembina and Peace River Arch areas of Alberta. Numerous low risk vertical and horizontal drilling locations have been identified on 65,250 net acres of land. The acquisition provides the Company an additional high quality resource play along with a more balanced product portfolio. As at December 31, 2009, proved plus probable reserves from the acquired properties totaled mmboe, while the reserve life index, on a boe basis, was 8.1 years for the proved plus probable reserves and then current production levels. Brazeau, located in the West Pembina area of west central Alberta approximately 160 kilometres southwest of Edmonton, features year round access to a light oil resource style play with production from the Belly River formation. At January 1, 2011, the Brazeau property consisted of approximately 23,600 net acres of land (11,800 net undeveloped acres), 1,107 boe/d of net productive capacity, 3,748 mmboe of Company interest proved plus probable reserves, 63 producing wells along with associated facilities and infrastructure ownership. DeeThree maintains an average 80% working interest in the area. During 2011, the Company expects to horizontally drill three light oil locations at Brazeau. The Peace River Arch area in northwestern Alberta is comprised of six different producing properties with Valhalla/Rycroft being the single largest producing property. The area provides DeeThree stable, diversified production from the Montney, Charlie Lake, Bluesky, Spirit River and Doe Creek formations. The asset package gives the Company access to a production and land base in which its technical team has extensive experience and success in exploring and developing. At January 1, 2011, the Peace River Arch area consisted of approximately 68,000 net acres of land (20,708 net undeveloped acres), 724 boe/d of net productive capacity, 1,693 mmboe of Company interest proved plus probable reserves, 74 wells producing along with ownership in associated facilities and infrastructure, including a gas processing plant. The Company maintains an average 42% working interest in the area. During 2011, DeeThree plans to drill three horizontal wells in the Peace River Arch area, targeting Montney light crude oil.

17 Shifting Focus Property Focus: Balsam, Chinchaga, Killam Chinchaga Balsam Killam 5 producing wells (46% average working interest) 46 boe/d year-end production 1,528 net acres of undeveloped land At Balsam, Chinchaga and Killam, Alberta, DeeThree maintains an average 46% working interest in operations. The Balsam area, which is located approximately 570 kilometres northwest of Edmonton, is primarily accessible in winter. At December 31, 2010, the Balsam property consisted of approximately 608 net acres of land (456 net undeveloped acres), 15 boe/d of net productive capacity, 29.9 mmboe of Company interest proved plus probable reserves and one producing well. DeeThree maintains an average 95% working interest in the area. Located approximately 700 kilometres northwest of Edmonton, Chinchaga is also a winter access area. At December 31, 2010, the Chinchaga property consisted of approximately 1,080 net acres of land (432 net undeveloped acres), 16 boe/d of net productive capacity and three wells producing. The Company maintains an average 33.75% working interest in the Chinchaga area. Killam, located in central Alberta approximately 350 kilometres northeast of Calgary, features year round access. At December 31, 2010, the Killam property consisted of approximately 220 net acres of land, 15 boe/d of net productive capacity, 19.2 mmboe of Company interest proved plus probable reserves and one producing well. DeeThree maintains an average 33.75% working interest in the Killam area and operates its production. Year-over-year combined exit production rates from these properties remained relatively steady at approximately 46 boe/d or 6% of total corporate production in During 2010, the Company did not undertake any development activities in these areas due to its focus at Lethbridge; however, several opportunities do exist.

18 DeeThree Exploration Ltd Annual Report Sales Summary Three Months Ended December 31, Years Ended December 31, Natural gas (mcf/d) 3,691 3,636 4,258 3,257 Crude oil and NGLs (bbls/d) Total (boe/d) The Company s sales, revenue and cash flow increased slightly due to higher commodity prices and sales volumes. DeeThree s average production for 2010 was 727 boe/d. DeeThree will continue to build its drilling inventory in all areas of operation, yielding continued growth into 2011 and beyond. Land Summary Undeveloped Developed Total Gross Net Gross Net Gross Net (acres) (acres) (acres) (acres) (acres) (acres) 2010 Lethbridge 223, ,051 26,240 25, , ,585 Balsam Chinchaga 1, , ,200 1,080 Killam Other Total 226, ,579 28,970 26, , , Lethbridge 222, ,281 15,360 14, , ,935 Balsam Chinchaga 1, , ,200 1,080 Killam Other Total 225, ,809 18,090 15, , ,483 As at December 31, 2010, DeeThree controlled petroleum and natural gas leases covering 223,579 net acres of undeveloped land, a slight increase from the 222,809 net acres held at the end of Less than 5% of the Company s net undeveloped position is subject to expiry in 2011 and approximately 0.008% is subject to expiry in During 2010, DeeThree invested $485,000 for the acquisition of 11,650 net acres of petroleum and natural gas rights in the Lethbridge core area at an average cost of $39 per acre. Reserves Sproule Associates Limited ( Sproule ), an independent petroleum engineering firm, evaluated the natural gas, crude oil and NGLs reserves of the Company as at December 31, 2010 and Sproule based their evaluation on land data, well and geological

19 Shifting Focus information, reservoir studies, estimates of on-stream dates, contract information, current hydrocarbon product prices, operating cost data, capital budget forecasts and future operating plans provided by DeeThree, and prepared their report in accordance with the Canadian Securities Administrators National Instrument NI Standards of Disclosure for Oil and Gas Activities. The required disclosure of the reserves estimates and future net revenue of the Company as at December 31, 2010, based on forecast prices and costs, are outlined below along with the economic assumptions used in preparing those estimates. For purposes of computing such units, natural gas is converted to equivalent barrels of oil using a conversion factor of six thousand cubic feet of gas to one barrel of oil. This conversion ratio of 6:1 is based on an energy equivalent conversion for the individual products at the burner tip and does not represent a value equivalency at the wellhead. Such disclosures of boes may be misleading, particularly if used in isolation. Summary of Oil and Gas Reserves The following table outlines the oil and gas reserves of the Company by product type on a gross (before royalties) and net (after royalties) basis: Natural Gas Crude Oil NGLs Boe Gross Net Gross Net Gross Net Gross Net (mmcf) (mmcf) (mbbls) (mbbls) (mbbls) (mbbls) (mboe) (mboe) Proved Developed producing 6,470 5, , Developed non-producing 1, Undeveloped Total proved 7,664 6, ,327 1,098 Probable 1,543 1, Total proved plus probable 9,207 7, ,599 1,327 Note: Table may not be additive due to rounding. Net Present Values of Future Net Revenue The net present values of future net revenue of the Company s reserves at various discount rates on a before tax basis are outlined below. Before Income Taxes Discounted At 0% 5% 10% 15% 20% (000s) ($) ($) ($) ($) ($) Proved Developed producing 20,281 15,486 12,533 10,547 9,126 Developed non-producing 5,463 4,434 3,705 3,165 2,751 Undeveloped Total proved 26,352 20,432 16,675 14,091 12,209 Probable 6,509 3,997 2,760 2,055 1,609 Total proved plus probable 32,862 24,428 19,435 16,146 13,819 Note: Table may not be additive due to rounding.

20 DeeThree Exploration Ltd Annual Report Reconciliation of Company Interest Reserves by Principal Product The reconciliation of the Company s gross proved, probable and proved plus probable reserves for December 31, 2010 is as follows: Natural Gas Crude Oil Proved Proved Plus Plus Proved Probable Probable Proved Probable Probable (mmcf) (mmcf) (mmcf) (mbbls) (mbbls) (mbbls) January 1, ,151 2,041 12, Technical (1,834) (470) (2,304) 5 5 Exploration discoveries infill Drilling extensions 1, ,116 Improved recovery Acquisitions Economic factors (242) (102) (343) Production (1,545) (1,545) (6) (6) December 31, ,664 1,543 9, NGLs Total Proved Proved Plus Plus Proved Probable Probable Proved Probable Probable (mbbls) (mbbls) (mbbls) (mboe) (mboe) (mboe) January 1, , ,060 Technical (1) (1) (300) (78) (378) Exploration discoveries infill Drilling extensions Improved recovery Acquisitions Economic factors (1) (1) (41) (17) (58) Production 1 1 (263) (263) December 31, , ,600 Note: Table may not be additive due to rounding.

21 Shifting Focus Total Future Net Revenue The following table provides a breakdown of the various components of total future net revenue on an undiscounted basis for proved and proved plus probable reserves: Future Net Revenue Well Before Operating Abandonment Income Revenue Royalties Costs Costs Taxes (000s) ($) ($) ($) ($) ($) Proved , ,402 3, , , , , , , , , , , , , , , , , , , , , , , , Remainder 6, , ,861 Total proved 48,727 7,967 12, ,962 Proved plus probable , ,415 3, ,640 1,179 1,481 3, ,864 1,011 1, , ,264 1,087 1, , , , , , , , , , , , , , , , , , , Remainder 12,464 1,542 4, ,485 Total proved plus probable 61,498 9,860 17, ,471 Note: Table may not be additive due to rounding.

22 DeeThree Exploration Ltd Annual Report Summary of Pricing and Inflation Rate Assumptions The economic parameters, as determined by Sproule, assumed in preparing the forecast prices and costs reserves report are outlined below. Price Forecast Effective December 31, 2010 Currency WTI Edmonton Henry Alberta Exchange Cushing Light Hub AECO-C Year Rate Oklahoma Par Louisiana Spot ($US/$CDN) ($US/bbl) ($CDN/bbl) ($US/mmbtu) ($CDN/GJ) Historical Forecast Remainder +1.5%/yr +1.5%/yr +1.5%/yr +1.5%/yr +1.5%/yr Reserve Life Index The reserve life index of DeeThree has been calculated using 2011 estimated production volumes and gross proved and proved plus probable reserves using forecast prices and costs, all of which were taken from the December 31, 2010 Sproule reserves report. The reserve life index of the Company as at December 31, 2010, on a boe basis, was 6.4 years for total proved reserves and 6.3 years for total proved plus probable reserves. Proved Probable Proved Expected Expected Proved Plus Plus Proved Probable Production Production Proved Probable (years) (years) Natural gas (mmcf) 7,664 9,207 1,174 1, Crude oil and NGLs (mbbls) Total (mboe) 1,327 1,

23 Shifting Focus Finding and Development Costs and Recycle Ratio The recycle ratio is a measure for evaluating the effectiveness of a company s re-investment program. The ratio measures the efficiency of capital investment, which is accomplished by comparing the operating netback per boe to that year s reserves finding and development ( F&D ) cost per boe. In 2009, the Company achieved an average F&D cost that was in the top decile at $9.71/boe on a proved basis and $8.63/boe on a proved plus probable basis. In 2010, however, given the depressed natural gas prices, coupled with the Company s drilling results throughout the year, DeeThree recorded negative reserves additions, and as a result, is unable to calculate an F&D cost. Consequently, the Company has not presented F&D costs or recycle ratios for Net Asset Value Years Ended December 31, (000s, except per share amounts) ($) ($) Present value of petroleum and natural gas reserves (1) 19,435 29,721 Net undeveloped land (2) 41,900 22,281 Working capital 28, Proceeds from stock options (3) 4,253 1,830 Net asset value 74,549 54,460 Diluted shares outstanding (#) (4) 94,091 16,760 Net asset value per share (1) Total proved plus probable, discounted at 10%, before tax per the Sproule December 31 reserves evaluations. (2) Based on a third party evaluation as at December 31, (3) Calculated proceeds from in-the-money options using a 2010 year-end closing common share price of $4.30 per share (2009 $2.34 per share). (4) Calculated as basic shares outstanding at December 31 plus in-the-money options.

24 DeeThree Exploration Ltd Annual Report Strong year-over-year results and disciplined cost management give DeeThree the ability to invest in growth and seize opportunities to build value.

25 Shifting Focus Management s Discussion and Anaylsis Introduction DeeThree is a Calgary based junior oil and gas company actively engaged in natural gas and crude oil exploration, development and production primarily in southern Alberta. DeeThree commenced operations in 2007 as a private company, and on June 25, 2009, completed a reverse takeover transaction with Royal Capital Corp., a public capital pool company, and began trading on the TSX Venture Exchange under the symbol DTX in June On October 20, 2010, DeeThree s listing for its common shares was transferred to the Toronto Stock Exchange. The following Management s Discussion and Analysis ( MD&A ) reports on the financial condition and the results of operations of DeeThree Exploration Ltd. ( DeeThree or the Company ) for the three months and years ended December 31, 2010 and 2009 and should be read in conjunction with the audited financial statements and accompanying notes. All financial measures are expressed in Canadian dollars unless otherwise indicated. This commentary is based on the information available as at, and is dated March 24, Non-GAAP Terms This MD&A contains the terms funds from operations and funds from operations per share, which should not be considered an alternative to or more meaningful than cash flow from operating activities as determined in accordance with Canadian generally accepted accounting principles ( GAAP ) as an indicator of the Company s performance. These terms do not have any standardized meaning as prescribed by GAAP. DeeThree s determination of funds from operations and funds from operations per share may not be comparable to that reported by other companies. Management uses funds from operations to analyze operating performance and leverage, and considers funds from operations to be a key measure as it demonstrates the Company s ability to generate cash necessary to fund future capital investments and to repay debt. Funds from operations is calculated using cash flow from operating activities as presented in the statement of cash flows before changes in non-cash working capital and settlement of retirement costs. DeeThree presents funds from operations per share whereby per share amounts are calculated using weighted average shares outstanding consistent with the calculation of earnings per share. The following table reconciles funds from operations to cash flow from operating activities, which is the most directly comparable measure calculated in accordance with GAAP: Three Months Ended December 31, Years Ended December 31, (000s) ($) ($) ($) ($) Funds from (used in) operations (19) 435 1,607 1,112 Abandonment and reclamation charges (19) (39) Changes in non-cash working capital (12) (474) 79 (48) Cash flow from (used in) operations (50) (39) 1,647 1,064 Cash flow from operating activities for the three-month period ended December 31, 2010 was a deficit of $50,000 ($nil per basic and diluted share) compared to a deficit of $39,000 ($nil per basic and diluted share) in the same period of During 2010, the Company s cash flow from operating activities was $1,647,000 ($0.07 per basic and diluted share) versus $1,064,000 ($0.08 per basic and diluted share) in 2009.

26 DeeThree Exploration Ltd Annual Report The Company considers corporate netbacks as a key measure as it demonstrates its profitability relative to current commodity prices. Corporate netbacks are comprised of operating, funds flow and net loss netbacks. Operating netback is calculated as the average sales price of its commodities (including gains/losses from physical fixed priced contracts), and then subtracts royalties, transportation costs and operating expenses. Funds flow netback starts with the operating netback and further deducts general and administrative costs, interest expense and adds interest income. To calculate the net loss netback, DeeThree takes the funds flow netback and deducts stock-based compensation expense as well as depletion, depreciation and accretion charges, any impairment expense and future income taxes. There is no GAAP measure that is reasonably comparable to netbacks. See the section entitled Netbacks (per unit) for the operating netback calculations. Net debt and working capital deficiency, which terms represent current assets less current liabilities and bank debt, is used to assess efficiency, liquidity and the general financial strength of the Company. There is no GAAP measure that is reasonably comparable to net debt or working capital. Other Measurements All dollar amounts are referenced in Canadian dollars. Where amounts are expressed on a barrel of oil equivalent ( boe ) basis, natural gas volumes have been converted to oil equivalence at six thousand cubic feet of gas to one barrel of oil. This conversion ratio of 6:1 is based on an energy equivalent conversion for the individual products, primarily applicable at the burner tip and does not represent a value equivalency at the wellhead. Such disclosure of boes may be misleading, particularly if used in isolation. Readers should be aware that historical results are not necessarily indicative of future performance. Forward-Looking Statements Certain statements contained in this MD&A may constitute forward-looking statements. These statements relate to future events or the Company s future performance. All statements other than statements of historical fact may be forward-looking statements. Forward-looking statements are often, but not always, identified by the use of words such as seek, anticipate, plan, continue, estimate, expect, may, will, project, predict, potential, targeting, intend, could, might, should, believe and similar expressions. These statements involve known and unknown risks, uncertainties and other factors that may cause actual results or events to differ materially from those anticipated in such forward-looking statements. The Company believes that the expectations reflected in those forward-looking statements are reasonable, but no assurance can be given that these expectations will prove to be correct and such forward-looking statements included in this MD&A should not be unduly relied upon by investors. These statements speak only as at the date of this MD&A and are expressly qualified, in their entirety, by this cautionary statement. In particular, this MD&A contains forward-looking statements pertaining to the following: projections of market prices and costs, supply and demand for natural gas and crude oil, the quantity of reserves, natural gas and crude oil production levels, capital expenditure programs, treatment under governmental regulatory and taxation regimes, expectations regarding the Company s ability to raise capital and to continually add to reserves through acquisitions and development, and projections of market prices and costs. With respect to forward-looking statements contained in this MD&A, the Company has made assumptions regarding, among other things, the legislative and regulatory environments of the jurisdictions where the Company carries on business or has operations, the impact of increasing competition and the Company s ability to obtain additional financing on satisfactory terms. The Company s actual results could differ materially from those anticipated in these forward-looking statements as a result of the risk factors included in this MD&A such as: volatility in the market prices for natural gas and crude oil; uncertainties associated with estimating reserves; geological, technical, drilling and processing problems; liabilities and risks, including environmental liabilities and risks inherent in natural gas and crude oil operations; incorrect assessments of the value of acquisitions; and, competition for, among other things, capital, acquisitions of reserves, undeveloped lands and skilled personnel. This forward-looking information represents the Company s views as at the date of this MD&A and such information should not be relied upon as representing its views as of any date subsequent to the date of this MD&A. DeeThree has attempted to identify important factors that could cause actual results, performance or achievements to vary from those current expectations or estimates expressed or implied by the forward-looking information. However, there may be other factors that cause results, performance or achievements not to be as expected or estimated and that could cause actual results, performance or achievements to differ materially from current expectations. There can be no assurance that forward-looking information will prove to be accurate, as results and future events could differ materially from those expected or estimated in such statements. Accordingly, readers should not place undue reliance on forward-looking information. The Company disclaims any intention or obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise, except as expressly required by applicable securities legislation.

27 Shifting Focus Financial and Operating Results Sales Volumes Three Months Ended December 31, Years Ended December 31, Natural gas sales (mcf/d) 3,691 3,636 4,258 3,257 Crude oil and NGLs sales (bbls/d) Total sales (boe/d) Total sales (boe) 58,425 57, , ,688 For the fourth quarter of 2010, the Company s production averaged 635 boe/d compared to 623 boe/d in the same period of 2009 and 678 boe/d recorded in the third quarter of This represents a 2% year-over-year increase, which was primarily attributable to the Company s drilling success throughout 2009 and 2010, and a 6% decrease from the third quarter of 2010, which was due to natural declines on its current production base and the Company electing not to direct any capital towards its natural gas behind pipe volumes, and as a result, not bringing on-stream any new production. DeeThree currently has approximately 375 boe/d of behind pipe volumes. For the year ended December 31, 2010, DeeThree s production averaged 727 boe/d versus 558 boe/d a year ago. During 2010, production was comprised of 4,258 mcf/d of natural gas or 98% of the Company s production and 17 bbls/d of crude oil and NGLs or 2% of total corporate production. The year-over-year increase was again directly attributable to the Company s drilling activity. Revenue and Prices Three Months Ended December 31, Years Ended December 31, (000s) ($) ($) ($) ($) Revenue Natural gas (1) 1,353 1,456 6,614 4,684 Crude oil and NGLs Total revenue 1,483 1,563 7,073 5,018 Average Prices Natural gas ($/mcf) (1) Crude oil and NGLs ($/bbl) Total sales price ($/boe) Benchmark Pricing Natural gas NYMEX ($US/mmbtu) AECO-C 5A daily index ($/mcf) Crude oil West Texas Intermediate ($US/bbl) Edmonton Light ($CDN/bbl) Foreign exchange Canadian to U.S. dollar U.S. to Canadian dollar (1) Natural gas revenue and price includes realized gains/losses from physical fixed priced contracts.

28 DeeThree Exploration Ltd Annual Report During the final quarter of 2010, revenue decreased 5% to $1,483,000 from $1,563,000 recorded in the comparative period of 2009 due to a 7% decrease in the Company s overall realized price to $25.38/boe from $27.27/boe recorded last year offset by a 2% year-over-year increase in production. During the 2010 three-month period, DeeThree realized an average natural gas price of $3.98/mcf (including a $0.39/mcf hedging gain from physical fixed priced sales contracts) and $71.15/bbl for crude oil and NGLs. For the corresponding period of 2009, the Company realized a natural gas price of $4.35/mcf and a combined crude oil and NGLs price of $67.91/bbl. For the year ended December 31, 2010, revenue totaled $7,073,000 versus $5,018,000 in 2009 with an average sales price of $26.65/boe compared to $24.64/boe received the prior year. DeeThree s current production profile is weighted 98% to natural gas, and as a result, revenues are largely reliant on Canadian natural gas prices that are determined by a variety of factors such as weather patterns, liquefied natural gas imports, North American supply and demand, storage levels in North America and alternative fuel sources. DeeThree s production is sold within Canada and is marketed to one significant North American purchaser. Royalties Three Months Ended December 31, Years Ended December 31, (000s) ($) ($) ($) ($) Total revenue 1,483 1,563 7,073 5,018 Total revenue, excluding hedging gains 1,350 1,563 6,548 5,018 Royalties , Percent of revenue, excluding hedging gains (%) Royalty expenses consist primarily of freehold royalties relating to the Lethbridge property acquisition and royalties paid to provincial governments relating to the Company s non-core areas. The freehold royalty payable to the vendor in connection with the acquisition is a sliding scale royalty determined monthly on a well-by-well basis using a calculation that is based on the Alberta New Royalty Framework as announced on October 25, 2007 with a cap of 30%. The sliding scale varies based on productivity (a higher royalty is payable from wells with higher production rates) and commodity prices (a higher royalty is payable in times of higher natural gas prices). For the fourth quarter of 2010, royalties totaled $153,000 or 11% of revenue (excluding hedging gains) compared to $303,000 or 19% of revenue for the same quarter in 2009 and $186,000 or 13% of revenue (excluding hedging gains) in the third quarter of The year-over-year royalty rate decreased primarily as a result of the Company recording additional annual 2009 freehold mineral tax royalties in the fourth quarter of 2009 resulting in slightly higher than normal royalties in that quarter. The period-over-period decrease was primarily due to the decline in production rates. During the year ended December 31, 2010, royalties totaled $1,024,000 or 16% of revenue (excluding hedging gains) versus $554,000 or 11% of revenue a year ago, which was attributable to higher rate wells coming on-stream throughout 2010, particularly in the first half of the year when royalty rates averaged 18%. Operating Expenses Three Months Ended December 31, Years Ended December 31, (000s) ($) ($) ($) ($) Operating expenses ,314 1,753 Operating expenses ($/boe)