2018 Q1 FINANCIAL REPORT

Transcription

1 2018 Q1 FINANCIAL REPORT FINANCIAL AND OPERATING HIGHLIGHTS Three Months Ended March 31, (unaudited) Financial Income and Investments ($ millions) Petroleum and natural gas sales Percent Change Funds flow from/(used in) operating activities (0.30) 1.50 (120) Cash flows from operating activities (68) Net loss (4.33) (0.54) (702) Net capital expenditures (40) Per Share, Basic Funds flow from/(used in) operating activities ($/share) (0.01) 0.05 (120) Cash flows from operating activities ($/share) (63) Net loss ($/share) Balance Sheet at Period End ($ millions) (0.14) (0.02) (600) Property, plant and equipment (7) Exploration and evaluation assets (22) Total assets (11) Convertible debentures at maturity Net debt Shareholders equity (39) Total Common Shares Outstanding at Period End (millions) Operating Average Daily Production Oil and liquids (bbl/d) 1,949 2,016 (3) Natural gas (mmcf/d) (15) Equivalent (boe/d) 2,427 2,579 (6) Average Selling Price (before the impact of financial risk management contracts) Oil and liquids ($/bbl) Natural gas ($/mcf) (19) Undeveloped Land at Period End (thousand net acres) (18) Throughout this report, the calculation of barrels of oil equivalent ( boe ) is based on the conversion ratio that six thousand cubic feet of natural gas is equivalent to one barrel of oil. For a further discussion about this term, refer to the Management s Discussion and Analysis section in this report. Funds flow from operating activities is an additional GAAP term that represents net earnings/(loss) except for non-cash items. Funds flow from operating activities have been restated to exclude asset retirement expenditures. For a further discussion about this term, refer to the Management s Discussion and Analysis section in this report. Net debt is a non-gaap measure that represents bank debt (if any) plus the convertible debenture of $41.94 million or $57.50 million (prior to March 31, 2017) and any working capital excluding unrealized assets/liabilities FIRST QUARTER REPORT 1

2 Message to Shareholders (1) (2) Zargon Oil & Gas Ltd. has released financial and operating results for the first quarter of Specific financial and operating highlights in the first quarter of 2018 include: Funds flow from operating activities of a negative $0.30 million compare to the positive $1.59 million recorded in the prior quarter, and the positive $1.50 million reported in first quarter of The reduction in funds flow is primarily due to Zargon s first quarter 2018 realized hedging losses of $0.85 million and higher one-time operating and transportation costs. First quarter 2018 production averaged 2,427 barrels of oil equivalent per day essentially unchanged from 2,416 barrels of oil equivalent per pay in the prior quarter and a six percent decrease from the 2017 first quarter rate of 2,579 barrels of oil equivalent per day. First quarter 2018 capital expenditures totaled $1.50 million, a $0.95 million decrease from the $2.45 million recorded in the prior quarter. The cash constrained reduced program was primarily allocated to reactivations and waterflood optimizations. No wells were drilled in the quarter. First quarter 2018 abandonment and reclamation costs totaled $0.61 million, a $0.26 million decrease from the $0.87 million recorded in the prior quarter. Discussion (1) Zargon s first quarter results reflected the following challenges: WTI oil hedge losses: For the first half of 2018, Zargon has hedged 1,000 barrels of oil per day at an average WTI oil price of $70.33 Canadian dollar per barrel. WTI oil prices averaged $79.51 Canadian dollar per barrel in the first quarter and are currently exceeding $88 Canadian dollar per barrel. Although Zargon s first quarter realized hedge loss was $0.85 million, we did not receive an offsetting benefit in our field prices received due to the large increase in WTI-WCS differentials. WTI-WCS differentials: Zargon s realized field prices for our Alberta properties tracks closely (small premium) to the posted WCS prices. For the 2018 first quarter, the WTI-WCS differential averaged $30.76 Canadian dollar per barrel, almost double the actual 2017 WTI-WCS differential of $15.57 Canadian dollar per barrel. This field price reduction was not protected by our WTI hedges and resulted in a significant decrease in field revenues. Although April 2018 differentials have remained elevated, the May 2018 differentials have improved dramatically and have returned to the $21.50 Canadian dollar per barrel level. Operating Costs: The first quarter operating costs were elevated due to a combination of workover expenditures (non-capitalized) on a set of challenging reactivations, higher electricity costs and cold weather related operational costs. Looking forward, we expect to return to our historical operating costs for the remainder of the year. Natural gas economics and shut-ins: This summer s Alberta natural gas pricing outlook remains challenging, and we have proactively shut-in our uneconomic natural gas properties. For the 2018 second half, we are now forecasting an average natural gas rate of 1.91 million cubic feet per day. Capital programs: With the sharp reduction in first quarter cash flows, we have deferred spending on our discretionary oil exploitation capital programs until the third quarter of this year, when our WTI oil hedges will have expired and the current forward curve for WTI prices and WTI-WCS differentials are predicting a 26 percent improvement in our average field price from first quarter levels. These capital deferrals are having an impact on our oil production and for the 2018 second half, we are now forecasting an average oil and liquids rate of 1,830 barrels of oil per day. 2 ZARGON OIL & GAS LTD.

3 Fortunately, the outlook for Zargon is improving dramatically with the recent ramp up in WTI oil prices, the June 30 expiry of our out of the money hedges, the May 2018 improvement of the WTI-WCS differentials, the return to base level operating costs for the remainder of the year and the resumption of our oil exploitation capital programs in the second half of this year. For further information regarding Zargon s properties, opportunities and outlook, please refer to our updated corporate presentation, which is available at Strategic Alternatives Process Update (1) Zargon s Board of Directors recognizes that Zargon is a suboptimal size to operate as a public oil and gas Company in Canada, and continues to explore alternatives to allow Zargon to continue as part of a larger, better capitalized entity. The Board also recognizes, that Zargon s long-life, low-decline oil exploitation assets have significant upside potential in a period of prolonged higher oil prices. In addition to this option value to higher oil prices, Zargon brings a TSX listing and more than $150 million of non-capital losses that could have significant value in a more favourable Canadian energy investment climate. In an effort to realize these unrecognized values, Zargon has previously initiated a strategic alternatives process and continues to seek outcomes that will maximize the value for the Company and its stakeholders. (1) Please see comments on Forward-Looking Statements in the Management s Discussion and Analysis section in this report FIRST QUARTER REPORT 3

4 MANAGEMENT S DISCUSSION AND ANALYSIS Management s discussion and analysis ( MD&A ) is a review of Zargon Oil & Gas Ltd. s 2018 first quarter financial results and should be read in conjunction with the unaudited interim consolidated financial statements and related notes for the three months ended March 31, 2018 and the audited consolidated financial statements and related notes for the year ended December 31, The consolidated financial statements have been prepared in accordance with International Financial Reporting Standards ( IFRS ) as issued by the International Accounting Standards Board ( IASB ), which are also generally accepted accounting principles ( GAAP ) for publicly accountable enterprises in Canada. All amounts are in Canadian dollars unless otherwise noted. All references to Zargon or the Company refer to Zargon Oil & Gas Ltd. In the MD&A, natural gas is converted to a barrel of oil equivalent ( Boe ) using six thousand cubic feet of gas to one barrel of oil. In certain circumstances, natural gas liquid volumes have been converted to a thousand cubic feet equivalent ( Mcfe ) on the basis of one barrel of natural gas liquids to six thousand cubic feet of gas. Boes and Mcfes may be misleading, particularly if used in isolation. A conversion ratio of one barrel to six thousand cubic feet of natural gas is based on an energy equivalency conversion method primarily applicable at the burner tip and does not represent a value equivalency at the wellhead. Given that the value ratio based on the current price of crude oil as compared to natural gas is significantly different from the energy equivalency of 6:1, utilizing a conversion ratio on a 6:1 basis may be misleading as an indication of value. The following are descriptions of additional GAAP measures used in this MD&A: The MD&A contains the term funds flow from operating activities ( funds flow ), which should not be considered an alternative to, or more meaningful than, cash flows from operating activities as determined in accordance with IFRS as an indicator of the Company s financial performance. This term does not have any standardized meaning as prescribed by IFRS and, therefore, the Company s determination of funds flow from operating activities may not be comparable to that reported by other companies. The Company evaluates its performance based on net earnings and funds flow from operating activities. The Company considers funds flow from operating activities to be a key measure as it demonstrates the Company s ability to generate the cash necessary to repay debt and to fund future capital investment. It is also used by research analysts to value and compare oil and gas companies, and it is frequently included in published research when providing investment recommendations. The following are descriptions of non-gaap measures used in this MD&A: The Company uses the term debt net of working capital or net debt. Debt net of working capital, as presented, does not have any standardized meaning prescribed by IFRS and may not be comparable with the calculation of similar measures for other entities. Debt net of working capital, as used by the Company, is calculated as the convertible debenture of $41.94 million ($57.50 million prior to March 31, 2017) and any working capital excluding unrealized derivative assets/liabilities. Operating netbacks per boe equal total petroleum and natural gas sales per boe adjusted for realized derivative gains and/or losses per boe, royalties per boe, operating expenses per boe and transportation expenses per boe. Operating netbacks are a useful measure to compare the Company s operations with those of its peers. Funds flow netbacks per boe are calculated as operating netbacks less general and administrative expenses per boe, transaction costs per boe, interest and financing charges per boe, interest on the convertible debenture per boe, asset retirement expenditures per boe, cash portion of exploration and evaluation per boe, other expense per boe and current income taxes per boe. Funds flow netbacks are a useful measure to compare the Company s operations with those of its peers. 4 ZARGON OIL & GAS LTD.

5 References to production volumes or production in this document refer to sales volumes. Forward-Looking Statements This document offers our assessment of Zargon s future plans and operations as at May 14, 2018, and contains forward-looking statements including: our expectations for the improvement in our WTI-WCS differentials referred to under the heading Discussion ; our expectations for our remaining 2018 operating and transportation expenses referred to under the heading Discussion ; our expectations for our production referred to under the heading Discussion ; our expected sources of funds for capital expenditures referred to under the heading Liquidity and Capital Resources; our expectations for our remaining first half of 2018 capital budget program and the second half of 2018 capital budget program referred to under the heading Discussion ; and our strategic alternatives process referred to under the headings Strategic Alternatives Process Update and Outlook. Such statements are generally identified by the use of words such as anticipate, continue, estimate, expect, forecast, may, will, project, should, plan, intend, believe and similar expressions (including the negatives thereof). By their nature, forward-looking statements are subject to numerous risks and uncertainties, some of which are beyond our control, including such as those relating to results of operations and financial condition, general economic conditions, industry conditions, changes in regulatory and taxation regimes, volatility of commodity prices, escalation of operating and capital costs, currency fluctuations, the availability of services, imprecision of reserve estimates, geological, technical, drilling and processing problems, environmental risks, weather, the lack of availability of qualified personnel or management, stock market volatility, the ability to access sufficient capital from internal and external sources and competition from other industry participants for, among other things, capital, services, acquisitions of reserves, undeveloped lands and skilled personnel. Risks are described in more detail in our Annual Information Form, which is available on our website and at Forward-looking statements are provided to allow investors to have a greater understanding of our business. You are cautioned that the assumptions, including among other things, future oil and natural gas prices; future capital expenditure levels (including ASP); future production levels; future exchange rates; the cost of developing and expanding our assets; our ability to obtain equipment in a timely manner to carry out development activities; our ability to market our oil and natural gas successfully to current and new customers; the impact of increasing competition, our ability to obtain financing on acceptable terms; and our ability to add production and reserves through our development and acquisition activities used in the preparation of such information, although considered reasonable at the time of preparation, may prove to be imprecise and, as such, undue reliance should not be placed on forward-looking statements. Our actual results, performance, or achievements could differ materially from those expressed in, or implied by, these forward-looking statements. We can give no assurance that any of the events anticipated will transpire or occur, or if any of them do, what benefits we will derive from them. The forward-looking information contained in this document is expressly qualified by this cautionary statement. Our policy for updating forwardlooking statements is that Zargon disclaims, except as required by law, any intention or obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. This MD&A has been prepared as of May 14, FIRST QUARTER REPORT 5

6 FINANCIAL & OPERATING RESULTS Petroleum and Natural Gas Sales Three months ended March 31, ($ millions) Percent Change Petroleum sales Natural gas sales (32) Petroleum and natural gas sales First quarter 2018 gross petroleum and natural gas sales of $9.71 million were six percent below the $10.31 in the preceding quarter but consistent with the $9.69 million in the first quarter of First quarter 2018 realized oil and liquids field prices averaged $52.48 per barrel before the impact of financial risk management contracts and were six percent higher than the $49.30 per barrel recorded in the 2017 first quarter. The quarter over quarter decrease in sales was due to a significantly increased Western Canadian Select ( WCS ) price differential of $30.76 per barrel, compared to $15.60 per barrel in the fourth quarter of Our Alberta field price ties closely with the WCS prices, and despite a 13 percent first quarter of 2018 over fourth quarter 2017 improvement in WTI prices expressed in Canadian dollars, our corresponding Alberta field price decreased nine percent. Natural gas field prices received averaged $1.98 per thousand cubic feet in the first quarter of 2018, a 19 percent decrease from the 2017 first quarter prices. Pricing Three Months Ended March 31, Average for the period Natural Gas: Percent Change NYMEX average daily spot price ($US/mmbtu) AECO average daily spot price ($Cdn/mmbtu) (23) Zargon realized field price ($Cdn/mcf) (19) Zargon realized natural gas field price differential ($Cdn/mcf) (58) Crude Oil: WTI ($US/bbl) Edmonton par price ($Cdn/bbl) Western Canadian Select ( WCS ) price ($Cdn/bbl) (1) Zargon realized field price before the impact of financial risk management contracts ($Cdn/bbl) Zargon realized field price after the impact of financial risk management contracts ($Cdn/bbl) (4) Zargon realized oil field price differential (1) WTI ($Cdn/bbl) to WCS ($Cdn/bbl) differential (1) Calculated as Zargon s realized field price before the impact of financial risk management contracts ($Cdn/bbl) as compared to Edmonton par price ($Cdn/bbl). 6 ZARGON OIL & GAS LTD.

7 Volumes Oil and liquids production volumes during the 2018 first quarter were 1,949 barrels per day, a one percent increase from the preceding quarter rate of 1,924 barrels per day due to our 2017 waterflood modification, reactivations and recompletion programs offset by the reduction in conventional capital spending. Natural gas production volumes decreased three percent in the 2018 first quarter to 2.87 million cubic feet per day compared to 2.95 million cubic feet per day in the prior quarter (Q million cubic feet per day). Natural gas production declines continued as a result of the shut-in of uneconomic gas production resulting from low field prices and naturally occurring production declines. Production by Core Area Three Months Ended March 31, Oil and Liquids (bbl/d) Natural Gas (mmcf/d) Equivalents (boe/d) Oil and Liquids (bbl/d) Natural Gas (mmcf/d) Equivalents (boe/d) Alberta Plains North Alberta Plains South 1, ,270 1, ,365 Williston Basin Risk Management Contracts 1, ,427 2, ,579 Zargon's commodity price risk management policy, which is approved by the Board of Directors, allows for the sale of up to a certain percentage of its estimated before royalty production volumes for each commodity up to a 30 month period. Zargon may also enter into interest rate swaps. For accounting purposes, an unrealized gain or loss from forward sale commodity contracts is recorded based on the fair value ( mark-to-market ) of the contracts at the period end. Realized and unrealized gains/losses on risk management contracts are included in gain/loss on derivatives in the consolidated statement of earnings/(loss) and their fair value is reflected in derivative assets or derivative liabilities on the consolidated balance sheets. In the 2018 first quarter, lower contract prices versus WTI oil prices resulted in a net realized loss on derivatives of $0.85 million compared to a $0.03 million net realized gain in the first quarter of The unrealized loss on derivatives in the first quarter of 2018 was related to oil contract losses of $0.36 million compared to $1.83 million gain in the first quarter of These non-cash unrealized derivative gains or losses are generated by the change over the reporting period in the mark-to-market valuation of Zargon s risk management contracts. Commodity price volatility has resulted in significant fluctuations in the mark-to-market amount of unrealized derivative assets and liabilities. Zargon s commodity risk management positions are described in Notes 11 and 12 to the unaudited interim consolidated financial statements. Royalties Three months ended March 31, ($ millions) Percent Change Royalties Percentage of revenue 13.2% 10.3% First quarter 2018 royalties of $1.29 million increased eight percent compared to the prior quarter and 29 percent from the 2017 first quarter, primarily due to the increase in crude oil prices. The variations in 2018 FIRST QUARTER REPORT 7

8 royalty rates generally track changes in production and volumes. First quarter of 2018 royalties were 13.2 percent of gross sales compared to 10.3 percent in the first quarter of Operating Expenses and Transportation Expenses Three months ended March 31, ($ millions) Percent Change Operating expenses Transportation expenses Total expenses Total expenses ($/boe) First quarter 2018 operating expenses and transportation expenses of $6.01 million on a total dollar basis were up compared to $5.03 million recorded in the prior quarter and $5.11 million recorded in the first quarter of First quarter 2018 operating costs were significantly higher than expectations due to a combination of workover expenditures (non-capitalized) on a set of challenging reactivations, higher electricity costs and cold weather related operational costs. Looking forward, we anticipate operating costs to return to historical totals as the impact of higher electricity costs is offset by the reduction of costs realized from the shut-in of uneconomic natural gas properties. Operating Netbacks Three Months Ended March 31, Oil and Liquids ($/bbl) Natural Gas ($/mcf) Oil and Liquids ($/bbl) Natural Gas ($/mcf) Sales Royalties (7.30) (0.02) (5.28) (0.12) Realized gain/(loss) on derivatives (4.85) 0.17 Operating expenses (27.57) (4.08) (23.48) (2.68) Transportation expenses (0.68) (0.19) Operating netbacks (2.12) (0.35) General & Administrative ( G&A ) Expenses Three months ended March 31, ($ millions) Percent Change G&A expenses (16) G&A expenses ($/boe) (11) G&A expenses of $0.97 million and $4.43 per barrel of oil equivalent in the first quarter of 2018 reflected Zargon s ongoing G&A cost containment initiatives and were lower than the $1.16 million and $1.00 million reported in the first quarter of 2017 and the fourth quarter of 2017, respectively. Transaction Costs Transaction costs for the 2018 first quarter were $0.07 million compare to $0.03 million in the prior quarter and $0.11 million in the first quarter of 2017 and related to Zargon s ongoing strategic alternatives review. 8 ZARGON OIL & GAS LTD.

9 Interest and Financing Charges on Bank Debt Interest and financing income in the 2018 first quarter and in the prior quarter were essentially nil, and compares to the $0.02 million of the interest and financing income in the first quarter of Interest and financing charges are minimal since the termination of the credit facility in the fourth quarter of Interest on Convertible Debentures Zargon has borrowings through its convertible debentures, which were issued in May 2012 and mature on December 31, Zargon may redeem the convertible debentures with cash or through the issuance of Zargon common shares priced at 95 percent of the then current Zargon share price. Interest is payable semi-annually at a rate of eight percent (six percent prior to April 1, 2017), calculated on the gross proceeds of $41.94 million ($57.50 million prior to March 31, 2017). Interest charges of $0.84 million in the first quarter of 2018 were unchanged compared to both the prior quarter and the first quarter of For more details, please refer to Note 7 of the interim consolidated financial statements. Current Tax The current tax expense for the first quarter of 2018 and the prior quarter were nil (Q nil). Total corporate tax pools as at March 31, 2018 are approximately $199 million, comparable to the $197 million of tax pools available to Zargon at December 31, Estimated Tax Pools ($ millions) March 31, 2018 Canadian oil and natural gas property expenses Canadian development expenses 12 Canadian exploration expenses 6 Capital cost allowance 24 Non-capital losses 154 US tax pools 1 Other 2 Estimated tax pools FIRST QUARTER REPORT 9

10 Corporate Netbacks Three Months Ended March 31, ($/boe) Petroleum and natural gas sales Royalties (5.88) (4.29) Realized gain on derivatives (3.89) 0.13 Operating expenses (26.97) (21.86) Transportation expenses (0.55) (0.15) Operating netbacks General and administrative expenses (4.43) (4.99) Transaction costs (0.30) (0.46) Interest and financing charges Interest on convertible debentures (3.84) (3.70) Current tax recovery Funds flow netbacks (1.38) 6.48 Depletion and Depreciation Expense Depletion and depreciation expense for the first quarter of 2018 decreased six percent at $3.21 million compared to $3.41 million in the first quarter of On a per barrel of oil equivalent basis, the depletion and depreciation rates were $14.68 and $14.69 for the first quarter of 2018 and 2017, respectively. The 2017 calendar year depletion and depreciation rate was $14.58 per barrel of oil equivalent. Accretion of Asset Retirement Obligations and Convertible Debentures The accretion expense of asset retirement obligations for the first three months of 2018 was $0.37 million was essentially unchanged compared to the first quarter of Year-over-year adjustments are due to actual abandonment and reclamation costs and changes in the estimated future liability for asset retirement obligations resulting from changes in cost assumptions and adjustments in Zargon s well count due to drilling programs and property acquisitions or dispositions. The debt portion of Zargon s convertible debenture is also accreted over its term, up to the total maturity value of $41.94 million ($51.70 million prior to March 31, 2017). Accretion on the convertible debenture for the 2018 first quarter is $0.11 million compared to $0.37 million in the 2017 first quarter. Shared-based Compensation Expensing of share-based compensation in the first quarter of 2018 totalled $0.04 million, which is slightly lower than the $0.05 million incurred in the first quarter of Unrealized Foreign Exchange The Company had an unrealized foreign exchange gain of $0.02 million during the first quarter of 2018 compared to a gain of $0.01 million in the prior quarter (Q $0.04 million loss). Gains and losses result from transactions in US dollars when they are translated into Canadian dollars. The volatility in the US/Cdn dollar creates non-cash translation gains/losses. 10 ZARGON OIL & GAS LTD.

11 Exploration and Evaluation Expenses Non-cash exploration and evaluation expenses for the 2018 first quarter of nil million compared to first quarter of 2017 expenses of $0.05 million. Exploration and evaluation expenses are primarily related to undeveloped land expiries. Deferred Tax The deferred tax expense for the first quarter of 2018 was essentially nil compared to a recovery of $0.10 million in the first quarter of Funds Flow from Operating Activities Funds flow from operating activities in the 2018 first quarter was a negative $0.30 million and compares with the $1.59 million and $1.50 million reported in the preceding quarter and the first quarter of 2017, respectively. The decrease in funds flow compared to the prior quarter and the 2017 first quarter was primarily a result of higher operating and transportation expenses and a significant realized derivatives loss. Details of the change in fund from operating activities during 2018 and 2017 are as follows: ($ millions) Q1 Q4 Q3 Q2 Q1 Funds flow from operating activities, beginning of quarter Revenue and royalties: Volume (0.17) (0.75) 0.59 (0.19) 0.28 Price (0.42) 1.78 (0.72) (0.09) 0.17 Royalties (0.09) (0.06) (0.02) (0.12) 0.03 Realized Derivatives (0.24) (0.84) 0.26 (0.06) 0.03 Expenses: Operating and transportation (0.98) (0.16) 0.24 (0.24) General and administrative 0.03 (0.11) Transaction costs (0.03) Interest and financing 0.01 (0.01) Current taxes (0.03) Funds flow from operating activities, end of quarter (0.30) Net Loss A net loss of $4.33 million for the 2018 first quarter was 702 percent higher than the $0.54 million net loss in the first quarter of 2017, largely due to higher royalties, operating expenses and loss on realized and unrealized derivatives. The net earnings/(loss) track the funds flow from operating activities for the respective periods and non-cash charges, which include depletion and depreciation, unrealized derivative gain/(loss), land expiries, accretion, gain on convertible debentures and deferred taxes. On a per diluted share basis, the 2018 first quarter net loss was $0.14, compared to a net loss of $0.02 from the 2017 first quarter FIRST QUARTER REPORT 11

12 Capital Expenditures Three Months Ended March 31, ($ millions) Undeveloped land Geological and geophysical (seismic) Drilling and completion of wells Well equipment and facilities ASP project and exploitation costs ASP chemical costs Exploration and development Property acquisitions 0.13 Property dispositions (0.41) Net property acquisitions (0.41) 0.13 Total net capital expenditures excluding administrative assets Administrative assets Total net capital expenditures LIQUIDITY AND CAPITAL RESOURCES Total net capital expenditures (including net property acquisitions) totalled $1.50 million in the first quarter of 2018 and were 40 percent lower than the same period in Field expenditures of $1.89 million for the first quarter of 2018 were 20 percent lower than the 2017 first quarter. The first quarter 2018 field capital expenditures (excluding net property acquisitions) were allocated to Alberta Plains North - $0.22 million, Alberta Plains South - $1.40 million and Williston Basin - $0.27 million and included the drilling of nil net wells, unchanged from the first quarter of Included in the Alberta Plains South capital expenditures is the $0.88 million incurred on the Little Bow ASP project. Of the total ASP amount, $0.23 million was spent on project and exploitation costs while $0.65 million was spent on chemical costs for the facility. At March 31, 2018, the Company s combined debt net of working capital (excluding unrealized derivative assets/liabilities) was $40.79 million, which compares to $38.41 million of net debt at the end of December 31, The $40.79 million debt net of working capital consists of the $41.94 million of convertible unsecured subordinate debentures, which is partially offset by net cash balances. The Company has borrowings through its convertible debentures, which were issued in May 2012 and mature on December 31, Zargon may redeem the convertible debentures with cash or through the issuance of Zargon common shares priced at 95 percent of the then current Zargon share price. Interest is payable semi-annually at a rate of eight percent (six percent prior to April 1, 2017), calculated on the gross proceeds of $41.94 million ($57.50 million prior to March 31, 2017). The volatility of oil and natural gas prices, uncertainty or modifications regarding royalties and Canadian income tax rules and global economic/political concerns have, on occasion, restricted the oil and natural gas industry s ability to attract new capital from debt and equity markets. Zargon s operational results and financial condition, and, therefore, the funds available to be allocated to capital expenditures, are dependent on the prices received for oil and natural gas production. For the quarter ended March 31, 2018, net capital expenditures totalled $1.50 million, which was $0.70 million higher than the cash flows from operating activities (after changes in non-cash working capital) of 12 ZARGON OIL & GAS LTD.

13 $0.80 million. For the quarter ended March 31, 2017, net capital expenditures totalled $2.51 million, which was $0.01 million lower than the cash flows from operating activities (after changes in non-cash working capital) of $2.52 million. Zargon relies on access to debt and capital markets to the extent that net capital expenditures exceed cash flows from operating activities (after changes in non-cash working capital). Over the long term, Zargon expects to fund capital expenditures with its cash flows from operating activities; however, it may fund growth through additional debt and equity issuances. In the crude oil and natural gas industry, because of the nature of reserve reporting, the natural reservoir declines and the risks involved in capital investment, it is not possible to distinguish between capital spent on maintaining productive capacity and capital spent on growth opportunities. Therefore, maintenance capital is not disclosed separately from development capital spending. At May 14, 2018, Zargon Oil & Gas Ltd. had million common shares outstanding. Pursuant to the stock option plan and the share award plan, there are currently an additional 0.32 million common share awards issued and outstanding and 1.25 million stock options issued and outstanding. Capital Sources and Uses Three Months Ended March 31, ($ millions) Funds flow from/(used in) operating activities (0.30) 1.50 Change in cash Change in convertible debenture (13.37) Asset retirement costs (0.61) (0.14) Changes in working capital and other 1.18 (0.16) Total capital sources CONTRACTUAL OBLIGATIONS AND CONTINGENCIES Zargon has certain contractual obligations relating to the lease of head office space, ASP related contracts and natural gas transportation sales contracts that extend for longer than one year as set out in the table below: ($ millions) Total to to 2022 Thereafter Head office lease and other ASP related contracts Total LIABILITY MANAGEMENT RATING On June 20, 2016, the Alberta Energy Regulator ("AER") issued Bulletin which put in place certain interim measures for transfers of AER regulated assets including a requirement that all transferees demonstrate that they have a Liability Management Rating ("LMR") of 2.0 or higher immediately following the transfer. At May 5, 2018, Zargon's LMR was Although there is a significant level of uncertainty around the application of Bulletin , it could restrict Zargon from buying or selling oil and gas assets, which could negatively impact its business FIRST QUARTER REPORT 13

14 CHANGES IN ACCOUNTING POLICIES The Company s changes in accounting policies are discussed in Note 3 to the Financial Statements. FUTURE CHANGES IN ACCOUNTING POLICIES The Company s future changes in accounting policies are discussed in Note 3 to the Financial Statements. MANAGEMENT AND FINANCIAL REPORTING SYSTEMS Zargon is required to comply with National Instrument Certification of Disclosure in Issuers Annual and Interim Filings, otherwise referred to as Canadian SOX ( C-Sox ). The 2018 certificate requires that the Company disclose in the interim MD&A any changes in the Company s internal controls over financial reporting that occurred during the period that have materially affected, or are reasonably likely to materially affect, the Company s internal control over financial reporting. The Company confirms that no such changes were made to the internal controls over financial reporting during the first quarter of Because of their inherent limitations, internal controls over financial reporting may not prevent or detect misstatements, errors or fraud. Control systems, no matter how well conceived or operated, can provide only reasonable, not absolute assurance that the objectives of the control systems are met. Zargon uses the 2013 Committee of Sponsoring Organizations of the Treadway Commission ( COSO ) Framework. OUTLOOK In 2015 Zargon formed a Special Board Committee (the Committee ) to examine alternatives available to maximize shareholder value. The Company continues to evaluate strategic alternatives available to Zargon which may include a sale of the Company or a portion of the Company s assets, a restructuring of the Company s current capital structure, the addition of capital to further develop the potential of the assets, a merger, a farm-in or joint venture, or other such options as may be determined by the Board of Directors to be in the best interests of the Company and its stakeholders. 14 ZARGON OIL & GAS LTD.

15 SUMMARY OF QUARTERLY RESULTS Q1 Q2 Q3 Q4 Q1 Petroleum and natural gas sales ($ millions) Net loss ($ millions) (0.54) (1.71) (3.51) (3.55) (4.33) Net loss per diluted share ($) (0.02) (0.06) (0.11) (0.12) (0.14) Funds flow from/(used in) operating activities ($ millions) (0.30) Funds flow from/(used in) operating activities per diluted share ($) (0.01) Cash flows from operating activities ($ millions) 2.52 (0.59) Cash flows from operating activities per diluted share ($) 0.08 (0.02) Net capital expenditures ($ millions) Total assets ($ millions) Convertible debentures ($ millions) (1) Net debt Average daily oil and liquids production (bbl) 2,016 1,921 2,037 1,924 1,949 Average daily natural gas production (mmcf) Average daily production (boe) 2,579 2,500 2,628 2,416 2,427 Average oil production weighting (%) Average realized commodity field price before the impact of financial risk management contracts ($/boe) Funds flow netback ($/boe) (2) (1.38) (1) Amount is full future face value of the convertible debentures FIRST QUARTER REPORT 15

16 2016 Q1 Q2 Q3 Q4 Petroleum and natural gas sales ($ millions) Net (loss)/earnings ($ millions) (8.82) (5.27) (17.81) Net (loss)/earnings per diluted share ($) (0.29) (0.17) 0.38 (0.58) Funds flow from/(used in) operating activities ($ millions) (0.40) 3.56 (0.51) 0.92 Funds flow from/(used in) operating activities per diluted share ($) (0.01) 0.12 (0.01) 0.03 Cash flows from operating activities ($ millions) (1.77) Cash flows from operating activities per diluted share ($) (0.06) Net capital expenditures/(dispositions) ($ millions) (90.29) 1.43 Total assets ($ millions) Bank debt ($ millions) Convertible debentures ($ millions) (1) Net debt Average daily oil and liquids production (bbl) 3,503 3,413 2,915 1,952 Average daily natural gas production (mmcf) Average daily production (boe) 4,176 4,010 3,480 2,449 Average oil production weighting (%) Average realized commodity field price before the impact of financial risk management contracts ($/boe) Funds flow netback ($/boe) (1.05) 9.77 (1.58) 4.07 (1) Amount is full future face value of the convertible debentures, $41.94 million as at March 31, 2017 or $57.50 million prior to March 31, Additional information regarding the Company and its business operations, including the Company s Annual Information Form for December 31, 2017, is available on the Company s SEDAR profile at 16 ZARGON OIL & GAS LTD.

17 CONSOLIDATED BALANCE SHEETS (unaudited) ($ thousands) Notes ASSETS March 31, 2018 December 31, 2017 Cash and cash equivalents 2,861 4,095 Trade and other receivables 3,569 3,888 Deposits and prepaid expenses 1,703 1,908 Total current assets 8,133 9,891 Long term deposits Property, plant and equipment, net 4 126, ,908 Intangible exploration and evaluation assets 5 1,790 1,735 Total assets 136, ,552 LIABILITIES Trade and other payables 6,977 6,362 Derivatives 11,12 1,507 1,151 Total current liabilities 8,484 7,513 Convertible debentures 7 41,061 41,461 Asset retirement obligations 6 63,971 64,812 Deferred tax liabilities 4,159 4,045 Total liabilities 117, ,831 Commitments and contingencies 6,13 EQUITY Shareholders capital 8 262, ,231 Accumulated other comprehensive income 4,629 4,412 Contributed surplus 10 9,403 9,651 Equity component of debentures 7 3,570 3,570 Deficit (260,964) (257,143) Total equity 19,156 22,721 Total equity and liabilities 136, ,552 See accompanying notes to the interim consolidated financial statements FIRST QUARTER REPORT 17

18 CONSOLIDATED STATEMENTS OF EARNINGS/(LOSS) AND COMPREHENSIVE INCOME/(LOSS) (unaudited) Three Months Ended March 31, ($ thousands, except per share amounts) Notes Petroleum and natural gas sales 9 9,713 9,689 Royalties (1,285) (996) PETROLEUM AND NATURAL GAS REVENUE, NET OF ROYALTIES 8,428 8,693 Gain/(loss) on unrealized derivatives 11,12 (356) 1,829 Gain/(loss) on realized derivatives 11,12 (850) 31 GAIN/(LOSS) ON DERIVATIVES (1,206) 1,860 TOTAL INCOME 7,222 10,553 Operating 5,890 5,075 Transportation General and administrative 968 1,159 Transaction costs Exploration and evaluation 5 50 Gain on convertible debentures 7 (458) Gain on sale of properties 4 (29) Share-based compensation Unrealized foreign exchange (gain)/loss (19) 37 Impairment loss on marketable securities 135 Depletion and depreciation 4 3,206 3,410 EXPENSES 10,241 9,603 EARNINGS/(LOSS) BEFORE FINANCE EXPENSES AND INCOME TAXES (3,019) 950 Interest and financing charges (2) (15) Interest on convertible debentures Accretion on convertible debentures Accretion of asset retirement obligations FINANCE EXPENSES 1,314 1,589 LOSS BEFORE INCOME TAXES (4,333) (639) Current tax recovery Deferred tax expense/(recovery) 1 (96) INCOME TAXES EXPENSE/(RECOVERY) 1 (96) NET LOSS FOR THE PERIOD (4,334) (543) Currency translation adjustment recognized in other comprehensive loss 217 (79) OTHER COMPREHENSIVE EXPENSE/(LOSS) FOR THE PERIOD 217 (79) TOTAL COMPREHENSIVE EXPENSE/(LOSS) FOR THE PERIOD (4,117) (622) NET LOSS PER SHARE Basic Diluted See accompanying notes to the interim consolidated financial statements. (0.14) (0.02) (0.14) (0.02) 18 ZARGON OIL & GAS LTD.

19 CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY (unaudited) ($ thousands) Notes Shareholders Capital Accumulated Other Comprehensive Income Contributed Surplus Equity Component of Convertible Debentures Deficit Total Equity Balance at December 31, ,231 4,412 9,651 3,570 (257,143) 22,721 Net loss for the period (4,334) (4,334) Share-based compensation Exercise of share awards (287) Convertible debenture IFRS 9 adoption Translation differences on foreign subsidiary Balance at March 31, ,518 4,629 9,403 3,570 (260,964) 19,156 Balance at December 31, ,902 4,902 10,614 3,640 (247,833) 32,225 Net loss for the period (543) (543) Share-based compensation Exercise of share awards (894) Equity component of convertible debentures 7 (70) (70) Translation differences on foreign subsidiary (79) (79) Balance at March 31, ,796 4,823 9,773 3,570 (248,376) 31,586 See accompanying notes to the interim consolidated financial statements FIRST QUARTER REPORT 19

20 CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited) Three Months Ended March 31, ($ thousands) Notes OPERATING ACTIVITIES Net loss for the period Adjustments for non-cash items: (4,334) (543) Gain on convertible debenture 7 (458) Gain on sale of properties (29) (Gain)/loss on unrealized derivatives 11, (1,829) Depletion and depreciation 4 3,206 3,410 Accretion of asset retirement obligations Accretion of convertible debentures Share-based compensation Unrealized foreign exchange (gain)/loss (19) 37 Impairment loss on marketable securities 135 Deferred tax expense/(recovery) 1 (96) Exploration and evaluation expenses 5 50 Funds flow from/(used in) operating activities (302) 1,503 Asset retirement expenditures 6 (613) (143) Changes in operating working capital 1,715 1,164 Net cash from operating activities 800 2,524 INVESTING ACTIVITIES Additions to property, plant and equipment 4 (1,862) (2,383) Additions to intangible exploration and evaluation assets 5 (46) (123) Proceeds from disposal of property, plant and equipment Change in long term deposits (403) Changes in investing working capital (537) 1,120 Net cash used in investing activities (2,034) (1,789) FINANCING ACTIVITIES Redemption of convertible debentures, including transaction costs 7 (13,370) Changes in financing working capital 7 (2,047) Net cash (used in)/provided by financing activities (15,417) NET CHANGE IN CASH DURING THE PERIOD (1,234) (14,682) CASH, BEGINNING OF PERIOD 4,095 24,855 CASH, END OF PERIOD 2,861 10,173 See accompanying notes to the interim consolidated financial statements. 20 ZARGON OIL & GAS LTD.

21 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS For the three months ended March 31, 2018, with comparative figures for 2017 (unaudited). 1. REPORTING ENTITY Zargon Oil & Gas Ltd. ( the Company or Zargon ) is a publicly traded corporation, incorporated in Canada, with its head office located at Suite 1100, th Avenue SW, Calgary, Alberta. The consolidated financial statements of the Company as at and for the period ended March 31, 2018 and its 2017 comparative periods are comprised of the Company and its wholly owned subsidiaries. The Company is engaged in the exploration, development and production of oil and natural gas in Canada and the United States ( US ) and conducts many of its activities jointly with others; these financial statements reflect only the Company s proportionate interest in such activities. 2. BASIS OF PRESENTATION (a) Statement of compliance: The unaudited interim consolidated financial statements for the three month period ended March 31, 2018 have been prepared in accordance with International Financial Reporting Standards ( IFRS ) as issued by the International Accounting Standards Board ( IASB ) applicable to the preparation of interim financial statements, including International Accounting Standards ( IAS ) 34, Interim Financial Reporting. The same accounting policies and methods of computation were followed in the preparation of these unaudited interim consolidated financial statements as were followed in the preparation of the audited annual consolidated financial statements for the fiscal year ended December 31, 2017 with the exception of new and amended accounting standards that have been evaluated and disclosed in Note 3. The disclosures provided below are incremental to those included with the audited annual consolidated financial statements. These unaudited interim consolidated financial statements for the three month period ended March 31, 2018 should be read in conjunction with the annual consolidated financial statements for the year ended December 31, These consolidated financial statements were approved and authorized for issue by the Board of Directors on May 14, (b) Basis of measurement: The interim consolidated financial statements have been prepared on the historical cost basis except for the derivative financial instruments and the investment in marketable securities which are measured at fair value. (c) Functional and presentation currency: Items included in the financial statements of each consolidated entity are measured using the currency of the primary economic environment in which the entity operates (the functional currency ). The interim consolidated financial statements are presented in Canadian dollars, which is Zargon s functional currency. The financial statements of subsidiaries that have a functional currency different from that of Zargon ( foreign operations ) are translated into Canadian dollars as follows: assets and liabilities - at the closing rate at the date of the balance sheet, and income and expenses - at the average rate of the period (as this is considered a reasonable approximation to actual rates). All resulting changes are recognized in other comprehensive income as currency translation adjustments. If Zargon disposes of its entire interest in a foreign operation, or loses control, joint control, or significant influence over a foreign operation, the foreign currency gains or losses accumulated in other comprehensive income related to the foreign operation are recognized in earnings. If Zargon disposes of part of an interest in a foreign operation which remains a subsidiary, a proportionate amount of foreign currency gains or losses accumulated in other comprehensive income related to the subsidiary are reallocated between controlling and non-controlling interests. (d) Use of estimates and judgements: The preparation of financial statements in conformity with IFRS requires management to make judgements, estimates and assumptions that affect the application of accounting policies and the reported amounts of assets, liabilities, income and expenses. Actual results may differ from these estimates. Estimates and underlying assumptions are reviewed on an ongoing basis. Revisions to accounting estimates are recognized in the period in which the estimates are revised and in any future periods affected FIRST QUARTER REPORT 21